government regulation of financial activities
DESCRIPTION
Government regulation of financial activities. Problem: there will always be people who want to cheat or cut corners: theft, fraud, misrepresentation, etc. Ex ante solutions Government: legislation, regulation Private: reputation, contracts, arbitration Ex post solutions - PowerPoint PPT PresentationTRANSCRIPT
Government regulationof financial activities
Problem: there will always be people who want to cheat or cut corners: theft, fraud, misrepresentation, etc.
Ex ante solutions Government: legislation, regulation Private: reputation, contracts, arbitration
Ex post solutions Gov’t: fines, imprisonment, injunctions Private: shunning, expulsion
Financial services
Broad classes of financial services Intermediation Brokerage Investment banking Many firms offer some or all of these
services
Financial intermediation
Match savers with borrowers (businesses and households)
Primary example: deposit banking Accept deposits from savers Loan money to businesses and
households Interest rate spread is the primary
income source
Deposit banking
Commercial banks are the primary providers of deposit banking
Also Savings and Loan (emphasize mortgage lending)
And Credit Unions (non-profit) Deposit forms
Demand deposits (checking accounts) Savings accounts Currently pay essentially zero interest
Deposit banking
Loan forms Households
Home mortgages Automobile loans Personal loans
Businesses General purpose loans Factoring – purchase of accounts
receivable
Deposit banking
Problems that can arise when loans go bad insolvency: liabilities exceed assets
a serious problem that can lead to closure illiquidity: not enough cash to meet
liabilities usually easy to remedy by borrowing from
other banks or from the Fed
Deposit banking Deposit banks are inherently illiquid
Only a small fraction of deposit liabilities are backed by reserves (currency and accounts at the Fed)
Most deposits can be withdrawn on demand
Most loans cannot be called on short notice
Possibility of a “bank run” if too many depositors want their money simultaneously
Deposit Insurance
Almost all banks carry deposit insurance Provided by the Federal Deposit Insurance
Corporation (FDIC) Banks pay insurance premium based on
risk – a small fraction of insured deposits FDIC typically arranges mergers of failed
banks FDIC has failed to maintain reserves equal
to 1.15% of insured deposits
Bank Subsidies and Protections
Deposit insurance may be under-priced Potential competitors are barred from the
marketplace (e.g., WalMart) Banks were bailed out during the 2008
financial crisis. “Too big to fail” Implicit bailout protection encourages
risky behavior (“moral hazard”)
Bank Regulation
Deposit banks are regulated by a confusing array of Federal and State agencies
Federal Reserve FDIC Comptroller of the Currency State bank regulatory agencies
Main requirements 10% reserves on deposit liabilities Minimum levels of shareholder capital
FDIC insurance engendersmoral hazard
Encourages bank managers to take more risk
Discourages depositors from paying attention to how banks manage their deposits
Leads people to believe that deposit risk has been eliminated when in fact it has been socialized
FDIC vs. Private Insurance FDIC is governed by politics, not the
marketplace Coverage limits set by Congress Premium rates limited by statutes
Private insurance companies manage moral hazard with risk assessment
Private insurance companies face competition and must engage in price discovery
Brokerage
Brokers match buyers with sellers Real estate brokers Stock brokers Insurance brokers Marriage brokers (?)
