week 3

• Regulation is done to constrain the use of monopoly power and maintain market integrity
• Constraining monopoly power ensures that big players are not allowed to perform actions that reduce the welfare of the public
• Regulation is done to protect the essential needs of ordinary people, where mistakes could devastate welfare
• Regulation is done to correct the market to prevent events where the cost of market failure exceeds both private costs and the cost of regulation
• The banking sector is the most heavily regulated sector because the risks of financial failure are significant on the wider economy
• The financial sector has a significant maturity mismatch, with assets (loans) being longer term and riskier than liabilities (deposits)
• The failure of one institution can reduce confidence in the whole system
• The financial sector is heavily regulated because financial institutions trade much more among themselves compared to other sectors
• In the case of higher risk, financial institutions may restrict credit to improve liquidity ratios, which can raise the probability of default of other borrowers, weaken the economy, and reduce societal welfare
• The Domino model involves bank A borrowing from bank B who borrows from bank C, creating a chain where if A defaults, B will suffer losses and potentially default as well
• The Domino model assumes that asset prices are fixed at their book values, which is unrealistic as asset prices do change
• The Domino model also assumes that Financial Institutions (FIs) are passive and do not react to other banks' failures, which is unrealistic as FIs take action when anticipating events
• Contagion in the Domino model occurs through asymmetric information, where depositors become concerned about the safety of their deposits and withdraw their deposits from banks that have not yet defaulted, leading to the failure of initially uninvolved banks
• Loss Spiral involves the value of assets being valued using marked-to-market valuation, so price changes as the stock market changes
• In a downturn, asset price falls, so banks experience a loss
• Losses in the loss spiral reduce funding liquidity because there is a loss of trust in companies to repay loans
• This loss of trust means Financial Institutions (FIs) must sell assets, which further reduces asset value and worsens the spiral
• In 2002, there was a loss spiral within the life insurance sector in the European life insurance market
• Reducing stock prices triggered regulatory constraints, leading insurers to sell stocks to reduce risk exposure, which further decreased prices and set off a loss spiral
• Regulatory constraints involved insurance companies having to pass resilience tests to ensure solvency even in a 25% market downturn
• The insurance crisis was alleviated through a temporary suspension of solvency resilience tests
• The government has safety nets in place to prevent bank panic, runs, and a deterioration of trust within the banking system
• The government can act as a lender of last resort by directly lending money to institutions via the central bank to bail out banks and provide liquidity support
• Deposit insurance is given by the government to guarantee the first £85,000 depositors money in a bank if a bank fails, reducing the risk of bank runs
• The government acts as a safety net through recapitalisation of troubled banks
• The government safety net introduces a Moral Hazard because financial institutions are incentivised to take excessive risks, knowing they will be bailed out if necessary
• Financial intermediaries do not impose as much discipline under the government safety net, as they know they will not suffer losses if the institution fails
• The government safety net is attractive to risk-loving entrepreneurs, leading to adverse selection
• The 'too big to fail' issue arises when the failure of large institutions would cause major financial disruption, so the government guarantees repayment of large uninsured creditors
• Adverse selection occurs as there is less reason to monitor financial institutions' activities, making it easier for them to engage in fraud and embezzlement
• As financial institutions become more interconnected, more are classified as 'too big to fail,' increasing moral hazard incentives and the fragility of the financial system
• The government safety net is being considered for extension to new activities such as security underwriting, insurance, and real estate activities
• Restrictions on risky assets are imposed by the government to reduce risk-taking and promote diversification
• Risky assets provide Financial Institutions (FIs) with higher earnings if they pay off, but if they don't and the FI fails, everyone loses
• Risk-based capital requirements require banks to hold a certain amount of capital as a proportion of their risk-weighted assets as capital buffers
• Risk-based capital requirements are set so that FIs must hold more equity capital against higher-risk assets
• Direct Financial Supervision (prudential supervision) oversees the operations and actions of FIs to reduce moral hazard and adverse selection
• On-site examination means banks are given CAMELS ratings, which regulate bank behaviors and can lead to the closure of a bank if their rating is low enough
• CAMELS rating stands for:

  • Capital adequacy
  • Asset quality
  • Management
  • Earnings
  • Liquidity
  • Sensitivity to market risk
• Disclosure requirements mean regulators require FIs to follow specific accounting principles and disclose a range of information to reduce the free rider problem