Principles of Financial Regulation - Riassunti

Principles of financial regulation

The financial system

The financial system is the subject of financial regulation. Any modern economy is based on specialization and exchanging goods through money. Families spend less than what they earn (surplus spending units, SSU) and, on the other side, government and industries need more money than what they spend (deficit spending units, DSU). It is necessary that money flows from SSU to DSU because the government and industries are capable of using the money right.

The alternative is that SSU hide the cash under the mattress or put it in the bank, but the remuneration of this deposit is 0, which is not a smart choice. The interest rate takes into account the utility/disutility to have immediately the money or later (intertemporal situation rate). Also, the lender has a credit risk, so the interest rate also contains a premium. The interest rate considers both the time and the credit risk.

The financial system is the object that provides the money to flow from SSU to DSU, but there are many obstacles:

• Transaction costs: Transaction costs express the idea that each action has a cost. If transaction costs are too high, the relevant activity may not be performed because they exceed the profit from the relevant activity.
• Asymmetrical information: Through asymmetrical information a lot of problems can arise because the person with superior information may exploit this situation. This immoral situation is called "moral hazard" and is inefficient: there is a waste of resources. Another implication is the so-called agency cost: a certain agent does something for the principal, affecting the welfare of the principal. In doing so, the agent knows more than the principal: there is asymmetrical information that could be exploited (e.g., the secretary that buys a sandwich and gives less change). The principal, to avoid this situation, could monitor the agent, but monitoring implies a significant cost. On the other side, there are bonding costs: costs that burden the agent to assure the principal that everything is fine. The sum of these costs can be so high that the relationship breaks up. The law has invented a lot of tools to manage agency costs, in particular to preserve trust: if the principal has trust in the agent there is no problem. The law then is really interested in preserving this trust. The last implication is adverse selection: this is a situation in which, in a transaction, one of the parties has relevant information that the counterparty does not have. For example, when we buy a used car, we have a probability of buying a "lemon", because sellers could be cheaters. If we know that the probability is 20%, we discount the price by this probability: the buyer, even if the right price is 20K, offers 16K (20K * 20%). In this case, the good sellers leave the market, and only the bad sellers remain: the market fails. To distinguish bad sellers from good sellers we use many tools, such as the brand of the goods. Adverse selection could affect the market, and we have an example in the under-pricing of the IPOs. IPOs take place when a company, which was private, goes public. These are the average first-day returns on European IPOs. The returns are between 10 and 30% the IPOs are typically under-priced, and this is because of adverse selection: a buyer of an IPO does not actually know if the company is good or bad and so it discounts the initial offer.
• Diversity in preferences: The SSU are risk-averse and prefer short-term loans. The DSU instead prefer long-term loans and are risk-tolerant. Reaching an agreement is then more difficult.

Solutions to financial system problems

To manage these problems, we have two solutions:

• Banking: This consists of collecting savings and lending money. Banking solves the problem of transaction costs: transaction costs are managed through an intermediation of a bank. Banks also are specialized in their job, so there are economies of scale. The bank is the central counter party (CCP), has a very strong form of intermediation:
  • Economically speaking, it allows the money to arrive from the SSU to the DSU.
  • Legally speaking, the bank is in between the SSU and the DSU: both the SSU and the DSU write a contract with the bank. We split one contract (between the SSU and the DSU) with two contracts.
  Banking solves the problem of asymmetric information:
  • The bank can distinguish better the bad borrowers from the good borrowers thanks to its experience.
  • The bank is the best debtor in the market, the SSU can be reassured.
  Banking solves the problem of diversity in preference:
  • The bank can satisfy both SSU, signing short-term debt with low risk, and DSU, giving long-term loans with high risk. This is made possible because the depositors don’t use so often the money in the bank, so it’s fine to lend money in the long term.
  However, the bank is structurally unstable: if every borrower asks for its money, the bank might not satisfy everyone. There are a set of rules to avoid the so-called bank run. The profit from a bank is the difference between the interest rates. The SSU and the DSU could get rid of the bank to share the 4% profit of the bank. The problem is that, when the bank is gone, all the problems we saw earlier arise.
• Capital market: This is a form of weak intermediation. An example can be the investment funds. In the capital market:
  • Transaction costs are managed through specialized intermediaries providing investment services or asset management services. In this case, we have an intermediary that does not take responsibility if the DSU does not repay the debt; only the transaction cost problem is solved.
  • The SSU does not have the "shield" of the bank (which is the best borrower and can distinguish between good and bad borrowers). The problem of asymmetric information is then overcome with mandatory disclosure: there is a legal duty for the DSU to disclose to the SSU all the information useful for the decision of the SSU.
  • To avoid the problem of adverse selection, a solution can be the reputational intermediation: an intermediary lends its reputation to overcome the asymmetry information. DSU can use recommendations to show they are good borrowers.
  • To avoid the problem of diversity in preferences, the solutions are:
    • Secondary markets: The primary market is the market in which a credit/debt is formed. A secondary market is the market in which the contractual position created is sold to another party. Doing so, we can manage the problem in differences in time. To facilitate this transaction, the law invented the so-called securities (titoli di credito): which are a piece of paper that contains a bunch of legal rights.
    • Stock exchange: A stock exchange is a market in which all the buyers and sellers of securities get together, and this allows the transaction costs to be lower and lower. This relates to the concept of market liquidity: a market in which we can enter or exit a certain position as easily as possible. The more liquid a marketplace is, the easier it is to solve the problem of diversity in preferences.
    • Diversification: Regarding the differences in preferences in risks, a key concept is diversification. Using a diversified portfolio, there is a lower overall risk, and an investment in a risky asset could be done if the major part of the portfolio is used in a lower-risk company.

