Lecture 9 - Economic analysis of financial regulation

Question 1

What happened before deposit insurance?

Answer 1

• A bank failure meant that depositors would have to wait to get their deposit funds until the bank was liquidated; at that time, they would be paid only a fraction of the value of their deposits. depositors would be reluctant to put money in the bank thus making banking institutions less viable.
• Depositors lack of information about the quality of bank assets can lead to bank panics. They are unable to tell if their bank is good or bad and recognise that they might not get their money back. As banks operate on a ‘sequential service constraint’, depositors have a very strong incentive to show up at the bank first, because if they are last in line, the bank may run out of funds and they will get nothing.

Question 2

Uncertainty about the health of the banking system in general can lead to runs on banks both good and bad, and the failure of one bank can hasten the failure of others (referred to as the contagion effect). If nothing is done to restore the public’s confidence…

Answer 2

A bank panic may ensue.

Question 3

What does a government safety net do?

Answer 3

It can short circuit runs on banks and bank panics and by providing protection for the depositor, it can overcome reluctance to put funds in the banking system.

Question 4

One form of the safety net is deposit insurance. What is this?

Answer 4

A guarantee such as that provided by the central bank or government backed deposit insurance institutions such as the Federal Deposit insurance Corporation (FDIC) in the US in which depositors are paid off in full on the first $100,000 they have deposited in a bank if the bank fails. With fully insured deposits, depositors do not need to run to the bank to make withdrawals even if they are worried about their bank’s health. After the establishment of the FDIC in 1934, bank failures averaged fewer than 15 per year until 1981.

Question 5

A bank panic and a chain of bank failures can cause a…

Answer 5

Severe recession. As the banking system collapses, businesses and consumers cannot
acquire the funds they need. Consumption and investment will plummet leading to falls in aggregate spending and aggregate income. Rescuing troubled banks is also very costly.

Question 6

Governments have often stood ready to provide support to domestic banks facing runs in the absence of explicit deposit insurance. One way they provide support is through…

Answer 6

Lending from the central bank to troubled institutions as the Federal Reserve did during the subprime financial crisis. This form of support is referred to as the ‘lender of last resort role of the central bank. In other cases, funds are provided directly to troubled institutions, as was done by the Bank of England in 2008 during a particularly virulent phase of the financial crisis.

Question 7

Banks are not the only financial intermediaries that can…

Answer 7

Pose a systemic threat to the financial system. When financial institutions are very large or highly interconnected with other financial institutions or markets, their failure has the potential to bring down the entire financial system.

Question 8

Governments can also…

Answer 8

Take over (nationalise) troubled institutions and guarantee that all creditors will be repaid their loans in full. In 2009 following the banking crisis, the uk governments took a 43% stake in the Lloyds Banking Group. In 2008, the Royal Bank of Scotland Group, one of the largest banks in the world, received a capital injection form the UK government which took a share of 60% of the company. In 2009, a further capital injection took the government stake in the bank to 84%.

Question 9

What is the most serious drawback of the government safety net?

Answer 9

The moral hazard problem. The existence of insurance provides increased incentives for taking risks that might result in an insurance payoff. With a safety net depositors and creditors know that they will not suffer losses if a financial institution fails, so they do not impose the discipline of the market place on these institutions by withdrawing funds when they suspect the financial institutions is taking on too much risk. Consequently, financial institutions with a government safety net have an incentive to take on greater risks than they otherwise would, with taxpayers paying the bill if the bank fails.

Question 10

A further problem with a government safety net like deposit insurance arises because of…

Answer 10

Adverse selection, the fact that the people who are most likely to produce the adverse outcome insured against (bank failure) are those who most want to take advantage of the insurance. As depositors and creditors are protected by a government safety net they have little reason to impose discipline on financial institutions. Risk loving entrepreneurs might find the finance industry a particularly attractive one to enter - they know that they will be able to engage in highly risky activities. Even worse, because protected depositors and creditors have so little reason to monitor the financial institution’s activities, without government intervention outright crooks might also find finance an attractive industry for their activities because it is easy for them to get away wth fraud and embezzlement.

Question 11

As the failure of a very large financial institution makes it more likely that a major financial disruption will occur, financial regulators are…

Answer 11

Naturally reluctant to allow a big institution to fail and cause losses to its depositors and creditors.

Question 12

The term ‘too big to fail’ is not applied to a policy in which…

Answer 12

The government provides guarantees of repayment of large uninsured creditors of the largest banks, so that no depositor or creditor suffers a loss, even when they are not automatically entitled to this guarantee. The deposit insurance guarantors (typically the central bank) would do this by using the purchase and assumption method, giving the insolvent bank a large infusion of capital and then finding a willing merger partner to take over the bank and its deposits.

Question 13

Why is the term ‘too big to fail’ misleading?

Answer 13

When a financial institution is closed or merged into another financial institution, the managers are usually fired and the stockholders in the financial institution lose their investment.

Question 14

What is the problem with the ‘too big to fail’ policy?

