Economic Analysis of Financial Regulation
12 important questions on Economic Analysis of Financial Regulation
Name the basic categories of financial regulation (8)
- Government safety net (deposit insurance, LLR, TBTF)
- restrictions on asset holding (because banks are more prone to panics, they are subject to strict regulation to restrict their holding of risky assets such as common stock)
- capital requirements (risk weighting)
- prompt corrective action (USfederal law mandating progressive penalties against banks that exhibit progressively deteriorating capital ratios.)
- licensing and examination
- assessment of risk management (greater emphasis on evaluating the soundness of a banks management proceses with regard to controlling risk)
- disclosure requirements (adhere to accounting standards or disclose info
- consumer protection (consumers credit transactions to proceed smoothly)
What is the most important factor for the succes of a deposit insurance?
What is the most serious drawback of the government safety net?
- Most importantly moral hazard
- But also adverse selection (because depositors and creditors protected by a government safety net have little reason to impose discipline on financial institutions, risk loving entrepreneurs might find the financial industry a particular attractive one to enter)
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What are TBTF banks, why do they create a moral hazard?
Deposit insurance schemes cover investors up to a certain level. Above that depositors would still have incentives to monitor the banks. When depositors know banks are too big to fail, this incentive to monitor the bank has been taking away. Why would they pull out their investments if the government would step in when trouble is faced.
What challenges does financial consolidation pose to financial regulation? (2)
- increased size of financial institutions increases to big to fail problems
- financial consolidation of banks with other services may mean the government safety net is extend to new activities
How did the Basel I risk weights result in regulatory arbitrage? Did it increase risk?
- What are the three pillars of Basel III.
- Name three criticisms of Basel III
Pillars
- Capital requirements
- Supervision
- Transparency
Criticism:
- complexity
- risk weights reliant on credit ratings
- Procyclical (demands banks hold less capital when times are good, and more when times are bad, thereby exacerbating credit cycles)
How to come up with a sound risk management rating (5)
- 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
- adequacy of controls to prevent fraud or unauthorised activities on the part of employees
- guidelines on bankers remuneration and bonuses that feed into risk-taking behaviour
What does Basel III introduce?
- liquidity buffers (enough for cash outflows of 30 days)
- capital requirements are strengthened
- countercyclical buffers
- Leverage ratio (counter ballooning balance sheets)
What are the disadvantages of regulation?
- Too-big to fail banks
- Direct costs of compliance that regulation places on banks
- requires well trained regulators (Watch out for regulatory capture)
What is the response of banks on capital regulation. (3 arguments) What are the counter arguments made by regulations?
- Charging customers higher rates
- reducing credit (to meet the higher capital ratios)
- and weakening the economic recovery by starving businesses of funds for growth
Th counter-argument made regulators is that banks with higher capital ratios are:
- actually safer banks
- Paying a lower risk premium for funding
- facing a lower cost of capital
Future regulation will focus on limiting agency problems, making the originate-to-distribue model and the financial system work better. Name a few examples (9)
- Increased regulation of mortgage brokers
- Fewer subprime mortgage products
- Regulation of bankers compensation
- Higher capital requirements
- Countercyclical capital requirements
- Heightened regulation to limit financial institutions risk taking
- Increased regulation of credit-rating agencies
- Additional regulation of derivatives
- The danger of overregulation
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