Content

o read and make at least three comments on the prescribed readings

o Marks are achieved based upon the quality (not the quantity) of your commentsthough you must at least make three comments and your top four comments will be used to determine your score

o The comments should be distributed throughout the assigned reading.

o Comments could be to:

Highlight and explain/demonstrate/exemplify key points

Draw connections between the reading and prior learning (e.g. from a reading in an earlier topic)

Draw connections between the reading and discussion points (reading questions, case study questions, assignment)

What needs to be read and annotated:

Assuming these annotations are representative of these students' annotations for this assignment (and also that their annotations are distributed throughout the entire assignment and submitted on time), they would obtain the following evaluations for their body of annotations: Meets expectations: Alison's annotations reveal interpretation of the text and demonstrate his understanding of concepts through analogy and synthesis of multiple concepts. His responses are thoughtful explanations with substantiated claims and/or concrete examples. He also poses a profound question that goes beyond the material covered in the text. Finally, he applies understanding of graphical representation to explain the relationship between concepts. Improvement needed: While Beth asks possibly insightful questions, she does not elaborate on thought process. She demonstrates superficial reading, but no thoughtful reading or interpretation of the text. When responding to other students' questions, she demonstrates some thought but does not really address the question posed. Deficient: Cory's annotations have no real substance and do not demonstrate any thoughtful reading or interpretation of the text. His questions do not explicitly identify points of confusion. Moreover, his annotations are not backed up by any reasoning or assumptions.Cory:I remember, in high school, being amazed at how quickly 76 CHAPTER 4 MOMENTUM carts could travel on these tracks - air would blow up through these tiny holes evenly distributed along the length of the track n the preceding two chapters, we developed a math- Figure 4.2 Low-friction track and carts used in the experiments described and the cart would essentially float on the air and consequently - ematical framework for describing motion along a in this chapter. the cart would move very quickly with the slightest push. straight line In this chapter, we continue our study of motion by investigating inertia, a property of objects that Alison: Although there is no way to create frictionless surfaces, I affects their motion. The experiments we carry out in find it interesting that we consider experiments "in the absence of studying inertia lead us to discover one of the most funda friction." In a way, this relates back to Chapter 1.5 where we talked about the importance of having too little or too much information in mental laws in physics-conservation of momentum. our representations. In some cases, the friction is so insignificant 4.1 Friction that we ignore it (simplifying our representation). Picture a block of wood sitting motionless on a smooth You may wonder whether it is possible to make surfaces Beth: Does this only apply to solid surfaces? I feel as if a sub wooden surface. If you give the block a shove, it slides some that have no friction at all, such that an object, once given stance that floats on water either has negligible or very little friction. distance but eventually comes to rest. Depending on the a shove, continues to glide forever. There is no totally fric- smoothness of the block and the smoothness of the wooden tionless surface over which objects slide forever, but there Cory: Why is this? I don't get it. surface, this stopping may happen sooner or it may hap- "are ways to minimize friction. You can, for instance, float an pen later. If the two surfacesin contact are very smooth and _object on a cushion of air. This is most easily accomplished Alison: I believe this applies to almost every surface, although I'm slippery, the block slides for a longer time interval than if with a low-friction track-a track whose surface atted not sure if water would count more as resistance than friction. the surfaces are rough or sticky. This you know from every- with little holes through which pressurized air blows. The Anyways, the best example I could think of would be a surf board. day experience: A hockey puck slides easily on ice but not air serves as a cushion-on which a conveniently shaped ob If people who were paddling in the same direction as the waves on a rough road. ject can float, with friction between the object and the track experienced no resistance, they would continually speed up, and Figure 4.1 shows how the velocity of a wooden block all but eliminated. Alternatively, one can use wheeled carts eventually reach very high speeds. However, in reality if they were decreases on three different surfaces. The slowing down is with low-friction bearings on an ordinary track. Elqure 4.2 two stop paddling they'd