Chapter 11: The Economics of Financial Regulation

2. The Great Depression as Regulatory Failure

Remedies

1. Deposit insurance (FDIC) to prevent bank failuresEncourages asymmetric information and creates moral hazard.

2. Glass-Steagall restricted bank activities, separating commercial and investment banksLess competitive industry, less innovation.

3. Securities and Exchange Commission (SEC) created to screen for adverse selection in public incorporations, offset asymmetric information, monitor moral hazardIncreases costs of access to capital and thus entry to markets; decreases competition, discourages growth.

4. Better But Still Not Good: U.S. Regulatory Reforms

1989 Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA)• re-regulation of S&Ls, bailout of S&Ls.

1991 the Federal Deposit Insurance Corporation Improvement Act (FDICIA)• continued the bailout of the S&Ls and the deposit insurance fund, raised deposit insurance

premiums, and forced the FDIC to close failed banks using the least costly method.

1994 Riegle-Neal Interstate Banking and Branching Efficiency Act• overturned most prohibitions on interstate banking.

1999 Gramm-Leach-Bliley Financial Services Modernization Act• repealed Glass-Steagall, allowing the same institutions to engage in both commercial and

investment banking activities.

4. Better But Still Not Good: U.S. Regulatory Reforms

Results

More competition consolidationMore activities conglomeration

“Too big to fail” or the “Bigness Dilemma”

Size creates efficiencies of scale and allows for diversification… does size create moral hazard?

5. Basel II, III, and Dodd-Frank

International regulatory standards

The Bank for International Settlements (Basel, Switzerland)

1988 Basel IMeasured Capitalization requirement by risk weighting:

Ranking assets by risk and using their risk-adjusted, weighted average capital ratio.

In conventional measures of capital requirements and liquidity,Capitalization requirement based on minimum leverage ratio =Capital/Assets, treating all assets as equally risky.

5. Basel II, III, and Dodd-Frank

International regulatory standards

The Bank for International Settlements (Basel, Switzerland)

2008 Basel II(announced 2004)

Three “pillars” of regulation:

CapitalSupervisory review processMarket discipline

5. Basel II, III, and Dodd-Frank

International regulatory standards

The Bank for International Settlements (Basel, Switzerland)

2008 Basel II(announced 2004)

The supervisory review process assesses:

C = CapitalA = Asset qualityM = ManagementE = EarningsL = Liquidity (reserves)S = Sensitivity to market risk

Three “pillars” of regulation:

•Capital•Supervisory review process•Market discipline

5. Basel II, III, and Dodd-Frank

International regulatory standards

The Bank for International Settlements (Basel, Switzerland)

2008 Basel II(announced 2004)

Problems of Capital assessment and Supervisory review process :• variables difficult to ascertain• variables difficult to verify• variables are volatile• off-balance sheet activities• low motivation for regulators• Asymmetric information• Principle agent

Three “pillars” of regulation:

•Capital•Supervisory review process•Market discipline

5. Basel II, III, and Dodd-Frank

International regulatory standards

The Bank for International Settlements (Basel, Switzerland)

2008 Basel II(announced 2004)

Market discipline:• Bank regulators should see themselves

as aides, as helping bank depositors (and other creditors of the bank) and stockholders to keep the bankers in line.

• Most important in less-developed countries where regulators are more likely to be “on the take.”

Three “pillars” of regulation:

•Capital•Supervisory review process•Market discipline

5. Basel II, III, and Dodd-Frank

International regulatory standards

The Bank for International Settlements (Basel, Switzerland)

2019 Basel III(announced 2004)

• U.S. implementation of Basel II was disrupted by the worst financial dislocation in 80 years.

• Intense lobbying pressure combined with the uncertainties created by the 2008 crisis led to numerous changes and implementation delays.

• Dodd-Frank Wall Street Reform and Protection Act (2010) mandates the creation of a new:– Financial Stability Oversight Council– Office of Financial Research– Consumer Financial Protection Bureau;– Advanced warning system that will attempt to identify and

address systemic risks before they threaten financial institutions and markets.

5. Basel II, III, and Dodd-Frank

• Dodd-Frank Wall Street Reform and Protection Act also calls for:– More stringent capital and liquidity requirements for LCFIs– Tougher regulation of systemically important non-bank

financial companies– The breakup of LCFIs, if necessary– Tougher restrictions on bailouts– More transparency for asset-backed securities and other

“exotic” financial instruments– Improved corporate governance rules designed to give

shareholders more say over the structure of executive compensation.

5. Basel II, III, and Dodd-Frank