Chapter 10: Economic Analysis of Financial Regulation

Question 1

payoff methof

Answer 1

Allow the bank to fail and pays off depositors up to the insurans limit (whatever happens most of the clients will get there money back)

Question 2

kinds of government safety net (for bank panics/ many banks fail simultianeously)

Answer 2

• short circuits bank failures and contagios effect
• payoff method
• purchase and assumption method
• Lending from the central bank to troubled institutions (lender of last resort)

Question 3

Purchase and assumption method

Answer 3

(typically more costly): reorganization of the bank by finding a merger partner that assumes the bank’s failed liabilities so no depositor or creditor looses money.

Question 4

Drawbacks of the Government Safety Net

Answer 4

• Moral Hazard:
Depositors do not impose discipline of marketplace, Financial institutions have an incentive to take on greater risk than otherwise (they will not be punished by there clients if they do, the clients have a garenty return of 1D)

• Adverse Selection:
Risk-lovers find banking attractive. Depositors have little reason to monitor financial institutions

Question 5

types of Financial Regulation

Answer 5

1. Restrictions on asset holdings
2. Capital requirement
3. Prompt Corrective Action
4. Chartering and Examination
5. Assessment of Risk Management
6. Disclosure Requirements
7. Consumer Protection
8. Restrictions on Competition

Question 6

Restrictions on Asset Holdings, how?

Answer 6

Attempts to restrict financial institutions from too much risk
taking:

• Bank regulations (Promote diversification, Prohibit holdings of common stock)
• Capital requirements (Minimum leverage rati, Basel Accord: risk-based capital requirements, Regulatory arbitrage)

Question 7

Capital Requirements

Answer 7

Government-imposed capital requirements are another way of minimizing moral hazard at financial institutions

with two forms:

• Leverage ratio
• risk based capital requirements

Question 8

Leverage ratio

Answer 8

is any one of several financial measurements that look at how much capital comes in the form of debt (loans) or assesses the ability of a company to meet its financial obligations.

Question 9

Risk-based capital requirements

Answer 9

refers to a rule that establishes minimum regulatory capital for financial institutions. exist to protect financial firms, their investors, their clients, and the economy as a whole.

Question 10

Regulatory arbitrage

Answer 10

is a Limitations of Basle Accord
- def: : banks keep on their books assets that have the same
risk-based capital requirement but are relatively risky

Question 11

Basel Accord

Answer 11

are a series of three sequential banking regulation agreements (Basel I, II, and III) set by the Basel Committee on Bank Supervision (BCBS). The Committee provides recommendations on banking and financial regulations, specifically, concerning capital risk, market risk, and operational risk.

Question 12

the 3 pillars of Basel Accord

Answer 12

• Pillar 1 links capital requirements for large, internationally active banks
more closely to actual risk of three types: market risk, credit risk, and
operational risk.

• Pillar 2 focuses on strengthening the supervisory process, particularly
in assessing the quality of risk management in banking institutions and
evaluating whether these institutions have adequate procedures in
place for determining how much capital they need

• Pillar 3 focuses on improving market discipline through increased
disclosure of details about a bank’s credit exposures, its amount of
reserves and capital, the officials who control the bank, and the
effectiveness of its internal rating system

Question 13

3. Prompt Corrective Action

- If financial institution’s capital falls to low levels, 2 serious problems can occur:

Answer 13

1. Bank is more likely to fail because it has a smaller capital cushion should it suffer from loan losses
2. With less capital the financial institution is more likely to take on excessive risks (bigger moral hazard problem)

Question 14

Classification of 5 groups of bank capital:

to correct problems/ prompt corrective action

Answer 14

Well – adequately – undercapitalized - significantly undercapitalized – critically undercapitalized

Question 15

4. Chartering and Examination

Answer 15

Financial supervision or prudential supervision to reduce adverse selection and moral hazard, by:

• Chartering
• Exminations

Question 16

Chartering

Answer 16

(screening of proposals to open new financial institutions to prevent
undesirable people from controlling them) to prevent adverse selection

Question 17

Examinations

Answer 17

(scheduled and unscheduled) to monitor capital requirements and
restrictions on asset holding to prevent moral hazard

Question 18

5. Assessment of Risk Management

Answer 18

Greater emphasis on evaluating soundness of management processes for
controlling risk. rating based on:

• Quality of oversight provided by board and senior management
• Adequacy of policies and limits for all risky activities
• Quality of the risk measurement and monitoring systems
• Adequacy of internal controls to prevent fraud or unauthorized activities by employees

Question 19

6. Disclosure Requirements

Answer 19

To avoid the free rider problem regulators require financial institutions to reveal information

Question 20

Mark-to-market (fair-value) accounting:

Answer 20

assets are valued in the balance sheet at what they would sell for in the market

Question 21

subprime mortgage crisis

Answer 21

illustrated the need for greater consumer protection. Many borrowers took loans they did not understand and were beyond their means to repay (NINJA loans: no income, no job, and no assets)

Question 22

8. Restrictions on Competition

Answer 22

Justified as increased competition can also increase moral hazard incentives to take on more risk.

Disadvantages:
• Higher consumer charges
• Decreased efficiency of banking institutions

Question 23

microprudential supervision

Answer 23

what Before the global financial crisis, the regulatory authorities engaged in.
- def: which is focused on the safety and soundness of individual financial institutions.

Question 24

macroprudential supervision

Answer 24

what the global financial crisis has made it clear that there is a need for.
- def: which focuses on the safety and soundness of the financial system in the aggregate.

Question 25

Regulation likely to be seen in the future (to prevent crisis)

Answer 25

• Increased regulation of mortgage brokers
• Fewer subprime mortgage products
• Regulation of banker’s compensation
• Higher capital requirements
• Countercyclical capital requirements
• Heightened regulation to limit financial institutions’ risk taking
• Increased regulation of credit-rating agencies
• Additional regulation of derivatives

Question 26

Danger of overregulation

Answer 26

• Too much or too poorly designed regulation could hamper the
efficiency of the financial system.

• Choking financial innovation that can benifit households and
businesses