Financial Institutions Management: A Risk Management Approach 10th Edition by Anthony Saunders Solu
27. What is the purpose of the Home Mortgage Disclosure Act? What are the social benefits desired from the legislation? How does the implementation of this legislation create a net regulatory burden on financial institutions?
The HMDA was passed by Congress to prevent discrimination in mortgage lending. The social benefit is to ensure that everyone who qualifies financially is provided the opportunity to purchase a house should they so desire. The regulatory burden has been to require a written statement indicating the reasons why credit was or was not granted.
28. What legislation has been passed specifically to protect investors who use investment banks directly or indirectly to purchase securities? Give some examples of the types of abuses for which protection is provided.
The Securities Acts of 1933 and 1934 and the Investment Company Act of 1940 were passed by Congress to protect investors against possible abuses such as insider trading, lack of disclosure, outright malfeasance, and breach of fiduciary responsibilities.
29. How do regulations regarding barriers to entry and the scope of permitted activities affect the charter value of financial institutions?
The profitability of existing firms will be increased as the direct and indirect costs of establishing competition increase. Direct costs include the actual physical and financial costs of establishing a business. In the case of FIs, the financial costs include raising the necessary minimum capital to receive a charter. Indirect costs include permission from regulatory authorities to receive a charter. Again in the case of FIs this cost involves acceptable leadership to regulators. As these barriers to entry are stronger, the charter value for existing firms is higher.
30. What reasons have been given for the growth of investment companies at the expense of “traditional” banks and insurance companies?
The recent growth of investment companies can be attributed to two major factors:
a. Investment companies differ from banks and insurance companies in that they give savers cheaper access to the direct securities markets. They do so by exploiting the comparative advantages of size and diversification, with the transformation of financial claims, such as maturity transformation, a lesser concern. Thus, open-ended mutual funds buy stocks and bonds directly in financial markets and issue savers shares whose value is linked in a direct pro rata fashion to the value of the mutual fund’s asset portfolio. Similarly, money market mutual funds invest in short-term financial assets such as commercial paper, CDs, and Treasury bills and issue shares linked directly to the value of the underlying portfolio. To the extent that these funds efficiently diversify, they also offer price risk protection and liquidity services.
b. Recent episodes of financial distress in both the banking and insurance industries have led to an increase in regulation and governmental oversight, thereby increasing the net regulatory burden of “traditional” companies. As such, the costs of intermediation have increased, which increases the cost of providing services to customers.
31. What events resulted in banks’ shift from the traditional banking model of “originate and hold” to a model of “originate and distribute?”
As FIs adjusted to regulatory changes brought about by the likes of the FSM Act, one result was a dramatic increase in systemic risk of the financial system, caused in large part by a shift in the banking model from that of “originate and hold” to “originate to distribute.” In the traditional model, banks take short term deposits and other sources of funds and use them to fund longer term loans to businesses and consumers. Banks typically hold these loans to maturity, and thus have an incentive to screen and monitor borrower activities even after a loan is made. However, the traditional banking model exposes the institution to potential liquidity, interest rate, and credit risk. In attempts to avoid these risk exposures and generate improved return-risk tradeoffs, banks shifted to an underwriting model in which they originated or warehoused loans, and then quickly sold them. Indeed, most large banks organized as financial service holding companies to facilitate these new activities. More recently activities of shadow banks, nonfinancial service firms that perform banking services, have facilitated the change from the originate and hold model of commercial banking to the originate and distribute banking model. These innovations removed risk from the balance sheet of financial institutions and shifted risk off the balance sheet and to other parts of the financial system. Since the FIs, acting as underwriters, were not exposed to the credit, liquidity, and interest rate risks of traditional banking, they had little incentive to screen and monitor activities of borrowers to whom they originated loans. Thus, FIs failed to act as specialists in risk measurement and management.