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Lecture 10: Bank regulation - Coggle Diagram
Lecture 10: Bank regulation
Introduction
Capital
is the primary means of
protection against insolvency
Major functions of capital
Protect uninsured
depositors, bondholders and creditors in case of insolvency and liquidation
Protect FI insurance funds and the
taxpayer
(?)
Protect FI owners
against increases in insurance premium
Absorb unanticipated losses
=> enable FI to continue as a going concern
Partially fund the
FI's real investment activities
explicit vs implicit insurance
higher capital
lower cost of funds
source of financing
regulation is costly => decreases economic efficiency
banking crises are
systemic and contagious
Capital and insolvency risk
Net worth
:
Market value
of assets -
Market value
of liabilities
Book value
: asset and liability values based on
historical cost
Economists
prefer market value while
regulators
prefer book value
Market value of capital
losses in assets value are first borne by
equity holders
if losses exceed the value of equity =>
liability holders
will be affect
sufficient capital
=> protect liability holders from losses
capital acts as
insurance fund
protect liability holders against
insolvency risk
(increases in
net worth
=>
insolvency protection
increases)
useful ratio to assess insolvency:
net worth to assets
Mark to market =>
immediate revaluation
of net worth
Arguments
Difficult to implement
: large amount of assets are non- traded
Introduces
unnecessary variability
into an FI's earnings: unrealized paper capital gains/ losses passed to income statement
FIs are
less willing to take longer term asset
exposures: because it is more sensitive to change in interest rate
Book (historical) value of capital
Components
Retained earnings
Loan loss reserve
: special reserve set aside of retained earnings to meet expected and actual losses
Surplus value of shares
Par value of shares
Book value of equity:
price paid on shares
when originally offered
Managerial discretion
: tendency to defer write- downs of bad loans => window dressing =>
misleading
losses in asset values
do to adverse interest rate changes
might not recognized in book value
Discrepancy
of market to book value of equity
Measure of discrepancy:
Market to Book ratio = MV/ BV
MV/ BV decreases => book value
overstates
the market net worth