MGT 470 Ch 14 Financial Regulation (cs3ed) v1.0 Nov 15
Ch 14: Financial Regulation
The Need for Financial Regulation
The main reason for financial regulation is due to information
asymmetry; parties to a financial contract do not have the same
information
Information asymmetry leads to…
 adverse selection in which one party has a potential advantage
over the other
 moral hazard in which one party takes more risk at the expense
of some other party
The factors above compel the govt’ to:
 protect investors
many of whom are unable to judge the soundness of their
financial institutions
while competition is supposed to discipline all institutions in the
industry, in practice, only force of law can ensure a bank’s integrity
small investors rely on the govt’ for protection against
mismanagement and malfeasance
 protect bank customers from monopolistic exploitation
the tendency for small firms to merge into larger ones reduces
competition and ultimately creates monopolies
monopolies exploit their customers by raising prices to earn
unwarranted profits; reduced competition allows this
The govt’ intervenes to prevent financial institutions from
becoming too large and force even large banks to face competition
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MGT 470 Ch 14 Financial Regulation (cs3ed) v1.0 Nov 15
The Need for Financial Regulation (continued)
The factors above compel the govt’ to: (continued)
 safeguard the stability of the financial system
the combination of liquidity risk (what’s this?) and information
asymmetry means the financial system is inherently unstable
a financial firm can collapse much more quickly than an
industrial company
a financial firm can create and destroy the value of its assets in an
astonishingly short period and a single firm’s failure can bring down
the entire system
the govt’ provides a safety net for small depositors, i.e. FDIC
the govt’ is also the “lender of last resort” to major financial
institutions
but the lender of last resort option may encourage financial
institutions to take on too much risk so the govt’ provides regulation
and supervision to minimize this
The Government Safety Net
The safety net can (and has) stopped bank panics and banks runs
The safety net has two parts: Federal Deposit Insurance Corporation
(FDIC) and the “lender of last resort” function
The FDIC uses two primary methods to handle a failed bank:
 “payoff method” allows the bank to fail and pays off
depositors up to $250k
 “purchase and assumption method” in which the FDIC
reorganizes the bank, typically by finding a willing partner who
assumes the bank’s liabilities
“Lender of last resort”
 funds are provided directly from the treasury to the troubled
institution
 institutions requesting such assistance subsequently usually
receive considerable govt’ scrutiny
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MGT 470 Ch 14 Financial Regulation (cs3ed) v1.0 Nov 15
Moral hazard and the govt’ safety net: Since depositors and creditors
know they have some measure of “insurance” if a bank fails, they tend
not to enforce sufficient discipline on financial institutions
Adverse selection and the govt’ safety net:
 since financial institutions have a safety net upon which to fall
back on, they may be tempted to make riskier investments than
the would otherwise do; the risk is passed on to the tax payer
 the existence of the safety net may attract criminals to the
financial industry
Financial consolidation and the govt’ safety net:
 the Riegle-Neal Interstate Banking and Branching Efficiency
Act of ‘94 and the Gramm-Leach-Bliley Financial Services
Modernization Act of ‘99 have lead to larger and more complex
financial organizations
 the increased size of financial institutions as a result of
financial consolidation increases the “to big to fail” problem; this
increases the moral hazard and adverse selection problem
 the consolidation of banks with other financial services firms
means that the govt’ safety net may be extended to previously
uncovered activities such as securities underwriting, insurance
and real estate; this extends the scope of the moral hazard and
adverse selection problem
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MGT 470 Ch 14 Financial Regulation (cs3ed) v1.0 Nov 15
Regulation and Supervision of the Financial System
Government officials employ two strategies to mitigate the risks
created by the government safety net
Government Regulation establishes specific rules for financial
intermediaries to follow
The goal of govt’ regulation is not to eliminate all risks that
investors face
The goal is to minimize the cost of financial crises to tax payers
Banks and other financial intermediaries are regulated by a
combination of various federal and state organizations
 commercial banks: FDIC, Office of the Comptroller of the
Currency, the “Fed” and state authorities
 savings banks/savings & loans: FDIC, Office of the
Comptroller of the Currency, and state authorities
 credit unions: National Credit Union Administrations and state
authorities
Regulatory competition:
 regulators force each other to innovate, improving the quality
of regulation
 allows bank manager to “shop” for the most lenient regulators
Example: AIG was supervised by the small U.S. Office of Thrift
Supervision (OTS) which also supervised Countrywide
Mortgage, IndyMac and Washington Mutual, all of which failed
during the financial crisis of ‘07’09. OTS had little experience
supervising the insurance business. AIG qualified for OTS
supervision by buying a small savings bank years earlier
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MGT 470 Ch 14 Financial Regulation (cs3ed) v1.0 Nov 15
Regulation and Supervision of the Financial System (continued)
Government Regulation (continued)
Shadow Banking System:
These are non-bank financial intermediaries that provide services
that compete with or substitute for those provided by traditional banks,
i.e. brokerage firms, consumer and mortgage finance firms, insurance
firms, investment companies (hedge funds & private equity firms),
money-market mutual funds (MMMFs) and bank-created asset
management firms called special investment vehicles (SIVs)
Emergence of these types of firms is the result of the acts of law
cited on p.3
Since these types of firms are relatively new, regulatory agencies
have less experience regulating them
The Securities Exchange Commission (SEC) and the Commodity
Futures Trading Commission (CFTC) provide some regulation of the
shadow banking system
Asset Holding Restrictions and Minimum Capital Requirements
One way to prevent banks from exploiting the safety net is to restrict
their balance sheets
Restrictions on the type of assets a bank can hold:
 U.S. banks cannot hold common stock
 U.S. banks cannot hold bonds rated below “investment grade”
(below BBB- S&P and Fitch rating system)
 holdings from any single bond issuer cannot exceed 25% of
the banks total capital
 size of loans to any single borrower cannot exceed 25% of the
banks total capital
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MGT 470 Ch 14 Financial Regulation (cs3ed) v1.0 Nov 15
Regulation and Supervision of the Financial System (continued)
Government Regulation (continued)
Asset Holding Restrictions and Minimum Capital Rqmts (continued)
Minimum Capital Requirements
 a bank’s capital represents its net worth to its owners What is
“capital” in this context?
