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Financial Institutions and Regulations > Regulation of banks > Flashcards

Regulation of banks Flashcards

1
Q

What are the three main differences between banks and non-financial firms ?

A
  • Banks engaged in maturity transformation
  • Banks finance loans typically characterized by asymmetric information
  • Cusomers of bank = creditors
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2
Q

What are the consequences about banks as maturity transformators ?

A
  • Inherently unstable and prone to liquidity crises

* Risk of financial contagion

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3
Q

What is the consequence about banks as delegated monitors ?

A
  • Banks’ assets = opaque + hard to value for outsiders

* Huge liquidation costs due to loss of information capital

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4
Q

What is the consequence of customers being the banks’ creditors

A

Banks are financed by large numbers of uninformed depositors.

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5
Q

What are the justifications behind bank regulation ?

A
  • Market failure
  • Customer protection
  • Favoritism of interest groups and other pollical reasons
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6
Q

Why do banks emerge ?

A

Because they reduce market imperfections mainly caused by asymmetric information

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7
Q

What happens when a bank suddenly fails ?

A

It confronts its customers and the public with the market imperfections

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8
Q

What are the strong negative externalities of bank failures ?

A
  • Contagion may affect other institutions without any direct links to failing bank
  • Failing bank’s borrowers face sudden refinancing + liquidity problems as loans = opaque and cannot be easily transferred to other institutions
  • Costs of default inflicted upon small uninformed depositors may be politically unacceptable
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9
Q

Why do negative externalities cause market failure ?

A

Banks ignore costs of negative externalities when making economic decisions

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10
Q

What happens as government and/or central bank rescues large banks to prevent contagion and liquidity crises in real sector ?

A
  • Large banks enjoy implicit subsidies as creditors anticipate government aid
  • Anticipation of eventual government aid induces moral hazard + gives banks incentive to take excessive risks
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11
Q

What are the reasons behind customer protection ?

A
  • Non-financial firms usually financed by professional, well-informed creditors
  • In contrast, banks finance themselves in large parts with deposits from small uniformed and dispersed agents
  • Deposits and payment services offered by banks play crucial role in economic transactions
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12
Q

What are the main problems affecting public regulation in practice ?

A
  • Regulatory capture
  • Forbearance
  • Biased objectives
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13
Q

What is the problem with the regulatory capture and public regulation ?

A

Authorities advance concerns of sector they regulate instead of pursuing optimal regulation

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14
Q

What is the problem with the forbearance and public regulation ?

A

Authorities try to avoid conflicts or to cover up own mistakes

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15
Q

What is the problem with the biased objectives and public regulation ?

A

Authorities follow policial goals such as promoting national champions instead of implementing optimal regulation.

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16
Q

What are the two tools of public regulation for maintaining financial stability ?

A
  • Preventive (ex-ante) measures

* Curative(ex-post) measures

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17
Q

What are the objectives of the preventive measures ?

A
  • Aim at increasing banks’ safety and soundness

* Reduce potential for contagion

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18
Q

What are the curative measures’ objectives ?

A
  • Support banks to avoid failure

* Reduce fallout of eventual failures

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19
Q

What is meant by asset restrictions ?

A

Banks either required to hold certain assets or restricted from certain investments as for example :

  • Requrirement to hold bonds
  • Restrictions on holding shares
  • Encadrement du crédit
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20
Q

What are the drawbacks from asset restrictions ?

A
  • Regulator has to determine assets too risky to hold

* Likely to be misused for political goals

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21
Q

What is meant by restrictions on activities ?

A

Banks prohibited from undertaking certain activities or offering certain products

22
Q

What are the advantages and disadvantages of restrictions on activities ?

A

• Advantages
o Separation of retail/commercial banking from investment banking reduces risk of cross-contamination
o Better allocation of resources form societal perspective

• Disadvantages
o Less diversification
o Loss of synergies

23
Q

What are the consequences of the advantages of restrictions on activities ?

A
  • High private return investment banking may crowd-out resources from high societal return commercial banking
  • Avoid cross-subsidization of investment banking activities via cheap funding obtained from deposit taking
24
Q

What is meant by limits on interbank-competition ?

A

Limit competition in banking sector and create rents for banks

25
Q

What are the various regulatory tools ?

A
  • Asset restrictions
  • Restrictions on activities
  • Limits on interbank-Competition
  • Limits to large exposures
  • Liquidity requirements
  • Capital requirements
  • Deposit insurance
  • Lending of last resort
  • State guarantees and bail outs
26
Q

What is the potential trade-off between financial stability and full competition ?

A
  • Banks’enjoy limited liability + have private knowledge about risk of their opaque assets
  • Value of banking licenses increases if competition limited and banks can earn rents
27
Q

What is the consequence to the bank’s enjoy limited liability and private knowledge about their opaque assets ?

