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MFL7
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MFL7
Untitled Deck
Study
1
Question
Regulation of the Financial Sector
Answer
Financial systems in most countries were highly regulated until the early 1980s. This followed the end of the Bretton Woods system of fixed exchange rates in 1973 and also most capital controls in the 1970s. Regulation of the financial system, often termed prudential policy, was also used to control monetary policy.
2
Question
Reasons for Deregulation
Answer
The reason for deregulation in the 1980s was the rise in competition of offshore banking, such as the Eurocurrency markets, which escaped many of the domestic regulations. During the 1980s, foreign banks were allowed to operate in domestic markets for the first time.
3
Question
UK Deregulation in 1987
Answer
In the UK during 1987, there was deregulation of the services banks could offer, such as allowing stockbroking services.
4
Question
Financial Crises in the Early 1990s
Answer
In the early 1990s, some countries had financial crises, such as Finland, due to too much deregulation.
5
Question
Reasons for Regulation
Answer
There are four main reasons for financial regulation: 1. Asymmetric information 2. The principal-agent problem 3. Moral hazard 4. Externalities.
6
Question
Asymmetric Information
Answer
Managers of financial firms, sellers of market-based financial products, financial advisers, etc., generally have more information about the products they are offering or recommending than the buyers. This is because the products are complex and the purchases are often one-off.
7
Question
Principal-Agent Problem
Answer
Related to asymmetric information, investors employ the management and staff of a financial institution to act as their agents in dealing with that institution or with markets, and need to ensure that agents do their best.
8
Question
Incentives for Managers
Answer
Managers may have numerous incentives to ensure that their firm prospers and may receive performance-related bonuses. Investors need to ensure that their stockbroker or financial adviser is acting in their best interest.
9
Question
Moral Hazard
Answer
A case of regulating against the effects of regulating. Deposit insurance schemes intended to reduce risk for investors may encourage institutions and investors to behave more recklessly than they otherwise would, defeating the original purpose.
10
Question
Externalities
Answer
Externalities in economics are costs or benefits for people other than the transactors. Financial firm failure is generally viewed as more serious than non-financial firm failure due to external benefits from financial activity.
11
Question
Externalities
Answer
Costs or benefits for people other than the transactors in an economic transaction.
12
Question
Impact of Financial Firm Failure
Answer
The failure of financial firms is generally viewed as more serious than nonfinancial firms due to external benefits from financial activity, particularly in banks operating the payments system.
13
Question
Private Benefits of Financial Activity
Answer
Private benefits to depositors, borrowers, and banks are paid for by interest rates, fees, etc. Failure of a bank can lead to loss of means of payment and a contagious rush of deposit withdrawals, potentially collapsing the payment system.
14
Question
Interbank Market and Confidence
Answer
Contagion leads to the spread of problems in the banking system, as one bank's failure undermines confidence, causing depositors to rush to draw cash from even sound banks. Panic demands for cash can be met through overnight loans in the interbank market.
15
Question
Self-regulation
Answer
Regulations and enforcement are in the hands of market practitioners working for a self-regulatory organization (SRO) responsible for a particular area of financial activity. Advantages include flexibility and insider knowledge, but disadvantages include agency capture and regulatory sympathy towards the regulated.
16
Question
Statutory Regulation
Answer
Requires legislation and a publicly appointed and paid body to monitor compliance and bring prosecutions where necessary. Advantages include a strong and unbiased approach to wrongdoing, but it lacks flexibility and problems may not be identified until they become serious.
17
Question
Statutory regulation
Answer
Requires legislation and a publicly appointed and paid body to monitor compliance and bring prosecutions where necessary. Advantages include a strong and unbiased approach to wrongdoing. Disadvantages include lack of flexibility and problems not identified until they become serious.
18
Question
Types of regulation
Answer
The relevant types of regulation in financial markets and their participants include: a) Disclosure requirements b) Regulation of exchanges c) Licensing requirements d) Restrictions on activity
19
Question
Disclosure requirements
Answer
Companies wishing to have their shares publicly traded in organized exchanges are required to disclose a wide variety of information about their financial position. Directors are required to make public their own buying or selling of the firm's shares.
20
Question
Regulation of exchanges
Answer
Participants are required to get the best price when trading on behalf of clients. Insider trading is usually illegal.
21
Question
Licensing requirements
Answer
Most types of financial activity require participants to be licensed, primarily to exclude undesirable individuals from managing other people's money and to increase confidence in the system. Licensing also provides a sanction; persistent offenders can lose their license.
22
Question
Restrictions on activity
Answer
The range of activities undertaken by firms may be restricted to prevent conflicts of interest.
23
Question
Other forms of regulation for banking
Answer
These include capital adequacy, deposit protection, liquidity requirements, and exposure to risk limits.
