CHAPTER 10 Economic Analysis of Financial Regulation 235 Particularly controversial in the wake of the subprime financial crisis is the move to mark-to-market accounting (also called fair-value accounting), in which assets are valued on the balance sheet at what they could sell for in the market (see the FYI box, Mark-to-Market Accounting and Financial Stability) Consumer Protection The existence of asymmetric information also suggests that consumers may not have enough information to protect themselves fully Consumer protection regulation has taken several forms First is truth in lending, which requires all lenders, not just banks, to provide information to consumers about the cost of borrowing including a standardized interest rate (called the annual percentage rate, or APR) and the total finance charges on the loan Legislation also requires creditors, especially credit card issuers, to provide information on the method of assessing finance charges and requires that billing complaints be handled quickly The subprime mortgage crisis in the United States and Canada s short experiment with subprime lending have illustrated the need for greater consumer protection because so many borrowers ended up taking out loans that they could not understand and which were well beyond their means to repay The result was millions of foreclosures, with many households losing their homes Because weak consumer protection regulation played a prominent role in this crisis, there have been increasing demands to beef up this regulation, not only in the United States but in other countries as well, as is discussed in the FYI box, The Subprime Mortgage Crisis and Consumer Protection Regulation Restrictions on Increased competition can also increase moral hazard incentives for financial institutions to take on more risk Declining profitability as a result of increased comCompetition petition could tip the incentives of financial institutions toward assuming greater risk in an effort to maintain former profit levels Thus governments in many countries have instituted regulations to protect financial institutions from competition These regulations have taken different forms in the past, one being preventing nonbank institutions from competing with banks by engaging in banking business Although restricting competition propped up the health of banks, restrictions on competition also had serious disadvantages: they led to higher charges to consumers and decreased the efficiency of financial institutions, which did not have to compete as vigorously Thus, although the existence of asymmetric information provided a rationale for anticompetitive regulations, it did not mean that they would be beneficial Indeed, in recent years, the impulse of governments in industrialized countries to restrict competition has been waning Summary Asymmetric information analysis explains what types of financial regulations are needed to reduce moral hazard and adverse selection problems in the financial system However, understanding the theory behind regulation does not mean that regulation and supervision of the financial system are easy in practice Getting regulators and supervisors to their job properly is difficult for several reasons First, financial institutions have strong incentives to avoid existing regulations by exploiting loopholes Thus, regulation applies to a moving target: Regulators are continually playing cat-and-mouse with financial institutions financial institutions think up clever ways to avoid regulations, which then lead regulators to modify their regulation activities Regulators continually face new challenges in a dynamically changing financial system and unless they can respond rapidly to change, they may not be able to keep financial institutions from taking on excessive risk This problem can be exacerbated if regulators and supervisors not have the