slow down and only the waves would due to friction-the resistance to motion that one surface or shows low-friction carts you may have encountered in your slowly push them to shore object encounters when moving over another. Notice that, lab or class. Although there is still some friction both for during the interval covered by the velocity-versus-time low-friction tracks and for the track shown in Figure 4.2, Beth: Is it possible to have a surface, in real life, that inflicts NO graph, the velocity decrease as the block slides over ice is this friction is so small that it can be ignored during an friction at all? hardly observable The block slides easily over ice because experiment. For example, if the track in Figure 4.2 is hori- there is very little friction between the two surfaces. The zontal, carts move along its length without slowing down effect of friction is to bring two objects to rest with respect appreciably. In other words: Beth: Doesn't air resistance factor into this at all? to each other-in this case the wooden block and the sur- face it is sliding on. The less friction there is, the longer it In the absence of friction, objects moving along a Alison:The key word is "appreciably". In the absense of friction, takes for the block to come to rest. horizontal track keep moving without slowing down. the cart does not slow down appreciably but still would a little due to air resistance Figure 4.1 Velocity-versus-time graph for a wooden block sliding on Another advantage of using such carts is that the track three different surfaces. The rougher the surface, the more quickly the velocity decreases. constrains the motion to being along a straight line We can then use a high-speed camera to record the cart's position at various instants, and from that information determine its Cory:a) yes b) concrete has the acceleration of greatest magnitude speed and acceleration. Beth: I would think that they are not constant because if we @ 4.1 (3) Are the accelerations of the motions shown in think of the formula F=ma, the force of friction is different in every Figure 4.1 constant? (b) For which surface is the acceleration case. CONCEPTS largest in magnitude?[ polished wood Alison:As a theoretical question about inertia, if an object in 4.2 Inertia motion will stay in motion, but is being affected by friction, will it concrete We can discover one of the most fundamental principles of slow down perpetually but remain in motion, or will it eventually physics by studying how the velocities of two low-friction stop completely due to the friction? Just curious. carts change when the carts collide Let's first see what hap- Beth: With friction everything slows down to a half at one point Ice pens with two identical carts. We call these standard carts because we'll use them as a standard against which to com- or another. It is only if an outside force acts on the object if that pare the motion of other carts. First we put one standard object will maintain motion after the effects of inertia. polished wood cart on the low-friction track and make sure it doesn't Cory : Standard carts: identical carts in mass, shape, etc. I like move Next we place the second cart on the track some dis- this notion of standard carts, it provides a good baseline to compare tance from the first one and give the second cart a shove to- other motion and to understand the concepts before building on it. concrete ward the first. The tworearts collide, and the collision alters the velocities of both. Cory : Great visual representation of friction! It is interesting how this compares the velocity of things on different surfaces Alison : The rougher the surface, the more friction between the surface and the wooden block, and thus acceleration will be greater2.3 Why Do We Regulate? Public interest and private interest theories of regulation are designed to explain why regulation is attempted.4 This section examines these two BANKING REGULATORY THEORIES 29 theories of regulation, and more particularly their application to banking regulation. 2.3.1 Public Interest Theory Ultimately, the public interest theory of regulation rests upon the concept of the public interest, and how the public interest is identified or con- structed. In public interest theory, regulatory authorities are presumed to be guided by the public interest, and regulatory rules and processes are modelled so as to satisfy and advance the public interest. Public interest is never a static concept, and is subject to continuous redefinition to reflect evolving economic, social, and cultural changes. standards concerning bank exit policies. A robust exit policy could avoid credit and liquidity losses to depositors, avoid full insolvency triggers, and avoid contagion.45 As the GFC made evident, the specialized United States banking insolvency regimes have worked fairly well. This is witnessed by the reasonably smooth transfer or liquidation of a number of US banking institutions.46 The Banking Act 2009 in the UK was enacted to provide a new and permanent framework for dealing with banks in financial dif- ficulties, and aims ultimately to protect and enhance the stability of the UK nancial system and protect depositors and public funds.