(7) REGULATIONS OF FINANCIAL INSTITUTIONS I

Core Reading
• ME, 17 & 18 or M Ch 10
• HSW Ch12

Financial Regulation Rationale: Asymmetric Information

• Financial intermediaries are well suited to solving adverse selection and moral hazard problems
o Make private loans avoids the free-rider problem
• Creates another asymmetric information problem:
o Depositors unable to assess the quality of the bank’s assets lead to panic as an insufficient
value of assets can lead to insolvency.

Bank Failure: Bank Run & Bank Panics

• Bank failure: when a bank is unable to meet its obligations to pay depositors and creditors
o Depositors need to wait until the bank is liquidated to get deposits
§ All assets sold
• Negative externalities of a bank failure:
o Information contagion:
§ One bank failure may trigger bank runs on other banks
o Balance sheet contagion:
§ Risk spill overs developing into systemic risks
o Disruptions of economic activities:
§ Financial crises
§ Large economic crises
• Companies can’t get loans to finance operations.
• If the public is uncertain about the banking system, they rush to withdraw their deposits & lending
early to secure payment (first come first serve)
o Everyone withdrawing early forces the bank to liquidate assets (fire sale) triggering further
uncertainty and another bank run
• Customers don’t know if the banks are taking on too much risk
o This can lead to a bank panic
§ Many banks fail simultaneously as people make bank runs on good & bad banks as
people’s panic is contagious

1. Regulation: Deposit Insurance

Safety net to prevent bank panics:
• USA:
o Deposit insurance is provided by the Federal Deposit Insurance Corporation (FDIC) with a
$250,000 limit
§ 1930-1933 (before FDIC) the average number of bank failures was > 2000/year
§ After FDIC (founded in 1934), average bank failures were <15/year until 1981.
• UK:
o Deposit insurance is provided by the Financial Services Compensation Scheme (FSCS) with
a limit of £85,000 (up from £75,000 on 30 Jan 2017)
§ Larger depositors suffer losses
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Unintended Consequences
• Creates moral hazard
o Incentives for banks to take on greater risk as they have insurance so bare less cost during
failure
• Creates adverse selections
o Fewer incentives for screening and monitoring borrowers
• Too-Big-To-Fail problem:
o Regulators don’t want to shut down large &systematically important banks
§ Government guarantees repayment of large, uninsured creditors of largest banks,
§ Depositor & Creditor don’t suffer losses
o Greater problems of moral hazard and adverse selection
o Financial consolidations generate more large banks and complex firm structures mixing
with other non-banking business

2. Regulation: Lender of Last Resort

• Lending through the central bank during a crisis
o Funds provided directly to struggling financial institutions
• Or nationalising a bank assuming all its liabilities
o Making sure depositors and lenders get their money back

Example: Bank Run

• Northern Rock on 13th September 2007
• The country’s 5th largest mortgage lender asked the Bank of England for emergency liquidity
support.
• This triggered the first major run on a British bank since the failure of Overend Gurney in 1866.
• On 22 February 2008, the bank was nationalised.
 (7) REGULATIONS OF FINANCIAL INSTITUTIONS I

Main Types of Financial Regulation

(1) Restrictions on Asset Holdings
• Reduces moral hazard problem
o As risky assets have a higher return potential
o Hard for depositors & lenders to acquire the bank’s risk information so cannot prevent the
bank’s activities themselves
• Therefore, government limits banks’ risky asset holdings e.g. common stock

(2) Capital Requirements

• Reduces moral hazard problem
• Higher capital requirements force institutions to take more care
o If it fails they will lose more capital
§ The leverage ratio must be >5%
• If <3% triggers regulation
• Limiting other off-balance sheet activities
o Banks are required to hold at least 8% of risk-weighted assets as capital

(3) Prompt Corrective Action

• Well-capitalised banks (exceed minimum requirement) are given priveleges e.g. allowed to
underwrite securities
• Under-capitalised banks are unallowed to pay interest on deposits with higher than avg. interest
rates
o And required to submit corrective action plans

(4) Financial Supervision: Chartering & Examination

• New institutions are screened to prevent undesirable people from controlling them
o Required to submit quarterly call reports to reveal assets & liabilities etc.
o On-site examinations studying bank books
§ Assessment of Risk Management
• Assess bank books, management, asset holdings

(5) Disclosure Requirements

• Regulators require financial institutions to follow standard accounting principles
o Disclose a range of information helping to assess the quality of an institution’s portfolio &
the amount of risk exposure
o SEC (Securities & Exchange Commision) requires files such as annual reports with income
statements, balance sheets and cash flow statements

(6) Consumer Protection

• Global crisis showed the need for consumer protection, as many borrowers took loans without
understanding terms
o Consumers may not have enough information to protect themselves
• Requires all lenders to provide information about the cost of borrowing, including standardized
interest rate (called the annual percentage rate, or APR) & the total finance loan charges.

