Financial Regulation

Question 1

What are the main aims of financial regulation?

Answer 1

• Maintain market integrity
• Reduce market failure
• Correct market externalities
• Prevent competition distortion

Question 2

What are the main failures of financial institutions?

Answer 2

• Informational contagion of FIs with maturity mismatch create uncertainty in financial markets
• Credit contraction: As FIs provide credit to borrowers, failed bank’s customers lose access to credit, other banks are less likely to loan out due to uncertainty
• Liquidity spiral: the increased sales and reduction in asset price creates solvency issues
• Interconnectivity between FIs increases contagion between firms
• Fis reduce credit for higher liquidity/capital ratios: This increases default probability
• Self amplifying spirals- reduction in credit, reduction in Asset price

Question 3

What is the Domino Model? Why is it useful?

Answer 3

• The domino model assumes an simplified balance sheet (no shareholders equity)
• Banks take deposits and borrow debt
• Asset prices are fixed
• Bank one owes money to bank two, thus bank two suffers idiosyncratic loss
• Bank 2 will therefore reduce their capital asset ratio and reduce lending, meaning Bank one suffers a liquidity shock
• The source of contagion is asymmetric information [depositor’s don’t know the quality of loans]
• BUT: prices change, FIs will take active action to stop this occuring

Question 4

What is the Loss-Margin Spiral?

Answer 4

• Balance sheets are assessed using mark-to-market value
• Price falls lead to losses, FIs have worsening liquidity
• Increased risk measures (C:A increased)- reducing asset prices further
• Regulation (such as increasing CRR) can worsen the cycle
• If risk increase, FIs sell of riskier assets, the price of asset falls and the spiral occurs
• Risk is dependant on Bank behaviour- respondant to regulation

Question 5

How can Government Safety Nets act as financial regulation?

Answer 5

• Attempts to resolve the lack of information on bank loans
• Government acts as a lender of last resorts, deposit insurance and recapitalisation of troubled banks- reducing bank runs
• BUT: FIs would be incentives to increase risk and lose discipline- ‘too big to fail’ (GFC 2008)
• UK Government created a new emergency lending facility

Question 6

How can Restriction on risky assets act as financial regulation?

Answer 6

• Risky assets provide FIs with higher earnings- unless they fail
• Government aims to reduce risk by FIs, through promoting diversification

Question 7

How can Capital Requirements act as financial regulation?

Answer 7

• FIs are forced to hold a certain amount of equity capital
• If this fails, they lose a lot =>reducing risk
• Leverage ratio maximum and other regulatory restrictions [BASEL 1= 8% of assets]

Question 8

How can Financial Supervision act as financial regulation?

Answer 8

• 3 types: Financial supervision, bank licensing, on-site examination
• Given CAMELS ratings;
  allowing to enforce Cease and Desists or close the bank
• CAMELS: Capital Adequacy, Asset quality, Management, Earnings, Liquidity, Sensitivity to market risk

Question 9

How can Disclosure Requirements act as financial regulation?

Answer 9

• FIs must adhere to accounting principles
• Aim to increase market information and limit excessive risk

Question 10

How can Consumer Principles act as financial regulation?

Answer 10

• Consumer’s don’t have the knowledge therefore require protection
• Increases market information
• This view was especially extended following the SPM crisis

Question 11

How can Macroprudential Supervision act as financial regulation?

Answer 11

• MICRO: Each individual FI has the idea around compliance to regulation, but doesn’t consider endogenous risk
• MACRO: Accounts for endogenous risk
• In a boom, risk drops. Therefore, macroprudential supervision should be countercyclical

Question 12

What Regulation Acts have been passed in Britain?

Answer 12

• 1979 Banking Act: Extend the BoE’s regulatory powers and deposit insurance
• 1998 Banking Act: BoE gicen operational responsibility
• 2009 Banking Act: Provision for nationalisation of banks (RBS) and laws on insolvency
• 2012 Financial Services Act: Overhall of regulatory structure- FPC, PRA, FCA