\" Rigorous bank exit measures provide certainty in the event of nancial turmoil. The \"stabilization powers\" implemented by the Banking Act 2009 recog nize not only the interest of depositors and creditors of failing banks, but also their counterparties' interests.43 The social objectives of banking regulation appear to be less obvious, but are just as important. Social regulatory objectives include objectives such as increasing home ownership or channelling resources to particu lar sectors of the economy or population.\" Bank credit can be directed, for example, to target disadvantaged sections of society or the economy. For instance, a key goal of the Community Reinvestment Act (1997) in the United States is to induce banks to extend their credit to lowerincome neighborhoods and areas.50 Boosting economic development is an objec- tive also largely believed to underpin banking regulation.51 Other regula tory objectives include making funds available for small businesses, and for students to finance education-related spending? These regulatory measures seek to redistribute income and stabilize the macro-economy. Particularly in developing economies, regulation plays a pivotal role in achieving developmental and social goals. Banks are regulated in a way designed to achieve those social objectives.\" Finally, banking regulation also aims to combat financial crime including fraud and money launder- ing.5'1 One of the objectives of the soon to be disbanded regulator, the FSA was to prevent financial crime, to facilitate its detection, and to monitor its incidence.\" In summary, the public interest theory of regulation has two ori gins: economic and social. In this light, regulation is established largely in response to economic concerns and is created to solve economic problems. 2.3.2 Private Interest Theory The private interest theory of regulation posits that regulation is driven by the private interests of the government, the regulators, and the 34 BANKING REGULATION IN CHINA regulated. The more the government attempts to regulate, the more it will fall under the control of specific and self-seeking groups in soci- ety.\" The private interest theory of regulation comes in two guises. One focuses specifically on the interests of politicians and political parties. It contends that, through regulation, politicians or political parties make their own demands to which private industries must respond.\" Political interests pursue their own preferences and disregard the public good?3 A second stand of the theory suggests that regulation is captured by pri- vate industries and \"is designed and operated primarily for the benefit of those industries.\"59 Under the private interest theory, banking regulation is primarily shaped by the respective private interests of the government, the regulators, and the regulated entities. Since banks have an historic role in allocating credit and deciding where money goes, through banking regulation the government inu- ences the national credit supply, which, in historical terms, is a matter that predates concerns with systemic stability. This historical function of banks has served governments across time and cultures, and govern- ments regulate banks to facilitate the financing of government expendi- tures, to funnel credit to politically attractive ends, and more generally to maximize the welfare and inuence of politicians and bureaucrats.60 Banks provide a source of funding that meets those needs of govern- ment. Instead of raising taxes or borrowing, governments frequently use banks as a source of nance to fund their initiatives.\" Government aggrandizement also could be perceived as a side effect of banking regu- lation.62 Through regulatory acts, government or a regulator might want to achieve a self-benefiting side effect, and may not be concerned with the direct consequence for banks. In good times, banks make large contribue tions to political campaigns; in bad times, bank failures can get politi cians into electoral hot water.63 The second guise of the private interest theory of banking regula- tion holds the view that banking regulation is pursued for the benefit of the regulated, that is, the banks themselves. Banks, as commercial enti- ties, ultimately seek to enhance profitability and increase their returns. Therefore, banking regulation that fails to take account of the incentives and private interests of banks is potentially counterproductive. Impeding entry, restricting the scope of business operations, maintaining high lev- els of government ownership, and retaining arbitrary regulatory discre- tion may contribute to corruption and undermine the efficiency of the banking system.