Fintech and other innovations

Fintech combines finance and technology. It’s a way of identifying solutions in finance more efficiently by the use of information technology. For example, instead of asking for a loan or for help in getting some investments, we can go to a website and post a project and ask if someone wants to lend us money or invest in our company. Example: Lendix is a platform where SMEs may register and look for loans. Obviously, there is asymmetry information, but the platform allows the immediate contact between the parties with no intermediary cost. This platform is not a bank, so it doesn’t provide a strong intermediation (we don’t know how the borrower is using the money and if he will return it). "Credimi" is a fintech platform; the transaction is done in a digital platform, the logic is the same as banking. To participate in Credimi, you have to prove to be credible. The website puts together people but does some form of analysis of the borrower and the lender to evaluate if the project is good or is a "lemon".

Big data is data that everybody produces using a computer. These data are collected, processed, and can provide lots of information. For example, Amazon realizes what a certain person buys, identifies its taste and the financial resources. Alibaba, Google, and all these platforms have a lot of big data useful for SSU and DSU, and they are moving to become financial players.

Theoretical question about financial systems

Is there a system better than another? Is the capital market better than banking or vice versa? Why in the US are capital markets largely prevalent over banking, but in Italy or Germany is the exact opposite? There are many reasons that explain why in the US the capital markets developed so much. Having strong banks meant having strong power. As the banks were located in New York, the other states didn’t like New York to be so strong. This, together with the populist anger towards banks, led to the political decision of limiting the bank’s role (and this caused the capital market’s increase, as the money had to move from SSU to DSU). Where there is an economic condition where huge money transactions are needed, capital markets are the only alternative.

Is there a model better than another? No, there are models that work better in some situations and worse in other situations. We need to understand which are these criteria that make a model work better or worse.

Banking prerequisites and effects

Let’s start with banking: the prerequisite of banking is the relationship between the customer and the bank. When one of the parties shares some information with the other, the other party becomes a monopolist. So, when the bank provides a service and asks for a price (the interest rate), the price of the service may be influenced by the monopolistic power over the information. The lender enjoys the monopolistic power, and the price may be too high relative to the actual value of the project financed, because the bank had a "head on" the actual value of the project, or too low because the bank wants to keep the customer. This relationship causes strong bonds between firms and customers, that have strong barriers of entry and are very resilient. There is a disincentive to radical innovation: radical innovation, that may determine a boost of the firm, but the bank might not want to finance it or could ask for a very high interest rate. All these factors explain why banking was so effective after WW2.

Capital markets and their characteristics

Now we focus on capital markets, that are called "arm’s length system", which means that there is a relationship keeping a distance. In capital markets, information is public, so there is no monopolistic power over the information. This determines that the interest rate reflects the value of the project. Also, as there are no barriers to entry, the resilience is non-existent.

In conclusions, there are situations in which:

• Capital markets work perfectly:
  • Big projects.
  • Developed economies.
  • Radical innovation.
• Banks work much better:
  • Developing situations.
  • Capacity of absorbing shocks.

Very important is the fact that governments like banks rather than capital markets, because banks can be controlled much better. Banks allow politicians to operate "in the dark" (do unpopular but necessary reforms without the electors realizing). The banking system, which is an oligopoly, is more favorable to incumbents. On the other hand, capital markets are more favorable to newcomers.

