Regulatory Environment for Banking & Finance (FINA 2001)

Semester 1 – Year 2014/15

Simple and easy; something that everyone can understand!

Lecturer: Warrick Ward

elementsofbanking@yahoo.com or e-learning (Moodle)

Lecture 1 – The Financial System

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 shortly)

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, “go-betweens” 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 crucial for the

entire economy

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.orto facilitate efficient allocation of capital and risk.

The Functions of the Financial System

1. Clearing and settling payments2. Pooling resources3. Transferring resources & specialisation4. Managing risk5. Providing information6. 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 yearsLong-term: Term >10 years

2. Equity –The holder is in an ownership position and only has a residual claim on the assets of the issuer.

Residual claim means that any benefit of the firm’s 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 = equity2. 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.

How is this possible and who are the main players?

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 IntermediariesContractual 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 long-term 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 IntermediationFinancial intermediaries improve the efficiency of financial markets. The reasons are

the following:

1) Individuals’ small savings can get a higher interest rate when they aremarketed as a part of a larger loan.

2) Households and small firms, for which it would be impossible to getfunds as direct finance, can get relatively large loans from banks.

3) Financial intermediaries reduce the costs of collecting information ofall 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 superior information when compared with non-financial entities in evaluating the risk related to a certain client.

Financial Intermediation5) 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 informationAdverse 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 gapRating agenciesRegulation: 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 monitoringfree-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 hazardInvestor Relation departmentsmonitoring: corporation law, auditors, making firms more

transparentreducing the incentive-gap: employee option planscorporate 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 cost-effective, 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

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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 arm’s 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 compliance related enforcement activities and actions.‑

How to Regulate Entities?

• Micro-prudential supervision – concerned with individual registrants– Governance

• Board’s 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