1. Copyright © 2014 Pearson Canada Inc. Chapter 10 ECONOMIC ANALYSIS OF FINANCIAL REGULATION

2. Copyright © 2014 Pearson Canada Inc. 10-2 Learning Objectives 1.Explain bank regulation in the context of asymmetric information problems 2.Characterize how the CDIC handles failed banks and detail recent CDIC developments 3.Outline the banking crises that have occurred in Canada and other countries throughout the world

3. Copyright © 2014 Pearson Canada Inc. 10-3 Asymmetric Information and Bank Regulation I Government Regulator OSFI Government safety net: Canadian Deposit insurance Corporation (CDIC) -protecting bank customers Bank of Canada works as“Lender of Last Resort” -Providing liquidity for banks

4. Copyright © 2014 Pearson Canada Inc. 10-4 * Some advocates of free financial market may argue Government Safety Net may make the banking system less stable through: Moral Hazard and Adverse Selection –depositors do not be cautious as their deposits are insured, depositors have little reason to monitor financial institutions –and thus not impose marketplace discipline(avoiding bad ones). –financial institutions have an incentive to take on greater ris

5. Copyright © 2014 Pearson Canada Inc. 10-5 * Ultimately, the government may foster financial monsters: “Too Big to Fail” Big banks assume the government would not dare to ignore when they are in troubles, and the government will have to rescue them with public funds.

6. Copyright © 2014 Pearson Canada Inc. 10-6 ** Just note that The Most Important Summary Slide for Chapter 10s and 13 is the next one! Out of 5 areas of Financial Regulation or Supervision, the most concrete one is Risk Management, particularly Risk Management through Capital Requirements.

7. Copyright © 2014 Pearson Canada Inc. 10-7 Major Five Areas of Government Regulations Financial Supervison by OSFI 1) Bank Ownership Restriction to foster competition, fairness. - A single shareholder at 20% in a ‘large bank’($12 billion); A single shareholder at 65% in a ‘medium size bank($2-12 billion); 2) Risk Management to enhance Stability. -Capital Adequacy Requirements(CAR) for Pillar II risks and - Disclosures on other Risk Management for Pillar 3 risks **Internal Capital Adequacy Assessment Process to be in place 3) AML/ ATFT Self-Surveillance for Transparency *Some part overlapping with FINTRAC 4) Accounting/Auditing/Disclosure Requirements for Transparency, Internal Control, and again Transparency -Accounting: IFRS newly adopted as opposed to Canadian GAAP -Auditing is to secure Internal Control; Banks should have 3 layers of Defense lines(3 Pillars of Basel Accord) -Disclosure is enhanced with Bill 198 (Canada) corresponds to the Sarbanes-Oxley Act (U.S.) 5) Customer Protection for Fairness

8. Copyright © 2014 Pearson Canada Inc. 10-8 Risk Management 1.By having the adequate amount of Capital, banks may be manage a certain kind of Risks. It is called (regulatory) Capital Adequacy Requirements (CAR<-regulator) through Internal Capital Adequacy Assessment Process(<-Compliants = Banks) or ICAAP 2.

9. Copyright © 2014 Pearson Canada Inc. 10-9 Capital Adequacy Requirements(CAR) -How much Capital should be set aside to manage Risks? Depending on capital used, there are different minimum Requirements for Capital or adequate Ratios: 1)Common Equity Tier 1 Capital Ratio 2)Tier 1 Capital Ratio 3)Total Capital Ratio -What are the actual required minimum ratios? 1)In Basel Accord, the minimum Total Capital Ratio is known as BIS ratio, which is set 8% worldwide for now. 2) In Canada, the minimum total capital ratio is set at 8% + capital conservation buffer 2.5% = 10.5%

10. Copyright © 2014 Pearson Canada Inc. 10-10 It is the most important concept in Chapters 10 and 13, and for the test You are expected to be technically familiar with CAR and ICAAP: “How to Calculate the Capital Adequacy Requirements or Capital Adequacy Ratios (including the ‘BIS ratio)”. It is complex, yet its simplified presentation is explained here. Click here. Please, make sure that you can do the last simplified exercise question at the end.Click here

11. Copyright © 2014 Pearson Canada Inc. 10-11 Restrictions on Competition Justified as increased competition can also increase moral hazard incentives to take on more risk Disadvantages –higher consumer charges –decreased efficiency

12. Copyright © 2014 Pearson Canada Inc. 10-12 Is that all of Bank Regulations?

13. Copyright © 2014 Pearson Canada Inc. 10-13 Nature of Canadian government’s financial sector regulations Principle Based Regulation (Canada) versus Rule Based Regulation (U.S., and other countries) paper by Han and Ibbott(2009)

14. Copyright © 2014 Pearson Canada Inc. 10-14 The textbook authors put the following table here in Chapter 10, but I have covered it in Chapter 11 in conjunction with the Canadian banking history. Thus it is not new. I am just keeping it here for your reference.

15. Copyright © 2014 Pearson Canada Inc. 10-15 Major Financial Legislation in Canada