When to bail out

Even the proponents of free economy accept some form of regulatory intervention on organizations that become mighty powerful. The regulatory authorities have a right to intervene, if the market forces are giving unfair advantages such as monopoly or pollution. Commercial banks can become mighty powerful and at the same be very fragile. Even flourishing capital markets have not undermined the importance of commercial banking.
Commercial banks are a widely used tool to stimulate the economy through loans that stimulate consumption and investment. Therefore, in essence the health of the banking sector is directly related to the health of an economy. Liquidity risk is inherent to commercial banking because the depositors can come and claim their deposits at anytime. A mismatch of time to maturity of advances and deposits can create severe problems. For instance, a wave of panic-stricken withdrawals can essentially bankrupt a bank in no time.
This can trigger systematic risk and leave the entire economy shaken. The banks need to monitor their asset liability management statistics because any mismanagement can lead to bank runs or cash shortages. For these problems, central banks require of commercial banks to insure their deposits and provide them with liquidity support. By providing liquidity support central banks regulate the money market and injecting cash in the economy when demanded. These solutions in effect lead to other problems.

For example, in insured deposits, depositors stop monitoring a bank’s performance and the banks increase their risk appetite by increasing lending. To address this issue the central bank requires banks to maintain a minimum capital adequacy ratio, and regulate insurance premiums to be proportional to the risk of a bank’s lending. However, recent stats suggest that capital adequacy is not a safe determinant to monitor banking sector. Commercial banks start to over rely on central bank’s liquidity support and tend to lend high premium loans to institutions with lower credit ratings.
Even if such lending results in volatility in the money market such variations are small compared to the bank’s capital. Central bank needs to be proactive rather than be reactive because the public cost of economic instability and high interest rates is too high. Even the Basel II addresses risk capital framework but does not address provisioning for funding. The emphasis should be on liquidity rather than on solvency alone. Therefore, commercial banks need to be scrutinized through stricter prudential regulations.

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