Agreements to get money flowing

There are many agreements to get the money flowing between SSU and DSU in banking and capital markets. When we talk about banking, there are two main contracts:

• The deposit: The SSU gives the money to the bank and this has many functions:
  • The bank takes care of the money of the depositor.
  • The deposit is a loan, in fact, the bank pays an interest to the depositor.
• A loan: A contact under which a bank gives money to the firm and this firm is bound to repay this money with an interest. Another type of loan is a credit line: instead of giving the money all together, the bank makes available to give the money to the DSU whenever it needs.

In capital markets, we have many financial instruments to get the money flowing:

• A bond: A piece of paper (called security) which incorporates the right to be repaid of money lent to the issuer of the piece of paper. These bonds can circulate in secondary markets. There is a risk, called credit risk, which is the risk that the counterparty doesn’t pay the money back. The higher the credit risk, the higher the interest rate.
• A share: A piece of paper (security) which incorporates the right to participate in the life of a company by voting (administrative rights) and to get dividends, as far as they exist and the majority of the shareholders decides to distribute them. As the shareholder is part of the company, it doesn’t have the claim to get the money back. The real key of this investment, which is riskier than bonds, is the resale in secondary markets (and the price reflects how the company is perceived). In this case, there are many risks: the management of the company, the agency problem affecting the company (managers exploiting shareholders), exogenous risks. Investing in shares is much riskier but has much greater returns.
• There are other forms of hybrid financial instruments, just like:
  • Subordinated debt, which is a bond that will be paid back after all the other debt holders, just before shareholders.
  • Preferred shares with no voting rights, but the holders of the shares are paid before the other shareholders.
• Derivatives: Instruments whose value depends on some underlying asset. The derivatives are important because they can shift risk. The risk can be pre-existing with respect to the contract (hedging) or the risk can also manifest after the contract (speculation). Through the price of the derivative, we say something about the actual value of the assets the derivative is written.
• Mutual funds: A "box" full of a different composition of assets. The key point is that the participants get a return proportionate to the contribution in the box. Mutual funds have a great competitor: EDFs, which are funds replicating indexes in the market (this is a passive management fund). They are much cheaper than mutual funds.

All these instruments are financial instruments, which are the target of many laws.

Why do we need to regulate the financial system?

The new classical argument about free markets states that free and inform contracts and market discipline could be enough, no law is needed. Market discipline: a person behaves well out of egoistic interest (e.g., if a person misbehaves can compromise a relationship, which is against the person’s own interest). This model is wrong, and that’s why the law is so important, because:

• The perfect condition market does not exist (in reality there are externalities, asymmetrical information, transaction costs). Also, contracts could affect other parties different from the contracting parties (and these people don’t have a word in the negotiation). This imperfection of the market hinders the latter to work properly.
• People behave not only according to economy, but also according to other values.

The law is then fundamental to:

• Adjust market failures.
• Distribute resources.
• Can be influenced by individual preference.

Economic perspective of financial regulation

We will approach the question of why does the law govern the financial system:

• Economic perspective: We’ll focus on efficiency.
• Political perspective: We’ll focus on individual interest.
• Legal perspective: We’ll focus on justice.

Economic approach: The economic approach is based on the idea that sometimes the market mechanism doesn’t work, and we need the law to regain efficiency.

Externalities and their impact

• Externalities: Consequences that go beyond the contract. Externalities can be negative or positive. When we have either positive or negative externalities, we don’t have an efficient allocation of resources.

Negative externalities

The blue curve is the supply curve and the red curve is the demand curve, the point of intersection is the point of the optimal price. In case of a negative externality, the curve of the supply becomes the light blue curve, which is based on the MPC (marginal private cost): the quantity of the production is based only on its own cost, it doesn’t take into consideration the cost that its activity is imposing on third parties (e.g., the price of the marijuana doesn’t take into consideration the negative effects on society). We have two points of equilibrium:

• Point A is the equilibrium in a free market.
• Point B is the efficient equilibrium, we take into consideration society as a whole.

The triangle ABC is a welfare loss. We need to fix the market by moving upwards the light blue curve until it reaches the MSC curve (Marginal Social Cost). We internalize the externalities (e.g., the driver of a car that has to pay the victims if it’s the cause of an accident; or the bank that is obliged by law to avoid lending all the money that it receives).

Positive externalities

With positive externalities, we have the MSC and MPC swapped. The solution, in this case too, is the internalization of externalities (e.g., a bad professor that exploits the great service provided by the university, the solution could be a valuation by the students; a bad financial advisor exploits the great name of the university in which he graduated, the solution could be an authorization: financial advisors have to be registered by law).

Asymmetric information and monopolies

• Asymmetric information: Another way in which the market could fail is asymmetric information (which we already talked about).
• Monopoly: The fourth way in which markets could fail is through monopoly power.