Chapter Four & Five: Economic Analysis of Banking Regulation & Non-Bank Finance PDF

Chapter Four Economic Analysis of Banking Regulation  INTRODUCTION The financial system is heavily regulated, with banks being among the most regulated entities. A framework is developed to explain the form of financial regulation. Regulatory processes may be ineffective in many countries world...

Chapter Four Economic Analysis of Banking Regulation  INTRODUCTION The financial system is heavily regulated, with banks being among the most regulated entities. A framework is developed to explain the form of financial regulation. Regulatory processes may be ineffective in many countries worldwide. Cont. Asymmetric Information in Finance Asymmetric information causes adverse selection and moral hazard issues in financial contracts. Adverse selection refers to a situation where one party in a transaction can take advantage of the other party's lack of information before the transaction occurs Moral hazard arises after a transaction has occurred and refers to the situation where one party takes risks because they do not bear the full consequences of those risks. Types of financial regulation The government safety net restrictions on asset holdings capital requirements, prompt corrective action chartering and examination assessment of risk management disclosure requirements consumer protection, and restrictions on competition. The government safety net Financial intermediaries, like banks, tackle adverse selection and moral hazard through private loans, but this creates asymmetric information issues for depositors. Lack of information about bank quality can lead to bank panics and instability in the financial system. where lenders (banks) cannot distinguish between high-risk and low-risk borrowers. Forms of Government Safety Net Deposit insurance and government support for banks during crises are key components. Not limited to banks, the safety net extends to other interconnected financial institutions. Cont.. Moral Hazard Concerns Government safety nets can lead to moral hazard, encouraging risk-taking by institutions knowing they are protected. Lack of market discipline can result in risky behavior and potential financial crises. Too Big to Fail Large institutions deemed 'too big to fail' face moral hazard issues and may engage in riskier activities. Financial consolidation exacerbates the too-big-to-fail problem, increasing systemic risk and financial fragility. Restrictions on Asset Holdings Regulations limiting asset holdings aim to mitigate excessive risk-taking spurred by moral hazard. Risky assets can yield high returns but pose significant risks, potentially burdening depositors and creditors in case of failure. Challenges arise in monitoring institutions for risk levels, hindering depositors and creditors from enforcing discipline.  Capital Requirements Government-imposed capital requirements to reduce moral hazard by incentivizing financial institutions to engage in less risky activities. Capital serves as a buffer during economic shocks, enhancing financial stability and resilience. Prompt Corrective Action Low capital levels heighten the risk of bank failures and encourage excessive risk-taking, necessitating timely intervention to avert financial crises. Regular examinations ensure compliance with regulations, enhancing transparency and reducing risks in the industry.  Assessment of Risk management Shift towards evaluating risk management processes to gauge financial institution stability. Emphasis on sound risk management practices, including oversight, policies, risk measurement, and internal controls. Disclosure Requirements Mandated disclosure of information enhances market discipline and transparency. Disclosure regulations improve market efficiency by providing stakeholders with essential information to assess risk and make informed decisions. Restrictions on Competition Competition restrictions can intensify moral hazard by incentivizing excessive risk-taking. While historically used to safeguard banks, competition restrictions can lead to consumer disadvantages and decreased efficiency. The Savings and Loan Crisis and Its Aftermath Early Stage of the Crisis Financial innovation led banks to seek riskier ventures like real estate and leveraged buyouts. Deposit insurance increased moral hazard, encouraging excessive risk-taking. Deregulation and new financial instruments widened the scope for risk, worsening the crisis. Later Stage of the Crisis: Regulatory Forbearance Regulators refrained from closing bankrupt institutions, adopting regulatory tolerance. Regulatory tolerance increased moral hazard, leading to risky investments by insolvent institutions. Political influences and principal-agent problems contributed to regulatory failures and increased the crisis. CHAPTER FIVE NON BANK FINANCE INSURANCE COMPANIES Fundamentals of Insurance Insurance involves assuming risk for a fee to protect against potential losses. People pay for insurance due to risk aversion, preferring certainty over potential financial losses. Without insurance, individuals would need to maintain liquid reserves for emergencies, causing financial stress and uncertainty. Principles of Insurance Relationship between insured and beneficiary Accuracy in information disclosure, no profit from insurance. Insurance companies require a large number of insureds to spread risk. Losses must be quantifiable, and the probability of loss occurrence must be computable. CONT. Adverse Selection and Moral Hazard in Insurance Adverse selection involves individuals with higher risks seeking insurance more actively. Moral hazard arises when insured parties do not take precautions due to coverage. Insurance companies combat moral hazard with deductibles and contract terms. Selling Insurance Insurance companies need to market their products as insurance does not sell itself. Insurance companies face challenges in selling appropriate coverage and combating adverse selection. TYPES OF INSURANCE (discussion) Life Insurance: Protects against loss of income due to death, offering various products like term, whole life, and universal life. Health Insurance: Covers medical expenses, often provided through employer programs. Property and Casualty Insurance: Covers property against accidents, disasters, theft, and liability for harm caused to others. Reinsurance: Insurance companies can transfer a portion of their risk to another company through reinsurance. Credit Default Swaps: Offer insurance against default on financial instruments, shifting default risk to a third party. Monoline Insurance: Specializes in credit insurance alone, ensuring timely repayment of bond principal and interest in case of default. Pension funds Defined-Benefit Pension Plans Guarantees specific benefits upon retirement based on a formula using years worked and final salary. Employer bears the responsibility of ensuring adequate funding for promised payments. Plans can be fully funded, overfunded, or underfunded based on contributions and investment performance. For example, a pension benefit may be calculated by the following formula: In this case, if a worker had been employed for 35 years and the average wages during the last three years were Br 50,000, the annual pension benefit would be 0.02 x Br 50,000 x 35 = Br 35,000 per year Cont… Defined-Contribution Pension Plans Contributions are specified, and retirement benefits depend on fund earnings. Employee and employer contribute to the fund, with investments managed by trustees. Increasingly popular by require participants to understand investment diversification. Mutual funds Mutual Funds: Investment Vehicle for Small Investors Concept Mutual funds pool resources from small investors to buy securities, offering benefits of lower costs and diversification. Investors can benefit from professional management and reduced risk through diversification. Historical Evolution Originating in the 1800s, mutual funds became popular by investing in American railroad bonds. Growth slowed after the 1929 stock market crash but regained momentum later. Cont... Benefits of Mutual Funds Liquidity intermediation allows quick and low-cost conversion of investments into cash. Denomination intermediation provides access to securities otherwise unattainable by small investors. Diversification, cost advantages, and managerial expertise attract investors to mutual funds. Types of mutual fund Equity Funds: Invest in stocks, offering varied investment objectives. Bond Funds: Include strategic income, corporate, and government bond funds. Hybrid Funds: Combine stocks and bonds for diversified investment. Money Market Funds: Invest in money market securities, offering liquidity and convenience. Mutual Fund Structure Open- vs Closed-End Funds: Open-end funds allow continuous investment and redemptions, offering liquidity and flexibility. Organizational Structure: Shareholders, board of directors, investment advisors, and other service providers manage fund activities. Conflicts of Interest Sources of Conflict: Asymmetric information and misalignment of interests between shareholders, directors, and investment advisors can lead to governance breakdowns. Governance Challenges: Free-rider problem hinders effective monitoring, necessitating regulatory oversight to ensure fair treatment of investors. THE END!