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

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

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

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

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

7. 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.

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

9. 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

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

11. before FDIC
bank panics
1819, 1837, 1857, 1873, 1884, 1893, 1907,
after FDIC
no national bank panics

12. 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

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

14. 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

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

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

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

18. 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

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

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

21. 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