Topic 6: Regulation, Financial Regulation And Central Banking

Front 1

Regulation:

Command and Control

Back 1

Involve the imposition of differentcriminal sanctions.

Benefits:

- Clear and strong sanctions against certain unwanted acts

- Strong political act using law to support public.

Problems:

- Potential for regulatory capture

- Legalism - growth of complex rules

- Enforcement of law can be expensive and complex.

Front 2

Regulation:

Self-regulation

Back 2

- Common in the professions

- Cheap and has a high commitment of firms

Problems:

- distrust

- enforcement difficult

Front 3

Regulation:

Incentive-based regimes

Back 3

- use of economic incentives

- i.e. subsidies, taxes

- these approaches to not demand enforcement or monitoring, and hence no regulators.

- Easily avoided or ignored

- These incentives may take a very long time to become affective and impact hard to predict.

Front 4

Central Bank: key roles

Back 4

1. Manage monetary policy and ensure price stability or low inflation.
   
2. Regulate the financial system (to ensure market and institutions operate in an orderly manner).

Front 5

Open Market Operations

Back 5

Involves a central bank selling or buying government debt to/from the private sector to increase or reduce short term interest rates.

=> CB sells govt securities the MS decreaes, I increases.

=> CB buys govt securities the MS increases, I decreases.

Front 6

Other forms of monetary policy

Back 6

Special deposits:

Moral suasion: CB will make informal requests to alter bank behaviour (often over lunch)

Direct controls over interest rates

Front 7

Expansionary Monetary Policy

Contractionary Monetary Policy

Back 7

Expansionary:

- open market purchases by CB

- discount rate decreases

- reserve requirement ratio decreases

Note: the application of monetary policy has become more challenging due to growth in number of financial firms, and the amount of "hot money" flowing from one financial system to the next. (due to hedge funds and internationalisation due to liberalisation).

Front 8

CB: The Lender of Last Resort

Back 8

This may encourage moral hazard, as banks which are "too big to fail" act recklessly knowing the CB will bail them out.

Front 9

International Roles

Back 9

• Bank for International Settlements (BIS): acts as a bank for CBs and a forum for discussion of pressing concerns.
• Basel Committee
• International Monetary Fund (IMF)
• OECD
• World Bank (for developing nations)

Front 10

Future for Central Banks (CBs)

Back 10

Internationalisation of financial markets has made it difficult to control inflation in last 20 years.

CBs reluctant to intervene with price bubbles because they believe the market is efficient, and that intervention would be ineffective.

In the future, CBs must ensure financial stability more robustly through regulation and commentary on events.

New polocy tools: quantitive easing & TARP fund of Fed.

Front 11

Nature of Financial Regulation

Back 11

• Ensuring orderly markets (release of info)
• Market confidence (capital adequacy, dealing with market manipulation, insider trading/ fraud
• Systemic stability and spill-over risks.

Front 12

The need for Financial Regulation

Back 12

• Scams
  
• Obfuscation: wilfully ambiguous
• Front running: buying stocks ahead of clients
• Churning: high turnover of stocks to generate commission on portfolios managed
• Conflicts of interest
• Incentive problems
• Accounting frauds

Front 13

Types of Financial Regulation

1) macro-prudential or Systematic Regulation

2) micro-prudential or Prudential Regulation

3) conduct of business

Back 13

(Macro) Systematic regulation:

• Reduce potential of financial crash.
• Often involve govt intervention to provide deposit insurance and act as a lender of last resort, bailout institutions.

(Micro) Prudential Regulation:

• Ensuring firms don't become insolvent before contracts are fulfilled.
• Monitor by assessing quality and capital adequacy.

Conduct of Business Regulation

• ensure markets operate in fair and orderly fashion.
• provide retail customers with protection
• protect customers from bad investment advice.

Front 14

Forbearance

•Regulatoryforbearance: renegotiation of regulation to solve time inconsistencies.

Back 14

Time inconsistency of regulation when remedies to a problem ex-post (after an event) are sub-optimal whilst the same regulation may be optimal ex-ante (before the event occurs).

•Theexerciseof regulatory forbearance can reduce problems of adverse publicity, potentialreductions in public confidence and political costs of seeing a firm go out ofbusiness.

•Byexercising forbearance moral hazardproblems may arise as firms ignore regulations.

Front 15

Cost of Regulation & Reg. Capture

Back 15

• Compliance Costs (often passed onto consumers)

• Regulators Capture

Capture: Regulators pursue interests of industry they regulate.

If the public interest ins poorly defined, this may allow private interests to be reflected in regulators actions.

Front 16

Problems with Basel 1

(Capital requirements)

Back 16

• Too focused on credit risk
• Failed to account for market risk
• 1996 Basel Committee permitted large banks to estimate amount of capital necessary to cover market risk. -> Used VAR (criticised)

Companies found ways around Basel 1:

• Capital arbitrage; sell best quality loans and keep riskiest.
• Securitization; appeared to turn risky loans into safe bonds justified by high credit ratings coming from questionable credit enhancers.
• "One size fits all" approach to capital regulation; Basil 1 failed to recognize that no two banks are alike in terms of risk profiles.

Front 17

Basel 2

Back 17

Set up a system in which capital requirements would be more sensitive to risk and protect against more types of risks.

• Added operational risk
• Promoted banks internal risk mgmt methodologies
• Incorporated supervisory review and market discipline as part of risk assessment.

=> gradually phased in for largest international banks.

Front 18

Three Pillars of Basel II

Back 18

1. Minimum capital requirements

2. Supervisory review process

3. Market discipline. i.e. prudent management and transparency in reporting.

Front 19

Basel III

Back 19

- Improving capital base

- Higher capital requirements

- Pro-cyclicality

- Enhanced risk coverage. Stress testing of on and off balance sheet risks to better account for counterparty risk.