Chapter 14. Regulating the Financial System Panics and crises Government safety net Financial system regulation

In economics, people respond to incentives regulation needed to counteract sometimes, regulation creates the wrong incentives

Panics and Crises With banking collapse, Comes financial collapse, And then economic collapse. Why are banks so vulnerable? Depositor withdrawal on demand

Anatomy of a panic Insolvency or BELIEF of insolvency of a bank: Bank run Bank illiquidity Fear spreads to other banks: contagion Bank panic

Government safety net Banks get more protection than nondepository institutions Role in indirect finance Illiquid assets to back liquid liabilities

Lender of last resort Government central bank to provide liquidity to banks when needed. Prevent a panic Doesn’t always work E.g. Great Depression Should help with illiquidity NOT insolvency.

Deposit Insurance FDIC established 1934 prevents depositors from panicking and withdrawing funds Prevents a “run on the bank”

2 types of action payoff method FDIC closes down insolvent bank depositors paid up to $100,000 FDIC sells off assets often depositors with more than $100,000 often given full refund

purchase & assumption method FDIC finds a healthy bank to buy failing bank -- FDIC offers incentives no depositor losses more common method

before FDIC bank panics 1819, 1837, 1857, 1873, 1884, 1893, 1907, 1930-33 after FDIC no national bank panics

Problems w/ deposit insurance moral hazard insurance gives less incentive to be careful depositors less careful in selecting bank banks less careful with depositor money

adverse selection if depositors not policing banks, questionable people, knowing this, attracted to banking

FDIC policies make problems worse “too big to fail” FDIC gives preferential treatment to larger bank failures -- covering deposits > $100,000 -- prevent large losses moral hazard/adverse selection worse for larger banks

Regulation & supervision Many regulators—dual system Banks FDIC Comptroller of the Currency Federal Reserve System State authorities

Competition Repeal of McFadden, Glass Steagall in 1990s Mergers must be approved Community needs must be met Tradeoff between competition & profitability

Asset restrictions Banks cannot hold common stock Restrictions on bond quality and diversity of holdings Restrictions on how much lending to other banks

Capital Requirements Minimum capital as % of risk adjusted assets counteract moral hazard problems capital is lost if failure capital reduces risk-taking well-capitalized banks less supervision lower deposit insurance premiums

Disclosure Disclosure about loan and deposit terms APR Fees Financial statements under certain accounting rules (GAAP)

Bank Supervision limiting ownership bank examinations (unannounced) asset risk bank loans capital requirement managing risk

Regulatory challenges Derivative risk is not always reflected in the balance sheet Regulated combined financial services Are regulators too specialized? Goal: overall financial stability Not stability of ALL institutions