week 5
Page 1: Introduction
Lecture Title: Financial Regulation
Instructor: Dr. Orkun Saka
Institution: University of London, City
Course Code: EC2028
Year Established: 1894
Page 2: Reading Assignments
Relevant Book Chapter: Mishkin, 12th Edition, Chapter 10: Economic analysis of financial regulation
Page 3: Learning Objectives
Identify the reasons for and forms of a government safety net in financial markets.
Discuss how government actions may distort bank incentives to "play safe" in financial markets and create moral hazard.
List and summarize types of financial regulation and how each reduces asymmetric information problems.
Page 4: Bank Behavior
Banks often behave irresponsibly due to lack of accountability.
Notable cases of irresponsible behavior include:
Lending rate-fixing by global banks such as Barclays, HSBC, JPMorgan Chase, etc.
Cultural considerations in banking leading to moral hazards.
Page 5: Presentation Announcement
Interaction noted: live content display during presentations.
Page 6: Banking & Moral Hazard (1/5)
Bank Panics:
Can force healthy banks into bankruptcy.
Deposit insurance mitigates the risk of bank runs and contagion effects.
Methods of Deposit Insurance:
Payoff method
Purchase and assumption method
Government Safety Nets:
Lender of last resort (LOLR) - central bank support to troubled institutions.
Liquidity provision (e.g., Quantitative Easing).
Direct bailouts (government loans or equity injections).
Page 7: Banking & Moral Hazard (2/5)
Systemic Importance of Banks:
Banks as natural diversifiers but also systemically important.
A bank's failure can lead to wider financial system failures.
Total government cost of bailing banks often less than costs of bank failures.
Problems with Government Bailouts:
Knowing they can be bailed out, banks take excessive risks.
Adverse selection in the banking sector encourages riskier behaviors.
Page 8: Banking & Moral Hazard (3/5)
Moral Hazard from Insurance:
Deposit insurances and government bailouts can cause banks to act irresponsibly.
Example Investment Decision:
Project costing £70 million with uncertain outcomes ($90 million or $30 million).
Exploration on whether such risk would be considered by banks versus individuals.
Page 9: Banking & Moral Hazard (4/5)
Game Theory Dynamics:
A representation of interactions between banks, the economy, and the government.
Outcomes depend on decision overlapping between bank behaviors and government reactions.
Page 10: Interactive Content
Engagement noted: responses during presentations for insights on subgame perfect equilibrium paths.
Page 11: Banking & Moral Hazard (5/5)
Ensuring Credibility of No-Bailout Promises:
Ex-ante Actions:
Institutional reforms and punishments for banks.
Regulatory Actions: Regulating banks to encourage more responsible behaviors.
Page 12: Financial Regulation 1: Restrictions on Asset Holdings
Banks prefer riskier investments due to low capitalization.
This leads to risk being shifted onto creditors and depositors.
Regulations:
Promote diversification and restrict exposure to high-risk assets (e.g., common stock).
Page 13: Financial Regulation 2: Capital Requirements
Capital requirements minimize moral hazards in financial institutions.
Minimum leverage ratio set at ~5%.
Basel Accord introduced risk-weighted capital requirements across asset categories.
Regulatory arbitrage issues with preferences for risky assets despite capital risk categories defined.
Page 14: Financial Regulation 3: Prompt Corrective Action
Regulatory authorities intervene when bank capital falls below critical levels, requiring:
Capital restoration plans
Restrictions on asset growth
Approval for new business lines, etc.
Page 15: Financial Regulation 4: Chartering and Examination
Financial supervision through chartering and examinations aims to prevent adverse selection.
Monitoring Factors:
Capital adequacy, asset quality, management practices, earnings, liquidity, and market risk sensitivity.
Requires periodic reporting from banks.
Page 16: Financial Regulation 5: Assessment of Risk Management
Evaluating risk management may include:
Oversight quality from senior management.
Adequacy of risk activity policies.
Effectiveness of internal controls.
Page 17: Financial Regulation 6: Disclosure Requirements
Required adherence to accounting standards with transparency on various information.
Aims to reduce information asymmetries between banks and stakeholders, enhancing market discipline.
Page 18: Financial Regulation 7: Consumer Protection
Regulations guide banks to disclose vital information to consumers.
Protects against consumer abuse and risky loan practices, such as NINJA loans.
Page 19: Financial Regulation 8: Restrictions on Competition
Justification for restrictions due to increased competition leading to moral hazards.
Previous laws (Glass-Steagall Act) aimed to limit risk-taking.
Disadvantages:
May lead to higher costs for consumers and reduced efficiency.
Page 20: Lecture Summary
Recap of:
Government safety nets for banks
Moral hazards associated with banking
Types and implications of financial regulation.