Introduction to Banking and Finance Unit 2

1. Introduction to Banking and FinanceUnit 2 REGULATION

2. To understand the structure of the financial system, it is important to examine the regulatory environment in which it operates. Despite considerable deregulation over the period since the late 1970s, introduced to improve competition in a system which was rife with restrictive trade practices, re-regulation was considered necessary in order to provide greater protection for investors and savers.

3. The Rationale for Government Intervention Financial markets and institutions play a pivotal role in modern economies and are responsible for: • huge sums of investors’ money, • running the money transmission and payments service upon which the whole (increasingly global) economy is crucially dependent, • they are major employers and significant foreign exchange earners • they allocate financial capital to its most productive use.

4. Government regulation is usually rationalised on the grounds of “market failure”: ie, left to itself the market would produce a sub-optimal outcome. Four instances of market failure frequently cited as requiring government intervention are: • the externalities problem • the problem of asymmetric information • the problem of moral hazard • the principal-agent problem

5. The Externalities Problem Through the payments system financial institutions link both users (deficit units) and lenders (surplus units) of funds, which means that problems arising within the financial sector have a potentially disastrous impact on the whole economy, unlike the failure of commercial firms or even whole industries which tends to be largely local in impact.

6. The Problem of Asymmetric Information Directors and managers of companies can access information regarding the soundness of their companies and their likely policies which is superior to that of potential lenders or investors. Could lead to problems: • insider dealing • concealment of relevant information from investors. Consequently, most countries have insider trading laws prohibiting the trading in shares on information that is not freely available in the public domain.

7. Other regulations such as: • listing requirements for companies seeking a quotation • the continuing obligations of fully listed companies • ongoing obligations of smaller companies listed on the Alternative Investment Market (AIM), impose disclosure requirements on companies to make a great deal of financial information public to potential and existing investors.

8. The Moral Hazard Problem This arises from the the idea that providing insurance against the possible occurrence of an event will render the event more likely to occur than if it were not insured against. Deposit protection schemes, such as under the Banking Act 1987 and the Building Societies Act, 1986, guarantees savers/investors their funds (or a proportion of them) should a deposit-taking institution get into difficulties. Could encourage financial institutions to take on more risk than they otherwise would do, knowing that savers/investors will be compensated if problems arise. Similarly with the pensions protection scheme and government support for FIs in credit crunch.

9. The principal-agent problem The directors and managers of financial institutions are agents for the shareholders and investors in the institution. A potential problem exists when directors and managers pursue their own interests at the expense of those of the shareholders and investors, such as when they are on Performance Related Pay (PRP) which encourages them to take undue risks with shareholders’ and investors’ funds. Therefore, they are required to disclose information on the financial performance of the company and are subject to rules on their dealing.

10. Which type of market failure could be depicted by each of the following? a)A manager pursuing his/her own interests instead of those of the client. b)An institution taking on more risk than it should because of investor/saver insurance. c)Major liquidity problems throughout the financial system. d)Insider trading

11. a) b) c) d)

12. The case against regulation of the financial sector Imposing additional compliance costs: • loss of potentially profitable business Encourages concentration of financial activities: • in areas that are favoured by the regulators rather than clients Excessive licensing requirements: • restrict competition • excess profits for the licensed institutions • higher prices for the customers • reduce or limit innovation to overcome the restrictions imposed by the regulations Over-regulation: • can drive business away to less regulated foreign centres The regulatory framework may be inappropriate.

13. The case for regulation of the financial sector Numerous cases of: • Fraud; eg Robert Maxwell pension fund scandal, the Barlow-Clowes affair, Barings • Inappropriate selling; eg pensions mis-selling scandal, endowment mortgages • High profile bank failure due to fraud and lack of prudential controls (eg JMB; BCCI); UK fringe bank crisis in 1973 following introduction CCC Suggests that some degree of regulation is necessary

14. Bank of England intervened in Fringe Banks’ Crisis and JMB with a “Lifeboat” operation. Justified on grounds of fear of contagion • Bingham inquiry investigated the BCCI failure. They reported in 1992. • Critical of the Bank of England’s lack of intervention when faced with overwhelming evidence of impropriety: • recommended establishment of Special Investigations Unit of the Bank of England to examine any warning signs received by the Bank. • One of the main lessons was that banking group structures which deny supervisors a clear view of how their business is conducted should be outlawed, a feature that was subsequently addressed by the Basle Committee in July 1992.

