Financial Institutions

Financial institutions provide a broad range of products and services, including serving as an intermediary between providers and users of capital, asset and risk management, and transaction executions.

Financial institutions differ from other companies as follows:

1. Systemic importance. Financial institutions are necessary for the smooth functioning and overall health of the economy. As an intermediary between providers and users of capital, there are often inter linkages between financial institutions.

These interdependencies introduce a system wide risk of failure when one of the member institutions fails, the contagion effect. As a deposit taking institution, banks are especially prone to the risk of a bank run. To avoid financial contagion, bank deposits are often insured up to a certain limit by the government.

2. Regulated.

Given the significance of financial institutions, they are often highly regulated. Regulations include minimum capital requirements, minimum liquidity requirements, and limits on risk taking.

3. Assets. The assets of financial institutions tend to be financial assets such as loans and securities that are usually reported at fair value. This contrasts with other companies that primarily own tangible assets reported at depreciated historic cost.

Due to global inter linkages between financial institutions, financial contagion may spread beyond a single economy. To manage this global systemic risk, global and regional regulatory bodies coordinate rules and oversight. Uniformity in standards also seeks to prevent regulatory arbitrage.

One of the most important global organizations is the Basel Committee on Banking Supervision, a standing committee of the Bank of International Settlements. The Basel committee develops the regulatory framework for banks (currently Basel III) with the objective of increasing the banking sector’s ability to absorb economic and financial shocks.

The three pillars of the Basel III framework are the maintenance of minimum levels of capital, liquidity, and stable funding.

Minimum required capital for a bank is based on the risk of the bank’s assets. The riskier a bank’s assets are, the higher its required capital. Basel III specifies that a bank should hold enough liquid assets to meet demands under a 30 day liquidity stress scenario.

The Basel III framework requires stable funding relative to a bank’s liquidity needs over a one year time horizon. Stability in funding is proportional to the tenor of the bank’s deposits; longer term deposits are more stable than shorter term deposits. Stability also depends on the type of deposit (e.g., consumer deposits are more stable than interbank market funds).

Other global organizations that coordinate regulations include the:

1. Financial Stability Board, which seeks to coordinate actions of participating jurisdictions in identifying and managing systemic risks.

2. International Association of Deposit Insurers, which seeks to improve the effectiveness of deposit insurance systems.

3. International Organization of Securities Commissions (IOSCO), which seeks to promote fair and efficient security markets.

4. International Association of Insurance Supervisors (IAIS), which seeks to improve supervision of the insurance industry.