Regulatory Environment for Banking &

Finance (FINA 2001)

Semester 1 Year 2014/15

Lecturer: Warrick Ward

elementsofbanking@yahoo.com or e-learning
(Moodle)
Lecture 1 The Financial System
Simple and easy; something that everyone can understand!

New Senior Executive - Largest

Insurance Company

Why study finance?

The World is Crazy!!

Overview- Financial System &

Markets
What is the financial system and is
there a need for a financial system?
What is its purpose?
Defined as a set of institutions,
instruments, and markets which
foster savings and directs funds to
their most efficient use.
Co-ordinates and allocates the
coincidence of wants of economic
actors. Transfer funds from savers to
borrowers (More to be discussed

The Participants of the

Financial System
Savers are considered the suppliers of
funds.
Borrowers are demanders of funds.
Financial markets serves as the meeting
place where transactions between
borrowers (units with a shortage of funds)
and lenders (units with excess funds) are
conducted.
Financial intermediaries act as brokers, gobetweens or middle men.

Motivation to understanding the

financial system
Massey needs money for
launching of their new firm.
Where do they get it?
Financial markets
The banks
Own resources

An Institutional Overview of the Financial

System

Markets & instruments

Stock-, bond-, money-, foreign exchange (FX)- and commodity
markets
Derivatives markets in developed exchanges for all the above.

Intermediaries
Deposit banks, investment banks, private banks, insurance
firms, mutual funds, pension funds, venture capital funds,
trusts, etc.

Information providers
Rating firms (any in the Caribbean?), performance evaluators,
analysts, Reuters, Bloomberg.

Public institutions & regulators

Regulators, legal fraternity, central banks, tax payer,
international bodies (BIS, IMF, IBRD (World Bank), etc.)

Governments and households

The Financial System Circular Flow of Resources

The Relevance of the Financial

System
The financial system, and the financial
prices it produces are becoming
increasingly important:
The sector is growing as a percentage of GDP as well as
its contribution to GDP.
The financial sector is becoming more complicated and
more risk-orientated

Financial volatility, higher number and type of

financial instruments and contracts
The system is more competitive and global
Participation in the system is becoming more important in
both corporate and personal decision-making.
Financial prices and architecture are becoming more

The Functions of the Financial

System
Markets create value: savers get interest income
that they can spend afterwards, while investors
make profits sometimes higher than the interest
payments on savings
The primary function of any financial system is to
facilitate the allocation and deployment of
economic resources in an uncertain environment.
or
to facilitate efficient allocation of capital and risk.

The Functions of the Financial

System

1. Clearing and settling payments

2. Pooling resources
3. Transferring resources &
specialisation
4. Managing risk
5. Providing information
6. Dealing with incentive problems

The Financial System Some key concepts

Entities with surplus funds savers - ( Income >

Consumption) through the financial system lend to those
who have a shortage of funds demanders of credit (Consumption > Income).

Direct finance refers to those instances where entities

borrow directly from lenders without the intervention of an
intermediary (indirect finance). There are risks. What are
some of these risks?
Example:

- Company A borrows money from directly from Company

B OR
- An investor through an internal agreement makes a
direct investment into a company, or buys a new issue of
stock directly from an issuing company.

The Financial System Some key

concepts
Indirect finance occurs when
there is the use of an intermediary
in the execution of a transaction.
Debt Securities represent

the claims on
the activities/assets of the security issuer.
They serve as assets for the person who buys them,
and liabilities for the individual or firm that sells or
issues them.
Example: If TCL needs to borrow funds in order to
build a new cement plant, it can directly borrow
funds from a lender by selling bonds.

The Financial System Some key concepts

Primary markets are those in which newly-issued

instruments are offered to initial buyers.
Secondary markets refer to markets in which
previously-issued instruments are offered for resale.
In the region the stock exchanges tend to offer
securities in which market - the secondary or primary
market?
Risk-sharing, liquidity, and information services are
provided in the secondary markets.

The Financial System Some key concepts

Debt vs. Equity
Firms/Individuals can obtain funds in through either debt or equity
or a combination
1. Debt/Fixed Income Securities Instruments that provide the holder with a claim on the
assets of the issuer. Example bonds, term loans, commercial paper, mortgages, etc.
Short term debt: Term < 1 year
Intermediate-term: 1 year < Term < 10 years
Long-term: Term >10 years
2. Equity The holder is in an ownership position and only has a residual claim
assets of the issuer.

on the

Residual claim means that any benefit of the firms income is derived AFTER all others have
been paid including interest pmts, wages, taxes. Note dividends are paid from NET INCOME.
Disadvantage - as an owner of the company, you are last for your claim to income or assets.
Advantage - Can benefit if the firm does really well. The stock price could double or triple in a
short period of time, while as a bondholder/debtholder, you are paid a fixed rate of return.

