Strategic Asset Allocation.
Private market debt investment is a type of investment that is usually linked... Read More
It is important for financial institutions to be highly regulated because they have a direct impact on the non-financial sector of the economy. As a result, when large financial institutions fail, it can ripple through the economy, causing unemployment, lack of funds, or inability to make pension payments.
An institution's capital must be sufficient to absorb shocks to both asset and liability values. This implies limiting the volatility of the value of the institution's portfolio of shareholder capital. Since these factors vary by jurisdiction, no specific set of constraints is testable. What may be testable is the goals, methods, and commonalities among these constraints within each jurisdiction, in other words, the high-level aspects.
Pension funds regulations commonly cover the following aspects of a pension fund operations, including:
Failure to comply with key regulations may result in loss of operating licenses and/or loss of tax benefits, where applicable, which provides a strong incentive to comply. As an example, US corporate pension plans are subject to significant regulatory oversight. The Employee Retirement Income Security Act of 1974 (ERISA) regulates vesting, funding requirements, and payouts.
Most governments around the world provide favorable tax treatment for retirement savings. Different forms of favorable tax treatment may apply. Here are a few examples: reduced taxes on retirement plan contributions, favorable tax rates on investment income and/or capital gains, and lower tax rates on benefit payments during retirement. Governments typically place restrictions on plan design, governance, and investment activities in order for plans to qualify for the favorable tax treatment
National legislation typically establishes sovereign wealth funds, which include details on:
Typically, sovereign wealth funds are given tax-free status by the legislation that governs them. SWFs may be ineligible to claim withholding taxes or tax credits that are ordinarily available to taxable investors. As SWFs invest in offshore markets, they also need to consider any tax treaties that may exist between the countries in which they are investing and their own country.
Charitable organizations, including endowments and foundations, are typically subject to rules and regulations in their country of domicile that:
A fiduciary is a person or entity who holds a legal or ethical relationship of trust with one or more other parties. This means going above and beyond what is legally required and always acting in the best interest of the client. A fiduciary can often be held legally responsible for failure to act in such a manner and could be held liable in court for disadvantaging their client.
Endowments are usually tax-exempt. This involves three key elements:
For banks and insurance companies, the liabilities to depositors, the claims of policyholders, and the amounts due to creditors are clearly and contractually defined. This means heightened regulation. For example, if an endowment fails to make a payout to the local university, this will negatively affect the ability of the university to meet its mission in perpetuity. However, it is unlikely to send shockwaves through the local economy, as might happen if a bank were unable to meet their legally required payouts on deposit accounts. This could lead to a run on banks or worse.
The regulation of financial institutions centers on making sure banks and insurance companies have adequate capitalization to absorb losses rather than allowing losses to be borne by the rest of the financial system or the real economy–including depositors, insurance policyholders, creditors, or taxpayers. This can be achieved through requirements for:
As it pertains to insurance companies, regulation focuses on limiting the size and concentration of potential policy claims. In addition to limiting potential losses from assets and liabilities–or from other operational risks–regulators may mandate certain minimum required capitalization. Since the 2008 financial crisis, new legislation in the US has aimed to:
In terms of taxation, banks and insurance companies typically are taxable entities, and the industry-specific tax rules can be quite complicated. As taxable entities, banks and insurance companies must manage their investment programs with consideration of after-tax returns.
Banks and insurers are held to a higher standard of financial reporting, including all of the following:
Question
As it relates to regulation for banks and insurers, regulation often focuses on all but which of the following requirements:
- Diversification.
- Asset quality.
- Minimum return requirements.
Solution
The correct answer is C.
Minimum return requirements would have the opposite effect when compared to the first two choices. If minimum returns were a regulatory concern, many institutions would need to hold a larger percentage of riskier assets in order to meet the minimum. This could lead to much unneeded financial instability.
A is incorrect. Diversification of an institution's portfolio can help ensure its viability through financial turmoil. Excessive investments in riskier assets can cause increased volatility, which can spill over into the local economy.
B is incorrect. A minimum asset quality, in the same vein, reduces the riskiness of an institution's portfolio. For example, a large bank with primarily sub-prime mortgage loans on its balance sheet is at greater risk of underperforming during a financial crisis, which could negatively affect the institution as a going concern, just when the local economy may need it the most.
Portfolio Construction: Learning Module 5: Portfolio Management for Institutional Investors; Los 5(d) Describe the focus of legal, regulatory, and tax constraints affecting different types of institutional investors