Chapt-4 Regulating the Financial System (Flash).pptx

Financial Markets and Institutions

1. Financial Markets and Institutions CHAPTER FOUR: REGULATING THE FINANCIAL SYSTEM

2. Chapter Objectives After completing this chapter, learners will be able to: Some Facts on Financial Systems Justify reason for regulation Explain objectives of financial markets regulation Identify forms or types of financial market regulation Identify types of regulation for commercial banks

3. 4.1 Why Regulation? market is highly exposed to fraudulent speculation and insider manipulations to ensure stability or market imperfections or operation of the market to correct unfair distribution resources to protect shareholders and t o promote public confidence . Unlike non-financial enterprises , a failure of one bank or security market does not end in itself It has a knock-on defect on all other banks and or securities markets and ultimately the economy at large

4. 4.2 Some Facts on Financial Systems Large portion of bank loans are either originated by government agencies or carried government guarantees Example , There are government loan programs for small businesses, for housing , for exports, and for a host of other worthy causes. 2. There are (were) Financial failures everywhere: In 1990s crises in financial institutions have rocked Chile, Hong Kong etc. Argentine Economic Crisis of 2001–2002 Uruguay banking crisis of 2002 The world financial crises of 2007-2009. The  2008–2014 Spanish financial crisis Russian financial crisis of 2014–2016

5. Some Facts on Financial Systems: Cont’d 3. The stock market is, first and foremost, a forum in which individuals can exchange risks. Funds are raised to finance new ventures and expand existing activities . Market Failure Financial market regulation is justified because the market mechanisms of competition and pricing could not manage it self with out help. The financial crises of the world are believed to be the result of market failures.

6. Some Facts on Financial Systems: Cont’d The competitive markets theories are based the premise that there is perfect flow of information in the market. But in reality there is imperfect flow of information. For example, investors (buyers of securities) and the management of the firms (sellers) have unequal opportunity to information about: Solvency of the FIs Financial and operating performance results Management and its philosophy

7. 4.3 What is the rational for government Intervention? The following are some of the frequently cited failures requiring intervention to correct (Keith p 434): The externalities problem The problem of asymmetric information The Principal-agent Problem The moral hazard problem

8. What is the rational for government Intervention ?: Cont’d Externalities Problem How financial system play a pivotal role in the economy? By providing a payment mechanism for the entire economy and By linking both lends and users of funds. This means that problem in the Financial sector can potentially have a disastrous effect on the entire economy .

9. What is the rational for government Intervention?: Cont’d 2. Problem of Asymmetric Information Asymmetric information means investors and managers are subject to uneven access to or uneven possession of information. The management and directors of a company as well as FIs have more information than the investors (suppliers of fund) on: Soundness of the company Its likely policies For this reason the following regulations are necessary: a law that prohibits insider trading Regulation on disclosure requirements or obliging companies to make financial information to potential and actual investors

10. What is the rational for government Intervention?: Cont’d 3. The Principal-Agent Problem Managers and directors are agents of shareholders or investors ( principals) There is potential problem that the directors and managers could pursue their own interest at the expense of the shareholders and investors. For this reason they are obliged to disclose information on the financial performance of the company and are subject to rules on their own dealings

11. What is the rational for government Intervention?: Cont’d 4. The moral hazard Problem By moral hazard mean that an insurance against an event occurring will make the event more likely to occur than if the event was not insured against. For example, a deposit insurance protection scheme will guarantee investors their funds should a deposit taking institution get into difficulty.

12. What is the rational for government Intervention?: Cont’d However , this may encourage depositors to channel more of their funds into risky FIs which are more likely to run into problems and thereby lead to a higher loss of deposit than the case no deposit protection insurance policy exists. Moral hazard in the context of financial transactions refers to the risk that the borrower might divert the fund to some unproductive (undesirable) areas of investment viewed from the lenders side which will make it less likely that the loan will be paid back.

13. 4.4 Objectives of Government For Financial Markets Regulation The government is responsible for the following activities : Consumer protection Ensuring bank solvency Improving macroeconomic stability Ensuring Competition Stimulating growth Improving the allocation of resources

14. Objectives of Government For Financial Markets Regulation Objectives include: Promoting financial stability Macroeconomic stability: controls over the financial exchanges, clearing houses and securities settlement system. Microeconomic stability: general rules on the stability of all business enterprises and entrepreneurial activities. For example, legally required amount of capital borrowing limits risk based capital ratios limits to portfolio investments etc.