24
Question
Costs of regulation
Answer
In deciding how strict regulation should be and what form it should take, there are four issues to consider: 1) Moral hazard 2) Agency
25
Question
Reckless Behavior
Answer
When individuals feel protected, they may behave more recklessly, leading to less prudent monitoring and decision-making.
26
Question
Agency Capture
Answer
When a regulatory body becomes too aligned with the views of the regulated firms, often due to recruiting individuals from those firms and maintaining close connections with them.
27
Question
Compliance Costs
Answer
The costs associated with adhering to regulations, such as providing additional information about products, setting up compliance departments, and meeting regulatory requirements.
28
Question
Effect of Regulation on Costs
Answer
Regulation adds costs to firms, similar to imposing a tax, leading to a shift in the supply curve (SL to SL0) and a decrease in activity volume (from 0L to 0M) while increasing prices (from P to P0).
29
Question
Inefficiencies of Regulation
Answer
Regulation reduces the efficiency of banks, making them less profitable, impeding economic growth, and creating barriers for new entrants into the banking industry.
30
Question
Forms of Regulation
Answer
Regulation can involve structurally regulating banks' activities, as seen in the Glass-Steagall Act of 1933 which separated commercial banks from securities trading in the United States.
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Untitled Deck
Study
1
Question
Basel 3
Answer
Basel III is a set of international banking regulations developed by the Basel Committee on Banking Supervision to strengthen the regulation, supervision, and risk management of the banking sector.
2
Question
Basel 3 Potential Drawbacks
Answer
Potential drawbacks of Basel III include a decline in annual growth due to banks passing on the cost of extra capital to borrowers and reduction in borrowing.
3
Question
Basel 3 Regulation
Answer
Basel III includes more explicit regulation of the derivatives market, off-balance sheet items, and increased capital requirements for trading and derivatives.
4
Question
Counterparty Credit Risks
Answer
Basel III addresses exposure to central counterparty risks and aims to increase capital requirements for trading and derivatives.
5
Question
Dodd Frank Act
Answer
The Dodd-Frank Act, introduced by the US Congress in 2010, aims to protect consumers in the finance sector and watch for potential threats to the entire financial system through the creation of the Consumer Financial Protection Bureau and the Financial Stability Oversight Council.
6
Question
Volcker Rule
Answer
The Volcker Rule prohibits insured depository institutions and their affiliates from engaging in proprietary trading, acquiring or retaining equity interests in hedge funds or private equity funds, and sponsoring hedge funds or private equity funds.
7
Question
Effectiveness of Volcker Rule
Answer
The Volcker Rule was not as effective as hoped and was believed to have done more harm to the economy than good. It was difficult to enforce, reduced liquidity in some markets, and led to various amendments in 2019.
8
Question
MiFID II
Answer
Markets in Financial Instruments Directive (MiFID II) is a regulation across the EU aimed at establishing a single market in investment services and activities. It provides passporting rights and aims to enhance investor protection and market transparency.
9
Question
Mifid
Answer
Markets in Financial Instruments Directive Mifid was originally set up in 2007 and aimed at establishing a single market in investment services and activities.
10
Question
Passporting Rights
Answer
The ability of an investment firm authorised in one EEA country to provide investment services or perform investment activities in another EEA country without requiring additional authorisation.
11
Question
Mifid II
Answer
Introduced in early 2018, it aims to strengthen regulation to prevent a further financial crisis in the EU, increase transparency in the investments sector, regulate over-the-counter (OTC) trading, impose regulations on algorithm trading and high frequency trading, require detailed trade reports, and include more financial instruments in the regulatory framework.
12
Question
Future Regulation
Answer
The aim is to have all countries regulated equally, possibly implemented by a body such as the IMF. It aims to control the use of derivatives and securitization, limit the use of off-balance sheet items, and ensure capital buffers are more related to the risk of the loans.
13
Question
Summary of Financial Regulation
Answer
Financial activity is complex and risky, requiring protection and oversight. Regulation can rely on statutory power or self-regulation, and takes various forms such as licensing, information disclosure, and restriction of activity. The UK has transitioned from self-regulation to a more statutorily based approach in recent years.
14
Question
Financial Regulation
Answer
It carries costs that are ultimately passed on to the users of the system.
Untitled Deck
Study
1
Question
Asymmetric information
Answer
Managers of financial firms, sellers of market-based financial products, financial advisers, etc. generally have more information about the products they are offering or recommending than the buyers.
2
Question
Principal-agent problem
Answer
Investors employ the management and staff of a financial institution to act as their agents in dealing with that institution or with markets. How can the principals ensure that agents do their best?
3
Question
Incentives for managers
Answer
Managers may have numerous incentives to ensure that their firm prospers, such as performance-related bonuses. Investors need assurance that their stockbroker has made the best trades and that their financial adviser is recommending the best products for them.
4
Question
Moral hazard
Answer
A case of regulating against the effects of regulating. Interventions like deposit insurance may encourage institutions and investors to behave more recklessly, defeating the original purpose.
