What is the main rationale for financial regulation?
To address problems caused by asymmetric information
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| Term | Definition |
|---|---|
| What is the main rationale for financial regulation? | To address problems caused by asymmetric information |
| What is asymmetric information in finance? | A situation where one party to a transaction has more or better information than the other |
| How does adverse selection occur in financial markets? | It arises before a transaction when those most likely to produce an undesirable outcome are the ones most likely to seek out loans or insurance. |
| What is moral hazard in the context of banking? | It occurs after a transaction when borrowers or institutions take on riskier behavior because they are protected from the consequences. |
| What is the purpose of the government safety net | To protect depositors and maintain confidence in the financial system through mechanisms like deposit insurance and lender-of-last-resort support. |
| What is deposit insurance? | A guarantee that depositors will be repaid even if the bank fails |
| Name one benefit of deposit insurance. | It prevents bank runs by assuring depositors that their funds are safe. |
| Name one drawback of deposit insurance. | It can increase moral hazard as banks may take more risks knowing deposits are insured. |
| What does 'too big to fail' mean? | Large financial institutions are so interconnected that their failure would threaten the entire financial system |
| What are restrictions on asset holdings? | Regulations that prevent banks from holding risky assets like corporate stock to reduce risk exposure. |
| What are capital requirements? | Rules mandating banks to hold a certain amount of equity capital relative to their assets to absorb losses. |
| What are the two main types of capital requirements? | Leverage ratio (based on total assets) and risk-based capital requirements (adjusted for risk level of assets). |
| What are the Basel Accords? | International agreements that set standardized capital requirements and risk management rules for banks. |
| What did Basel III introduce? | Stricter capital requirements |
| What is prompt corrective action (PCA)? | A regulation requiring regulators to intervene early when a bank’s capital falls below certain thresholds. |
| What is financial supervision? | The process of monitoring and examining financial institutions to ensure they follow laws and maintain sound practices. |
| What is chartering in banking regulation? | The process of granting a license to a financial institution |
| What is a bank examination? | An in-depth inspection of a bank’s financial condition and risk management practices by regulators. |
| What is risk management assessment? | Evaluation of how effectively a bank identifies |
| What are disclosure requirements? | Rules mandating that banks provide accurate financial and risk information to promote transparency and market discipline. |
| Why is consumer protection important in financial regulation? | It prevents deceptive practices and ensures fair treatment of borrowers and investors. |
| What is the main goal of restricting competition in banking? | To maintain financial stability by preventing excessive risk-taking driven by competitive pressure. |
| What is a potential downside of restricting competition? | It may reduce efficiency and innovation in the financial sector. |
| What is international financial regulation? | Cooperation among countries to regulate multinational financial institutions and prevent cross-border crises. |
| What organization coordinates international banking standards? | The Basel Committee on Banking Supervision (BCBS). |
| What is regulatory arbitrage? | When banks exploit differences in national regulations to avoid stricter rules. |
| How does asymmetric information justify government intervention in finance? | Because markets alone cannot ensure that institutions behave prudently or share accurate information. |
| What is the difference between microprudential and macroprudential regulation? | Microprudential focuses on individual institutions’ safety; macroprudential aims to protect the entire financial system. |
| What caused the spread of deposit insurance globally? | Financial crises in multiple countries led governments to adopt it to restore trust and prevent panics. |
| Why can deposit insurance be risky in developing countries? | Weak supervision can make moral hazard effects stronger |
| What are the objectives of financial regulation? | To ensure financial stability |
| How do regulators enforce capital requirements? | Through minimum capital ratios and regular stress testing. |
| What role does transparency play in regulation? | It allows investors and depositors to make informed decisions limiting asymmetric information. |
| What is meant by 'market discipline'? | The idea that investors will punish risky institutions by withdrawing funds or demanding higher returns. |
| What is the link between regulation and moral hazard? | Regulation seeks to limit moral hazard by imposing capital and risk constraints on financial institutions. |
| How did the Global Financial Crisis influence financial regulation? | It led to stronger global standards |
| What is systemic risk? | The risk that the failure of one institution will trigger widespread instability in the financial system. |
| What is the lender of last resort? | A central bank function that provides emergency liquidity to solvent but illiquid banks during crises. |
| Why is prompt corrective action considered effective? | It forces early intervention before insolvency occurs |
| What is the main challenge of international financial regulation? | Coordinating standards across countries with different priorities and levels of enforcement. |