Lectures Economics of Financial Regulation
2020/2021 – Radboud University Nijmegen
Index
Lecture 1: Introduction and financial instruments.................................................................................. 2
Lecture 2: Overview of Financial Instruments & Introduction to corporate finance ............................ 11
Lecture 3: Adverse selection ................................................................................................................. 23
Lecture 4: Regulation of insurance markets.......................................................................................... 33
Lecture 5: Insider trading ...................................................................................................................... 44
Lecture 6: Take-over and the market for control .................................................................................. 58
Lecture 7: Convex Incentives and Excessive Risk .................................................................................. 74
Lecture 8: Bank runs – Deposit Insurance ............................................................................................. 86
Lecture 9: Overview of Regulation landscape ....................................................................................... 90
Additional lectures on financial instruments ........................................................................................ 99
1. Bonds ......................................................................................................................................... 99
2. Futures and forwards .............................................................................................................. 101
3. Long versus Short .................................................................................................................... 102
4. Swaps ....................................................................................................................................... 104
5. Options .................................................................................................................................... 105
1
,Lecture 1: Introduction and financial instruments
Introduction
This course is about the economic underpinnings why we have a certain form of regulation. The
motivation behind regulation.
Professor Stefan Zeisberger. Economics & Management.
Why Study economics of financial regulation?
Law makers discuss new regulation. Economics behind it play a large role, but sometimes it is
neglected. It is very important to look at the economic underpinnings. If you want to have effective
financial regulation or maybe even an efficient one, then you need to understand the economics
behind it.
Effective: it reaches the goal. It does the job.
Efficient: It does that job at the lowest possible input.
Example: The former president of the Federal Reserve (Central Bank System of the US). Article about
this. About the large financial crash from some years ago. There was a huge problem, there was a
huge bubble that eventually bursted. Now we have to find out what were the reasons for this. After
having out what the reasons were, they had to come up with effective or efficient financial
regulation. The article is about where in the law making process they tried to prevent another crisis
to happen.
Example: CEO makes 15.6 million dollars on average. This is about CEO compensation, whether this is
justified or not. What kind of regulation is in place to limit CEO compensation.
Practicalities
→questions about content of the course
→questions about organization of the course
Topics
First 2 lectures: Generally economics. Not so much about regulation. Not so much about theory. It
will be about the essence.
• Overview of financial instruments
• Introduction to corporate finance
This is to understand the basic mechanisms about the economy and the firm.
After that we will deal with topics that have to do with financial regulation.
• Adverse selection in financial services
• Insurance markets
• Market structure and insider information
o What is an insider?
o Is inside trading good or bad? That is not always so clear.
• Take-overs and the market for control
• Incentive systems and excessive risk (of CEO’s)
• Bank runs, deposit insurance and Bank Insolvency Regimes
2
, • Behavioral aspects of financial regulation
Financial instruments
A financial instrument (asset, securities) is a claim to future cash flows.
In finance we are always interested in the future cash flows, we pretty much never look back. What
kind of payments can we expect? Example: If you own a company share then you are entitled to
having the share for dividends payments. If the firm is liquidated, you will also receive some money if
something is left. You have some rights on future cash flows.
That is different from real assets.
Financial assets versus real assets →
• Real assets are used in the production of goods and services, e.g. machines, materials,
buildings.
• Financial assets are claims on future cash flows or claims on real assets.
Financial instruments are traded in financial markets: a place where supply and demand meets. It’s
much easier to claim financial assets than real assets. That’s one reason why we have them. We will
talk about this in more detail later in the course.
Note: Do not use the words we use in class on an exam. Do not learn the stuff by hard, but try to
really understand. Use your own words to describe it.
Uses of Financial Instruments
• Consumption smoothing:
o When your income streams and desired consumption stream do not overlap
(otherwise so-called hand-to-mouth consumer)
o E.g. You want to buy a car or a house (or a VIP ticket to a Justin Bieber Concert)
o Options: saving, borrowing, investing, etc.
o If you want to buy a house in the near future, then you probably don’t have all the
money for it. Then you borrow money from the bank. The mortgage is a financial
instrument. It is tradable, a financial asset.
So whenever you earn more than you spend or vice versa, then you might have a financial
instrument or asset involved.
If you have some savings and you invest in a company, that is also a kind of consumption smoothing.
You don’t want the money right now, but you want it later so you save it and you invest.
So you’re trying to smooth your consumption over time.
If you always spend the money that you have and there is no possibility for saving or investing, then
you would call it a hand-to-mouth consumer. You find an apple and you eat it right away. But if you
take the apple home and you save it for a day and you eat it tomorrow, that’s consumption
smoothing.
