C9: Economic Analysis of Financial Regulation

What is asymmetric information?

When one party has more information than another in a financial transaction

What two problems arise from asymmetric information?

Adverse selection and moral hazard

Why is asymmetric information important in banking?

Depositors cannot assess bank risk

What is a bank panic?

Widespread bank failures due to mass withdrawals

What causes bank runs?

Depositors withdraw funds due to fear of bank insolvency

What is the sequential service constraint?

First-come, first-served withdrawal system

Why does this constraint cause bank runs?

Incentivizes depositors to withdraw early

What is the contagion effect?

Failure of one bank triggers failures of others

Why are bank panics harmful?

They reduce lending and damage the economy

What is a government safety net?

Measures to protect the financial system from collapse

What is the main purpose of a safety net?

Prevent bank runs and ensure financial stability

What is deposit insurance?

Government guarantee of deposits up to a limit

How does deposit insurance prevent bank runs?

Depositors know they will be repaid fully

What is CDIC?

Canadian agency that insures deposits

What is the CDIC coverage limit?

$100,000 per depositor per account

What types of deposits are insured by CDIC?

Chequing, savings, GICs, term deposits

What is NOT insured by CDIC?

Stocks, bonds, mutual funds, ETFs, crypto

What are the two methods CDIC uses to handle bank failure?

Payoff method and purchase-and-assumption

What is the payoff method?

CDIC pays insured deposits and liquidates the bank

What is purchase-and-assumption?

Another bank takes over all liabilities

Which CDIC method is more common?

Purchase-and-assumption

What is lender of last resort?

Central bank lending to troubled institutions

What other forms of safety net exist?

Bailouts, nationalization, guarantees

What is systemic risk?

Risk that failure spreads across the financial system

Why are large institutions dangerous?

They can trigger systemic collapse

What is moral hazard?

Incentive to take excessive risk when protected

How does deposit insurance create moral hazard?

Depositors stop monitoring banks

What is adverse selection in financial safety nets?

Risky firms are more likely to enter banking

Why might “crooks” enter finance under safety nets?

Lack of monitoring enables fraud

What is too-big-to-fail?

Policy of protecting large institutions from failure

Why does too-big-to-fail increase moral hazard?

Large banks expect bailouts

How does too-big-to-fail affect depositors?

They stop monitoring large banks

What is a key problem with financial consolidation?

Increases systemic risk and TBTF problem

Why does consolidation worsen moral hazard?

More institutions are protected

What is financial regulation’s main goal?

Reduce asymmetric information problems

What are the 8 types of financial regulation?

Asset restrictions, capital requirements, prompt corrective action, chartering/exam, risk management, disclosure, consumer protection, competition limits

What are restrictions on asset holdings?

Limits on risky assets banks can hold

Why restrict asset holdings?

Reduce moral hazard and excessive risk

What is diversification regulation?

Limiting exposure to one borrower/sector

What is capital?

Bank’s equity (net worth)

Why are capital requirements important?

Increase loss absorption and reduce risk

What is leverage ratio?

Capital ÷ total assets

What leverage ratio defines well-capitalized banks?

Above 5%

What is risk-based capital?

Capital based on asset risk levels

What is Basel Accord requirement?

Capital ≥ 8% of risk-weighted assets

What are risk weights?

Weights assigned based on asset risk

Give examples of risk weights

0% (gov bonds), 20% (banks), 50% (mortgages), 100% (corporate loans)

What is regulatory arbitrage?

Exploiting differences between actual risk and regulatory risk

Why is regulatory arbitrage a problem?

Banks take on hidden risk

What are Basel II and Basel III?

Updated capital regulations improving risk measurement

What is prompt corrective action?

Early intervention when bank capital declines

Why is early intervention necessary?

Prevent failure and reduce moral hazard

What happens when capital falls?

Risk-taking incentives increase

What is financial supervision?

Oversight of financial institutions

What is chartering?

Screening who can operate a financial institution

Why is chartering important?

Prevents risky or fraudulent operators

What is examination?

Regular monitoring of banks’ activities

What is CAMELS rating?

System evaluating bank health

What does CAMELS stand for?

Capital, Assets, Management, Earnings, Liquidity, Sensitivity

What actions can regulators take after examination?

Force changes, restrict activities, close bank

How does supervision reduce asymmetric information?

Improves monitoring and discipline

What is risk management regulation?

Evaluating how banks manage risk

What are the 4 elements of risk management assessment?

Oversight, policies, measurement systems, internal controls

What is value-at-risk (VaR)?

Maximum expected loss over a period

What is stress testing?

Simulating extreme scenarios

Why is risk management regulation increasing?

New financial instruments increase risk

What are disclosure requirements?

Mandating information release

Why is disclosure important?

Reduces free-rider problem

What role does disclosure play?

Improves market discipline

What does Basel II emphasize?

Increased disclosure

What is consumer protection regulation?

Rules protecting borrowers

What is truth in lending?

Disclosure of loan costs (APR)

Why is consumer protection needed?

Consumers lack information

What was a failure of consumer protection?

NINJA loans in financial crisis

What are restrictions on competition?

Limits on competition to reduce risk-taking

Why can competition increase risk?

Banks take more risk to maintain profits

What is a drawback of limiting competition?

Higher prices and inefficiency

What is CDIC’s role beyond insurance?

Resolution authority for failed institutions

What is bail-in?

Losses absorbed by investors instead of taxpayers

What is difference between bail-in and bailout?

Bail-in uses private funds, bailout uses public funds

What is opting-out of CDIC?

Banks can operate without insurance

Why is opting-out important?

Increases monitoring by uninsured depositors

What is the overall trade-off of safety nets?

Stability vs increased risk-taking