The Research on the Central Bank’s Supervision with Asymmetric Information

The Research on the Central Bank’s Supervision with
Asymmetric Information
YANG Xin Song
School of Management and Economic, Jiangsu Teachers university of Technology,
Changzhou, P.R.China, 213001
Abstract: Finance is the core of the whole economic. The financial system’s state has an important
connection with economical development. The paper tries to give an analysis of the reason, the matter
and the strategy when the central bank supervises the financial system. In the end, some suggestions are
given as follows: the first, it should make full use of the role of the central bank as the final creditor; the
second, the punishment mechanism should be strictly enforced; the third, the central bank’s supervision
and the commercial bank’s management should be integrated.
Key words: central bank
asymmetric information
converse selection
moral risk
mixed strategy Nash’s equilibrium
1 Introduction
1.1 asymmetric information
In the information economic, the asymmetric information means that some participators hold some
information that others do not hold. It refers to two kinds. The first kind is the relevant knowledge’s
asymmetry. For the quality of the product, it is known for the sellers but unknown for the buyers. In
other words, the sellers know more information than the buyers do. The second kind is the behavior’s
asymmetry. For instance, after signing the contact, the employees know their own behavior, but
employers know nothing.
The first kind of asymmetry is named as converse choice. In the old vehicle market, the sellers
know their cars’ real quality, but the buyers don’t know. Therefore, the buyers have to offer the cars in
average price, then the cars of high quality will be out of the market, leaving only the cars of low quality.
The result is that the average quality of the old vehicles decreases and the cars of more relative high
quality will be out of the market. Finally, only the cars of the lowest quality can be in bargain and
extreme situation is that there will be no bargain. This is converse choice, in other words, converse
choice means that the products of low quality chase out the ones of high quality, just as the bad coin
chase out the good coin.
The second kind is named as moral risk. For example, the assurance company will compensate for
your car’s damage after you have bought assurance for your car, then your enthusiasm to cherish your
car will decrease. You will not buy a security lock of high quality in high price and be not care when you
park your car as you have not bought assurance for your car. The result is that the assurance company’s
benefit will be damaged.
1.2 the frangibility of finance system with asymmetric information
In financial market, converse choice and moral risk caused by asymmetric information exist widely.
Especially in credit market, relevant to the creditor, the borrower knows much more about his
investment’s property and benefit. The creditor knows less about the investment information.
Consequently, he has to sell his credit in average price, and then converse choice occurs. In addition, the
borrower promises to invest in a certain project. But after that, he is inclined to invest in a project of
high risk and high benefit, expecting for the success of the project to gain more benefit. This is moral
risk. In a market full of converse choice and moral risk, it will fail for bargaining directly. In other words,
the buyer and the seller can’t reach an agreement on the price because of the uncertainty of product and
service’s quality. As a financial agency, the bank decreases the rate of asymmetric information to some
extent. According to its advantages, after absorbing the saver’s deposit, the bank can make an evaluation
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for the borrowers based on risk before it makes the credit, which decreases the rate of converse choice
and limits moral risk because the bank will be in more advantage position to monitor and influence the
borrowers’ action.
Unfortunately, when converse choice and moral risk are limited and reduced, the emergency of
financial agency brings another kind of moral risk. Taking commercial bank as an example, it is a
high-debt enterprise, has limited liability system and tends to pursue high risk and high profit, so the
possibility of bankrupt is larger. The influence and the expansion of the bankrupt in financial system are
different from that in the general enterprise. They have huge exterior effects. Some bankrupts like
snowball and become bigger and bigger until financial crisis occurs. That one financial organization
close down will not only affect depositors in contact and other financial organizations, but also affect
borrowers (borrowers have to return the loan in advance and can’t gain the additional payment for
goods). The more critical situation is the second turn, then the third turn and so on. The effects maybe
increase turn by turn. The exterior effects and the infection effects of the financial organizations’
bankruptcy make the financial system very frail.
The last important point is that conformity behavior in a Prisoner's Dilemma further intensifies such
exterior effects of financial organizations. Conformity behavior is also called Herd Instinct or Butterfly
Effect. The most classical behavior in the financial market is the action of dealing with bank accounts of
depositors.
