Financial Regulation Flashcards
What is asymmetric information?
From the agency problem
Different parties do not have the same information available which causes adverse selection and moral hazard
Categories of financial regulation:
What is the government safety net?
Lending through central bank to troubled institutions, as a “lender of last resort”
There is a need for deposit insurance because it will short-circuit run on banks and bank panics, and overcome reluctance to put funds into the banking system
Moral hazard problem - take on more risk than they would without the government safety net
“Too big to fail”
Categories of financial regulation:
Restrictions on Asset Holdings
Regulation to minimise risky investments (high payout, high risk), because if they don’t pay off and the bank fails, depositors and creditors need to pay the price
Regulation helps to minimise moral hazard due to government safety nets
Categories of financial regulation:
Capital Requirements
Financial Institutions are forced to hold more capital
If they fail they have more to lose, therefore they are less likely to pursue risky activities
Capital can also act as a cushion when bad shocks occur, so it’s less likely that the bank will fail
Categories of financial regulation:
Prompt Corrective Action
The Federal Deposit Insurance Corporation (FDIC) must intervene earlier and more vigorously when a bank gets in to trouble
Banks that are “significantly” and “critically” undercapitalised (groups 4 and 5)
The FDIC is required to take prompt corrective actions for these banks, this includes requiring them to submit a capital restoration plan, restrict their asset growth, and seek regulatory approval to open new branches or develop new lines of business
What happens if capital levels fall too low?
The bank is more likely to fail because it has less cushion if they suffer loan losses or asset write-downs
The bank has less “skin in the game” so is more likely to take on excessive risks