Income mostly from commissions Real estate: about 6% Stock brokers: very low commissions
Stock brokerage
Firms that traditionally or primarily engage in brokerage typically do other things as well:
Bank subsidiaries (e.g., Schwab Bank) Hold securities for their own account,
thereby acting as dealers
Insurance for brokerage customers
Provided by Securities Investor Protection Corporation (SIPC)
Created by legislation but operates as a private, non-profit, self-funded corporation
Customer assets must be segregated Provides insurance against certain kinds of
malfeasance such as misappropriation of funds or unauthorized trading
Does not insure against market declines
Problems and solutions
Voluntary solutions Reputation Arbitration Industry associations
New York Diamond Dealers, 47th St. NYC
All Hasidic Jews Disputes settled by private arbitration Anyone failing to abide by arbitrators’ decisions
is subject to shunning and adverse publicity
The “Public Choice” approach to analysis of government
Applies economic tools to the analysis of politicians, bureaucrats and voters
Contrasts with the “public interest” viewpoint which assumes selfless dedication to the public welfare
Politicians motivated by re-election Bureaucrats want to keep their jobs Voters exhibit rational ignorance
Regulatory capture
Regulated industries have huge incentives to influence the agencies that regulate them
The general public has little or no knowledge of the regulation
Industry people know their business better than regulators
Regulators with the best of intentions may find their mission subtly shifted
Limited resources; revolving door
Regulator agencies have limited staff and budget
Often cannot possibly exercise detailed supervision over many large firms
Regulatory staff often work a few years in a regulatory agency then take jobs in one of the industries they regulated
Turf wars
The domains of regulatory agencies often overlap, leading to inter-agency “turf wars.”
Example: who should regulate futures contracts on stocks?
CFTC said all futures were in its domain SEC said anything involving stocks was
in its domain Promotes a “race to the bottom” as in the
case of the late Office of Thrift Supervision
False confidence
Government regulation can lead the public to believe they shouldn’t worry
Example: some Madoff investors told themselves securities markets are heavily regulated – nothing could go wrong
Hummel’s law of failure: Perceived market failure always leads to
calls for more government Perceived government failure always
leads to calls for more government
Sarbanes-Oxley
The collapse of Enron Corp. was a major scandal in 2001. It concealed off-balance-sheet operations
Ken Lay died in prison Jeffrey Skilling still in prison Enron’s auditor, the venerable Arthur
Anderson, was disbanded Also MCI, which engaged in fraudulent
accounting
Sarbanes-Oxley Sarbanes-Oxley was a regulator reform bill
passed in response to Enron & MCI scandals
CEOs must personally certify the accuracy of financial information
New bureaucracy established to oversee independent auditors
Additional disclosures required in financial statements
Criminal penalties for some offenses
Sarbanes-Oxley Outcomes
May have increased accuracy and thoroughness of financial reports
Compliance costs hit small firms harder than larger firms
Some foreign firms dropped NYSE listings to avoid Sarbanes-Oxley
May have reduced IPOs
Dodd-Frank
Passed in response to the financial crisis of 2008
Bailouts of large financial institutions Bailouts of GM and Chrysler Stock market crash (since recovered) Massive deficits
Official titles always reflect hoped-for results: “The Wall Street Reform and Consumer Protection Act”
Dodd-Frank
No one person understands its 2300 pages. Contains many references to other laws.
Despite its length, it left a great deal of rule-writing to bureaucracies. Although it passed in 2010, many of the rules are incomplete. Uncertainty hinders business recovery.
Dodd-Frank and the Volcker Rule
Prohibits banks from buying and selling securities for their own account, supposedly to lessen the prospect of future bailouts.
Four federal agencies share the responsibility for writing rules that implement the Volker rule. Turf wars!
Interested parties have been hard at work trying to influence the rules
Dodd-Frank and the Volcker Rule
Proprietary trading turns out not to be so easy to define. So exemptions have been carved out
Trading on behalf of customers Hedging Underwriting and market-making. Trading of their own securities
Crony capitalism
Adam Smith: business people hate competition and are eager to use government to suppress it
Government intrusion into the economy opens the door for businesses to seek advantages
Lobbying Campaign contributions Personal friendships
Crony capitalism
Laws governing complex economic activities are necessarily vague and incomplete.
Interpretation is left to the bureaucracy The door is open to business lobbying
The “military-industrial complex” is the granddaddy of them all
Close ties among defense contractors, military officials, employees and their dependents
Hummel’s law of failure
Perceived market failures always lead to calls for more government
Perceived government policies always lead to calls for more government