AP/ECON 3430 3.0 Monetary Economics I Fall 2016 Topic 8A: Bank Regulation Prof. Brenda Spotton Visano

Potential Benefits of a Financial Intermediary The firm issues liabilities against itself in payment for income earning assets Creates a portfolio of financial instruments – as Assets and as Liabilities – and seeks to maximize profit and minimize risk Adds value if there are economic benefits to asset transformation and information provision

Canadian Deposit-taking FIs Deposit-taking FIs (banks, credit unions) Sources of funds = Liabilities = Deposits (including demand deposits = medium of exchange “money”) Uses of Funds = Assets = Government Debt (T-Bills, Bonds) + Residential Mortgages Assets – Liabilities = Net Worth = Bank Capital = Shareholder Equity = 8% of Total Assets → Deposit-taking FIs are highly leveraged

Our 3430 Bank Balance Sheet Bank capital = 5% of Total Assets How much of a drop in the value of securities or of loan default would wipe out the bank’s equity? If there is a “run” on the bank, how might a problem of illiquidity force insolvency? If the value of securities fall in price by 30% or someone defaults on a $500 loan, Bank capital falls to $0

Our “3430 Class Bank of Deposit” Restrictions we self-imposed on our bank which assets (loans) would be acquired; which assets would be prohibited how much of our deposited reserves would be loaned out Does it matter if our Bank fails? What does a bank failure mean exactly? How does a bank fail? How might a problem of illiquidity cause insolvency? So what if a bank fails? Who cares? (Who is adversely affected and how?)

Managing the Firm’s Portfolio of Assets and Liabilities Portfolio Objectives: maximize return, minimize risk (liquidity or bankers’ risk, market risk, credit or default risk, and interest rate risk) Given that liabilities are highly liquid (convertible on demand into currency), how would you operate as the manager of this portfolio? What restrictions would you impose on yourself? Equity (Bank capital) restrictions? Asset restrictions?

Self-Regulation As the portfolio manager/bank owner - What mechanisms influence your individual portfolio choices? What mechanisms ensure the prudent management of risks? What pressures might undermine prudential behaviour? As a client/depositor of the bank, would you want to have the bank’s activities overseen/regulated by someone other than the owner/manager? Would you allow anyone to open a bank?

Additional Regulation Additional Regulation? We don’t regulate the inventory of convenience stores! Why impose outside regulation on financial firms? Who should regulate? Federal or Provincial Government? Industry? How? General types of regulation: Market conduct regulation (entry restrictions, licensing, and information disclosure) Prudential regulation (risk assessment and oversight; product restrictions; price restrictions) Government safety nets

Canada’s solution to regulation of Deposit-taking FIs Objectives of regulation: Preserve safety and soundness Protect consumers Enhance competition Prevent system-wide Financial Problems Promote national/social goals Who? “banks” – federal credit unions – both federal and provincial

Canada’s solution to regulation of Deposit-taking FIs (cont’d) How? Banks are heavily regulated in Canada: Entry restrictions (ownership rules) Asset-holding restrictions (prohibited from owning non-financial businesses) Minimum capital requirements (per Basle III) Reporting (disclosure) requirements (Office of the Financial Institutions (OSFI) Must be a member of Canadian Deposit Insurance Corporation (CDIC)

Regulation and the Structure of the Canadian Financial System Once upon a time (< 1990) there were 4 pillars… Enforced separation of deposit banks from trust companies separate from securities dealers (investment banks) separate from insurance companies With technological advance in information and communications plus globalization plus an increasingly widespread belief in benefits of “free” markets …then there were 3 pillars… Cross-pillar consolidation begins (1990s) with banks and securities firms (merging retail and investment banking firms)

Structure of the Canadian Financial System (cont’d) Deregulation and arguments in favor of mergers to capture economies of scope …and then there were 2 pillars… Further consolidation sees banks acquire trust companies (late 1990s) To “enhance consumer interests” and increase regulatory “efficiency” …and there was 1 pillar … Banks were permitted to retail insurance products directly and through holding companies (2006) Is there a risk of “too big to fail”?