Consumption smoothing is one reason why we have financial assets. Another reason is the allocation
of risks.
• Allocation of risk
o Diversification
3
, ▪ If you have already heavily invested in a certain firm (can also be human
capital!), makes sense to diversify.
▪ Law of large numbers says gains and losses will cancel out (mostly) → The
more investments you have, the safer it is.
▪ If you invest in the company that you work for, that is not very safe. If the
company will go bankrupt, you will not only lose your job, but also your
assets.
▪ It makes a lot of sense to use financials to diversify.
o Hedging
▪ When something not under your control could adversely impact your
performance, makes sense to hedge
▪ There are financial instruments that hedge a company against these risks.
▪ E.g.:
• interest rates: If you purchase a house, a bank will fix the mortgage
rate. You want to hedge against that the interest rates will go up in
the future.
• foreign exchange rates: How does the British pound develop
compared to the Euro?
• commodity prices, etc.
• Allocation of capital – Financing of projects, firms
Bottomline: without financial instruments the world would be way worse, because it would be much
less efficient the way the economy would work.
Actors in the market
• Households
o E.g. You! Putting deposits in banks, buying shares, buying insurances, etc.
• Firms
o E.g. A firm selling bonds to finance an expansion, Twitter offering their shares on
NASDAQ, an ice cream-maker hedging the risk of a bad summer by buying weather
options.
• Bank
o E.g. Acting as intermediary/broker for clients (Banks are between households and
firms) or engaging in proprietary trading (they trade for themselves or clients).
• Investment funds: Companies/institutions investing on behalf of clients (households or firms)
o Mutual funds, e.g. Robeco, Fidelity, Vanguard: Much more regulated, investing on
behalf of clients
▪ More regulation
o Hedge funds: limited private investment partnerships, with limited participation,
large minimum investment and high degree of illiquidity (usually at least a year)
▪ Much less regulation, but much higher requirement on investors
▪ E.g. Mutual funds are not allowed to short sell the market (we will learn later
on what short selling is)
• Pension funds
o E.g. ADP: Very long term liabilities, workers cannot withdraw before pension date.
• Sovereign Wealth Funds
o E.g. The Norwegian Sovereign Wealth Fund (owns 1 to 2% of world equity),
Government of Singapore Investment Corporation
4
2020/2021 – Radboud University Nijmegen
Index
Lecture 1: Introduction and financial instruments.................................................................................. 2
Lecture 2: Overview of Financial Instruments & Introduction to corporate finance ............................ 11
Lecture 3: Adverse selection ................................................................................................................. 23
Lecture 4: Regulation of insurance markets.......................................................................................... 33
Lecture 5: Insider trading ...................................................................................................................... 44
Lecture 6: Take-over and the market for control .................................................................................. 58
Lecture 7: Convex Incentives and Excessive Risk .................................................................................. 74
Lecture 8: Bank runs – Deposit Insurance ............................................................................................. 86
Lecture 9: Overview of Regulation landscape ....................................................................................... 90
Additional lectures on financial instruments ........................................................................................ 99
1. Bonds ......................................................................................................................................... 99
2. Futures and forwards .............................................................................................................. 101
3. Long versus Short .................................................................................................................... 102
4. Swaps ....................................................................................................................................... 104
5. Options .................................................................................................................................... 105
1
,Lecture 1: Introduction and financial instruments
Introduction
This course is about the economic underpinnings why we have a certain form of regulation. The
motivation behind regulation.
Professor Stefan Zeisberger. Economics & Management.
Why Study economics of financial regulation?
Law makers discuss new regulation. Economics behind it play a large role, but sometimes it is
neglected. It is very important to look at the economic underpinnings. If you want to have effective
financial regulation or maybe even an efficient one, then you need to understand the economics
behind it.
Effective: it reaches the goal. It does the job.
Efficient: It does that job at the lowest possible input.
Example: The former president of the Federal Reserve (Central Bank System of the US). Article about
this. About the large financial crash from some years ago. There was a huge problem, there was a
huge bubble that eventually bursted. Now we have to find out what were the reasons for this. After
having out what the reasons were, they had to come up with effective or efficient financial
regulation. The article is about where in the law making process they tried to prevent another crisis
to happen.
Example: CEO makes 15.6 million dollars on average. This is about CEO compensation, whether this is
justified or not. What kind of regulation is in place to limit CEO compensation.
Practicalities
→questions about content of the course
→questions about organization of the course
Topics
First 2 lectures: Generally economics. Not so much about regulation. Not so much about theory. It
will be about the essence.
