Now we're all set to start talking about bank regulation. And in this first episode, I will talk about the ideas behind that, the reasons and the major goals that it serves. So that is more or less philosophical, or let's say even theoretical thing, but we will see exactly why we need to study that. And we will also mention some measures taken. And we will see how they are falling within this context of the reasons. So bank regulation. First of all, a lot of people, when they hear the word regulation, they don't feel happy. A lot of people in the world believe that regulation, in general, is bad, it's limiting, it's restricting. It puts a burden on competing individuals, so this is bad in general. And all people say that whenever a regulation is relaxed, then all the markets, they actually develop much faster, and there is a lot more value creation, and so on and so forth. Now, we here will show that unfortunately, without the attention to regulation, we risk to find ourselves in a very bad situation. So the first idea here is, what is the reason for regulation? And the reason is basically, we have to fight the temptation. So remember that all that started, that the logic went as follows. So you have a bank or a bank-like institution. So you are exposed to the problem of a bank run. Therefore, you need deposit insurance as a way to prevent that. And if you have deposit insurance, then you start to behave importantly just because that provides sort of free lunch for you. And we said that we have to buy this way of regulation, fight this temptation. So I'll put this, fight the temptation. So here we're talking about moral hazard, as we can see. Well, you can always quote Oscar Wilde by saying, in one of his plays, one of his heroes said, I can resist everything but temptation. So clearly this is not perfectly within the idea of human nature. But so that adds up to that, so you have to specifically fight for that. Now in some more detail, things the idea is you have to pay for deposit insurance. So if you have this umbrella, then pay for it, in whatever form, we'll discuss in what form. And I think is behave yourself. If you do not engage in very risky schemes, then you'll all right. But if you do then you'll get punished and you'll be forced to pay dearly for that. Now this is the regulation as the reason for that. And another thing is the regulation as a signal. Well, when regulation is enforced that sends a signal to the public and to the market participants that we, the government, the regulators, we care. We care about this problem and we understand that if we don't then there will be negative results. So that is very important specifically for the market participants that are sort of small or weak who cannot protect themselves. We're not talking about huge investment banks or huge global banks if you will. So that is an important thing. And then also, there is some other thing, because unfortunately, regulation. Is always behind. So it's like I'll put a race. So investment banks and banks and other powerful financial institutions, they are always ahead. They find some new instruments, they find loop holes to regulation, they always would do everything in order to be able to create even the temporary monopoly and regulators, they react. Ideally we would like to think about proactive regulations so that we would sort of anticipates some problems to happen. But unfortunately, that doesn't work this way. So we also have to keep this in mind. And therefore, we have to realize that having said all that, the final thing, let's say, for the public. This is all that regulation is hope, because basically we see that this together, as a signal and as the efforts of regulations, we can see that we expect that someone will take care of the potentially most egregious cases of abuses. Because we cannot protect ourselves, so we expect that someone else would. So that is all about the first set of things about regulation. Then there is something else that's important to see here. First of all let's go back to the after S&L crisis situation. There's a lot of discussion and finally the United States some regulatory measures have indeed been taken. So let's say hat are these measures taken after S&L crisis. Well, remember there's a lot of discussion of that in the articles that are in handouts with this course. But the idea is very simple, it became clear that if we neglect certain things that accumulate there then we end up with a very big problem and a very big check for tax payers. So what was done later was that local authorities, Discretion was limited. Because remember we said that one of the reason why so many abuses took place and so why they had accumulated was that local authorities were really reluctant to change anything, because they were scared by the fact that they would not get reelected. Now another important thing is that geographical restrictions were relaxed. I do not like this. Well, I told you that, even as late as in the early 90s when I was a student at the business school, it was very difficult to find a client office of Citibank in California, and the client office of Bank of America in the state of New York. Well now it's completely different, because there's been a lot of development. And this idea of going nationwide and then global, that has since played the more important role. But maybe one of the most important things here was the market value reporting. Remember, we said that if you are allowed to keep showing your assets at their book value, and the assets of essence were mortgages. So if the rates would hike then the market value of assets would go down sharply and you will become a zombie organization. But if you are allowed to keep showing them at the market value, then the problem will not be recognized and dealt with. That was an important change. Now, I would like to add another facet to that let's say, when we talk about regulation, We can talk about the letter. And the spirit. Well, why am I touching this? Because let's say that we'll talk about Glass-Steagall Act, the famous piece of regulation that was put in place together with the introduction of the post-insurance back in the 30s. Now the main idea was to break up the greatest, the largest financial institutions forcefully. And say, well, you either are at commercial bank or the investment bank. Now, we talked about that in great detail when we discussed the business of investment banking. But for now the important thing is that by the 90s a lot of people started to argue that the Glass-Steagall act by that time had become obsolete, and it would not play its important role. And most of the financial market participants by that time had found some ways to circumvent that, found some loopholes. And as a result, people started to complain. Well, why bother? It's better to get rid of this yet. And as all of you know, in 1999 it was repealed. Now a lot of people argue that the depth and the scale of the crisis that, the peak of which was in 2007, 2008, and all the people believe that we are not yet over, the crisis is not yet over. Now they openly blame the depth and the scale of the crisis to the fact that the spirit of regulation at that time was different because the Glass-Steagall Act by that time had been repealed, and the people realized that you can do everything you like. Now, this is a key story that I am emphasizing here. That oftentimes, it's not exactly the letter of regulation than the spirit of that. So if you know that you're not supposed to behave this or that way, that sort of shapes up the overall behavior in the way that this is okay to do so and this is not okay to do so. So you don't have the weight until you are caught and then you are sued. It's just people they don't behave in a certain way. Now this is a question that is open. Some people disagree with that. But I would argue that this is very much important to see in all regulatory measures, but which is even more important in regulatory processes. Because I am now sort of completing this episode by just saying that ever since the regulatory process not only has been developing but also has taken a global scale. And in the episode to come we'll talk about what is known as the basal process. So this is the process of developing global, international regulation of the banking activity that was initiated soon after the S&L crisis in the US, because there were also some bad things happening in Europe too. And then it became a developing process that has reacted to some changes in the behavior of financial institutions and has been quite helpful and hopeful for the public as a process that provides some protection. So next episode we will discuss the Basel Process.
