Regulation is needed to help reduce any incidents of financial crisis, protect the consumers from fraud, ensure persons rights are withheld and ensures financial industries operate within legal and ethical boundaries. It is there as a safe haven for the poor who trust that banks would properly defend/protect their monies. What is the purpose of financial regulation? Financial regulation refers to the rules and laws firms operating in the financial industry example banks, credit unions and insurance brokers must follow. The purpose of financial regulation is to put rules in place to stop things from going wrong, and to safeguard the wider financial system and protect customers if things do go wrong. Who regulates banks and non-banking institutions? The ECCB (Eastern Caribbean Central Bank) regulates all banks and other financial institutions licensed under the Banking Act (2015). In Barbados the Financial Services Commission (FSC) are responsible for regulating non-banking institutions. Outline different approaches for measuring risks. Value-at-risk- provides the worst expected loss under average market conditions over a certain time period. Stress testing/ Sensitivity testing- techniques used by financial institutions to analyze the effects of exceptional but plausible events in the market. It overcomes the shortfall of VAR models. CAMELS- Capital adequacy, Asset quality, Management efficiency, Earnings & Profitability and Liquidity. This framework emphasizes the five parameters of the banking system by looking at its profits and loss statement to assess financial performance and balance sheet to assess the financial position of the banks. What role does deposit insurance play? Why was deposit insurance introduced? Deposit insurance plays a main role in managing bank failures. Its role is to stabilize the financial system in the event of bank failures, by assuring depositors that they will have immediate access to their funds even if the bank fails, thereby reducing a run on the bank. Deposit insurance was created to protect bank depositors and ensure a level of trust in the American banking system. Deposit insurance was introduced to protect bank depositors from losses caused by the bank’s inability to pay its debts when due. Deposit insurance is a part of the financial safety net which promotes financial stability. Objective of deposit insurance - - To provide an orderly means of compensating small depositors if the bank fails To reduce the probability of failure by reducing the risk of rumor-driven runs. (A run on the bank is when customers of a particular bank withdraw their deposits at the same time in fear of the bank’s solvency. Reduce fall out effects if failure does occur. Deposit insurance schemes should help to: - Define more clearly the role and extent of government support in protecting depositors. Protect uninformed small depositors from the risk of loss of their deposits and to protect the bank. Avoid speculative runs and protect depositors. Objectives of financial safety nets: - The prevention and resolution of systemic crises and the protection of depositors. When using financial safety net instruments, it is important to distinguish between the treatment of liquidity and solvency problems. The Central Bank (lender of last resort) and Deposit insurance provide financial safety nets for depositors. The role of the lender of last resort is to address liquidity problems. Deposit insurance’s primary role is to care for depositors if individual banking entities have solvency problems. How deposit insurance works - Cash deposits of all eligible accounts at the failed institution are aggregated and insured up to a maximum benefit amount. Deposits are not insured separately, hence all eligible accounts for everyone at different branches of the failed scheme are aggregated and insured amount issued. The deposit insurance would provide details on how the compensation will be made. Depositors do not need to file any claims. The DI would make an announcement through the TV, newspapers and at the affected bank or finance company. What is moral hazard and why is it used? Moral hazard deals with the behavior and attitudes of people. For example, a party protected from risk will act differently from if they were not protected. Those who have insurance may use it as a safety net or a justification to take on greater risks. What is adverse selection and why is it used? This deals with one party in a scenario have more accurate information about an aspect of product quality than the other and vice versa. Insurance tends to attract people most likely to take advantage of it. How to reduce moral hazard. - Deposit insurance should be explicit. Coverage should be low and restricted to certain types of deposits. If regulations are not clear both bankers and depositors tend to assume that authorities will bail out the banks and that deposits are therefore protected. Deposit insurance should be limited and inexpensive. How to reduce adverse selection. - The problem of adverse selection arises when there are deposit insurance characteristics that cause only weak banks to participate in the scheme. It can weaken the banking system precisely because it would end up protecting only the riskiest institutions. To guard against only weak banks joining the system, membership must be compulsory. Supervision – bank supervisors are charged with evaluating the safety and soundness of individual banking organizations. - The objectives of banking supervisors are to: Establish confidence in the financial system. Minimize the risk of losses for depositors and other creditors, License the provision of banking activities and Verify that a bank complies with the law. Types of supervision - Rule based- strict compliance of defined rules, based on historical analysis of the institution’s performance and case to case evaluation of individual operations. Risk based- emphasis on the activities developed by the institution (lines of business), the evaluation of risk profile is based on the institution’s capacity to manage risk and the implementation of adequate controls to mitigate them. Supervisory models Integrated