\" Policy makers and regulators should therefore not try directly to steer banking operations but instead should focus on the effec- tiveness of banking systems.65 BANKING REGULATORY THEORIES 35 However, while building the case for regulatory capture, the private interest theory fails to acknowledge the similarity in interest between the public and the regulated. Banks' interests in operating in a safe and sound banking environment overlap with the public's interest in achieving the same objective. This weakens the advocacy position of private interest theory in banking regulation. Private interest theory has been used to support arguments to the effect that government regulation is inefficient.66 In the wake of the GFC, and the perception that that episode would not have occurred had there been \"better\" regulation, these arguments has become less compelling to the public and have lost favor with government. The public interest theory of regulation is particularly relevant in an economic climate in which more banks fail and systemic instability is a possibility. Indeed, historically, liberal regulatory attitudes have given way to the particular regulatory considerations concerning a stronger role of government in banking regulation. In public interest terms, governments have of neces sity become more involved in achieving regulatory objectives in response to the GFC.\" One last observation concerning the private interest theory of regula- tion in the context of regulatory capture is that there is a convergence of the two guises of the private interest theory at the point of corrup- tion where regulation is distorted for the private ends of the government, or the regulator, and the regulated banks. Banks may offer extortion to maintain legal business under intimidation by regulators, and bribe to collude with regulators for protection of illegal business.\" Conversely, regulators may seek rent without violation, and take bribes with illegal collusion.69 Corruption can be interpreted as conrmation of the argu- ment of private interest theory that banking regulation is captured by the interests of the government] the regulator and banks. Regulation is also subject to inuence by pressure groups that com- pete for political favors.\" Interest group competition can be a key fac- tor determining regulatory outcomes?1 According to Becker, systems in which the State controls a large part of economic life are more vulnerable to the demands of powerful pressure groups than in capitalist econo- mies.\" Although the analysis of interest groups originally developed in the Western economies, it would appear that the interest group approach may be more relevant to established one-party systems than in demo- cratic societies.\" In a totalitarian society, by inuencing the control- ling power, groups can more readily advance their own interests than in democracies?1 Interest groups can divert benefits to their own groups at the expense of the public?5 Research has also demonstrated that effective 36 BANKING REGULATION IN CHINA special interest groups impede growth of the economy.76 In the context of banking regulation, banking regulators may pursue self-interest rather than social welfare.\" Private interest theory contends that social regulation confers general benets to a large group at the expense of small and powerful groups?3 In other words, although social regulation produces few direct benefits but signicant costs, private parties are beneficiaries of indirect effects of such regulation?-9 For example, indirect effects of social regulation, such as a competitive advantage gained, can be sufficiently large for private parties.\" 2.3.3 The Reinvigoration of Public Interest and Private Interest Debate Criticisms of nancial market regulation in the aftermath of the GFC have resulted in a reemergence of interest in exploring regulation in the light of the public and private interest theories. The balance between private interest and public interest needs to be redefined.81 Public inter- est in the banking system or the broader financial system includes the need to preserve financial stability, to protect depositors and consumers, to protect public nance, and to maintain the availability of key banks ing services for consumers.32 In the wake of the GFC, there has been a heightened appreciation that public interest may not always be met sim- ply by the operation of competitive markets.83 At the time of the GFC, regulators' limited regulatory power seemed insufficient to secure public interests. 3\" Private interest of regulators in the light of regulatory capture came under close scrutiny.\" Through government control and ownership of banks, the government in the United States advances the interest of inuential interest groups.36 The ultimate challenge for financial regula- tion is to align private interests with public interest." 2.4 What Do We Regulate? Arising from the underlying rationale as to why banks are regulated, there are three different types of regulation based on distinguishable regulatory objectives: systemic regulation, prudential regulation, and the regulation of business conduct. 