Answer 14

It increases the moral hazard incentives for big banks. If the central bank were willing to close a bank using the payoff method, paying depositors only up to the $100,000 limit, large depositors with more than $100,000 would suffer losses if the bank failed. Thus they would have an incentive to monitor the bank by examining the bank’s activities closely and pulling their money out if the bank was taking on too much risk. To prevent such a loss of deposits, the bank would be more likely to engage in less risky activities. However, once large depositors know that a bank is too big to fail, they have no incentive to monitor the bank and pull out their deposits when it takes on too much risk; no matter what the bank does, large depositors will not suffer any losses. The result of the too big to fail policy is that big banks might even take on greater risks, thereby making bank failures more likely. Similarly, the too big to fail policy increases the moral hazard incentives for non bank financial institutions that are extended a government safety net. Knowing that the financial institutions will get bailed out, creditors have little incentive to monitor the institution and pull their money out when the institution is taking on excessive risk. As a result, large or interconnected financial institutions will be more likely to engage in highly risky activities, making it more likely that a financial crisis will occur.

Question 15

What challenges does financial consolidation pose to financial regulation because of the existence of the government safety net?

Answer 15

• The increased size of financial institutions as a result of financial consolidation increases the too big to fail problem, because there will now be more large institutions whose failure would expose the financial system to systemic risk. Thus more financial institutions are likely to be treated as too big to fail, and the increased moral hazard incentives for these large institutions to take on greater risk can then increase the fragility of the financial system.
• Financial consolidation of banks with other financial services firms means that the government safety net may be extended to new activities such as securities underwriting, insurance or real estate activities etc. This increases incentives for greater risk taking in these activities that can also weakened the fabric of the financial system.

Question 16

Bank regulations that restrict asset holdings are directed at…

Answer 16

Minimising moral hazard, which can cost taxpayers dearly.

Question 17

As banks are most prone to panics, they are subjected to…

Answer 17

Strict regulations to restrict their holding of risky assets such as common stocks. Bank regulations also promote diversification, which reduces risk by limiting the euro amount of loans in particular categories or to individual borrowers. It is likely that non bank financial institutions may face greater restrictions on their holdings of risky assets. There is a danger, however, that these restrictions may become so onerous that the efficiency of the financial system will be impaired.

Question 18

How do capital requirements act as another way of minimising moral hazard?

Answer 18

When a financial institution is forced to hold a large amount of capital, the institution has more to lose if it falls and is thus more likely to pursue less risky activities. Additionally, capital functions as a cushion when bad shocks occur, making it less likely that the financial institution will fail, thereby directly adding to the safety and soundness of financial institutions.

Question 19

What is the Basel Accord?

Answer 19

Requires that banks hold as capital at least 8% of their risk weighted assets.

Question 20

Bank regulators have become increasingly worried about banks’ holdings of assets and about the increase in banks’…

Answer 20

Off balance sheet activities… activities that involve trading financial instruments and generating income from fees, which do not appear on bank balance sheets but nevertheless expose banks to risk.

Question 21

One limitation of the Basel Accord is that it could lead to…

Answer 21

Increase risk taking, the opposite of its intent.

Question 22

What are the problems if a financial institution’s capital falls to low levels?

Answer 22

• The bank is more likely to fail because it has a smaller capital cushion if it suffers loan losses or other asset write downs.
• With less capital, a financial institution has less ‘skin in the game’ and is therefore more likely to take on excessive risks. The moral hazard problem becomes more severe, making it more likely that the institution will fail.

Question 23

Financial supervision or prudential supervision is…

Answer 23

An important method for reducing adverse selection and moral hazard in the industry. This refers to overseeing who operates financial institutions and how they are operated.

Question 24

Methods of licensing financial institutions.

Answer 24

Through chartering, proposals for new institutions are screened to prevent undesirable people from controlling them. Regular on site examinations, which allow regulators o monitor whether the institution is complying with capital requirements and restrictions on asset holdings, also function to limit moral hazard.

Question 25

Bank examiners give a CAMELS rating. What six areas is this acronym based on?

Answer 25

Capital adequacy, asset quality, management, earnings, liquidity and sensitivity to the market.

Question 26

With this information about a bank’s activities, regulators can enforce regulations by taking formal actions such as…

Answer 26

Cease and desist orders to alter the bank’s behaviour or even to close a bank if its CAMELS rating is sufficiently low.

Question 27

Actions taken to reduce moral hazard by restricting banks from taking on too much risk help reduce the…

Answer 27

Adverse selection problem further, because with less opportunity for risk taking, risk loving entrepreneurs will be less likely to be attracted to the banking industry.

Question 28

Explain methods regulators counterparts in private financial markets.

Answer 28

• Licensing is similar to the screening of potential borrowers.
• Regulations restricting risky asset holdings are similar to restrictive covenants that prevent borrowing firms from engaging in risky investment activities.
• Capital requirements act like restrictive covenants that require minimum amounts of net worth for borrowing firms.
• Regular examinations are similar to the monitoring of borrowers by lending institutions.

