Ch11 - Regulation

Question 1

Benefits of regulation

Answer 1

• Alignment of interests: regulators act on behalf of customers of FIs (creditors)
• Solvency: reg makes companies stronger financially (e.g. capital rules)
• Oversight and Governance: additional level of governance, good for creditor. Disclosure rules enable a public good through info gathering and dissemination
• Systemic Risk and Contagion: public good created which benefits creditors as the potential for systemic risk (contagion) is lower in regulated environment

Question 2

Pitfalls of Regulation (1,2)

Answer 2

• Not all creditors treated equally: regulator’s constituency is the retail customer, therefore not all creditors are equal (investors, business cntrpty)
• Seizure and lack of orderly disposition: when regulators have to seize a company’s assets, the contractual rights of creditors may be subordinated to other stakeholders

Question 3

Pitfalls of Regulation - Moral Hazard

Answer 3

-Moral Hazard: incentive to take more risk as they know their customers are insured by regulator. Creditor may also rely too heavily on regulator’s work and not perform enough of its own diligence. Finally, customers may be more willing to do business with regulated entities, which may cause fast growth, associated with excessive risk taking and unfavourable outcomes

Question 4

Pitfalls of Regulation - Gamesmanship

Answer 4

• Decisions made by management affect by regulatory presence (organise itself with discretion)
  1. Organisational Arbitrage: management place key personnel, financing, strategy etc outside of regulatory supervision (e.g. SPVs manage cash outside supervis)
  2. Regulatory Arbitrage: decisions for operations, financing, strategy based on where it will get best regulatory treatment
  3. Ratings Arbitrage: company may decide to take on risk to gain favourable regulatory treatment
  4. Uneconomic Decision Making: entering into transactions that are favourable from a regulatory standpoint, but have low risk-adjusted returns or use more capital

Question 5

How Regulation Matters: Dodd-Frank Act 2010

Answer 5

-Mandates are to create a new agency responsible for implementing and enforcing compliance with consumer financial laws, capital requirements, derivative regulation, regulate credit rating agencies, incorporate Volcker Rule, make changes in the securitisation market etc

Question 6

How Regulation Matters: Basel III

Answer 6

-Measures developed to strengthen the regulation, supervision, and risk management of the banking sector.
1. Improve the sector’s ability to absorb shocks
2. Improve risks management and governance
3. Strengthen bank’s transparency and disclosures (microprudential regulation)
Sets minimum capital, liquidity requirements and maximum leverage for banks. RWA formula,

Question 7

How Regulation Matters: Solvency II

Answer 7

• Directive for supervision of insurance and pensions in the EU
• Lays out specific requirements for supervised institutions to recognise, measures, curtail, and allocate capital for credit risk exposure

Question 8

How Regulation Matters: Derivatives Regulation

Answer 8

• In the midst of being created
• Traditionally, transactions have been dealt with on an ad hoc basis
• The movement has been toward moving derivative transactions into exchanges and clearinghouses

Question 9

Explain table 12.1

Answer 9

See separate answer sheet