The Financial System Some key concepts

Money vs. Capital Markets

Money markets - Debt securities with less than one yr to

maturity. Considered safe, and liquid.
Capital markets - Equity and debt with more than one year to
maturity. Could be riskier.
Money Market Instruments:
- Treasury Bills (T-bills) with 3, 6, or 12 month maturities.
- Considered risk-free securities of the government
denominated in local currency.
- Commercial paper short-term debt instruments issued by
corporations to holders, such as other large companies,
insurance companies or banks. Could serve an example of
financial disintermediation.
- Banker's Acceptances A short-term credit instrument
guaranteed by a bank trypically to facilitate international
trade. Bank guarantees payment, usually of an import order.

The Financial Market: Some Basic Terms and

Concepts

Capital Market Instruments: Capital market

instruments refer to those instruments
whose maturity occur longer than one year
1. Stock = equity
2. Mortgages - Debt secured by real property (land
and/or buildings). Largest debt market in US. Note
securitisation of mortgage industry
3. Corporate Bonds: Long-term debt instruments to
finance firm operations.
4. Government bonds: Long-term debt instruments
issued by the government e.g. Treasury notes and
debentures. Note issues by statutory corporations,
municipalities and states.
5. Eurodollar securities - dollar-denominated assets
issued by a non-US issuer, e.g. Barbados external
capital markets debt.

Financial Intermediaries
Importance of financial markets There are benefits to
those with savings/excess funds. You have $5,000 to
invest for a period of time. There are thousands of
investment opportunities to choose from. You benefit
through the receipt of a rate of return, a reward for
postponing consumption.
Benefits those who either have a great business idea
or invention but have no funds. It is not always the
case where those with good ideas have money.

Financial intermediaries

With the current financial system individuals to live beyond their

current
income level using future income and escape the limitation
of current income. Transfer our purchasing power from the future to
the present.
- Example: We can buy a $40,000 car today without having all of
the cash.

Financial Intermediaries
Banks

and depository intermediaries accept deposits in the

form of chequing, saving and time deposits (or certificates of
deposits (CDs) which tend to offer a fixed term to maturity).
These deposits are liabilities for the bank and provide a source
of funds used to finance assets.

Depository institutions tend to lend the money out in the form

of business loans, consumer loans, and mortgages. These are
assets of the bank. Banks also invest in Government securities
and municipal/statutory corporation bonds. Usually not
allowed to own stocks, as there are regulatory restrictions on
the portfolio of their investments/trading book.
Profitable venture : Eg. financial intermediaries pay 3-4% to
attract deposits or other funds, then lend at 8-12%.

Financial Intermediaries
Contractual Savings Institutions:

Are financial
intermediaries that acquire funds at periodic intervals on a
contractual basis.

Unlike depository institutions can predict outflows with

greater degree of accuracy hence the liquidity of assets is not
as important as consideration for them and they tend to
invest their funds primarily in long-term securities such as
corporate bonds, stocks, and mortgages.
1. Insurance Companies - source of funds: premiums.
Assets:
stocks, bonds, mortgages, T-bonds. Mostly longterm assets based on actuarial projections.
2. Pension funds - Employer/employee or solicited
contributions provide source of funds. Assets are bonds and
stocks, usually through mutual funds.

Financial Intermediation
Financial intermediaries improve the efficiency of financial
markets. The reasons are the following:
1) Individuals small savings can get a higher interest rate when they
are
marketed as a part of a larger loan.
2) Households and small firms, for which it would be impossible to
get
funds as direct finance, can get relatively large loans from banks.
3) Financial intermediaries reduce the costs of collecting information
of
all borrowers and lenders. It would be very expensive for lenders
to identify all potential borrowers, and for borrowers to identify all
potential lenders.
4) If a lender/saver finds a potential borrower, that individual has the
problem of finding out whether the borrower is likely to repay his
debts. Financial intermediaries, on the other hand, have regular
information of the financial situation and credibility of their clients
by following the movements on their accounts. This gives them

Financial Intermediation
5) Financial intermediaries reduce the transaction costs which would
have to be paid if every lender and borrower himself writes an
appropriate loan contract, or pays the brokerage commission for the
transaction. Smaller transaction costs related to one large loan as
compared with many small loans creates economies of scale (lower
unit costs at a larger scale of operation) into the lending business.
6) Financial intermediaries create maturity transformations between
financial agreements. From a continuous inflow of small short-term
deposits from various sources with varying interest rates, a bank can
issue large long-term loans with a fixed interest rate. The deposit
base represents a pool of stable funds (Many people withdraw
money every day!)
7) The expertise and education of the personnel in banks allows them
to make better investment decisions as compared with small savers
with less information. The investing of large sums of money may
though create large losses in the case banks make unsuccessful
investment decisions.
8) If a bank has enough independent depositors and borrowers, the
risks related to one client do not threaten the existence of the whole
bank, which might happen in the case of a small financial unit.

Financial Intermediation
9) Serve as a conduit or transmission path for monetary policy.