approach- a single financial regulator is responsible for both safety and soundness and business conduct consideration. Twin peaks approach- this regime comprises two regulators, whose objectives are alternatively, systemic stability and market conduct and consumer protection. Prudential & Systemic- Central Bank Conduct of business, consumer protection- Securities Regulators. Why would a bank switch from using another approach to using the twin peak approach? Functional approach- pays no regard to the type of legal entity in question, but rather focuses on the types of transactions or products under regulation. One firm engaging in multiple types of transactions will be subject to multiple regulators. Institutional approach- focuses on the type of institution regardless of the product and services offered. It focuses on the form of legal entity under regulation and accordingly assigns a particular regulator. What is a loophole? A loophole is a way to get around regulation. People find loopholes to avoid their costs. Loopholes can be welfare-enhancing, offering regulated firms low cost compliance strategies. What causes loopholes? Complexity. Complex rules create incentives to bypass regulatory requirements created by the Dodd Frank Act or the Central Bank. Arbitrage is associated with loopholes in the law. Financial regulation imposes costs on the regulated, so regulation fosters incentives to avoid them. How to avoid loopholes? Consider the features of loopholes, keep it simple and less expensive. (the Dodd Frank Act has a number of loopholes) Define regulatory arbitrage. (Arbitrage taking advantage of low taxes or anything that has low prices.) Regulatory arbitrage is structuring products and services in such a way that it brings about the lowest regulatory burden and developing strategies to lower their costs. By focusing on the structuring of a financial product, a buyer can be protected. Forms of arbitrage - Evading regulatory requirements- the more rule-based regulation is, the more it is prone to loopholes. Shifting to another regulatory regime/country (most used) – favourable tax regulations in one country may attract a lot of financial business to these places. (Cayman Islands, Bermuda and Switzerland are tax haven countries. Shifting burdens to avoid taxes.) - Going beneath the radar – evading any regulatory regime. (Hegde fund industries are non-regulated industries that operate with the absence of regulation. Basically, utilizing an institution which does not bring about those fees and are not regulated. People utilize those industries and their funds as they would avoid taxes). This question is likely to come so know it well. If one of the large banks, JPMorgan Chase, Bank of America- fails, this Act would assist the bank supervisor in resolving the failed institutions and discuss two methods the regulator can use to resolve the failing banks. The Dodd Frank Act would assist in resolving the failed institutions such as the Bank of America, as this act seeks to protect consumers and taxpayers from the risks of investment. The purchase and assumption method can be used to resolve the bank’s failure. With this method a healthy institution purchases some or all the failing institution’s assets and assumes some of its liabilities. A new, temporary bank or financial institution is created and controlled in some cases by the financial services’ activity. Open bank assistance is another method where an insured bank that is in danger of failing receives assistance in the form of a direct loan, an assisted merger or purchase of assets. There is usually a change in management and requires substantial dilution of shareholder interest in the troubled institution. Mergers and acquisitions: a bank that experiences difficulties can be acquired by a healthy bank. (mainly a private sector solution). The Dodd Frank Act sought to protect consumers and taxpayers from the risks of investment. How does it work? The financial stability oversight council identifies risks that affect the entire financial industry. If any firms become too big, the FSOC will turn them over to the Federal Reserve. The act is designed to incentives whistleblowers to expose securities fraud. The Banking Act of 1933 did not make provision for the separation of two core bank activities. What are they and what was the name of the Act used to address loopholes? The Banking act 1933 did not make provisions for the regulation of bank holding companies and insurance companies. The name of the act used to address loopholes is the Dodd Frank Act of 2010 which was created after the Glass Steagall Act in 1933. This act aimed at mitigating loopholes in the financial industry, however, it eventually got its own loopholes. (The glass Steagall act did not approve of accepting deposits and making loans because its aim was to prevent banks use of deposits for speculation and prevent failed underwriting). Non depository institutions - Ally pay, fast cash(all payday loan) The loophole in the Glass Steagall Act caused the creation of the Dodd Frank Act. The Dodd Frank Act was created to improve accountability, transparency, and TBTF to protect consumers from abusive practices. (in relation to TBTF-The Dodd frank act identified risk in the financial industry, and any firm that is too big will be turned over to the Federal Reserve/ Central Bank who cause them to adjust their working capital). How can the Act improve accountability and transparency? The Act regulates credit rating agencies because these agencies help to fuel financial crises. Why? Because they give some institutions ratings they did not deserve. The Dodd Frank Act put measures in place to ensure transparency in their methodology and requires them to submit said methodology. What do credit rating agencies do? They seek firms and countries and assess their ability to repay loans. Examples of credit rating agencies in the Caribbean are standards & Poor’s and Moody’s. Example of how the Dodd Frank Act works, it seeks to protect homeowners by requiring better disclosure of what the loans were. Banks must prove that borrowers understand the risks. They also must verify the borrower’s