Lecture 8 Flashcards
Why must the financial sector be regulated?
Due to the presence of asymmetric information problems:
Adverse selection
Moral hazard
What is adverse selection?
A market situation where buyers and sellers have different info so that a participant might participate selectively in trades which benefit them at most, at the expense of the other party
E.g. used cars, insurance
What is moral hazard?
One party has not entered into the contract in good faith
Or had provided false details about its assets, liabilities or credit capacity
E..g borrowing/insurance, observe a change in behaviour
What do we aim to achieve with regulation?
- Protect the consumer against monopolistic exploitation
- Provide smaller, less informed, clients protection
- Ensure systematic stability
What is an example of network effects?
The use of a credit card company
The more a particular payment method is used and accepted as a medium of exchange, the _______ the ________________ that can be extracted by the providers of that standards
- Greater
- Monopoly rents
Monopolistic exploitation- what must the regulator ensure?
Fair and open competition
Reasonable access to these services
What are the different types of risks that consumers may face in their financial affairs?
Prudential risk
Bad faith risk
Complexity/unsuitability risk
Performance risk
What is prudential risk?
The risk that a firm collapses because of, for eg, inadequate capital
What is bad faith risk?
The trick from fraud, misrepresentation, deliberate misselling or failure to disclose relevant info
What is complexity/unsuitability risk?
The risk that consumers take on a financial contract that they don’t fully understand
What is performance risk?
The risk that investments don’t deliver the hoped returns
Is it the regulators role to insulate the consumers from performance risk?
No - this risk is permanent in financial products
What are banks’ roles in the financial system?
Allocate resources
Monitor borrowers
Play important roles in clearing and payments systems
How do banks allocate resources efficiently?
By screening borrowers and identifying firms with the most promising prospects
Why do banks monitor borrowers?
To make sure the funds are used properly
What are banks considered to be prone to, what does that mean and what does this lead to?
Prone to runs;
The threat of failure
Perceived threat
Leads to contagion effects absent in other sectors of the economy
Underpinning the regulatory system, ______ banks play a key role as the _________________ who is responsible for ____________________
- Central
- Lender of last resort
- The provision of liquidity under systematic crisis
If there’s a run on the banking system, the lender of the last resort provides what? What does this create and why?
The ultimate liquidity in order to stave off systematic failure
Created moral hazard bc banks know that they’ll be bailed out, so may ‘gamble for resurrection’.
What is the Bank for International Settlements (BIS)?
A international financial institution owned by central banks for foster international monetary and financial cooperation and serves as a bank for central banks
How does the Bank for International Settlements carry out its work?
Through its meetings programmes
Through the Basel Process - hosting international groups pursuing global financial stability and facilitating their interaction
Where is the Bank for International Settlements based?
Basel
Switzerland
Representative offices in Hong Kong and Mexico City
What are the difficulties of regulation?
Cost
Innovation and competition
Globalisation of markets
Capture
What are the costs of regulation incurred by?
The regulator and the regulated
Includes staffing of the regulatory office and
Development of guidelines
Costs of compliance
What’s the theory of regulation?
That the external costs of contagion should be internalised into the firms’ optimisation structures, equating the private and social costs
The regulatory environment may stifle the development of…? And what should it avoid as a result of this?
New, desirable products as a by products of the regulation of existing products
Should avoid creation of unnecessary barriers to entry of new firms
Th increasing international nature of markets calls for what?
International standards in excess of the informal arrangements
Or some level of harmonisation
Heterogenous levels of regulation do what to banks operating under the looser regulation?
Gives them a competitive advantage through lower costs of compliance
Make the assessment of counterparty risk more difficult
What is a concern about how regulators operate and why?
If they are operating in the best interest of the consumers
Bc they’re drawn from the financial sector and not from amongst consumers
What are the guiding principles of the new framework that was laid down in 1997 (establishing clear lines of responsibility)?
Accountability
Transparency
Non-duplication
Exchange of information
What is the HM Treasury responsible for?
The institutional structure of regulation as a whole
The legislation that determines it
When does the HM Treasury take responsibility?
When major systematic threats happen
When new legislative requirements arise
What does the HM Treasury have no responsibility for?
The Financial Services Authority (FSA)
Bank of England (BoE)
What was the Bank of England responsible for pre2007?
The overall stability of the financial system
The provision of liquidity
Stability of payments system
Acting as the lender of last resort
What was the Financial Services Authority responsible for pre2007?
Maintaining market confidence
Promoting public awareness
Protecting consumers
Reducing financial crime
A consensus has emerged that the ‘tripartite’ model of regulation had what?
Shortcomings that were a significant factor in the UK’s failure to predict or to adequately respond to the financial crisis
What is the Bank of England responsible for now?
Financial stability (at both macro and micro levels)
Which two new bodies support the BoE with its responsibility of financial stability?
The Financial Policy Committee at the macro-prudential level
The Prudential Regulation Authority (PRA) at micro-prudential level
What is the focus of the Financial Policy Committee now?
The macro economic and financial issues that may threaten long term growth prospects
Address any risks it identifies
How does the Financial Policy Committee address any risks it identifies?
By passing on its concerns to a new Prudential Regulation Authority (PRA) and Financial Conduct Authority
What is the Prudential Regulation Authority responsible for/what does it do?
The prudential regulation and supervision of banks, building societies, credit unions, insurers and major investment firms
Sets standards
Supervises financial institutions at the level of the individual firm
What is the goal of the Prudential Regulation Authority?
To promote safety and financial soundness of the firms it regulates
To contribute to the securing of an appropriate degree of protection for policyholders (specifically for insurers)
To achieve a healthy and successful economy
What does the Prudential Regulation Authority primarily focus on?
The harm that firms can cause to the stability of the UK financial system
What DOES the Financial Conduct Authority do?
Regulates financial firms providing services to consumers
Maintains the integrity of the UK’s financial markets
What does the Financial Conduct Authority focus on?
The regulation of conducts (i.e. misbehaviour) by both retail and wholesale financial services firms
What CAN the Financial Conduct Authority do?
Specify minimum standards
Place requirements on products
Investigate organisations and individuals
Ban financial products for up to a year while considering a permanent ban