2 An Example
2.1 The central bank’s dilemma as the final creditor
In the sense of commercial bank, the central bank is not a bank, but a government’s organization.
Instead of seeking for the largest benefit, its goal is to implement a certain target of the entire economic
such as avoiding the bankrupt of commercial bank and high rate of unemployed. The main function of
the central bank is to be as the final creditor, namely, when a bank meet crisis and other banks can’t or
wouldn’t like to provide credits to it, the central bank can and will provide such kind of credits because
the central bank has the rights to produce preparing money. The method of the central bank’s final
creditor includes credit, mergence and assurance respectively. If needed, it can adopt the method of
some bank’s expulsion from market as well, that is bankrupt.
In above we have analyzed asymmetry information and the frangibility of the finance system,
namely, the central bank must be as the final creditor. However, some limitations occur when the central
bank acts as the final creditor in practice. One of the limitations is that indistinct deposit insurance
intensifies moral risk of bank. Therefore, the whole bank system will assume more excessive risks.
Because there is a final creditor, a bank will suffer no loss when it absorbs additional funds and invest
them in some fields with high risk and high benefit. If the adventure can gain benefit, the bank will be
more prosperous; if the investment fails, the situation of bank will not be worse. After all, it is better to
be end of suffering impacts than be bankrupt. The second limitation is that it dilutes the depositor’s
function as a supervisor. Because the government will not let banks, especially large banks to bankrupt,
the depositors will lose the pressure when choosing the bank. Consequently, all depositors want to be
passengers of the downwind cars when there is no indistinct deposit insurance provided by the central
bank’s final creditor role, and finally, they all are passengers of the central bank’s downwind car.
2.2 The central bank’s strategy
In the follow example, the central bank takes some measures to control the commercial bank’s risk
for reducing its possibility of bankrupt. Of the measures, the most important is the supervision of the
commercial bank that engaged in the higher risk assignment or not. The central bank may select two
actions {checking, no checking}, and the commercial bank may have two selections {high-risk
assignment, low-risk assignment}. The payment is given as follow:
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Table 1.The payment of the central bank and the commercial bank
Central bank
Commercial bank
checking
No checking
High-risk assignment
Low-risk assignment
− T − K , T − CC
R H , −C S
RL − K ,−C C
R L ,0
Instruction: T is the payment of the commerce bank for high-risk assignment which maybe
include the punishment of being deprived out of the market.
C C is the center bank’s cost of supervision.
K is the commerce bank’s internal cost.
RH and RL are the income of the higher-risk and lower-risk assignment, of which the former
is greater.
C S is the cost of the commerce bank for higher-risk assignment when no checking is given.
This is a typical supervision game. We may give an overall investigation. When the canter bank is
checking, the commercial bank may select lower-risk assignment; but if the central bank has no
checking, the commercial bank may select higher-risk assignment. So repeatedly, we can see that the
game has no pure strategy Nash equilibrium. At first glance, it seems unreasonable to the game. In fact,
the game gives the reality a better portray. If there really exists purely strategic balance, when the central
bank checks, the commercial bank is engaged in a lower-risk assignment, but when the central bank
does not check, the commercial bank is for higher-risk assignment, which is turned into what we call “a
policy that can be ”. And this is what the central bank should avoid. Because of too high cost of
checking, the central bank can’t always check but has to check. It is reasonable that a mix strategy be
adopted.
The center bank’s strategy: δ C = (Q,1 − Q ) (namely, the center bank’s probability of checking is
Q , and of not checking is 1 − Q ).
The commercial bank’s strategy: δ F = ( P,1 − P ) (namely, the commercial bank’s probability of
high-risk assignment is P , and of low-risk assignment is 1 − P ).