Question 29

Once a bank has been licensed, it is required to…

Answer 29

File periodic reports that reveal the bank’s assets and liabilities, income and dividends, ownership, foreign exchange operations and other details. Banks are subject to examination by the bank regulatory agencies to ascertain its financial condition at least once a year. Bank examiners may make unannounced visits to the bank so that nothing can be swept under the rug in anticipation of their examination. The examiners study a bank’s books to see whether it is complying with the rules and regulations that apply to its holdings of assets. If a bank is holding securities or loans that are too risky, he bank examiner can force to get rid of them. If a bank examiner decides that a loan is unlikely to be repaid, the examiner can force the bank to declare the loan worthless (to write off the loan, which reduces the bank’s capital). If, after examining the bank, the examiner feels that it does not have sufficient capital or has engaged in dishonest practices, the bank can be declared a ‘problem bank’ and will be subject to further examinations.

Question 30

Traditional focus on reducing excessive risk taking by financial institutions is important although it is no longer felt to be adequate. A financial institution that is healthy at a particular point in time can be driven into insolvency extremely rapidly from trading losses. Thus an examination that focuses only on a financial institution’s position at a point in time may not be effective in indicating whether it will, in fact, be taking on excessive risk in the near future. Hence, bank examiners are now placing far greater emphasis on evaluating…

Answer 30

The soundness of a bank’s management process with regard to controlling risk.

Question 31

How is sound risk management assessed?

Answer 31

• The quality of oversight provided by the board of directors and senior management.
• The adequacy of policies and limits for all activities that present significant risks.
• The quality of the risk measurement and monitoring systems.
• The adequacy of internal controls to prevent fraud or unauthorised activities on the part of employees.
• Since 2010 a number of regulatory authorities have published guidelines on bankers’ remuneration and bonuses that feed into risk taking behaviour.

Question 32

The shift toward focusing on management processes has resulted in the adoption of processes to deal with trading risk and risk based on market movements. Explain these processes.

Answer 32

• Establish interest rate risk limits.
• Appoint officials of the bank to manage this risk.
• Monitor the bank’s exposure.
• Implement stress testing, which calculates losses under dire scenarios, or value at risk calculations, which measure the size of the loss on a trading portfolio that might happen 1% of the time.

Question 33

What are disclosure requirements?

Answer 33

To ensure that there is better information in the marketplace, regulators can require that financial institutions adhere to certain standard accounting principles and disclose a wide range of information that helps the market assess the quality of an institution’s portfolio and the amount of its exposure to risk.

Question 34

More public information about the risks incurred by financial institutions and the quality of their portfolios can better enable stockholders, creditors and depositors to…

Answer 34

Evaluate and monitor financial institutions and so act as a deterrent to excessive risk taking.

Question 35

Regulation to increase disclosure is needed to…

Answer 35

Limit incentives to take on excessive risk and to improve the quality of information in the marketplace so that investors can make informed decisions, thereby improving the ability of financial markets to allocate capital to its most productive uses.

Question 36

What is the mark to marketing accounting or fair vale accounting?

Answer 36

Assets are valued in the balance sheet at what they could sell for in the market.

Question 37

What does consumer protection entail?

Answer 37

The regulation requires all lenders, not just banks, to provide information to consumers about the cost of borrowing, including a standardised interest rate (called the annual percentage rate) and the total finance charges on the loan. Other regulations relate to the right of withdrawal by the consumer within 14 days of the credit contract at no financial penalty and the right to repay a debt contract early and to incur only reasonable costs.

Question 38

How does consumer protection mitigate adverse selection?

Answer 38

If bank customers

are well protected, criminals and unethical entrepreneurs will be less likely to enter the banking business.

Question 39

Advantages of bank regulation.

Answer 39

• The experience of the global banking crisis shows that the costs of a bank failure are met by the shareholders but the costs of the wider crisis are borne by the rest of the economy.
• Necessary to protect the depositor. Most depositors do not have the capacity or the inclination to monitor the risk taking activity of the bank managers.
• Safeguard the stability of the financial system.

Question 40

Disadvantages of bank regulation.

Answer 40

• Direct costs of compliance on banks (estimated to be between 5% and 10% of a bank’s operational costs).
• Regulation requires well trained regulators that know what the banks are about. In many cases, regulators are recruited from the ranks of the regulated giving rise to the potential for ‘regulatory capture’ and too cosy a relationship between the regulator and the regulated.
• Creating moral hazard.
• Self regulation which was the ethos of the UK banking system has been deemed too lax, whereas excessive regulation can be costly. Designing a proper regulatory system is therefore not easy.
• By curbing enterprise and risk taking, regulation can also reduce the efficiency of the financial system.
• Regulators are continually playing cat and mouse with financial institutions, financial institutions think up clever ways to avoid regulations, which then lead regulators to modify their regulation activities. Regulators continually face new challenges in a dynamically changing financial system and unless they can respond rapidly to change, they may not be able to keep financial institutions from taking on excessive risk. This problem can be exacerbated if regulators and supervisors do not have the resources or expertise to keep up with clever people in financial institutions seeking to circumvent the existing regulations.
• Subtle differences in the details may have unintended consequences.
• Banks have an incentive to lobby politicians so that regulators and
  supervisors will go easy on them.