Adverse selection: The Lemons

Problem
The presence of asymmetric information drives the
probability of adverse or negative selection.
Intermediaries reduce adverse selection (lemons
problem)
problem is reduced by the provision of information
Adverse selection reduces the attractiveness of direct finance
The key role of intermediaries, especially banks, is that they
reduce asymmetric information in financial markets.

Other mechanisms to reduce problems caused by the

information gap
Rating agencies
Regulation: laws on information releases, insider rules etc..
Reducing the incentive-gap: collateral

Lemons problem
Existence of asymmetric information Inequality of information. Borrower may
not reveal all information to the lender
about the riskiness of the project,
potential payoffs.
Example: The trade-in your old car.
You have better knowledge of the problems
than the average buyer.
Generally, the dealer has better knowledge
of the market for used cars.

Lemons problem
Solved?

Moral Hazard Problem

Intermediaries reduce moral hazard problems
The manager-owner problem involves costly monitoring
free-riding problem in public markets, but not in private
deals (e.g. venture capital funds, big owners, debtors
holding shares of equity)

Other mechanisms to reduce moral hazard

Investor Relation departments
monitoring: corporation law, auditors, making firms more
transparent
reducing the incentive-gap: employee option plans
corporate governance structures (employee option plans,
board structure, institutional ownership, shareholder
value focus) is taking over the role of big inside owners
self interested monitoring

The Need to Regulate General Thoughts

Regulation is seen as an important factor in economic development and
social welfare.
But regulation can impose direct and hidden costs on economic activity
and can inhibit risk-taking. (From a regulatory point of view is this
good or bad?)
The effectiveness of regulation/regulatory frameworks, with the key
considerations being whether regulatory frameworks are costeffective, and whether they are delivering the intended outcomes.
Need to assess the regulatory framework and effectiveness through the
use of ex-ante tools such as impact assessments, and ex-post tools
which examine the costs or burdens
imposed by regulation.
Assessing the effectiveness and efficiency of regulators as institutions,
including their structure, their
risk focus, and their enforcement
approach.

Objectives of Financial
Regulation
1.Over-arching goal
Build public and stakeholder confidence in the
financial system as a whole, thus
strengthening economic conditions.

2.Operational goals
Solvency Registrants ability to discharge all
obligations to the public
Market Conduct obligations are in fact
discharged in an equitable and timely manner

Motivation

31

Why Regulate?
Risks of not having regulation
Risk of wider, systemic market failure
Risk of market abuse by dominant companies
Risk of uncompetitive behaviour (detrimental to the
consumer)

Systemic risk:
Failure in one part of the financial system is liable to
have serious effects on other activities and
institutions: contagion.
Bank runs (e.g. Northern Rock)
Counter-party risk (e.g. interbank market seizes up)

Why Regulate?
Information asymmetry
Many consumers of financial services with
poor understanding of offered products
Clear vulnerabilities to exploitation

Fraud
Financial services activities are particularly
attractive
Preventive and punitive activity against
fraud is essential.

The Effectiveness of Regulatory

Frameworks
Regulatory independence
Key role of ensuring that regulated businesses supply
essential services at a fair price to the public.
In the confidence business All parties need be
confident in the regulator and its independence
A delicate balance - established as arms length bodies
from government.
Independence also allows more objectivity and
openness Decisions are made in the public interest,
and free from political pressure or pressure from
regulated entities.
Political influence exerted for one reason or another can
reduce the effectiveness of the regulatory framework
and raise the cost of regulation

Regulatory Burden?
Costs of regulation
Administrative costs (proving compliance to
the regulator)
Financial costs (actual payment of fees, etc.)
Policy costs (indirect costs which may be
imposed on business insofar as it reduces
productivity and innovation)
Cost of the regulator

How to Regulate Entities?

Simply need to set out a compliance regulatory
framework.
Framework sets out precise details regarding how the
FSC will execute its mandate for supervising
registrants' compliance with the provisions set out in
legislation, regulations and other forms of guidance
The framework is also the foundation for all
compliancerelated enforcement activities and
actions.

How to Regulate Entities?

Micro-prudential supervision concerned
with individual registrants
Governance
Boards Compliance Statements
Fit and Proper Requirements
Corporate Governance Code

Risk Management behavioural/conduct

Minimum capital ratios
Sectoral limits (e.g. < X% in tourism)
Lending practice rules (e.g. adequate documentation
requirement)
Large exposure limits (e.g. top 25 customers < Y%
loans)

How to regulate entities?

Micro-prudential supervision
Safety and soundness considerations
Risk Management
Enforcement
Removal unfit persons
Fines
Resolution mechanisms
Amend/remove licence

How to Regulate Entities?

Macro-prudential supervision concerned
with ensuring the stability of the financial system as
a whole. (New shared roles of the FSC with other
safety net participants, including the Barbados
Deposit Insurance Corporation)
State of the economy and threats to financial
stability (e.g. boom/bust, concentration of risk in
particular sectors, levels of indebtedness, solvency
levels, capital adequacy and credit growth)
Financial Stability Report, annual CBB publication