A

Incentive for banks to take excessive risks at public’s and uninformed depositors’ expense

28
Q

What are the consequences of banking licenses ?

A
  • Failing and loosing banking license more costly in case of limited competition → less excessive risk taking
  • Limited competition may lead to higher financial stability
29
Q

What is Keeley’s empirical stragegy ?

A

• Analyze risk taking behavior of 150 largest US bank holding companies between 1970 and 1986

• Measure market power using Tobin’s q :
q = Mkt value / book value
→ Banks with mkt power earn rents and exhibit a high q

30
Q

What is the simultaneity problem faced by Keeley ?

A

Mkt value is itself influenced by bank’s risk taking decision
→ Banks take more risk because increases mkt value
Use regulatory changes as instruments : influence mkt power q but are independent of banks risk taking decision

31
Q

What were Keeley’s main results ?

A
  • Mkt power negatively related to degree of liberalization in banking sector
  • Mkt power has large and significantly effect on banks’ risk-taking behavior
32
Q

Why do newer empirical studies question Keeley’s results ?

A
  • Interest rate shocks = main cause for increase in bank failures in 1980s & 1990s
  • Financial risks = mainly interest rate & exchange rate risk → generally increased after Bretton-Woods-System’s demise

→ Translate into higher risk in banks’ BS

33
Q

What are the policy implications of the limits Interbank-Competition

A
  • Limits on competition in banking sector may not be worth efficiency costs
  • However, banks in liberalized mkts should be monitored closely as banking crises often occur after deregulations

→ Special emphasis on large exposure limits, liquidity regulation and especially capital requirements

34
Q

What is meant by limits on large exposures ?

A

Limit maximum exposure vis-a-vis an individual counterparty in order to :
• Ensure diversificaiton

• Mitigate risk of contagion

35
Q

What is the aim of liquidity requirements ?

A

Aim at ensuring banks have enough liquid funds to cover eventual outflows

36
Q

What does liquidity requirements prevent ? And why is it especially important ?

A
  • Mitigate risk of contagion

* May be especially important if competition amon bank is intense as holding liquidity has opportunity costs

37
Q

What is the objectif of capital requirements ?

A

Strengthen banks’ safety and soundness by requiring adequate loss.absorption capacity

38
Q

What are the aims of deposit insurance ?

A

Ex-ante as well ex-post tool that aims at two goals :

  • Ex-ante : preventing bank runs by reassuring depositors
  • Ex-post : reducing depositors’ losses in case of failure
39
Q

Why is the government the natural and most credible provider of deposit insurance ?

A

Due to its ability to tax

40
Q

When does deposit insurance represent an implicit subsidy ?

A

When it is priced below actuarially fair premium

41
Q

When does deposit insurance induce moral hazard ?

A

When the premium is not correctly adjusted for risk

42
Q

Who is the lender of last resort and why ?

A

Central banks because of its ability to create money

43
Q

What is meant by state guarantees & bailouts ?

A

In case of insolvency, government injects capital into bank or provides guarantee for all or some of banks’ liabilities

44
Q

What is meant by the bank’s problems are resolved in an orderly fashion ?

A

Without undue costs for real economy and stress for financial system

45
Q

What are the tools available to solve the banks’ problemes in an orderly fashion ?

A
  • Debt restructuring
  • Merger
  • Bridge bank
  • Wind down/liquidation
46
Q

What are the advantages and drawbacks of self-regulation ?

A

Advantages
• Lower costs and higher efficiency
• Higher flexibility and speed
• Better acceptance within industry

Drawbacks
• Potential for conflicts of interest
• Risk of creating mkt power
• Lack of transparency

47
Q

What is the main intuition of the self-regulation’s theoretical model (DeMarzo) ?

A

Large number of agents compete and offer contracts in which repayment to customers depends on risky cash flow
• Realization of CF = privat information to agents
→ Moral hazard : agents misreport realized CF
→ Agents need to be disciplined, otherwise no trade

48
Q

What are the two possibilities to discipline the agents and avoid misreporting in DeMarzo’s model ?

A
  1. Carrot: offer agents bonus directly depending on realized CF and allows to earn rents
  2. Sich: Perform investigations and sanction misreporting agents

→ Agents prefer carrot which allows to earn rents

49
Q

What is meant by the fact that SRO and government can perform costly investigations ?

A
  • SRO = cost efficient but acts in agent’s interest
  • Government = inefficient but acts in customers’ interest

→ SRO confers mkt power to agents by favoring rents over investigations
→ Government relies more on investigations but is inefficient

50
Q

What is the solution to increase investigations performance ?

A

SRO with government insight:

  • SRO in charge of performing cost efficient investigations
  • Government oversees SRO and threatens to step in if SRO implements too lax investigation policy

→ Governement’s threat forces SRO to choose stricter investigation policy that gives agents less mkt power

Financial Institutions and Regulations (11 decks)

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