income, credit history and job status. The Act provides for new regulations of financial institutions while attempting to keep accountable the companies who fell during the crisis. It makes it unattractive for firms too become too large and safeguards are set in place in event a large company decides to endanger the status of the economy. Five aspects of the Dodd Frank Act Consumer protection- (consumer financial protection bureau) was created to examine and enforce regulations for all businesses engaged in issuing residential mortgage products, as well as for issuers of other financial products marketed to poor people. Systemic risk- (the financial stability oversight council) was created to monitor markets for asset price bubbles and the buildup of systemic risk and assist in the orderly liquidation of troubled financial firms. (the financial stability oversight council requires countries to draw up a financial stability report) Derivatives – bans banks from some of their derivatives dealing operations and imposes capital and margin requirements on firms dealing in derivatives and forces them to disclose more information about their activities. (Futures, forwards, and options are derivatives. It is a contractual agreement which buffers you from risk, the possibility something will go wrong. Derivatives require standardization and require firms to disclose more information about their products. ) Resolution authority – has to do with if the institution fails how would the institution address it. Volker rule – limits the extent to which banks or institutions that own a bank can trade with their own money, limits them from getting too big. (addresses TBTF) Dodd Frank Act creates new agencies while merging and removing others. The objective is to increase oversight. This means that the Central bank needed to amend their act. What is receivership? The regulator assumes control of the institution. If the institution fails, the regulator will take over the institution and everything is controlled by them. The Dodd Frank Act is a method of regulatory reform. More regulation is good to prevent crises but too much is bad as it stifles a company’s ability to adhere to these regulations. Risk - defined as the probability of a particular event (or hazard) occurring and the consequent severity of the impact of that event. Pure risk - some chance of loss and no chance of gain (e.g., fire risk, flood risk, etc.) Speculative risks - feature a chance to either gain or lose (including investment risk, reputational risk, strategic risk, etc.). Examples of types of risks: credit risks, moral hazard, liquidity risk and systemic risk. How to measure risks Technical approaches - seek to anticipate physical harms, average events over time and space, and use relative frequencies to specify probabilities. Economic perspective Psychological approach- focuses on individual risk perceptions. Cultural Approach/theories - attitudes to risk vary according to cultural biases along with attitudes and beliefs shared by a group, allowing the development of no single measure by which different cultural biases towards risk can be compared. Solutions for regulating risks. Legitimate rationale: reduce the price distortion in the market and therefore let individuals face the ‘true’ costs of their actions. For example, consumers will think differently about purchasing houses in flood plains should they face the ‘real’ costs of insuring their property against flooding. Risk Based Supervision is the technique of Offsite monitoring and Surveillance. Value-at-Risk Provides the worst expected loss under average market conditions over a certain time interval at a given confidence level. VAR gives the risk manager a sense of what he or she can expect to potentially lose in a given time interval, assuming “normal” market conditions. Stress Testing/ Sensitivity testing are techniques used by financial institutions to analyze the effects of exceptional but plausible events in the market on a portfolio's value. Stress testing helps to: overcome the shortfall of VAR models, communicate extreme scenarios throughout the institution, thereby enabling management to take the necessary precautions (limit systems, additional capital, and so on). A rating system is one by which borrowers/facilities are systematically assigned to (grouped into) rating grades according to the credit risk characteristics (rating criteria or risk factors) of the borrowers/facilities. Types of rating systems Expert judgement-based system Model based system Hybrid rating system- uses expert judgement-based system with quantitative guidelines and model based system with judgmental overrides. CAMELS: This model consists of five indicators: Capital adequacy, Asset quality, Management efficiency, Earnings & Profitability and Liquidity. The CAMEL framework emphasizes on the five parameters of the banking system by looking at its profit and loss statement to assess financial performance and balance sheet to assess the financial position of the bank. De-Risking: • “De-risking refers to the phenomenon of financial institutions terminating or restricting business relationships with clients or categories of clients to avoid, rather than manage, risk.” 1. Provide a clear explanation of why regulation is needed to address the issues arising. You must include the payday loan regulation implicitly declared in the case. What is a payday loan? A payday loan is a loan granted to a person who does not have ready access to cash and needs money until their next paycheck within the next two weeks maximum. These loans can carry interest rates from up to 300 – 400 % and more, given that there is no restriction on the amount of interest that banks can charge. 2. How do we determine whether a payday loan is good or bad? To determine whether a payday loan is good or bad one must look at the interest rates on the loan, which are typically high. Knowing the repayment terms would ensure you repay on time without generating more fees and understanding your financial position before taking out the loan would let you know if you can afford to repay it. (justify each option listed in your own words)
