Intro 2 Flashcards
What happened with Corona crisis?
Many people lost their jobs (especially in the entertainment sector), hence, their ability to spend decreased. Moreover, if we assume that these people all of a sudden cant pay their mortgages we go back to the financial crisis from 2008.
What is still an effect from 2008 crisis?
The negative interest rates or 0 IRs in some central banks to stimulate the economy
Why we had 2008 crisis?
A lot of mortgages given to subprime borrowers and all of a sudden they started to default and top of that about 25% were strategic, because house prices fell down and people thought why to pay 2x the current price. And if the legal state is not as good, you might or not ruin your credit score, f. e. in US you can move to another federal state. And then the banks had to sell the houses at loss.
Why are banks heavily regulated?
Banks play an important role in financial crisis. Every couple of years FC happens and sometimes its severe, sometimes its not
Why do we need regulation acc to basic economic theory?
Markets usually work pretty well, but need to be regulated in the case of market failure.
What is market failure?
Market failure is whenever a market doesn’t deliver a Pareto-efficient allocation of resources: one in which its not possible to improve one person’s situation without making someone else worse off.
The first theorem of welfare economics
the free market will achieve a Pareto-eff outcome provided that there’s perfect competition, full information and no externalities.
In practice, however, the competition isn’t perfect, info asymmetries exist, and externalities are rampant(inifinte)
Fin regulation is there to help with:
a) Protection against monopolies (competition is not perfect)
b) Consumer/ Investor protection (asymmetric info)
c) Systemic risk (from externalities) – for instance, banks are interlinked with each other and you don’t want the whole system to break down
d) Efficiency of monitoring
Most economic reg is concerned with
preventing unwanted concentration of market power. Most of finance is pretty competitive, not so much a problem (although for example the Dutch banking system is extremely concentrated, which is a problem because if one of these banks fail the consequences will be affecting a lot of people)
Protection against monopolies: One potential issue
platform effects - Its often efficient to use a single system (example: single payment system). A platform becomes more useful, the more other people will use it and then it gains some degree of monopoly power.
This allows companies to exploit people: In the US credit card companies charge 2-3% for a purchase using a card, even though costs are marginal.
Solution: regulate as a utility
Consumer protection
Many retail consumers of financial products often lack info and understanding of fin products. Thus, they need to be protected against themselves.
Risks to customers
a) Banks /insurance/ fund screwing the customer over - To prevent this, there is Conduct of Business regulation
b) Banks /insurance/ fund failing / collapsing – there is Prudential Regulations = regulating liquidity, solvency, riskiness, and general health of an institution
2 types of prudential regulation
- Micro-prudential regulation aims to maintain solvency of individual institutions.
- Systematic (macro-prudential) regulation aims to prevent contagion and widespread financial crisis.
Conduct of business / Behavioral regulation
•Includes regulating information disclosure, competence, fair business practices, marketing of products, honesty and integrity,etc
Example: life insurance – Turned out that only a fraction of the insurance premia was actually invested, most of it went to ”investment fees” instead.
•Regulatory tools: Licensing, (escalating) fines, entry qualifications, ethics standards, ombudsmen, etc. Can be self-regulated or externally imposed.
Types of investors
- Institutional investors (pension funds, hedge funds, so on) can be expected to be in a better position to evaluate an offer than a typical household investor
- Retail investors are likely to be less savvy / knowledgeable / experienced due to infrequent purchases, lack of repeated interactions, higher cost of acquiring information, limited ability or time to acquire the necessary skills. Even less ability to evaluate the soundness of an institution as a whole. Moreover, retail investors may not be able to monitor long-term contracts and even if through monitoring observe bad policy, unlikely to be able to change the institution’s course due to small size. Fin contracts are often acquired based on advice from professional advisors that have their own conflicts of interests. In addition, fin contract / investment may represent a much larger share of his/her wealth than a typical institutional investor
Which is regulated more heavily - institutional or retail investment?
retail investment
Reasons for prudential regulation
- Asymmetric info: very difficult for consumers to judge solvency of fin institutions , so market unlikely to function.
- Moral hazard: The value of an investment or contract is determined by the behavior of the institution after signing the contract and handing over your money
- There’re very large potential losses, and there’s a potential claim on a compensation or deposit insurance fund. Prudential reg is also partly aimed at protecting the interests of those who finance a safety net (tax payers are financing the bail out)
- In addition to these, there’re also Systematic rationales for regulation:
Whenever there’re large social costs (externalities) of a failure of a fin institution an these externalities aren’t included in the decision-making of the financial institution, there’s a case for additional regulation
Banks are inherently
unstable and contagious. One bank failure is likely to lead to others due to panics, credit exposure, and asset firesales. The failure of a bank immediately causes a credit crunch affecting both firms and households. Failing banks often have to be bailed out at considerable expense to the taxpayer and ultimately higher taxes, depressing the economy further.
What is included to see what happens if a bank is unable to pay its debts
stress test
Although all fin institutions merit regulation, banks are generally considered especially in need of regulation, because they’re:
a) Unstable due to maturity mismatch
b) Interlinked with other banks
c) Main or only source of lending for large n of borrowers
d) There’s moral hazard associated with gov or CB acting as lender of last resort
e) Manage the payment system
If other fin institutions fail, its less likely to cause contagion, doesn’t disrupt the payment system, there’s often no lender of last resort, and they usually hold liquid assets that can be sold off easily
Many fin contracts are
long term and need constant monitoring due to principal-agent problems – the value depends on the actions of the fin institution after the contract is signed
If every consumer’d monitor individually the incentives to do so’d be low and lead to lots of duplication and free riding . Therefore a specialized monitoring task may be more efficient.
Public choice theory
Fin Reg is offered in response to consumer demand, but not offered in a market setting. Therefore its likely to be over or under supplied. Fin Reg that eliminates all possibility of failure is likely to be too excessive (cost outweigh benefits). To some extent, regulating risks from investors regulates the very function of financial contracts. Reg may crowd out necessary monitoring by consumers (the moral hazard of reg)
-> Consumers assume safety and good conduct, while firms only seek to narrowly comply with regulatory requirements
Although the perceived cost of reg to voters is basically free, there’re some real costs:
a) Services not offered due to f.e. high entrance barriers
b) Lack of entrants decrease comp, increase p
c) Compliance costs passed on to consumers
These costs are hard to measure, and so some argue that reg is oversupplied
The threat of under regulation
Issue of reg arbitrage – firms domiciling the most regulatory favorable jurisdiction. Leading to a race to the bottom in an attempt to attract investment, resulting in an undersupply of reg and the exposure of consumers to unnecessary risk or could lead to under taxation
Some see the race to the bottom effect as inherently damaging, others see it as a healthy counter to the threat of overregulation