• Overview of financial instruments
• Introduction to corporate finance
This is to understand the basic mechanisms about the economy and the firm.
After that we will deal with topics that have to do with financial regulation.
• Adverse selection in financial services
• Insurance markets
• Market structure and insider information
o What is an insider?
o Is inside trading good or bad? That is not always so clear.
• Take-overs and the market for control
• Incentive systems and excessive risk (of CEO’s)
• Bank runs, deposit insurance and Bank Insolvency Regimes
2
, • Behavioral aspects of financial regulation
Financial instruments
A financial instrument (asset, securities) is a claim to future cash flows.
In finance we are always interested in the future cash flows, we pretty much never look back. What
kind of payments can we expect? Example: If you own a company share then you are entitled to
having the share for dividends payments. If the firm is liquidated, you will also receive some money if
something is left. You have some rights on future cash flows.
That is different from real assets.
Financial assets versus real assets →
• Real assets are used in the production of goods and services, e.g. machines, materials,
buildings.
• Financial assets are claims on future cash flows or claims on real assets.
Financial instruments are traded in financial markets: a place where supply and demand meets. It’s
much easier to claim financial assets than real assets. That’s one reason why we have them. We will
talk about this in more detail later in the course.
Note: Do not use the words we use in class on an exam. Do not learn the stuff by hard, but try to
really understand. Use your own words to describe it.
Uses of Financial Instruments
• Consumption smoothing:
o When your income streams and desired consumption stream do not overlap
(otherwise so-called hand-to-mouth consumer)
o E.g. You want to buy a car or a house (or a VIP ticket to a Justin Bieber Concert)
o Options: saving, borrowing, investing, etc.
o If you want to buy a house in the near future, then you probably don’t have all the
money for it. Then you borrow money from the bank. The mortgage is a financial
instrument. It is tradable, a financial asset.
So whenever you earn more than you spend or vice versa, then you might have a financial
instrument or asset involved.
If you have some savings and you invest in a company, that is also a kind of consumption smoothing.
You don’t want the money right now, but you want it later so you save it and you invest.
So you’re trying to smooth your consumption over time.
If you always spend the money that you have and there is no possibility for saving or investing, then
you would call it a hand-to-mouth consumer. You find an apple and you eat it right away. But if you
take the apple home and you save it for a day and you eat it tomorrow, that’s consumption
smoothing.
Consumption smoothing is one reason why we have financial assets. Another reason is the allocation
of risks.
• Allocation of risk
o Diversification
3
, ▪ If you have already heavily invested in a certain firm (can also be human
capital!), makes sense to diversify.
▪ Law of large numbers says gains and losses will cancel out (mostly) → The
more investments you have, the safer it is.
▪ If you invest in the company that you work for, that is not very safe. If the
company will go bankrupt, you will not only lose your job, but also your
assets.
▪ It makes a lot of sense to use financials to diversify.
o Hedging
▪ When something not under your control could adversely impact your
performance, makes sense to hedge
▪ There are financial instruments that hedge a company against these risks.
▪ E.g.:
• interest rates: If you purchase a house, a bank will fix the mortgage
rate. You want to hedge against that the interest rates will go up in
the future.
• foreign exchange rates: How does the British pound develop
compared to the Euro?
• commodity prices, etc.
• Allocation of capital – Financing of projects, firms
Bottomline: without financial instruments the world would be way worse, because it would be much
less efficient the way the economy would work.
Actors in the market
• Households
o E.g. You! Putting deposits in banks, buying shares, buying insurances, etc.
• Firms
o E.g. A firm selling bonds to finance an expansion, Twitter offering their shares on
NASDAQ, an ice cream-maker hedging the risk of a bad summer by buying weather
options.
• Bank
o E.g. Acting as intermediary/broker for clients (Banks are between households and
firms) or engaging in proprietary trading (they trade for themselves or clients).
• Investment funds: Companies/institutions investing on behalf of clients (households or firms)
o Mutual funds, e.g. Robeco, Fidelity, Vanguard: Much more regulated, investing on
behalf of clients
▪ More regulation
o Hedge funds: limited private investment partnerships, with limited participation,
large minimum investment and high degree of illiquidity (usually at least a year)
▪ Much less regulation, but much higher requirement on investors
▪ E.g. Mutual funds are not allowed to short sell the market (we will learn later
on what short selling is)
• Pension funds
o E.g. ADP: Very long term liabilities, workers cannot withdraw before pension date.
• Sovereign Wealth Funds
o E.g. The Norwegian Sovereign Wealth Fund (owns 1 to 2% of world equity),
Government of Singapore Investment Corporation
4
