The document discusses financial regulation and why it is important, focusing on regulations for banks. It addresses eight categories of banking regulations: (1) government safety nets like FDIC insurance that aim to protect depositors but can encourage moral hazard; (2) restrictions on asset holdings and capital requirements to reduce risk; (3) bank supervision through chartering and examinations; (4) assessing risk management; (5) disclosure requirements to provide transparency; (6) consumer protections; (7) restrictions on competition (now eliminated); and (8) lessons from the 1980s financial crisis when deregulation increased risks. While regulations aim to promote stability, they also sometimes introduce new problems or are insufficient to prevent crises.
2. Introduction
Financial system is among the most heavily regulated
sectors of the economy.
Banks are among the most heavily regulated of
financial institutions.
Why?
Regulations could sometimes impede development of
banks.
Regulations sometimes can’t prevent financial crisis.
Are banking regulations beneficial
3. Regulation
Regulations are legal restrictions promulgated by
government authority.
Applies to a moving target
calls for resources and expertise
Political pressures
4. Outline
Eight basic categories of banking regulations
For each regulation, we ask:
What’s the problem, why do we need regulation to
solve this problem?
What regulation? How does it help solve
problems?
Does regulation introduce new problems?
5. Government safety net why do we
need the ‘safety net’?
Problems:
(1) hard for depositors to get information about banks;
(2) reluctant to produce information due to free-riding
may reluctant to deposit money.
depositors lose money when bad banks fail
depositors of good banks also might lose money, due to
contagion effect
financial crisis
6. Government safety net FDIC comes
to the rescue
Regulation: government safety net
Federal Deposit Insurance Corporation (FDIC)
Payoff method: deposits of member banks paid up to
$100,000 in case of bank failure
Purchase and assumption method: promote M&A by
providing subsidized loans or buying some bad loans
so that:
Restore confidence
Prevent bank failure/ bank run (bank panic
7. Government safety net a mixed
blessing
Regulation created new problems:
Moral hazard:
Depositors sit back and relax.
Banks don’t have incentives to manage risks.
‘Heads banks win, tails the taxpayer loses’
Adverse selection
Risk-lovers find banking attractive
8. Review
Why are banks the most heavily regulated institutions?
Are banking regulations beneficial?
Use the example of ‘government safety net’, what’s the problem
between depositors and banks? What are regulation requirements?
Do these regulations cause new problems?
9. Government safety net ‘too big to
fail’?
Continental Illinois, 1984, FDIC guaranteed accounts
exceeding $100,000 and even bond holders.
Other large banks expect similar treatment and large infusion
of capital in case of insolvency.
Moral hazard
Larger and more complex banking organizations challenge
regulation
Increase “too big to fail” problem
Extends safety net to new activities such as securities
underwriting, insurance or real estate
10. Restrictions on asset holding
and bank capital requirements
Intention:
to restrict banks from too much risk taking
Restrictions on asset holding:
promote diversification;
prohibit holdings of stocks
Capital requirements:
Minimum leverage ratio: capital to total assets ratio
Minimum capital to risk-weighted assets ratio (Basel
Accord)
11. Bank supervision: chartering and
examination
Problem: adverse selection and moral hazard
Regulation: Bank supervision (prudential supervision) -
overseeing who operates banks and how they are operated.
Chartering: screening of proposals to open new banks to
prevent adverse selection.
On-site bank examinations: examinations to monitor capital
requirements and restrictions on asset holding, and CAMELS to
prevent moral hazard.
Filing periodic ‘call reports’
New problem: inadequate
12. Assessment of risk management
Problem: examine result at one point in time evaluate
processes of risk controlling
Trading Activities Manual of 1994 for risk management rating
based on
Quality of oversight provided
Adequacy of policies and limits
Quality of the risk measurement and monitoring systems
Adequacy of internal controls
Interest-rate risk limits
Internal policies and procedures
Internal management and monitoring
Implementation of stress testing and value-at-risk (VAR)
13. Disclosure requirements
Problem: depositors, shareholders and creditors lack
information about banks; free-riding
Regulation:
Require banks to adhere to standard accounting principles
and to disclose a wide range of information.
New problem and suggestions:
Source of information should extend from accounting books
to bank’s internal reports on risk management.
14. Consumer protection
Problem: depositors could not protect themselves due to
incomplete information
Regulation:
‘truth-in-lending’: banks need to explain provide full
information about cost of borrowing including interest
rate and finance charges on the loan
prohibit discrimination.
15. Restrictions on competition (now
mostly eliminated)
Problem: banks tend to take on more risk when
competition is hot
Regulation:
Branching restrictions (eliminated in 1994)
Glass Steaga ll Act (repealed in 1999)
New problems
Higher consumer charges
Decreased efficiency
17. New situation
In 1960s, 70s and early 80s, financial innovation and
new markets increase banks’ risks.
Increased deposit insurance led to increased moral
hazard.
Deregulation expand powers to S&Ls
Inexperienced S&Ls managers and Federal Savings
and Loan Insurance Corporation (FSLIC) can not keep
up with increasingly complicated business
Sharpe increase in interest rate and inflation rate
18. Aims of regulation
The objectives of financial regulators are usually:[
market confidence – to maintain confidence in the financial
system
financial stability – contributing to the protection and
enhancement of stability of the financial system
consumer protection – securing the appropriate degree of
protection for consumers.
reduction of financial crime – reducing the extent to which
it is possible for a regulated business to be used for a purpose
connected with financial crime.
regulating foreign participation in the financial markets.
19. Structure of supervision
Acts empower organizations, government or non-
government, to monitor activities and enforce actions. There
are various setups and combinations in place for the
financial regulatory structure around the global.
Supervision of stock exchanges -Exchange acts ensure that
trading on the exchanges is conducted in a proper manner.
Most prominent the pricing process, execution and
settlement of trades, direct and efficient trade
monitoring.[5][6]
20. Supervision of listed companies -Financial regulators ensure
that listed companies and market participants comply with
regulations under the trading acts. The trading acts demands that
listed companies publish regular financial reports, ad hoc
notifications or directors' dealings. Whereas market participants
required to Publish major shareholder notifications. The objective
of monitoring compliance by listed companies with their
requirements is to ensure that investors have access to essential
and adequate information for making an informed assessment of
listed companies and their securities.
21. Supervision of investment management - Asset
management supervision or investment acts ensures the
frictionless operation of those vehicles.[
Supervision of banks and financial services providers
Banking acts lay down rules for banks which they have to
when they are being established and when they are carrying on
their business. These rules are designed to prevent unwelcome
developments that might disrupt the smooth functioning of the
banking system. Thus ensuring a strong and efficient banking
system.
