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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