Topic 4

Financial Regulation

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 Outline
• Introduction
• Asymmetric Information and Financial
Regulation
• Other Regulations
• Macroprudential vs. Microprudential Supervision
• Other Issues for Regulators

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 Introduction
• The financial system is one of the most
heavily regulated industries in our
economy.
• Important to understand how banking
regulation work.

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 Asymmetric Information
and Financial Regulation
• In U.S., prior to Federal Deposit Insurance
Corporation (FDIC) insurance, bank failures mean
depositors lost money.
• “Good” banks needed to separate themselves from
“bad” banks.
• However, the inability of depositors to evaluate
the quality of a bank’s assets can lead to panics
and bank runs.
– Asymmetric information: Depositors do not
know the asset quality of banks. 4
 Asymmetric Information
and Financial Regulation
• Banks operate on a “first come, first service
basis”.
• Contagion effect as panic spread across all banks.
• Deposit Insurance is a government safety net
• Instil confidence in depositors
• Encourage placement of new deposits
• Two methods to protect depositor:
• Payoff method – pay depositors up to a pre-
determined amount (maximum amount)
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• Purchase and assumption method (M&A)
 Asymmetric Information
and Financial Regulation
• Problems of deposit insurance
• Moral hazard - deposit insurance encourages
banks to take on more risk.
• Adverse selection – high risk banks tend to
“buy” deposit insurance.
• What are the solutions?

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 Asymmetric Information
and Financial Regulation
• Problems of deposit insurance
• Too-big-to-fail policy – regulators don’t want
to close down large banks and use purchase and
assumption method to save the troubled bank.
• If banks were allowed to fail, large deposits
will be protected up to a certain amount (eg.
$250,000 in US and RM250,000 in Malaysia)
and this gives incentive to large depositors to
monitor the bank’s activities and banks have
less incentives to take more risk. 7
 Other Regulations
• Restrictions on Certain Asset Holdings
• Regulations limit the type of assets banks may
hold as assets.
• Banks may not hold certain risky assets such as
investment in shares and junk bonds, or limits
to certain lines of business (can involve in
financial services only).

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 Other Regulations
• Bank Capital Requirements
• Banks are required to hold a certain level of
capital that depends on the type of assets (risky
assets) that the bank holds.
• Under BASEL III (Pillar 1), Tier 1 capital
(common shares & retained earnings) must be
at least 7% of risk-weighted assets.
• In addition, a discretionary buffer of up to 2.5%
during high credit growth period.
• Why need high capital? 9
Application 1: Risk-Weighted Assets
• Under BASEL agreement, banks assets will be
weighted according to risk. The followings are
some examples:
• Secured residential property loans will be
weighted 35% (s.t. T&C).
• Commercial property loans will be assigned
weight of 100%.
• Corporate claims with a rating of AAA will be
weighted as 20%.
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 Other Regulations
• Liquidity Requirements
• To force banks to hold cash or liquid assets to
meet 30 days liquidity needs during stress
period.
• Under BASEL III, the Liquidity Coverage
Ratio (LCR) states that High Quality Liquid
Assets (HQLA) ≥ Anticipated Net Cash
Outflow in the Next 30 Days.

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 Other Regulations
• Liquidity Requirements
• High quality assets include
• (Level 1): reserve and securities issued by
government;
• (Level 2a & 2b): securities issued by entities
that are guaranteed by government,
investment grade private debt securities.

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 Application 2: Implication of
Liquidity Coverage Ratio
• What is the effect of the new Liquidity Coverage
Ratio on bank’s deposit taking strategy?

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 Other Regulations
• Prompt Corrective Action (Under BASEL 3 Pillar
2)
• A mechanism that allows regulators too assess,
monitor, control and take corrective actions on
ailing banks.
• Example: If a bank’s capital falls below the
required level, regulators can step in to prevent
bank failure.
• Example: If a bank’s don’t meet liquidity
requirements. 14
 Other Regulations
• Financial Supervision: Chartering and
Examination
• Address the issue of who manages and how it is
managed.
• Chartering – Regulators screen application for
new banking license.

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 Other Regulations
• Financial Supervision: Chartering and
Examination
• On-site examination – Examine whether banks
complied with regulations.
• Use CAMELS principles – Capital
adequacy, asset quality, management,
earnings, liquidity, and stress testing.
• Periodical reports and surprise audit.

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 Other Regulations
• Assessment of Risk Management
• Past examinations focused on the assets quality.
Now, focus on bank’s risk taking activities.
• 4 elements of risk management and control:
• Quality of board and senior management
oversight;
• Adequacy of policies limiting risk activity;
• Quality of risk measurement and monitoring;
• Adequacy of internal controls to prevent
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fraud.
 Other Regulations
• Disclosure Requirements
• Banks are required to adhere to standard
accounting practice (standardised reporting)
and periodical reporting (more information on
the bank’s risk and assets).
• Aim to prevent panics and limit incentives for
banks to take on excessive risk.
• Under BASEL 3 (Pillar 3), banks are required
to publish details of their risks, capital and risk
management. This will allow comparisons
between banks. 18
 Other Regulations
• Consumer Protection
• Consumers do not have enough information to
protect themselves.
• Examples:
• Information on cost of borrowings.
• Ways to lodge complaints.
• Information on investment products.

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 Other Regulations
• Consumer Protection
• Control over pricing.
• Examples:
• Financial Conduct Authority of UK is
studying whether to cap the interest rate
and fee charge on home (household)
credit.
• Interest rate can be as high of 1558% on a
13-week loan.
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Macroprudential vs. Microprudential
Supervision
• Microprudential
• Safety and soundness of individual bank.
• Looks at regulation requirements (eg. Capital
adequacy ratio and liquidity ratio).
• Insufficient as risk from shadow banking can
affect banks.

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Macroprudential vs. Microprudential
Supervision
• Macroprudential
• Safety and soundness of at the banking sector
level.
• Looks at whole financial system (eg. Liquidity
crunch).

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 Other Issues for Regulators
• Less regulations on government sponsored
financial institutions.
• Example: Fannie Mae and Freddie Mac
• Credit Rating Agency
• Conflict of interest
• Inaccurate rating
• Problem of Overregulation
• Affect efficiency and innovation
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 Further Readings
• Cecchetti and Schoenholtz (2021): Chapter 14
• Kidwell, Brimble, Docherty, Mazzola, and Basu
(2018): Chapter 13
• Mishkin and Eakins (2018): Chapter 18

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