15. Objectives of Government For Financial Markets Regulation B. To provide protection for investors against fraud or the dissemination of misleading or inadequate information. Example of Fraud: Deliberate manipulation of share prices concealment of crucial information from investors The sale of inappropriate policies Insider trading The misuse of investors ’ funds

16. Objectives of Government For Financial Markets Regulation C. Desire to promote fair and healthy competition to ensure competitive price for consumers D. To control the activities of FIs I n order to exert some degree of control over the level of economic activities, particularly with respect to monetary policy.

17. 4.5 Types of Government Regulations ( Fabozzi ,Keith) 1 . Disclosure Regulation to ensure actual financial information to potential investors or to avoid problem of information asymmetric and agency problems . 2. Financial Activities Regulation to restricts insider trading by insiders who are corporate officers and others in positions who know more about a firm’s prospects than general public. To prevent collude and defraud the general investing public.

18. Types of Government Regulations: Cont’d 3. Regulations of FIs T hese regulation restricts FIs’ activities in the vital areas of: Lending, and borrowing The idea of these restrictions is to: ensure that FIs do not take excess risks with investors’ funds and also limit potential conflicts of interest

19. Types of Government Regulations: Cont’d 4. Liquidity requirement to ensure that unnecessary problems due to insufficient liquidity to meet depositor's demand. For example, commercial banks are expected (legally required) to maintain a prudent level of cash reserve as a ratio of their deposit to meet withdrawal demands known as the reserve ratio .

20. Types of Government Regulations: Cont’d 5. Capital Adequacy requirement (long run solvency) Liquidity is essentially to maintain short-term cash to meet demand for deposit withdrawals . But Solvency or Capital adequacy to maintain a medium to long-term concept concerning the ability of an institution to meet its liabilities as they fall due. The need to maintain sufficient capital to ensure that the FI is regarded as a solvent and remains so even if there are losses on its assets can therefore serve a useful purpose.

21. Types of Government Regulations: Cont’d 6. Regulation of Foreign Participants This regulation limits the role foreigner firms can play in domestic markets and their ownership or control of FIs 7. Licensing regulations FI institutions should be licensed . to prevent undesirable individuals from running FIs and to ensure that FI does not act carelessly with investors’ fund.

22. 4.6 Regulation of the Commercial Banking (CBS) sector Because of the special role that CBs play in the financial system , banks are regulated and supervised by governments. The common regulations include: Minimum Capital requirement for CBs Capital Adequacy Liquidity requirement Asset Quality Portfolio diversification Ceiling imposed on interest rate payable on deposits Geographical restriction on branch banks Permissible activates for CBs

23. Regulation of the Commercial Banking (CBS ): Cont’d A. Minimum Capital requirement for CBs to formalize must have a minimum amount of equity capital to support their activates. For example in Ethiopia: The minimum paid up capital required to obtain a banking business license shall be Five Billion Birr, which shall be fully paid in cash and deposited in a bank in the name and to the account of the bank under formation. (Directive No. SBB/78/2021)

24. Regulation of the Commercial Banking (CBS): Cont’d B. Capital Adequacy R efers to the level of capital in an organization that is available to cover its risk All FI institutions are required to have a minimum amount of capital relative to the value of their assets. This means in the event of loss of assets, the organization should have sufficient funds of its own (rather than borrowed from depositors) to cover the loss. Capital adequacy standards refer to the percentage of assets that is financed by debt or it refers to the maximum level of debt versus equity (degree of leverage) that the FI can have

25. Regulation of the Commercial Banking (CBS): Cont’d C. Liquidity requirement Liquidity refers to the amount of available cash (or near cash) relative to FIs demand for cash The level of liquidity requirement depends on the stability of the market In Ethiopia Current liabilities = Demand (current) deposits + savings deposits + time deposits + similar liabilities Any licensed bank shall maintain liquid assets of not less than 25% (twenty five percent) of its total current liabilities.

26. Regulation of the Commercial Banking (CBS): Cont’d D. Asset Quality Asset quality refers the risk to earnings derived from loans. It measures the degree of risk that some of the loan portfolio will not be repaid. This regulations limit the portfolio that may be extended as unsecured loan . E. Portfolio diversification This refers to FIs’ need to ensure that they have not concentrated their portfolio in one geographic sector or one market segment

27. Regulation of the Commercial Banking (CBS): Cont’d F. Ceiling imposed on interest rate payable on deposits. No interest payable on demand account Countries impose ceiling on the maximum interest rate that could be paid by banks on deposits other than demand (checking) account . G. Geographical restriction on branch banks Some federal or local states prevent large banks from expanding geographically and thereby forcing out or taking over smaller banking entities, possibly threatening competition.

28. Regulation of the Commercial Banking (CBS): Cont’d H. Permissible activities for commercial Banks Limitations can be imposed on the areas of bank investment. Example of Ethiopia (see Directive No. SBB/65/2017 )

29. End of Chapter-4