Lecture 6- Regulation of the Financial Sector

Question 1

What was the reason for deregulation in the 1980s?

Answer 1

The rise in competition of offshore banking, such as the Eurocurrency markets, which escaped many of the domestic regulations

Question 2

What are the 4 main reasons for regulating the financial sector?

Answer 2

• Asymmetric information
• The principal-agent problem
• Moral hazard
• Externalities

Question 3

How is their asymmetric information in financial markets?

Answer 3

Managers of financial firms and sellers of financial products have more information on the products they’re selling than the buyers because the products can be complex and are often one-off purchases such as a pension scheme

Question 4

What are the 2 main approaches to regulation?

Answer 4

• Self-regulation

- Statutory regulation

Question 5

What is the main advantage of self-regulation?

Answer 5

Flexibility as insiders know best, how the system works and where things can go wrong; market practitioners are the best judges of unprofessional behaviour

Question 6

What is the main disadvantage of self-regulation?

Answer 6

Agency capture which is the tendency to the regulators to be too sympathetic to the regulated because they are often dependent on regulated firms for their funding and because staff regard themselves as still members of the industry they are regulating

Question 7

What are the 4 main types of regulation?

Answer 7

• Disclosure requirements
• Regulation of exchanges
• Licensing requirements
• Restrictions on activity

Question 8

What are the 3 main costs of regulation?

Answer 8

• Moral hazard
• Agency capture
• Compliance costs

Question 9

Describe the principal-agent problem in the context of financial markets

Answer 9

Investors employ the management of financial institutions to act as their agents. However, managers may have other motivations such as performance-related bonuses meaning the investors can’t be sure they’re making deals at the optimal price

Question 10

Describe moral hazard in the context of financial markets

Answer 10

A deposit insurance scheme is intended to reduce risk for investors. But such intervention may encourage institutions (and investors) to behave more recklessly than they otherwise would, defeating the original purpose

Question 11

Describe how there can be externalities in the context of financial markets

Answer 11

If a bank fails, people lose their means of payment. This is likely to be contagious – depositors will rush to withdraw from other banks and the payment system could collapse

Question 12

What is the main advantage of statutory regulation?

Answer 12

Should be able to take a strong and unbiased approach to wrongdoing

Question 13

What is the main disadvantage of statutory regulation?

Answer 13

Problems aren’t identified until they become serious and it takes time to introduce legislation

Question 14

Describe disclosure requirements

Answer 14

If companies wish to have their shares publicly traded in organised exchanges, they are required to disclose a wide variety of information about their financial position

Question 15

Describe regulation of exchanges

Answer 15

Participants are required to get the best price when trading on behalf of clients

Question 16

Describe licensing requirements

Answer 16

Requires participants to be licensed. This is intended to exclude undesirable individuals from managing other people’s money and to increase confidence in the system

Question 17

How might a firm incur compliance costs?

Answer 17

By having to setup internal controls such as compliance departments to make sure they’re meeting regulations

Question 18

How does imposing regulation affect a firm’s supply curve?

Answer 18

It’s as if they’ve had an additional tax levied on them; the supply curve shifts left as a result of the additional costs

Question 19

Give 3 main inefficiencies of regulation in the banking sector

Answer 19

• Well regulated banks are less profitable than less well regulated banks, so open to takeover by them
• Cost to the macroeconomy, an efficient banking system increases economic growth
• Makes it difficult for new entrants into the banking industry due to high start up costs and other barriers to new entrants

Question 20

What are the 3 main forms of regulation?

Answer 20

• Regulating the structure and activities of banks
• Liquidity requirements
• Capital adequacy

Question 21

How can banks’ structure and activity be regulated?

Answer 21

The Glass-Steagall act prevents commercial banks trading securities and investment banks from taking deposits

Question 22

What is the main way banks’ liquidity is regulated?

Answer 22

Monitoring banks’ reserve ratios

Question 23

What is the point of regulating Capital Adequacy?

Answer 23

intended to ensure that the bank has sufficient funds committed by stakeholders to absorb any negative shock that might occur to assets, without threatening the wealth of depositors

Question 24

What is Basel 1 focused on?

Answer 24

Basel 1 is primarily focused on the threat to asset values arising from default and requires a risk assets ratio of 8%

Question 25

What are the 3 main pillars of Basel 2?

Answer 25

• Minimum capital requirements using a modified version of the RaR approach of Basel 1
• Periodic reviews by the regulator of how a bank goes about determining its own capital adequacy and exposure to risk
• The requirement that these processes be made public so that the market can judge which banks have good procedures in place. This ‘market discipline’, it is hoped will encourage the spread of best practice.

Question 26

What is a main potential drawback of Basel 3?

Answer 26

Potential slowdown in growth due to banks passing on the cost of extra capital to borrowers and reduction in borrowing

Question 27

Describe the Dodd Frank act

Answer 27

Created to protect retail customers in the finance sector by limiting trading of banks and hedge funds especially with respect to complex derivatives

Question 28

What are the main components of the Volcker Rule?

Answer 28

Prohibits banks from proprietary trading or holding any stake in a hedge fund or private equity house

Question 29

How does Mifid work?

Answer 29

It was setup with the intention of creating a single market in investment activities

Question 30

What changes did Mifid 2 bring?

Answer 30

Mifid 2 is mainly concerned with increasing transparency in investments and regulate OTC trading