If the commercial bank’s probability of high-risk assignment is P, the center bank’s expectation of
utility is VC (δ C , δ F ) :
Vc(δc, δf ) = Q[ P(T − Cc) + (1 − P)( −Cc)] + (1 − Q )[ P(−Cs ) + (1 − P).0]
dVc / dQ = P (T − Cc) + (1 − P)( −Cc) − P(−Cs ) = 0
Therefore, P* = C C /(T + C S )
If the central bank’s probability of checking is Q*, the commercial bank’s expectation of utility is
VF (δ C , δ F ) :
VF (δc, δf ) = P[Q(−T − K ) + (1 − Q ) RH ] + (1 − P)[Q ( RL − K ) + (1 − Q) RL]
dVF / dP = Q(−T − K ) + (1 − Q) RH − Q( RL − K ) − (1 − Q) RL = 0
Therefore, Q* = ( R H − R L ) /(T + R H )
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The mixed strategy Nash equilibrium is Q * . We then know that the central bank’s probability of
checking is P * and the commercial bank’s probability of high-risk assignment is P * . One
expression is that the destination of one participator with mixed strategy gives uncertainty to other
participators. And the other participators know the probability of one strategy, but not know which pure
strategy the participator may select. If the central bank’s probability of checking is Q * , the
commercial bank has no certainty for high-risk assignment, which can reduce the moral risk of
commercial bank to some degree.
We may know that the commercial bank’s probability of high-risk assignment relates to the cost of
supervision, the penalty and the cost of high-risk assignment to the society. The more is the cost of
supervision, the more is the commercial bank’s probability for high-risk assignment. And the more is the
cost of high-risk assignment to the society, the lower is the commercial bank’s probability for high-risk
assignment.
3 Conclusion
To understand the reason, the matter and the strategy of the central bank’s supervision, it is very
important for the central bank to play a significant role in the financial system.
(1) Making full use of the status and the function of the central bank as the final creditor. The
externality of the finance industry’s operation straightly threatens the social stabilization. Many
developed countries have set up financial public security networks, of which the central bank is the core,
to prevent single bankrupt’s spreading to the whole bank system. Although the role of the central bank
as the final creditor has some limitations, the positive effects in protecting the depositors’ benefit and
keeping the stabilization of the financial system are more important. Many countries’ practical
experience such as the financial crisis of the USA in 1929 and LTCM events in 1997 has showed this.
(2) Making punishment mechanism stringent. In the last part of analysis of the central bank’s
supervision, it offers a way to reduce moral risk. It is necessary to punish those who do high-risk
investment and to compel those who have illegal capital up to some proportion and often break the rules
to retreat from the market. Although the central bank tends to protect the bank from going bankrupt, it
doesn’t mean that it should protect all the banks from going bankrupt. As China entered WTO and the
state-owned banks were transformed into commercial banks, the central bank can expulse some bank to
drop out of the market in some cases and will not affect the financial stability.
(3) Combining the exterior supervision with banks’ interior management. New supervision
philosophy thinks that when risk factors increase under new financial situations, the main principle is to
strengthen rather than to weaken. But for the same reason, supervision authorities lie in the disadvantage
position objectively in the information asymmetric reality. Successful financial supervision largely
depends on financial organizations’ self-discipline and the functions of marketplace mechanism. That
doesn’t mean that the supervision department can let them alone or shift off the responsibilities, instead,
it should pay attention to stimulate the consistent system arrangement and combine the exterior
supervision with interior spontaneous response to realize effective supervision. One new kind of
assorted system arrangement is so called “Pre-Commitment”, that is the bank and supervisor to agree on
stimulant contract and the bank to commit the maximum loss amount in some time in advance. For
example, the bank can choose the inside model such as VAR model to compute the maximum loss
amount in a quarter or in a half year or in ten days. If the amount exceeds, it should be punished by the
authority such as the central bank. Hence, on one side, the supervision department only has to pay
attention to the result but not the process; one the other side, the bank will intend to improve the inside
model for his own benefit, since both too much commitment and too little commitment are not good for
the bank. If the maximum loss amount committed is too little, it will easily be punished; if the maximum
loss amount committed is too much, it needs to satisfy more requirements of capital. Hence, this
contract is consistent and self-realizable.
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The author can be contacted from e-mail: [email protected]
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