Financial Institutions Management: A Risk Management Approach 10th Edition by Anthony Saunders Solu

 
22.    If financial markets operated perfectly and costlessly, would there be a need for financial institutions?
 
To a certain extent, financial institutions exist because of financial market imperfections. If information is available costlessly to all participants, savers would not need FIs to act as either their brokers or their delegated monitors. However, if there are social benefits to intermediation, such as the transmission of monetary policy or credit allocation, then FIs would exist even in the absence of financial market imperfections.
 
23.    Why are FIs among the most regulated sectors in the world? When is the net regulatory burden positive?
 
FIs are required to enhance the efficient operation of the economy. Successful financial institutions provide sources of financing that fund economic growth opportunities that ultimately raise the overall level of economic activity. Moreover, successful financial institutions provide transaction services to the economy that facilitate trade and wealth accumulation. 
 
Conversely, distressed FIs create negative externalities for the entire economy. That is, the adverse impact of an FI failure is greater than just the loss to shareholders and other private claimants on the FI's assets. For example, the local market suffers if an FI fails and other FIs also may be thrown into financial distress by a contagion effect. Therefore, since some of the costs of the failure of an FI are generally borne by society at large, the government intervenes in the management of these institutions to protect society's interests. This intervention takes the form of regulation.
 
However, the need for regulation to minimize social costs may impose private costs to the FIs that would not exist without regulation. This additional private cost is defined as a net regulatory burden. Examples include the cost of holding excess capital and/or excess reserves and the extra costs of providing information. Although they may be socially beneficial, these costs add to private operating costs. To the extent that these additional costs help to avoid negative externalities and to ensure the smooth and efficient operation of the economy, the net regulatory burden is positive.
 
24.    What forms of protection and regulation do regulators of FIs impose to ensure their safety and soundness?
 
Regulators have issued several guidelines to insure the safety and soundness of FIs:
 
a.      FIs are required to diversify their assets. For example, banks cannot lend more than 15 percent of their equity to a single borrower.
b.      FIs are required to maintain minimum amounts of capital to cushion any unexpected losses. In the case of banks, the Basle standards require a minimum core and supplementary capital based on the size of an FIs’ risk-adjusted assets.
c.      Regulators have set up guaranty funds such as DIF for commercial banks, SIPC for securities firms, and state guaranty funds for insurance firms to protect individual investors.
d.      Regulators also engage in periodic monitoring and surveillance, such as on-site examinations, and request periodic information from the FIs.
 
25.    In the transmission of monetary policy, what is the difference between inside money and outside money? How does the Federal Reserve try to control the amount of inside money? How can this regulatory position create a cost for the depository institutions?
 
Outside money is that part of the money supply directly produced and controlled by the Fed, for example, coins and currency. Inside money refers to bank deposits not directly controlled by the Fed. The Fed can influence this amount of money by adjusting reserve requirement and discount rate policies. In cases where the level of required reserves exceeds the level considered optimal by the FI, the inability to use the excess reserves to generate revenue may be considered a tax or cost of providing intermediation.
 
26.    What are some examples of credit allocation regulation? How can this attempt to create social benefits create costs to a private institution?
 
Credit allocation regulation supports the FI’s lending to socially important sectors such as housing and farming. For example, the qualified thrift lender test (QTL) requires thrifts to hold 65 percent of their assets in residential mortgage-related assets to retain the thrift charter. Some states have enacted usury laws that place maximum restrictions on the interest rates that can be charged on mortgages and/or consumer loans. Such price and quantity restrictions may have justification on social welfare grounds—especially if society has a preference for strong (and subsidized) housing and farming sectors. However, they can also be harmful to FIs that have to bear the private costs of meeting many of these regulations. To the extent that the net private costs of such restrictions are positive, they add to the costs and reduce the efficiency with which FIs undertake intermediation.