Question

The dynamics of asset price bubbles weaken financial regulation just as financial markets begin to overheat and the risk of crisis spikes. At the same time, the failure of financial regulations adds further fuel to a bubble.

a) Explain the main features of financial bubbles.

b) Discuss the reasons for and against the prudential regulation of banks.

Answer 1

Financial bubble

A financial bubble is a significant increase in the price of an asset that does not reflect an increase in its true value.

People end up paying more, because the think it will eventually sell for more, but then when a correction happens, asset prices fall & the bubble "bursts"

There are 5 prominent features of a bubble

1) Displacement - The average investor gets lured in by a new shift in dynamics (idea of a revolutionary technology)

2) Boom - prices start rising slowly, but then gain tremendous momentum, setting up for a boom. The asset attracts widespread media coverage

3) Euphoria - Asset prices are now skyrocketing, and it is difficult to justify the valuaitons

4) Profit taking - The smart investors heed to the signs of the bubble and start selling their positions, now these assets are in the hands of not so smart investors and they do not know what to do with them

5) Panic - asset prices start to reverse and all the foolish investors start to sell at once, causing a crash in prices, which is called bursting of the bubble

Why should banks be regulated ??

In banking, the deposits received from households are considered as liabilities while loans offered constitute as its assets. Therefore, the bank’s balance sheet largely consists of liquid liabilities and illiquid assets. In any case where the public were to lose confidence in the banking system, a bank run would occur

Financial institutions and banks that are huge and highly interconnected impose systemic risk to the banking system. A default by a bank can lead to the default of its creditor banks on their own counter-parties and so on. This effect by one large bank may lead to a catastrophic effect on the rest of the other financial institutions

The depositors, being the creditors of a bank are usually not well informed on the bank’s investment activities. Moral hazard may emerge when banks engage in investments that are too risky at the cost of its depositors.

Having a regulator to monitor banks on the behalf of depositors provides assurance and maintains their confidence in the financial system

Why should banks not be regulated ??

As we discussed above, banks use financial leverage to lend. Since the more they lend, the more they grow, If tight regulations were removed, banks could grow much faster and so would the overall economy