15. Objectives of Government Regulation • Promote financial stability • Provide protection for investors/savers against fraud or the dissemination of misleading or inadequate information • Promote fair and healthy competition to ensure competitive prices for consumers • Control the activities of financial institutions in order to exert some measure of control over the level of economic activity, particularly in regard to monetary policy.

16. Types of Government Regulation Structural regulation • covers the activities, products and geographical boundaries within which financial institutions can operate. Prudential regulation • covers the internal management of financial institutions to ensure institutions have adequate capital to absorb possible losses, and sufficient liquidity to ensure they can meet their obligations. Investor protection • covers measures designed to protect investors from mismanagement of funds, malpractice and fraud.

17. Regulations coming within these Classifications • Licensing regulations • Disclosure requirements • Deposit Insurance • Restrictions on activities • Exposure limits • Liquidity requirements • Capital adequacy • Regulation of Securities’ Exchanges

18. Legislation Banking Act 1979; • Distinguished between recognised banks and licensed deposit-takers Banking Act 1987; • All institutions to be similarly classified by FSA as “authorised institutions” and to be run by “fit and proper” people. £5m+ Capital to be a bank. Building Society Acts:1986; 1997 Financial Services Act 1986 Companies Securities (Insider Dealing) Act, 1985 Financial Services and Markets Act 2000 Banking Act 2009 – Special measures to deal with impact of credit crunch.

19. Banking Act 1987 • A Board of Banking Supervision was set up within the Bank of England. Banking supervision is now the responsibility of the FSA. • Banks are legally required to advise the FSA of any exposure of over 10% of its capital to any single customer, and to advise the Bank of England in advance of any proposed exposure of over 25%. •  Misreporting of information to be a criminal offence.

20. The FSA must be notified of the intention of any person or company to take control of an authorised institution – “fit and proper person”; competition rules; etc. • All authorised institutions are required to maintain appropriate records, books and internal control systems. • The banks’ auditors are required to take a more active role in bank supervision. • The FSA is obliged to monitor each bank more closely.

21. RATE (Risk Assessment, Tools and Evaluation) • A systematic framework for the consistent application of risk-based supervision across all banks. • Formal assessment between six months (high risk profiles) and two years(very low risk profiles); • CAMEL; B; COM. • Liquidity risk; Credit risk; Capital adequacy • Risk weighted assets • Basel Committee

22. Basel 1, Tier 1 and 2 Capital • Tier 1 = 4% of “core capital” • Core capital consists mainly of common stock, reserves and perpetual preference stock. • Tier 2 = the additional capital above tier 1 capital supporting the lending and deposit activities. • Consists of redeemable preference stock, subordinated debt and loan-loss reserves.

23. Risk weighting

24. Tier 1 &2 weight adjusted capital requirement. Bank A: Tier 1 = 0.04 x £1900 million = £76 m. Tier 1 + tier 2 = 0.08 x £1900 million = £152 m Bank B: Tier 1 = 0.04 x £2850 million = £114 m. Tier 1 + tier 2 = 0.08 x £2850 million = £228 m

25. Criticisms • Weightings arbitrary (eg mortgages weighted less than AAA companies) • All commercial loans treated as equally risky (eg AAA = BBB !). • All banks in all economies treated similarly • Lending priorities became distorted due to banks selling off some of their riskier loans in the secondary market so as to reduce their capital reserve requirements • While guidelines tackled capital adequacy, they neglected liquidity.

26. Basel 2 • Like Basel 1, required capital to be at least 8% of risk weighted assets. • Introduced 3 pillars: • Pillar1: Capital adequacy to match credit risk, market risk and operational risk. Some changes to the weightings: eg AAA companies get a lower weighting. Standardised approach or internal ratings based (IRB) approach to meeting capital adequacy requirements. • Pillar 2: Closer supervision of banks adopting an IRB approach. • Pillar 3: Market discipline raised though detailed risk management reporting requirements.

27. Basel 3 Rules Due to be phased in by January 2019. Will require banks to hold more capital.The main requirement of the new Basel 3 rules is for banks to have a minimum Tier 1 capital ratio of 7%. Many banks' Tier 1 ratios are already above this, but the Basel III regime is much stricter on what can be counted as Tier 1 capital.