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Chapter 11 Economic Analysis of Financial Regulation
© 2013 Pearson Education, Inc. All rights reserved.11-2 Asymmetric Information and Financial Regulation Bank panics and the need for deposit insurance: –FDIC: short circuits bank failures and contagion effect. –Payoff method. –Purchase and assumption method (typically more costly for the FDIC). Other form of government safety net: –Lending from the central bank to troubled institutions (lender of last resort).
© 2013 Pearson Education, Inc. All rights reserved.11-3 Government Safety Net Moral Hazard –Depositors do not impose discipline of marketplace. –Financial institutions have an incentive to take on greater risk. Adverse Selection –Risk-lovers find banking attractive. –Depositors have little reason to monitor financial institutions.
© 2013 Pearson Education, Inc. All rights reserved.11-4 Government Safety Net: “Too Big to Fail” Government provides guarantees of repayment to large uninsured creditors of the largest financial institutions even when they are not entitled to this guarantee Uses the purchase and assumption method Increases moral hazard incentives for big banks
© 2013 Pearson Education, Inc. All rights reserved.11-5 Government Safety Net: Financial Consolidation Larger and more complex financial organizations challenge regulation –Increased “too big to fail” problem –Extends safety net to new activities, increasing incentives for risk taking in these areas (as has occurred during the global financial crisis
© 2013 Pearson Education, Inc. All rights reserved.11-6 Restrictions on Asset Holdings Attempts to restrict financial institutions from too much risk taking –Bank regulations Promote diversification Prohibit holdings of common stock –Capital requirements Minimum leverage ratio (for banks) Basel Accord: risk-based capital requirements Regulatory arbitrage
© 2013 Pearson Education, Inc. All rights reserved.11-7 Capital Requirements Government-imposed capital requirements are another way of minimizing moral hazard at financial institutions There are two forms: –The first type is based on the leverage ratio, the amount of capital divided by the bank’s total assets. To be classified as well capitalized, a bank’s leverage ratio must exceed 5%; a lower leverage ratio, especially one below 3%, triggers increased regulatory restrictions on the bank –The second type is risk-based capital requirements
© 2013 Pearson Education, Inc. All rights reserved.11-8 Financial Supervision: Chartering and Examination Chartering (screening of proposals to open new financial institutions) to prevent adverse selection Examinations (scheduled and unscheduled) to monitor capital requirements and restrictions on asset holding to prevent moral hazard –Capital adequacy –Asset quality –Management –Earnings –Liquidity –Sensitivity to market risk Filing periodic ‘call reports’
© 2013 Pearson Education, Inc. All rights reserved.11-9 Assessment of Risk Management Greater emphasis on evaluating soundness of management processes for controlling risk Trading Activities Manual of 1994 for risk management rating based on –Quality of oversight provided –Adequacy of policies and limits for all risky activities –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)
© 2013 Pearson Education, Inc. All rights reserved Disclosure Requirements Requirements to adhere to standard accounting principles and to disclose wide range of information The Basel 2 accord and the SEC put a particular emphasis on disclosure requirements The Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board Mark-to-market (fair-value) accounting
© 2013 Pearson Education, Inc. All rights reserved Consumer Protection Consumer Protection Act of 1969 (Truth-in- lending Act). Fair Credit Billing Act of Equal Credit Opportunity Act of 1974, extended in Community Reinvestment Act. The subprime mortgage crisis illustrated the need for greater consumer protection.
© 2013 Pearson Education, Inc. All rights reserved Restrictions on Competition Justified as increased competition can also increase moral hazard incentives to take on more risk. –Branching restrictions (eliminated in 1994) –Glass-Steagall Act (repeated in 1999) Disadvantages –Higher consumer charges –Decreased efficiency
© 2013 Pearson Education, Inc. All rights reserved Macroprudential Vs. Microprudential Supervision Before the global financial crisis, the regulatory authorities engaged in microprudential supervision, which is focused on the safety and soundness of individual financial institutions. The global financial crisis has made it clear that there is a need for macroprudential supervision, which focuses on the safety and soundness of the financial system in the aggregate.
© 2013 Pearson Education, Inc. All rights reserved Table 1 Major Financial Legislation in the United States
© 2013 Pearson Education, Inc. All rights reserved Table 1 Major Financial Legislation in the United States (cont’d)
© 2013 Pearson Education, Inc. All rights reserved Figure 1 Bank Failures in the United States, 1934–2010 Source:
© 2013 Pearson Education, Inc. All rights reserved The 1980s Savings and Loan and Banking Crisis Financial innovation and new financial instruments increased risk taking Increased deposit insurance led to increased moral hazard Deregulation –Depository Institutions Deregulation and Monetary Control Act of 1980 –Depository Institutions Act of 1982
© 2013 Pearson Education, Inc. All rights reserved The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 Financial Institutions Reform, Regulatory and Enforcement Act of 1989 Federal Deposit Insurance Corporation and Improvement Act of 1991 –Cost of the bailout approximately $150 billion, or 3% of GDP.
© 2013 Pearson Education, Inc. All rights reserved Banking Crises Throughout the World “Déjà vu all over again” –Deposit insurance is not to blame for some of these banking crises –The common feature of these crises is the existence of a government safety net, where the government stands ready to bail out troubled financial institutions.
© 2013 Pearson Education, Inc. All rights reserved Figure 2 Banking Crises Throughout the World Since 1970 Sources: Data from Gerard Caprio and Daniela Klingebiel, “Episodes of Systemic and Borderline Financial Crises” mimeo., World Bank, October 1999; Luc Laeven and Fabian Valencia, “Resolution of Banking Crises: The Good, the Bad and the Ugly,” IMF Working Paper No. WP/10/46 (June 2010) and Luc Laeven, Banking Crisis Database at
© 2013 Pearson Education, Inc. All rights reserved Table 2 The Cost of Rescuing Banks in a Number of Countries
© 2013 Pearson Education, Inc. All rights reserved The Dodd-Frank Bill and Future Regulation The system of financial regulation is undergoing dramatic changes after the global financial crisis Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010: The most comprehensive financial reform legislation since the Great Depression
© 2013 Pearson Education, Inc. All rights reserved The Dodd-Frank Bill and Future Regulation (cont’d) The Dodd-Frank Bill addresses 5 different categories of regulation: –Consumer Protection –Resolution Authority –Systemic Risk Regulation –Volcker Rule –Derivatives
© 2013 Pearson Education, Inc. All rights reserved The Dodd-Frank Bill and Future Regulation (cont’d) There are several areas where regulation may be heading in the future: –Capital Requirements –Compensation –Government-Sponsored Enterprises (GSEs) –Credit Rating Agencies –The Danger of Overregulation
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