• BEO2000 Financial Institutions & Monetary Theory
• Lecture 11: Regulation of Financial Institutions
• Primary Sources:
• Backiciol et al. Basel II
• EBA, 2015, Implications of Basel III
• APRA, 2017, Supervisory Oversight and Response System
• APRA, 2018, Probability and Impact Rating System
• Learning Outcomes
• With respect to learning outcomes, you should be able to:
• a. Discuss the reasons that banks are regulated;
• b. Explain the broad regulatory structure in Australia;
• c. Explain the capital requirements arising from Basel;
• d. Review potential implications arising from Basel III;
• e. Explain how regulators monitor banks in Australia.
• Regulation
• Regulation is a mechanism for preventing failures, or confining their effects.
• Key aspect of regulatory examinations is to detect bank problems in time to correct them.
• The two most common types of failure are:
i. Insolvency
• Insufficient assets to cover liabilities
ii. Illiquidity
• Asset/Liability mismatch
• Regulation
• Broad regulatory responses:
i. Insolvency:
• Emphasise adequate capitalisation.
• Minimum capital standards in terms of risk-weighted assets.
• Severe sanctions for undercapitalisation.
ii. Illiquidity
• Regulators proactively monitor funding practices.
• Regulators can arrange for emergency funding
, • Reasons for Regulation
Regulation subjects financial institutions to certain requirements, restrictions and guidelines.
i. Financial institutions importance to society
• The power to allocate credit is a significant and valuable social and economic power.
• Role as income flow intermediary.
• Great social and economic costs
ii. Financial institutions operate in an asymmetric information environment.
• (i.e.,) difficult to expertly gauge a financial institution’s safety or soundness.
• Regulatory Issue: Too Big To Fail
• Financial regulators are reluctant to allow a big institution to fail
– Big banks expect their Central Banks to provide support if they are in danger of
failing.
– U.S. government implicitly promises full bailout of the largest institutions.
– A financial institution with a government safety net will act differently to those
without one.
– This creates a ‘two-tiered’ banking industry.
– Adds to the temptation of the largest institutions to ‘gamble’, thereby increasing
moral hazard incentives.
• Extends moral hazard to large NBFIs as well.
• Regulatory Structure: Australia
Legislation
• Key pieces of legislation for Australian financial institutions:
i. Reserve Bank Act 1959
ii. Banking Act 1959
iii. Financial Sector (Shareholdings) Act 1998
iv. Financial Sector (Collection of Data) Act 2001
v. Legislation Amendment (Financial Claims Scheme and other Measures) 2008
Supervision
– RBA
• System stability and payments system
– APRA
• Prudential regulation and supervision of ADIs
• Lecture 11: Regulation of Financial Institutions
• Primary Sources:
• Backiciol et al. Basel II
• EBA, 2015, Implications of Basel III
• APRA, 2017, Supervisory Oversight and Response System
• APRA, 2018, Probability and Impact Rating System
• Learning Outcomes
• With respect to learning outcomes, you should be able to:
• a. Discuss the reasons that banks are regulated;
• b. Explain the broad regulatory structure in Australia;
• c. Explain the capital requirements arising from Basel;
• d. Review potential implications arising from Basel III;
• e. Explain how regulators monitor banks in Australia.
• Regulation
• Regulation is a mechanism for preventing failures, or confining their effects.
• Key aspect of regulatory examinations is to detect bank problems in time to correct them.
• The two most common types of failure are:
i. Insolvency
• Insufficient assets to cover liabilities
ii. Illiquidity
• Asset/Liability mismatch
• Regulation
• Broad regulatory responses:
i. Insolvency:
• Emphasise adequate capitalisation.
• Minimum capital standards in terms of risk-weighted assets.
• Severe sanctions for undercapitalisation.
ii. Illiquidity
• Regulators proactively monitor funding practices.
• Regulators can arrange for emergency funding
, • Reasons for Regulation
Regulation subjects financial institutions to certain requirements, restrictions and guidelines.
i. Financial institutions importance to society
• The power to allocate credit is a significant and valuable social and economic power.
• Role as income flow intermediary.
• Great social and economic costs
ii. Financial institutions operate in an asymmetric information environment.
• (i.e.,) difficult to expertly gauge a financial institution’s safety or soundness.
• Regulatory Issue: Too Big To Fail
• Financial regulators are reluctant to allow a big institution to fail
– Big banks expect their Central Banks to provide support if they are in danger of
failing.
– U.S. government implicitly promises full bailout of the largest institutions.
– A financial institution with a government safety net will act differently to those
without one.
– This creates a ‘two-tiered’ banking industry.
– Adds to the temptation of the largest institutions to ‘gamble’, thereby increasing
moral hazard incentives.
• Extends moral hazard to large NBFIs as well.
• Regulatory Structure: Australia
Legislation
• Key pieces of legislation for Australian financial institutions:
i. Reserve Bank Act 1959
ii. Banking Act 1959
iii. Financial Sector (Shareholdings) Act 1998
iv. Financial Sector (Collection of Data) Act 2001
v. Legislation Amendment (Financial Claims Scheme and other Measures) 2008
Supervision
– RBA
• System stability and payments system
– APRA
• Prudential regulation and supervision of ADIs
