Copyright 2014 Pearson Canada Inc. Chapter 10 ECONOMIC ANALYSIS OF FINANCIAL REGULATION

Copyright © 2014 Pearson Canada Inc.

Chapter 10

ECONOMIC ANALYSIS OF FINANCIAL REGULATION

Copyright © 2014 Pearson Canada Inc. 10-2

Learning Objectives

1. Explain bank regulation in the context of asymmetric information problems

2. Characterize how the CDIC handles failed banks and detail recent CDIC developments

3. Outline the banking crises that have occurred in Canada and other countries throughout the world


Asymmetric Information and Bank Regulation IGovernment Regulator

•OSFI

Government safety net:

•Canadian Deposit insurance Corporation (CDIC) -protecting bank customers•Bank of Canada works as“Lender of Last Resort”-Providing liquidity for banks


* Some advocates of free financial market may argue

Government Safety Net may make the banking system less stable through:Moral Hazard and Adverse Selection

– depositors do not be cautious as their deposits are insured, depositors have little reason to monitor financial institutions

– and thus not impose marketplace discipline(avoiding bad ones).

– financial institutions have an incentive to take on greater ris


* Ultimately, the government may foster financial monsters: “Too Big to Fail”

• Big banks assume the government would not dare to ignore when they are in troubles, and the government will have to rescue them with public funds.


** Just note that

The Most Important Summary Slide for Chapter 10s and 13 is the next one!

Out of 5 areas of Financial Regulation or Supervision, the most concrete one is Risk Management, particularly Risk Management through Capital Requirements.


Major Five Areas of Government RegulationsFinancial Supervison by OSFI1) Bank Ownership Restriction to foster competition, fairness. - A single shareholder at 20% in a ‘large bank’($12 billion); A single shareholder at 65% in a ‘medium size bank($2-12 billion); 2) Risk Management to enhance Stability. -Capital Adequacy Requirements(CAR) for Pillar II risks and - Disclosures on other Risk Management for Pillar 3 risks **Internal Capital Adequacy Assessment Process to be in place3) AML/ ATFT Self-Surveillance for Transparency *Some part overlapping with FINTRAC 4) Accounting/Auditing/Disclosure Requirements for Transparency, Internal Control, and again

Transparency -Accounting: IFRS newly adopted as opposed to Canadian GAAP-Auditing is to secure Internal Control; Banks should have 3 layers of Defense lines(3 Pillars of Basel

Accord)-Disclosure is enhanced with Bill 198 (Canada) corresponds to the Sarbanes-Oxley Act (U.S.) 5) Customer Protection for Fairness


Risk Management1. By having the adequate amount of Capital, banks may

be manage a certain kind of Risks. It is called (regulatory) Capital Adequacy Requirements

(CAR<-regulator) through Internal Capital Adequacy Assessment

Process(<-Compliants = Banks) or ICAAP2.


Capital Adequacy Requirements(CAR)

-How much Capital should be set aside to manage Risks? Depending on capital used, there are different minimum Requirements for Capital or adequate Ratios: 1)Common Equity Tier 1 Capital Ratio2)Tier 1 Capital Ratio 3)Total Capital Ratio

-What are the actual required minimum ratios? 1)In Basel Accord, the minimum Total Capital Ratio is known

as BIS ratio, which is set 8% worldwide for now. 2) In Canada, the minimum total capital ratio is set at 8% +

capital conservation buffer 2.5% = 10.5%


• It is the most important concept in Chapters 10 and 13, and for the test

• You are expected to be technically familiar with

CAR and ICAAP: “How to Calculate the Capital Adequacy Requirements or Capital Adequacy Ratios (including the ‘BIS ratio)”.

It is complex, yet its simplified presentation is

explained here. Click here. Please, make sure that you can do the last simplified exercise question at the end.


Restrictions on Competition

• Justified as increased competition can also increase moral hazard incentives to take on more risk

• Disadvantages– higher consumer charges– decreased efficiency


Is that all of Bank Regulations?


Nature of Canadian government’s financial sector regulations

• Principle Based Regulation (Canada) versus

Rule Based Regulation (U.S., and other countries)

paper by Han and Ibbott(2009)


• The textbook authors put the following table here in Chapter 10, but I have covered it in Chapter 11 in conjunction with the Canadian banking history. Thus it is not new. I am just keeping it here for your reference.


Major Financial Legislation in Canada

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Copyright 2014 Pearson Canada Inc. Chapter 10 ECONOMIC ANALYSIS OF FINANCIAL REGULATION