2.4.1 SystemicRegulation Corresponding with the notion that banks are special, systemic regula- tion is primarily concerned with the inherent risk of systemic failures for Two components of the public interest have been identified; objectives and outcomes, and process and procedure.5 The objectives and outcomes component is that aspect of the public interest referred to as shared opin- ion, common good, common interest, and shared value by the public.l5 In practice, public interest represents a compromise in achieving a deli- cate balance among conicting interests? The other aspect of the public interest, process and procedure, refers to the objectives and outcomes that are served through fair, inclusive, and transparent procedures.3 Thus, in public interest terms, regulation should embody both appropriate process and appropriate outputs. Regulatory process should adhere to standards of due process that include notions such as fairness, transparency, and equity? Regulation should also full public ends and reect the shared values of the public.l0 The public interest theory apparently is a positive theory about what are appropriate regulatory processes and the ultimate goals of such regulation. Regulatory objectives and outcomes inevitably encom- pass social and economic considerations. Economic rationales for regula- tion are those most often referred to in the literature.11 The notion of public under the public interest theory in banking reg- ulation is an organic concept. From individual depositors, the notion of public has extended to wholesale customers. This shift toward a more comprehensive and inclusive consideration of the composition of the public has been accentuated by the GFC. Banks, intertwined through the interbank market, could also be captured as counterparties under the umbrella of \"public\". For example, after the GFC, the liquidity of banks has also been viewed as being a public good in the face of systemic market freezing.12 The wider application of "public" has complicated banking regulation and the regulators' task in achieving regulatory objectives. 30 BANKING REGULATION IN CHINA The justifications for banking regulation are predominantly economi- cally oriented. The public interest theory of regulation perceives that mar- kets for goods and services are imperfect. In Western economies, market mechanisms are normally employed to allocate resources efciently. However, unregulated markets are subject to failures including abuse of monopoly power, externalities, and exploitation of information asymme- try.\" Monopoly power restricts the number of firms that can operate in the market and hence determines prices and outputs.\" Externalities are situations where there is a divergence between private and social cost or, in other words, where the prices used in exchange by individuals do not reflect general social costs or benefits.15 Information asymmetry occurs where consumers and producers lack information about each other. Under such asymmetry, resources are misdirected away from their most highly valued uses. Government, through regulation, attempts to prevent the exploitation of monopoly power, to minimize the impact of externali- ties, and to improve information disclosure conditions. Thus, regulatory intervention aims to avoid or at least to mitigate the adverse outcomes of market imperfection, and seeks to provide a remedy for the market fail- ures of private enterprises. As applied to banking regulation, there are four economic grounds for government intervention. The first justication for government inter- vention is to ensure fair and open competition. Research has suggested that although there are some economies of scale in banking there is no tendency toward natural monopoly.\" With the absence of monopoly power and the fact that the financial industry is competitive, the regula- tory focus has extended to the promotion of fair and open competition in the banking sector. This is consistent with the public interest through the fundamental function of banks to allocate credit supply in a sound manner to creditworthy borrowers. In pursuing these objectives, regu- lators recognize the necessity of preserving a level playing field among (existing) banks for the benefit of customers.\" For instance, fair competi- tion among banks is the very purpose of the soon to be disbanded British Financial Services Authority (FSATs \"standalone compliance\" principle in every financial promotion.\" Regulators also strive to avoid unneces- sary regulatory barriers to entry or business expansion.19 On the other hand, in contrast to ensuring fair and open compe- tition, it is common for regulation to impose barriers to the entry of foreign banks and their ongoing operation.\" Through geographic and customer restrictions, foreign banks are allowed to operate in a con strained manner. Under the US National Bank Act of 1864, for example, a national bank was required to conduct its business at a single loca- tion.21 However, the easing of restrictions on foreign bank entry in some countries has been required by international bodies, such as the International Monetary Fund (IMF) and the WTO.\" More importantly, there has been a growing understanding among policy makers and reg- ulators that a policy of easing barriers on foreign bank entry may be beneficial to host countries.