5
Question
Externalities
Answer
External costs or benefits for people other than the transactors. The failure of financial firms is generally more serious than the failure of non-financial firms due to external benefits from financial activity, particularly in the case of banks operating the payments system.
6
Question
Contagion
Answer
The spread of a problem across financial institutions and markets due to undermined confidence, leading to events like bank runs and the rush for cash in the interbank market.
7
Question
What happens when there is a rush for cash from depositors?
Answer
Confidence in the system generally and depositors rush to draw cash from banks, which are perfectly sound. The interbank market spreads the rush for cash.
8
Question
What source does a bank facing panic demands for cash turn to?
Answer
One source will be overnight loans in the interbank market. When a bank withdraws or refuses to renew an interbank loan, there is the danger that the borrowing bank is then short of cash and cannot meet demands from its own customers.
9
Question
What is self-regulation?
Answer
In a self-regulatory system, regulations and their enforcement are in the hands of market practitioners usually working for a self-regulatory organization (SRO) responsible for a particular area of financial activity. Advantages include flexibility and insiders' knowledge, while disadvantages are mainly linked to agency capture.
10
Question
What is statutory regulation?
Answer
Statutory regulation requires legislation and a publicly appointed and paid body to monitor compliance and bring prosecutions where necessary. Advantages include a strong and unbiased approach to wrongdoing, while disadvantages include lack of flexibility and problems not being identified until they become serious.
11
Question
What are the types of regulation relevant to financial markets and their participants?
Answer
The types of regulation relevant to financial markets and their participants include: a) Disclosure requirements, b) Regulation of exchanges, and c) Licensing requirements.
12
Question
What are the disclosure requirements for companies wishing to have their shares publicly traded in organized exchanges?
Answer
If companies wish to have their shares publicly traded in organized exchanges, they are required to disclose a wide variety of information about their financial position. Directors are required to make public their own buying or selling of the firm's shares.
13
Question
What are the requirements for participants trading on behalf of clients on exchanges?
Answer
Participants are required to get the best price when trading on behalf of clients. Insider trading is usually illegal.
14
Question
What is the purpose of licensing requirements for financial activity?
Answer
Licensing requirements for most types of financial activity are intended primarily to exclude undesirable individuals from managing other people's money and to increase confidence in the system.
15
Question
Insider trading is usually illegal.
Answer
Insider trading is the illegal practice of trading stocks based on non-public, material information about a company.
16
Question
Licensing requirements
Answer
Most types of financial activity require participants to be licensed. This is intended to exclude undesirable individuals from managing other people's money and to increase confidence in the system. Licensing also provides a sanction (persistent offenders can lose their license).
17
Question
Restrictions on activity
Answer
The range of activities undertaken by firms may be restricted to prevent conflicts of interest. For example, in early 2002, the US investment banking world was shocked by the discovery that analysts working for the equities division of Merrill Lynch were publishing favorable reports on companies which were clients of Merrills investment banking arm even though they knew the companies shares were a poor investment.
18
Question
Costs of regulation
Answer
The case for regulating financial activity involves getting the best protection for the least possible cost. In deciding how strict regulation should be and what form it should take, there are four issues to consider: Moral hazard, Agency capture, Compliance costs, and Costs to firms.
19
Question
Regulation and Compliance
Answer
Firms may incur additional costs to set up internal controls and compliance departments to meet regulations. This is similar to adding a tax on the product, which results in a shift of supply from SL to SL0, leading to a decrease in activity volume (from 0L to 0M) and an increase in price (from P to P). Regulation can also reduce bank efficiency, limit new entrants, and have macroeconomic costs.
20
Question
Inefficiencies of Regulation
Answer
Regulation can reduce bank efficiency, making well-regulated banks less profitable and susceptible to takeover by less regulated banks. It can also hinder economic growth and create barriers to new entrants in the banking industry.
21
Question
Forms of Regulation
Answer
There are three main forms of banking regulation: regulating the structure and activities of banks, implementing liquidity regulations, and enforcing capital adequacy regulations.
22
Question
Liquidity Requirement
Answer
To enable regulators to monitor the liquidity of the banking system, banks are required to make frequent, even daily, statistical returns.
23
Question
Capital Adequacy Regulation
Answer
The regulation of capital adequacy ensures that a bank has sufficient capital committed by shareholders and long-term bondholders to absorb negative shocks to assets without threatening the wealth of depositors.
24
Question
Basel Committee
Answer
The Basel Committee is a committee of bank regulators from G10 countries, Switzerland, and Luxembourg, which meets in Basel and uses a secretariat provided by the Bank for International Settlements.
25
Question
Basel Accord (Basel 1)
Answer
In 1988, the Basel Committee established a set of guidelines for implementation from 1993 known as the Basel Accord or Basel 1. It focused on a risk assets ratio (RaR) calculated using tier 1 capital.