Financial Regulation

Chapter 11
 Asymmetric Information
and Financial Regulation

• Bank panics and the need for deposit

insurance:
o Federal Deposit Insurance Corporation

• Other form of government safety net:

o Lending from the central bank to troubled
institutions (lender of last resort).
 Government Safety Net
• Moral Hazard
o Depositors do not impose discipline of
marketplace.
o Financial institutions have an incentive to
take on greater risk.
• Adverse Selection
o Risk-lovers find banking attractive.
o Depositors have little reason to monitor
financial institutions.

Too big to fail

 Restrictions on Asset
Holdings
• Attempts to restrict financial institutions from
too much risk taking
o Capital requirements
• Minimum leverage ratio (for banks)
• Basel Accords (Basel I,1988; Basel II, 2004,
Basel III, 2010-2011 :
oRisk-based capital requirements
• Tier 1 Capital Ratio
• Total Capital Ratio
 Consumer Protection
• Consumer Protection Act of 1969 (Truth-in-
lending Act).
o Annual Percentage Rate (APR)
• Equal Credit Opportunity Act of 1974,
extended in 1976.
• Community Reinvestment Act of 1977 (and
various revisions).
o Lending
 Market Restrictions
• Usury
o Glass-Steagall Act of 1933
o Depository Institutions Deregulation and Monetary Control Act
of 1980
• Branching
o McFadden Act of 1927
o Depositiory Institutions Act of 1982 (Garn-St. Germain)
o Riegle-Neal Interstate Banking and Branching Efficiency Act of
1994
• Commercial/Investment Banking
o Glass-Steagall Act of 1933
o Gramm-Leach-Biley Financial Services Modernization Act of
1999.
 Figure 1 Bank Failures in the
United States, 1934–2010

Source: www.fdic.gov/bank/historical/bank/index.html.
 The 1980s Savings and
Loan and Banking Crisis
• Financial innovation and new financial
instruments increased risk taking
• Increased deposit insurance led to increased
moral hazard
• Deregulation
• Bailout
o $150 million (3% of GDP)
 Macroprudential Vs.
Microprudential Supervision
• Before the global financial crisis, the
regulatory authorities engaged in
microprudential supervision, which is focused
on the safety and soundness of individual
financial institutions.
• The global financial crisis has made it clear
that there is a need for macroprudential
supervision, which focuses on the safety and
soundness of the financial system in the
aggregate.
 The Dodd-Frank Bill and
Future Regulation
• The system of financial regulation is
undergoing dramatic changes after the
global financial crisis

• Dodd-Frank Wall Street Reform and

Consumer Protection Act of 2010: The most
comprehensive financial reform legislation
since the Great Depression
 The Dodd-Frank Bill and
Future Regulation (cont’d)
• The Dodd-Frank Bill addresses 5 different
categories of regulation:
o Consumer Protection
o Resolution Authority
o Systemic Risk Regulation
o Volcker Rule
o Derivatives
 The Dodd-Frank Bill and
Future Regulation (cont’d)
• There are several areas where regulation
may be heading in the future:
o Capital Requirements
o Compensation
o Government-Sponsored Enterprises (GSEs)
o Credit Rating Agencies
o The Danger of Overregulation