BANKING REGULATION

Question 1

What are the rationales for regulation?

Answer 1

-Ensure customer confidence
-Ensure systemic stability. Failure of one bank can spread to other banks. Regulation and supervision (social costs>private costs). Free-banking (regulation benefits<costs)
-Protect depositors from monopolistic exploitation
-Provide small depositors with protection
-◦ Monitoring is costly for small depositors
◦ Public pressure

Question 2

Briefly explain why goldsmiths started doing fractional reserve banking?

Answer 2

-Goldsmiths provided secure storage facilities for a fee and issued receipts in return
-More transactions led to better reputation. Trips to goldsmiths were time and economically consuming. Resulted in the exchange of receipts instead
-Belief that it was ready on demand
-Receipts replaced gold, fractional reserve occurred. Increased risk of insolvency but higher interest income

Question 3

Why is the banking sector risky?

Answer 3

-Prone to instability
-Illiquid assets and liquid liabilities and therefore prone to default
-Bank runs

Question 4

What is systemic (macro-prudential) regulation?

Answer 4

-Regulation is concerned with the safety and soundness of the financial system (part of ‘financial safety net’)

Question 5

What are the two systemic (macro-prudential) regulation?

Answer 5

-Lender of Last Resort (LoLR): CB provides liquidity to banking sector (bankers’ bank; IMF at global level)
-Deposit insurance (both implicit and explicit)

Question 6

What are Micro -) Prudential Regulation?

Answer 6

• Capital Regulation: solvency
• Conduct of Business Regulation
  -Bail-in
  -Prudential Regulation is concerned with consumer protection and
  involves monitoring and supervising banks’ asset quality and capital
  adequacy (Prudential Regulation Authority (PRA) in UK - Financial
  Services Authority (FSA) until 2013)

Question 7

Arguments against regulation

Answer 7

-‘Safety net’ arrangements create moral hazard
-Banks may benefit from regulatory forbearance: ease regulatory
requirements for troubled (illiquid) banks (‘time inconsistency’
problem)
-‘Agency capture’ problems: banks use regulation to their
advantage
- Cost of Compliance: passed to consumers

Question 8

Causes for modern regulatory reforms

Answer 8

• Internationalisation: increased presence of foreign banks in
  domestic financial sectors
• Globalisation:
• Financial Conglomeration
• Financial Innovation:

Question 9

What is Basel 1?

Answer 9

-Total Risk-Weighted Assets: RW A =
∑5
i=1 αi ∗ ri
-Banks are required to hold a Capital Ratio 8% of RW A
-Basel definition of capital is made by two elements:
-At least 50% of the Capital Base should be in Tier 1 form

Question 10

Criticisms of Basel 1

Answer 10

◦ Differences in taxes and accounting rules
◦ Apart form credit risk all other types of risks are ignored
◦ No recognition of risk diversification
◦ Risks are not necessarily the same in different countries
◦ Market value of banks’ assets is not considered
◦ Risk weight not accurately reflecting the risk associated with
assets

Question 11

Objectives of Basel 2

Answer 11

◦ Cover other types of risk
◦ Account for the risk mitigation efforts of banks
◦ Ensure that capital adequacy regulation does not prevent
competition
◦ Adopt more risk-sensitive capital requirements
◦ Make greater use of banks’ own internal risk assessments
◦ Bringing market discipline and regulatory monitoring to bear
part of regulation
◦ Adopt a more forward-looking approach that evolves with time

Question 12

Pillars of Basel 2

Answer 12

-Pillar 1: Minimum Capital Requirements
-Pillar 2: Supervisory Review Process
-Pillar 3: Market Discipline