Financial Regulation

Question 1

When the Bretton-Woods system break down?

Answer 1

1973

Question 2

What was the reason for deregulation in the 1980s?

Answer 2

The rise in offshore banking, such as the eurocurrency markets, which escaped many domestic regulations

Question 3

When were foreign banks first allowed to operate in domestic markets?

Answer 3

1980s

Question 4

What are the 4 reasons for regulation?

Answer 4

1. Asymmetric information
2. The Principal-Agent problem
3. Moral Hazard
4. Externalities

Question 5

Why is asymmetric information a reason to regulate?

Answer 5

People who work in finance have more information about the products than buyers because the products are complex and purchases are one-off so consumers cannot learn who can serve them best

Question 6

What is the Principal-Agent problem?

Answer 6

• Investors (principals) employ the management and staff of a financial institution to act as their agents in dealing with institutions or markets
• How can principals ensure that agents do their best?
  Examples:
• How can an investor be sure that their stockbroker has bought/sold a share ‘at best’
• How does an investor know that his financial advisor is really recommending the best for product

Question 7

What is the Moral Hazard problem?

Answer 7

• This is a case of regulating against the effects of regulation
• A deposit insurance scheme is intended to reduce risk for investors but such intervention may encourage institutions to behave more recklessly than they otherwise would, defeating the original purpose

Question 8

What is the problem of externalities?

Answer 8

• Costs/benefits for people other than the transactors
• Widely-held view that the failure of financial firms is more serious than the failure of non-financial firms because there are external benefits from financial activity - applies particularly to depositary banks
• If a bank fails and people lose their means of payment this is likely to be contagious - could cause multiple bank runs and the payment system breaks down

Question 9

What are the 2 different approaches to regulation?

Answer 9

• Self regulation
• Statutory legislation

Question 10

What is self regulation?

Answer 10

In a self-regulatory system, regulations and their enforcement are in the hands of market practitioners usually working for a self-regulatory organisation responsible for a particular area of financial activity

Question 11

Advantage of self regulation?

Answer 11

• Flexible compared to statutory legislation
• Insiders know best
• Market practitioners are the best judjes of unprofessional behaviour

Question 12

Disadvantages of self regulation?

Answer 12

Agency capture:
- SROs are dependent on the firms they are regulating for funding
- Staff int he SROs regard themselves as members of the industry they are regulating

Question 13

What is statutory legislation?

Answer 13

Requires legislation and a publicly appointed and paid body to monitor compliance and bring prosecutions

Question 14

What are disclosure requirements?

Answer 14

If companies are publicly traded, they are required to disclose a wide variety of information about their financial position. Directors are required to make public their own buying/selling of the firm’s shares

Question 15

What is regulation of exchanges?

Answer 15

Participants are required to get the best price when trading on behalf of clients - insider trading is usually illegal

Question 16

What is licensing requirements?

Answer 16

• Most types of financial activity requires a license
• Intended to eclsude undesirable individuals from managing other people’s money and to increase confidence

Question 17

What is Restrictions on Activity?

Answer 17

• Range of activities undertaken by firms may be restricted usually due to conflicts of interest

Question 18

What are 4 costs of regulation?

Answer 18

1. Moral hazard
2. Agency capture
3. Compliance costs
4. Inefficiencies

Question 19

What are the 3 main forms of regulation?

Answer 19

1. Regulating the structure and activities of banks
2. Liquidity requirements
3. Capital adequacy

Question 20

What did the Glass-Steagall Act of 1933 prevent?

Answer 20

Commercials banks from engaging in securities trading and prevented investment banks from taking deposits

Question 21

What was the ratio under Basel 1?

Answer 21

8%
- Many domestic regulators have a higher targer and many larger banks operate at a higher level

Question 22

What was Basel 1 primarily focused on?

Answer 22

Upon the threat to asset values arising from default

Question 23

What does Basel 2 try to do?

Answer 23

Tries to take account also of market risk (asset price fluctuations resulting from movements in market prices) and operational risk (which arises from the failure of a bank’s internal processes and procedures

Question 24

WHat are the 3 pillars of Basel 2?

Answer 24

1. Minimum capital requirements using a modified version of the RAR approach of Basel 1
2. Periodic reviews by the regulator of how a bank goes about determining its own capital adequacy and exposure to risk
3. The requirement that these processes be made public so that the market can judge which banks and good procedures in place and reward good banks with a lower cost of capital

Question 25

What is Basel 3?

Answer 25

- Global systematically important financial institutions (SIFIs) must have higher loss absorbency capacity to reflct the greater risks they pose to the financial system - Strenghthens microprudential regulations and supervisions, and adds a macroprudential overlay that includes capital buffers - Essentially requires an increase in tier 1 capital, as well as controversially a countercyclical capital buffer - Also requires more capital for derivatives and securitised assets - Stricter controls over liquidity, requiring at least a months worth of liquid assets - Introduces a leverage ratio as a supplementary measure to the Basel risk based measure - Achieve a macro-prudential goals of limiting the growth in credit during times of boom

Question 26

What did the Dodd-Frank Act create?

Answer 26

The Consumer Financial Protection Bureau to protect retail customers in the financial sector

Question 27

What else did the Dodd-Frank Act create?

Answer 27

The Financial Stability Oversight Council, to watch for potential threats to the entire financial system (macroprudential)

Question 28

What is the overall aim of the Dodd-Frank act?

Answer 28

To limit trading for banks and hedge funds especially with regard to complex derivative products

Question 29

What is one of the most important aspects of the Dodd-Frank Act?

Answer 29

The Volcker Rule

Question 30

What is the Volcker Rule?

Answer 30

Prohibits an insured depository institution and its affiliates from: - Engaging in proprietory trading - when an institution trades on its own accounting using its own capital rather than a customers - Acquiring any equity, partnership or other ownership interest in a hedge fund or a private equity fund

Question 31

Why was the Volcker Rule not as effective as hoped?

Answer 31

Due to a number of areas where the rules were insufficiently clear and are believed to have harmed the economy

Question 32

What does Mifid (EU) stand for?

Answer 32

Markets in Financial Instruments Directive

Question 33

When was Mifid set up and what was its aim?

Answer 33

Set up in 2007 with the aim of establishing a single market in investment services

Question 34

What was the aim of Mifid 2?

Answer 34

To strengthen regulation to try to prevent a further financial crisis in the EU - Aim to increase transparency in the investments sector - Aims to regulate OTC trading more - New regulations on algorithm trading and high frequency trading - Brokers have to provide detailed reports on trades such as prie and volume, need to store all communications including phone calls