Aims and Obj of Financial Regulation
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Financial Regulation andRegulatory Policy
Aims and Objectives of Financial
Regulation
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TOPIC & STRUCTURE
The objectives, techniques and scope offinancial regulation.
Rationale for regulation of financial services
Basic Features of Financial Self-Regulation The moral hazard issue.
Preventive versus protective regulation.
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LEARNING OUTCOME
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KEY TERMS
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Introduction
Financial system is among the most heavilyregulated sectors of the economy.
Banks are among the most heavily regulated offinancial institutions.
Why? Regulations could sometimes impede
development of banks.
Regulations sometimes cant prevent financialcrisis.
Are banking regulations beneficial?
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For regulations :1- Stability- Financial stability- Well manage
- Prudential regulation- Safety & soundness regulation (US)
- Regulations vs minimum
- The initial bankers belief
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Regulation
Regulations are legal restrictionspromulgated by government authority.
Applies to a moving target calls for resources and expertise
Political pressures
The changes in economy (from housing to soon) have effect on banks
Loans and interest rates are set by the bankNegara
Monetary policy set by the government
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Outline
Eight basic categories of bankingregulations
For each regulation, we ask: Whats the problem, why do we need
regulation to solve this problem?
What regulation? How does it help solve
problems? Does regulation introduce new problems?
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Government safety net- why do we need the safety
net? Problems:
(1) hard for depositors to get information
about banks; (2) reluctant to produceinformation due to free-ridingmay reluctantto deposit money.
depositors lose money when bad banks fail
depositors of good banks also might losemoney, due to contagion effect
financial crisis
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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 byproviding subsidized loans or buying some bad loans
so that:
Restore confidence Prevent bank failure/ bank run (bank panic)
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Government safety neta mixed blessing
Regulation created new problems:
Moral hazard: Depositors sit back and relax.
Banks dont have incentives to managerisks.
Heads banks win, tails the taxpayer loses
Adverse selection Risk-lovers find banking attractive
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Government safety nettoo big to fail?
Continental Illinois, 1984, FDIC guaranteedaccounts exceeding $100,000 and even bondholders.
Other large banks expect similar treatment andlarge infusion of capital in case of insolvency.
Moral hazard
Larger and more complex bankingorganizations challenge regulation Increase too big to fail problem
Extends safety net to new activities such as
securities underwriting, insurance or real estate
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Restrictions on asset holdingand 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 (BaselAccord)
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Assessment of risk management
Problem: examine result at one point in timeevaluate processesof risk controlling
Trading Activities Manual of 1994 for risk
management ratingbased 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)
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Disclosure requirements
Problem: depositors, shareholders and creditorslack 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 banks internal reports on risk management.
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Consumer protection
Problem: depositors could not protectthemselves due to incomplete information
Regulation: truth-in-lending: banks need to explain
provide full information about cost ofborrowing including interest rate and finance
chargeson the loan prohibit discrimination.
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Restrictions on competition(now mostly eliminated)
Problem: banks tend to take on more riskwhen competition is hot
Regulation: Branching restrictions (eliminated in 1994)
Glass-Steagall Act (repealed in 1999)
New problems Higher consumer charges
Decreased efficiency
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A review on major banking
legislations in the U.S. in the20thcentury
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New situation
In 1960s, 70s and early 80s, financial innovation andnew 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 andLoan Insurance Corporation (FSLIC) can not keep upwith increasingly complicated business
Sharpe increase in interest rate and inflation rate
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Situation worsened
Regulatory forbearance by FSLIC Did not close insolvent S&Ls
Substantially lowered capital requirements
Zombie S&Ls taking on high risk projects andattracting business from healthy S&Ls.
Bailout
Infusion of $15 billion to FSLIC
Competitive Equality in Banking Act of 1987, allowedFSLIC to borrow $10.8 billion
Still inadequate funds, situation deteriorated
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Principal-agent problem
Principal-agent problem Politicians and regulators are agents for
voters-taxpayers.
Regulators
little incentive to act in interest of the public wish to escape blame
want to protect careers thus are mostinfluenced by politicians
Politicians Lobbied by S&L which are major campaign
contributions
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The Financial Institutions Reform,Recovery, and Enforcement Act of
1989 (FIRREA)
Regulatory bodies restructured: shrink power of former regulatory bodies that supervised S&Ls
Enhanced enforcement powers of new regulators
Cost of the bailout approximately $150 billion New regulations for S&Ls:
Re-restricted asset choices
increased core-capital leverage requirements
Imposed same risk-based capital standards Moral hazard and adverse selection problems created by
deposit insurance are unsolved.
F d l D it I
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Federal Deposit InsuranceCorporation Improvement Act of
1991 Recapitalize the Bank Insurance Fund of the FDIC Increase ability to borrow from the Treasury
Higher deposit insurance premiums until the loanscould be paid back and reserves of 1.25% of insureddeposits maintained
Reform the deposit insurance and regulatory system tominimize taxpayer losses
Too-big-to-fail policy substantially limited
Prompt corrective action provisions
Risk-based insurance premiums
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Appendixuseful definitions
Bank failure: bank unable to meet its obligations to pay its
depositors and other creditors and so much go out of business.
Sequential service constraint: first-come first served rule.
Free-riding: the problem that occurs when people who do not pay forinformation take advantage of the information that other people have
paid for.
Leverage ratio: the amount of capital divided by the banks total
assets
Basel Accord: is an agreement among banking officials from
industrialized nations set up the Basel Committee on Banking
Supervision which implemented Basel Accord.
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Appendixuseful def. (contd)
CAMELS: Capital adequacy; Asset quality; Management; Earnings;
Liquidity; sensitivity to market risk.
Savings and Loan (S&L): depository institutions which obtain funds
primarily through savings deposits (often called shares) and timeand checkable deposits.
Regulatory forbearance: refrain from exercising regulatory right (in
case of 1980s S&L crisis, fail to put the insolvent S&Ls out of
business).
Principal agent problem: occurs when representatives (agents) suchas managers have incentives that differ from those of their employer
(the principal) and so act in their own interest rather than in the
interest of the employer.
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Q&A
QUESTION & ANSWER SESSION
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NEXT SESSION
Regulation of Financial sectors