\" Conversely, the GFC has raised the con cern that foreign banks, whose presence exposes a domestic banking system to potential international turmoils, might be a source of insta bility and contagion.24 The necessity of protecting the interests of individual depositors also provides a basis for regulation. Information asymmetry leads to the situ- ation where banks are more knowledgeable about business risks than their depositors, who neither have access to relevant information about the operations of banks, nor, very often, the acumen to understand the significance of any such information.25 It has long been appreciated that information asymmetry causes adverse selection, where banks possess and apply opportunistic information about loan customers and moral hazard, and where bank managers may engage in actions to divert eco- nomic resources for personal gain.26 Thus, small and uninformed retail depositors are regarded by regulators as incapable of monitoring bank operations and looking after their own interests.27 A lack of necessary skills and experience disadvantage retail customers and expose their vul- nerability. Retail customers do not make frequent repeat orders of con tracts and do not have the capacity to acquire information, and the failure of contracts is costly to them.23 As a result, information asymmetry is traditionally perceived as being more pervasive in retail than in whole- sale markets.29 Wholesale customers, including sovereign customers, corporate customers, and financial institutions, on the other hand, are normally sophisticated and professional.\" Therefore, it has been consid ered appropriate for retail banking to be regulated more vigorously than wholesale banking. However, following the GFC new circumstances arose when sophis- ticated wholesale investorssupposedly well equipped with skills and facilitiessought out the highest shortterm rates offered by weak banks, and thereby also became vulnerable.31 Their skills are equal to those of their contractual counterparts, the banks. The advent of ever more complicated banking products and services also, inevitably, undermines the wholesale customers' capacity to assess financial infor mation. Wholesale customers' exposure is most apparent, where they are not covered by effective deposit insurance schemes}:1 Therefore, in response, the traditional basis for banking regulation, to protect indi- vidual depositors, has extended to also safeguarding the interest of wholesale customers. Two other considerations derive from the notion that banks are special. Most commonly, bank deposits also constitute a primary source of the national credit supply. Banks accept deposits and make loans. Any break- down of the banking system will affect credit supply. The breakdown of the American banking system in 1933 triggered a massive contraction in credit supply and exacerbated the Great Depression.\" The provision of a payment system and effective credit circulation are essential to the func- tioning of a productive economy.\" The role of banks is thus central to the functioning of a nation's monetary policy. Ensuring a well-functioning banking system is pivotal to the national payment system and also to the national economy. Given the special status of banks, bank crises are generally perceived to pose greater adverse risk for economic stability than the failure of other types of businesses.35 It is the systemic risk phenomenon associated with banking institutions that makes them special.\" One essential goal of banking regulation is to prevent or mitigate crises that might cause the systemic collapse of banks, and even of the economy. Ultimately, banks are also interrelated through interbank markets where liquidity is transferred from banks with a surplus to banks with a deficit, and by payment systems, a system for clearing cheques and transmitting elec- tronic payments." Bank interaction through interbank markets and their dominance of payment systems creates the potential for widespread bank failure to cause severe economic disruption and even a banking panic.38 As illustrated in the recent Northern Rock case in the UK, banks are sus- ceptible to runs.39 Further, there is a fear of financial contagion spreading from one bank to another leading to the eventual collapse of the entire financial system.\" Therefore, distress at some banks triggered by an initial default can potentially spread and force other events of default in other banks. Contagion due to interbank claims and obligations may also be reinforced by indirect contagion on the asset side of the balance sheet where banks are forced to write down the value of their assets.'11 The col- lapse of Lehman Brothers caused market panic and led to a frozen inter- bank market.42 Moreover, financial risks have become increasingly complex and thus difcult to understand.'13 Preceding the GFC, hard-to-quantify dimen- sions of risk were largely neglected.\"14 Banks failed to grasp their own risk and counterparty risk. Those investing in complex products provided by banks also failed to understand their levels of risk. In the event of crisis, it is also in the public interest that banking regu latory measures are designed to restore market stability and market con- fidence. While the government may be prepared to act as lender of last resort in bad times, it is also important to implement applicable rules and