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Financial Regulation

Financial Regulation. Ivan J Kirov Fed Challenge Feb 4 2010. Paths Taken and Paths Forward. The Financial System. Financial Institutions Solve informational asymmetry Leverage economies of scale. Banks are Businesses, Too. Bank “Self-Regulation” At sign of trouble: Creditors pull out

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Financial Regulation

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  1. Financial Regulation Ivan J Kirov Fed Challenge Feb 4 2010 Paths Taken and Paths Forward

  2. The Financial System • Financial Institutions • Solve informational asymmetry • Leverage economies of scale

  3. Banks are Businesses, Too • Bank “Self-Regulation” • At sign of trouble: • Creditors pull out • Depositors withdraw • Difficult to raise money in capital markets • Hence capital kept on hand

  4. …Then again, maybe not • Finance is systemically important to the functioning of the economy

  5. Government Intervenes • Liquidity (Lender of last resort) • Traditional purview of central banks • Deposit insurance • In US, from Depression • Creditor guarantees • Mostly from last crisis • AIG • Citi

  6. Moral Hazard • Guarantees reduce risk in holding bank debt • Moreover, they insulate creditors from loss • Risk-taking proliferates • Financial institutions’ incentives become out of line with those of regulators Banks’ Equity as % of Assets Source: Economist

  7. Animal Spirits Contained • To avoid moral hazard implicit in support, governments impose financial regulatory structures

  8. Basel-2 • Basel-2: Current main international regulatory framework • Financial institutions must keep on hand at least 4% of risk-weighted assets • “On hand”: Tier-1 capital • “Risk-weighted”: According to GAAP, but in practice a firm-specific definition • Problems • Tier-1 capital includes debt-like instruments • Low capital margin • Limited regulation of leverage

  9. New Regulatory Proposals • Tobin Tax • Britain’s Bonus Tax • Obama’s Bank Levy • The Volcker Rule • Basel-3

  10. Tobin Tax • Originated by James Tobin in 1973 • FX transactions above “optimal level” – tax to bring them in line with public optimum. • Financial Tobin Tax is not strictly a form of regulation; more like enforced downsizing. • Problems: • How do governments know finance’s “optimal size”?

  11. Britain’s Bonus Tax • Dec. 10, 2009: UK gov’t imposes 50% tax rate on bank bonuses exceeding £25,000 • Largely politically motivated

  12. Obama’s Bank Levy • Tax on financial firms with >$50 billion in assets • Would raise $90bn over 10 years • To cover TARP fund • Applies mostly to risky activities • Proprietary trading desks • In practice: small, symbolic • Principle? Source: New York Times

  13. Volcker Rule • Semi-reinstatement of Glass-Steagall • Banks (or just deposit-taking institutions?) cannot engage in proprietary trading or invest in hedge funds or PE funds • Details still pending Congressional crucible Source: New York Times

  14. Basel-3 • Work-in-progress: refinement of Basel-2 rules • General thrust • Safe “Tier 1” capital more narrowly defined (mostly only equity) • Financial institutions cannot use proprietary risk models • Liquidity: banks must withstand 30-day credit freeze • Capital requirements increased to 6-8% of risk-adjusted assets

  15. Paths forward? • Liquidity regulation • Institutions pay for not-so-implicit guarantees • “Convertible capital” • Balance between institution-specific and system-wide regulation

  16. A Little Fun • Julian Simon: The Dismal Science? • “One can hardly imagine, I think, how poor we would be today were it not for the rapid population growth of the past to which we owe the enormous number of technological advances enjoyed today. . . . If I could re-do the history of the world, halving population size each year from the beginning of time on some random basis, I would not do it for fear of losing Mozart in the process.” -Edmund S. Phelps

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