 capital serves as a cushion against declines in the value of the
bank’s assets
 banks are required to keep their ratio of capital to assets
(capital divided by total assets) above some minimum level; this
is called the “leverage ratio”
a leverage ratio of 5% is considered “well capitalized”
a leverage ratio of below 3% triggers increased regulatory
restrictions on the bank
 banks are also required to hold capital in proportion to the
riskiness of their operations
a bank must compute the risk-adjusted level of its assets
a capital charge is assessed against this level
the rules for this are very complicated
banks have learned to “game” this rule; i.e. they buy securities
assessed as high grade which really aren’t
Disclosure Requirements
Banks and other financial intermediaries are required to provide…
 information to customers about the cost of their products:
this is the “small print” on bank products and service agreements
this is the nominal interest rate on a loan
the fees they will charge for products & services
 balance sheets and other financial statements to investors and
financial markets; this allows regulators and financial markets to
asses the quality of the bank and the riskiness of their holdings
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MGT 470 Ch 14 Financial Regulation (cs3ed) v1.0 Nov 15
Regulation and Supervision of the Financial System (continued)
Government Supervision
The goal is to reduce adverse selection and moral hazard
Supervision is done remotely using detailed reports banks are
required to file and through on-site examination
Every depository institution that is insured by FDIC is examined at
least once a year; examiners arrive unannounced
Supervisors use the following criteria to evaluate the financial health
of the banks they monitor
 capital adequacy
 asset quality
 management adequacy
 earnings
 liquidity
 sensitivity to risk
Challenges to Supervisors and Regulators
Due to legislation cited on p. 3 and other legal changes, commercial
banks are not just banks; they have become investment banks,
insurance companies, and securities firms all rolled into one
 different bank functions are supervised by different agencies,
both functionally and geographically
 examples include Bank of America, Wells Fargo, JPMorgan
Chase and Goldman Sachs
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MGT 470 Ch 14 Financial Regulation (cs3ed) v1.0 Nov 15
Regulatory Reform: The Dodd-Frank Act of 2010
The Dodd-Frank Wall Street Reform and Consumer Protection Act
imposes the most far-reaching changes in U.S. financial regulation
since the 1930’s
Four main goals:
Strengthening the financial system
encourage transparency and simplicity
forbids depository institutions from engaging in a variety of
risky activities such as trading securities for their own accounts,
investing in private equity funds and owning hedge funds
increases the liability of credit rating agencies for rating errors
and compels greater disclosure to limit these agencies’ conflict of
interest
requires firms that originate and distribute asset-backed
securities to have a vested interest in these securities through
partial ownership
Preventing crises through systemic risk management
 establishes a “super committee” of top regulators (the
Financial System Oversight Council – FSOC) which aims to
identify and forestall threats to the system
has the authority to designate certain firms as systemically
important financial institutions (SIFIs) making them subject to
enhanced oversight by the “Fed”
has the authority to close down SIFIs if they gravely threaten the
financial system
establishes the Office of Financial Research (OFR) which
expands regulator’s data gathering and analysis capacity to
support FSOC
Ending “Too Big to Fail”
Reducing Moral Hazard
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MGT 470 Ch 14 Financial Regulation (cs3ed) v1.0 Nov 15
Regulatory Reform: The Dodd-Frank Act of 2010 (continued)
Weaknesses:
Fails to sufficiently streamline the U.S. regulatory apparatus
Many govt’ guarantees still largely come for free; failure to charge
fees commensurate with the risk sustains moral hazard
The act largely ignores key shadow banks like MMMFs
It is unclear whether provisions in the act will substantially reduce
the “too big to fail” problem
Why should you care about financial regulation?
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