Walter W. HeeringNovember 2, 2012
EC386: Financial Regulation – Principles and Institutions
Lecture 4:Issues of financial regulation - Objectives, instruments, problems
(1) Financial regulation can be divided into structural and prudential (or ‘conduct’) regulation. Structural regulation has been abandoned almost completely by now. Recently, it has been argued that prudential regulation should be both micro-prudential as well as macro-prudential. The main failure of financial regulation contributing to the recent crisis is seen in its focus on the micro level, thus neglecting the macro level. The common assumption was that keeping microeconomic financial institutions sound is sufficient to keep the financial system as a whole stable. This has proved to be a ‘fallacy of composition’.
(2) World-wide the financial sector is much more regulated than other industries. In particular, this applies to the banking sector, which has a peculiar and pivotal function within financing. Three criteria were previously used to compare financial institutions with regards to their regulatory status: 1. The risk involved in their activities that may lead to their failure; 2. the interconnections among intermediaries that make them prone to a contagion effect; 3. their importance for the whole financial system and for the economy as a whole. According to these criteria three groups of financial intermediaries were distinguished in order of their regulatory needs: 1. Banks and other depository institutions (saving and loan associations; mutual saving banks; credit unions); 2. Investment intermediaries (finance companies; mutual funds; money market mutual funds); 3. Insurance companies and other contractual saving institutions (pension funds; governmental retirement funds). (3) Recently, however, there have been discussions about these priorities and about additional factors to be taken into account, such as: * Size of institutions matters due to two reasons: First, there is the issue of competition which depends on firms’ size relative to the market. Second, there is the issue of ‘too big to fail’. * Leverage (the ratio of debt to equity) matters because in a financial crisis rolling-over debt becomes precarious. * Maturity mismatch between assets and liabilities matters. Liquidity problems used to be seen as a specific banking problem. But we have learned that any kind of short-borrowing against long-term assets creates similar problems. Short-term borrowing is cheaper than long-term borrowing and is therefore highly preferred in times of bubbles. * Generally, short-termism of financial actors tends to amplify fluctuations in financial markets. (4) Generally, the objectives of financial regulations are the following, where a distinction is drawn between objectives on a microeconomic and macroeconomic level. 1. Microeconomic:
* Protection of customers.
* Mitigating asymmetries of information and externalities (battling market failures). * Ensuring the safety and soundness of financial institutions. * Facilitating funds allocation (taxing and government programs; credit subsidies for specific sectors; anti-discrimination). * Controlling market structure and preserving competition. 2. Macroeconomic:
* Smoothing fluctuations in financial markets (systemic stability). * Monetary control to provide monetary stability (low and stable inflation).
Note, however, that objectives may contradict each other.
(5) Instruments and tools used in regulation of the financial sector are schematically listed in the following table: Protective (ex post)| | Lender of last resort|
| | Deposit insurance|
Preventive (ex ante)| Structural| Restrictions on entry and/or business activities: * product line restrictions * geographic restrictions| | | Regulation of interest rates|
| Prudential| Chartering|
| | Portfolio...