(7) Competition Restrictions

• Falling profitability resulting from more competition can incentivise financial institutions to take
more risks to maintain profit levels.
• Branching Restrictions
 (7) REGULATIONS OF FINANCIAL INSTITUTIONS I

o Prevented nonbank institutions from competing with banks

o Not allowed to engage in banking business
• Improved health of banks, but had disadvantages:
o Higher charges to consumers and decreased efficiency of banking institutions
§ Asymmetric information was a rationale for anti-competitive regulations but was
not always beneficial
§ Recently, government efforts in industrialized countries to restrict competition
have reduced

Interbank Exposures and Balance Sheet Contagion

Network Analysis: Systematic interbank exposures
• Banks borrow and lend money to/from other banks too
• If one bank goes insolvent, it cannot pay back its debt to another bank which may lead to that
bank also becoming insolvent as the value of its assets falls etc. (further effect)

Bank Capital as Cushion for Asset Losses

Consider two banks:

Assume both banks lose $5m from bad loans

• The low-capital bank is now insolvent as it has negative capital and is unable to pay back the
$5m.
 (7) REGULATIONS OF FINANCIAL INSTITUTIONS I

Bank Capital as Opportunity Cost

Capital , EM , ROE
(The more money you keep in reserve, the less money you have available to invest to earn a profit)

Financial Ratios:

!"# %&'()#*
• Return on Assets (bank profitability) ROA = +**"#*

!"# %&'()#*
• Return on Equity (investor’s profitability) ROE = ,-.)#/
= 𝑅𝑂𝐴 ∗ 𝐸𝑀
+**"#*
• Equity Multiplier (Leverage) EM = ,-.)#/ 012)#13

Given the return on assets, the lower the bank capital, the higher the return for the owners of the
bank

Suppose for both banks that ROA = 1%

• High Capital Bank:

• Low Capital Bank:

Bank Capital: Trade-of and Policy

A trade-off in holding bank capital:
• Higher capital increases the security for insolvency
• Higher capital (relative to asset) increases the opportunity cost of profit, so less profit is made
• To increase ROE (increase EM so reduce capital or increase assets):
o Reduce bank capital by buying back the bank’s stock
o Reduce bank capital by paying higher dividends from retained earnings
o Keep capital the same, but issue more loans or CDs
 (7) REGULATIONS OF FINANCIAL INSTITUTIONS I

Basel Committee on Banking Supervision: international agreements in response to the financial crises,
banks are required to hold a minimum level of capital:

• Risk Weighted Assets (RWA): a proxy for the potential to generate unexpected losses (some
assets are safer, others are riskier)
• More important banks that would impact the economy are required to hold higher levels of
capital reserves

Basel III: Bank Capital and Risk-Weighted Assets

• Three types of capital

Current CRD & CRR capital requirements

• CET 1 capital ratio of 4.5% (CET 1 capital as %-age of total risk-
weighted assets)
• Tier 1 capital ratio of 6% (Tier 1 capital as %-age of total risk-
weighted assets)
• Total capital ratio of 8% (own funds as %-0age of total risk-
weighted assets)

If I have $100m and am investing in AAA assets, then to work out

the capital reserve needed, calculate the 8% (minimum
requirement) of the 20% of your investment.
i.e. $100m*0.2*0.08 = $1.6m

Basel III: Liquidity Regulation Measures

Banks are required to hold a minimum level of liquid assets and stable funding:
 (7) REGULATIONS OF FINANCIAL INSTITUTIONS I

• Liquidity Coverage Ratio (LCR)

• The Net Stable Funding Ratio (NSFR)

Basel III: Liquid Assets and Stable Funding

• Assets that qualify as ‘liquid’
 (7) REGULATIONS OF FINANCIAL INSTITUTIONS I

Example: Bank Capital, Stress Tests & Liquidity Ratios

• Banks started the stress test with a strong capital position in aggregate, and even at the low point
remain some way above the reference rate.