ECON 1009
INTERNATIONAL FINANCIAL INSTITUTIONS AND MARKETS
Tutorial Eleven/Week Twelve
Short Tutorial Questions (one to two sentence answers)
1 Regulation: What is the role of financial system regulation and why is it important?
Financial institutions are regulated because they provide goods and services that the economy
needs to function well. In addition, they function in an environment in which asymmetric
information is more the rule than the exception. Most consumers and businesses will disclose
their financial affairs to a financial institution if it is a necessary condition to obtain services.
However, consumers and businesses want their financial affairs to be confidential. As a result,
financial institutions are required to keep the information private but in doing so it is difficult
for depositors to have enough information to assess the institution’s soundness. Depositors, for
example, do not know whether their financial institution has made good loans and entered into
sound financial contracts. Unfortunately, because of the veil of uncertainty that exists when
information is limited, banks and other depository institutions in the past have been subjected
to runs and the financial system as a whole has encountered ‘panics’, in which people rush to
withdraw funds because they fear their bank or the banking system is unsound.
2 Regulation: What are the major lessons that have been learned from past bank failures?
Do you think that history can or will repeat itself? Why did the Australian financial
system fare comparatively well in the 2007–09 financial crisis?
One lesson from past bank failures is that, by guaranteeing deposits, the FDIC effectively
prevents bank runs. Depositors know the FDIC will pay them in an orderly manner. Runs in
recent years have been limited to a single bank and have not spread to other insured banks.
Another lesson is that regional or industry depressions are a major cause of bank failures.
Another lesson is that fraud, embezzlement, and poor management are the most notable causes
of bank failure. As long as these causes remain possible, then bank failures by definition remain
possible. If regulators are proactive in applying these lessons, however, then mass failures on
a scale reminiscent of the 1930s or the 1980s are unlikely.
3 Regulation: ‘Bank regulation is considered to be in the public interest. Therefore, the
more regulation, the better.’ Explain why you agree or disagree with this statement.
All regulation purports to be in the public interest. To assert categorically that more regulation
is necessarily better, one must assume that (1) “the public interest” has been conclusively
defined and (2) all regulations are conceived with equal deliberation and regard for likely
consequences. Too much regulation stifles innovation and competition; too little regulation
may leave the public inadequately protected. Regulators are responsible for finding the balance
between bank safety and economic stability on the one hand, and an efficient banking system
on the other. This is a difficult task.
4 Capital adequacy: What is meant by ‘capital adequacy’ for financial institutions and why
is it so important?
Capital adequacy is the maintenance of adequate levels of capital to enable an ADI to continue
to operate in the event of unanticipated losses or problems.
For regulators, the maintenance of adequate levels of capital relates directly to protecting
depositors. As the protection of depositor’s funds is the key function of prudential regulators,
capital adequacy requirements have been at the forefront of international developments in
financial sector regulation. The importance of capital management is clearly articulated in the
first section of APS110 — Capital adequacy:
‘Capital is the cornerstone of an ADI’s financial strength. It supports an ADI’s operations by
providing a buffer to absorb unanticipated losses from it activities and, in the event of problem,
enabling the ADI to continue to operate in a sound and viable manner while the problems are
addressed or resolved.’
