EXC 3732 Financial Bubbles, Crashes and Crises

• Financial sector is intrinsically fragile (borrowing short and lending long)
• intrinsically reliant on trust (suspected cause for fragility)
• main source of trouble are unexpected losses. (which are inevitable in a sector dedicated to forecasting the future)
• assymetric information -> adverse selection and moral hazard problems -> credit risk

• financial sector is partially opaque/ non-transparent
• feature not a bug: allows funding of new, unconventional or marginal projects/borrowers (banks won't reveal your business idea to others)
• enables diversification and efficient investment
• allows bad, unethical, misguided practices to foster and spread unchecked

• Fin. sys. provides necessary services in a monetary economy: transactions, credit, insurance
• Necessary for modern economies to function (as much as electricity)
• Fin. distress extremely costly for society at large

-> a necessary and important sector, intrinsically prone to dramatic collapse (because of opacity and fragility) requires regulation

- has always been regulated under any political/ideological regime (only a question of scope and effectiveness)

1. restrictions on asset holdings
2. capital requirements
3. chartering
4. disclosure requirements
5. general consumer protection
6. regulate competition
7. financial supervision

• risk: restrict amount of risk held
• liquidity: liquidity coverage ratio - given amount of very liq. assets
• diversification: diversification rules , limiting the share of total assets held in one or few asset classes

• two types
  • basic leverage ratio (capital/assets)
  • risk based capital requirements (capital/risk weighted assets)
• more equity -> more to loose -> less risk taking
• more equity capital gives safety buffer

>Prerequisites that have to be met to open a bank or other fin. institution

>Rules on disclosure of credit & risk exporsure, reserves, capital

• General consumer protection rules apply also in the financial services industry
• many court cases (also in Norway) based on allegations that banks violated rules              for consumer protection

• increased competition -> increased risk taking
• measures to reduce competition (to reduce risk taking) have included:
  • restrictions on branching
  • very strict chartering rules
  • restrictions on non-banks' ability to provide fin. services
  • restrictions on establishment and operation of foreign-owned banks

• incl. on-site examinations (of diff. areas)
  • analysis of asset holdings (loans, other investments)
  • .. of capital holdings (level, risk-weights)
  • assessment of the bank credit and risk management process (evaluate the bank credit routines, evaluate the banks risk management procedures)