3 - The Signaling Argument

Summary

In this chapter, I demonstrate why a small difference in preferences between the chief executive and financial bureaucrats renders signals vague. I also show why the threshold difference in preferences between the chief executive and signalers that generates completely uninformative signals is relatively low in the realm of bank regulation. I begin by defining some terms. I then describe the logic that links a significant difference in preferences between the chief executive and the central bank governor to lax regulation, when the governor is the sole signaler of information collected by bank supervisors. In Section 3.3, I address the scenario in which both the central bank governor and the finance minister are signalers.

DEFINING SOME TERMS

Banking Sector Robustness

The signaling models presented here focus on a key aspect of a banking sector's robustness: the degree to which a banking sector is capitalized relative to expected loan defaults. I focus on this aspect of robustness for the signaling model because signaling considerations are important in realms where some actors have private information, and this condition is often likely to be met when it comes to the relationship between capitalization and expected defaults, for the reasons listed in Chapter 1.

As per the principles of bank accounting, a bank that has a shareholder capital buffer that is insufficiently large to cover loan defaults is considered to be insolvent.