Financial Regulation

Financial Regulation: Ethic in Finance:
Summarize the class after each session. Class participation => 20%
4 Sessions: 4 summaries.
Session 1: Balance sheets, intermediaries, frictions (adverse selection & moral hazard)
in particular Akerlof’s “lemons model”.
I should be able to:

 Identify frictions in the financial system and name possible remedies.
 Identify situations in which regulatory arbitrage is present.
 Evaluate the appropriate regulatory environment for various financial institutions.
Who are financial intermediaries?
Entities that acts as the middleman between two parties in a financial transaction, such as a
commercial bank, investment banks, mutual funds and pension funds.
Collection of legal agreements: Laws, regulations, rules that we have decided on. Each
company, bank, financial institutions are a aggregates of contracts and agreements. Set of
legal agreements between the founders of entity.
Throughout foundation, the company needs to define accounting practices, shareholder’s right
(common shares voting), it’s business model, etc.
Any financial instrument is a contract: a loan is a legal agreement that allows the loaner to get
money whereas the bank receives interests. E.g. : Mortgages.
Bonds: 5-30 years of maturity where the buyer is entitled to money whereas the company has
some other rights.
Equity: Detaining equity means that we are co-owners of a company. (unlike bonds).
Ownership: Residual control rights. The owner of an asset is the one controlling it. Entitled to
vote in meetings.
Crypto: Some token that are equity do not entitle their owner to ownership of a company.
Financial system: set of contract. Financial instruments: contracts.
Savers are Households / Businesses / Government / Foreigners give their funds to Financial
Intermediaries which give these funds to borrower spenders (firms, government, households,
foreigners). This is the indirect finance.
Direct funds: Savers go to the financial markets which finances spenders.
Financial intermediaries:
- Financial advisors
- Credit Union
- Mutual funds / Investment trusts
- Insurance Companies :
- Pension funds :
- Commercial banks
- Investment banks
Pension funds / Insurance life are different.
Assets of the bank : loans, derivative, bonds, etc.

Liabilities of the bank: savings, deposits.
Asset side maturity: high. Liability side maturity: low. Consequence: fragility.
Assets of the pension fund: cash becomes government/high quality bonds or german bunds.
Liabilities of the pension fund: monthly social security payments.
Asset side maturity: low. Liability side maturity: high. Consequence: stability.
A pension fund can go bankrupt if the country goes bankrupt, if the yields on the bonds are
too low.
Two principal drivers of market failures in finance that require regulation: there are others as
well.
- Asymetric informations
o Adverse selection: breakdown
o Moral hazard:
o Consumer protection – balance the interests of unsophisticated consumers of
financial products and their sophisticated sellers.
- Externalities: not internalizing the consequences of the actions of a company.
o Overall consequence of an activity is not captured by the private interests of
those involved in the activity => internalize through taxation (Pigouvian tax?)
o Costs of financial system failure are > costs to the shareholders of a bank
failure => regulatory response; provide government insurance for depositors
and higher capital requirement than banks would otherwise wish to hold.
Banks are different:
They accept demand deposits (bank runs) and lend to each other (bank A lends from bank B).
That means that if a bank fails, the lender bank can fail as well. This is contagion: the
phenomenon that happens when spillover effects can hit other banks because of how much
interconnected the banking system. The failure of one bank can lead to the downfall of others.
Regulatory instruments:
- Ceilings on deposit interest rates;

- Restrictions on entry, size and mergers;
- Investment restrictions;
- Deposit insurance;
- Capital requirement;
- Monitoring and bank supervision.
Tools for regulating the financial sector:
1. Prudential regulation;
2. Resolution tools;
3. Oversight of clearing and settlement systems
4. Conduct of business regulation.
Financial intermediaries:
Balance sheets: A summary of the assets and liabilities of a bank.

Assets; Reserves, Cash, Securities/Bonds, Loans and Other Assets.
Liabilities; Checkable Overnight deposits, Non-transaction deposits (time deposits,
redeemable deposits -saving accounts), Borrowings (inter-bank loans, central bank loans,
other) & Bank Capital.
Deposits of household A are a liability for ban 1.

Retailers and households have deposits : transfers
Balance Sheet of a bank.
Bank 1
10+10 (loan issued Loan of Household Deposits of
by the bank) Household A
40 Loan of RetailerA Deposits of retailer 40
A
10 Reserves^1 M: Interest rate from 20
the Central Bank
Notes Equity of the +10
HSHOLDS
If the M interest rate increases, the banks cannot use Reserves or Note to compensate it.
Therefore, the interest rate of the loan will increase in consequence.
Liability: somebody helse has on the bank.
The households detain Equit
Transfer of deposits is always matched by the transfer of reserves for the Central Bank.
Adverse Selection Problems: The Lemons Problem.
The difference of information between the seller and the buyer is asymmetric informations.
Example of the cars:

Cars have different quality q: from “very good” q = b, to “bad” q = 0, bad cars = “lemons”.
The seller is privately informed about the quality q € (0,b).
The seller will accept any price p >= q.
The buyer is willing to pay any price =< alpha. Q with a > 1.
For any given q there exists a price € (q, alphaq) where buyer and seller mutually benefit from
the deal.
But! The buyer cannot observe q. => Building expectations.
The expected quality for the car for the uniform distribution.
P(E(q)) =< a*b/2. The price the buyer is willing to pay depends on the buyer’s expectations.
Case 1: a > 2. Then the buyer is willing to pay p >=b and all cars will be sold. High urgency,
will to pay any price.
Case 2: 1<a<2. Then the market breaks down. If the urgency isn’t high enough, the buyer will
never pay the price of the best quality car. If no one is willing to pay high quality cars, then
the best quality cars leave the market. The buyer will therefore manage his expectations. That
means there is even more cars that will be sold. And so forth, “race to the bottom”. If there is
asymmetric information, there is adverse selection. If a loan project is safe, their r is as low as
possible (almost 0).
However, I didn’t really understand the profit maximizing bank for the credit rationing.
Signaling: the privately informed agent has an incentive to provide a trustworthy (costly)
signal about his characteristics.
Collateral: In case of failure of the investment project the investor has other assets which can
be sold to meet the debt obligations.
co-pierre.georg@edhec.edu

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Financial Regulation: Ethic in Finance:

I should be able to:

Who are financial intermediaries?

Financial system: set of contract. Financial instruments: contracts.

Assets of the bank : loans, derivative, bonds, etc.

- Ceilings on deposit interest rates;

Tools for regulating the financial sector:

Balance sheets: A summary of the assets and liabilities of a bank.

Deposits of household A are a liability for ban 1.

Balance Sheet of a bank.

Liability: somebody helse has on the bank.

The households detain Equit

Adverse Selection Problems: The Lemons Problem.

Example of the cars:

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