51. If the government did not offer the too big to fail safety net:
A) Large banks would be more disciplined by the potential loss of large corporate accounts.
B) The moral hazard problem of insuring large banks would increase.
C) The moral hazard problem of insuring large banks would decrease.
D) a and b
E) a and c
Answer: E LOD: 2 Page: 359
A-Head: The Government Safety Net.
52. You hold an FDIC insured savings account at your neighborhood bank jointly with your father. Each of you has contributed equally into the account. The current balance in the account is $120,000. If the bank fails each of you will receive:
A) $60,000.
B) $50,000
C) $100,000
D) $120,000.
Answer: A LOD: 2 Page: 362
A-Head: The Government Safety Net.
53. You hold an FDIC insured savings account at your neighborhood bank. Your current balance is $125,000. If the bank fails you will receive:
A) $125,000.
B) $100,000.
C) $62,500.
D) $75,000.
Answer: B LOD: 1 Page: 362
A-Head: The Government Safety Net.
54. You have two savings accounts at an FDIC insured bank. You have $75,000 in one account and $40,000 in the other. If the bank fails, you will receive:
A) $75,000
B) $40,000
C) $115,000
D) $100,000
Answer: D LOD: 2 Page: 362
A-Head: The Government Safety Net.
55. You have savings accounts at two separately FDIC insured banks. At one of the banks your account has a balance of $50,000. At the other bank the account balance is $60,000. If both banks fail, you will receive:
A) $100,000.
B) $60,000
C) $110,000
D) $50,000
Answer: C LOD: 2 Page: 362
A-Head: The Government Safety Net.
http://groups.google.com/group/vuZs
56. Governments employ three strategies to contain the risks created by government safety nets. These include each of the following, EXCEPT:
A) Government supervision.
B) An excise tax on bank profits.
C) Government regulation.
D) Formal bank examination.
Answer: B LOD: 1 Page: 360
A-Head: Regulation and Supervision of the Financial System.
57. The purpose of the government's safety net for banks is to do each of the following, EXCEPT:
A) Protect the integrity of the financial system.
B) Eliminate all risk that investors face.
C) Stop bank panics.
D) Improve the efficiency of the economy.
Answer: B LOD: 2 Page: 360
A-Head: Regulation and Supervision of the Financial System.
58. Governments supervise banks mainly to:
A) Reduce the potential cost to taxpayers of bank failures.
B) Be sure the banks are following the regulations set out by banking laws.
C) Reduce the moral hazard risk.
D) All of the above.
Answer: D LOD: 1 Page: 360
A-Head: Regulation and Supervision of the Financial System.
59. Commercial Banks are regulated by a combination of agencies including each of the following, EXCEPT:
A) The Federal Reserve.
B) Office of Thrift Supervision.
C) State authorities.
D) Federal Deposit Insurance Corporation.
Answer: B LOD: 1 Page: 363
A-Head: Regulation and Supervision of the Financial System.
60. Savings banks and savings and loans are regulated by a combination of agencies which includes:
A) Federal Reserve System.
B) Office of the Comptroller of the Currency.
C) Office of Thrift Supervision.
D) The Internal Revenue Service.
Answer: C LOD: 1 Page: 363
A-Head: Regulation and Supervision of the Financial System.
61. Credit Unions are regulated by a combination of agencies which includes:
A) State Authorities.
B) The Federal Reserve.
C) The Federal Deposit Insurance Corporation.
D) a and c
Answer: A LOD: 1 Page: 363
A-Head: Regulation and Supervision of the Financial System.
62. Banks can effectively choose their regulators by deciding:
A) To be a private or public corporation.
B) To be a member of the Federal Reserve or not.
C) To purchase FDIC insurance or to forego the coverage.
D) To be chartered at the national or state level.
Answer: D LOD: 1 Page: 362
A-Head: Regulation and Supervision of the Financial System.
63. The fact that banks can be either nationally or state chartered creates:
A) Situations where some banks go unregulated.
B) Situations where banks operating in more than one state can escape regulation.
C) Regulatory competition.
D) a and b
Answer: C LOD: 2 Page: 362
A-Head: Regulation and Supervision of the Financial System.
64. One negative consequence of regulatory competition is:
A) It is expensive.
B) Financial institutions are over regulated at a cost to customers.
C) Financial institutions often seek out the most lenient regulator.
D) It minimizes competition.
Answer: C LOD: 2 Page: 362
A-Head: Regulation and Supervision of the Financial System.
65. A long standing goal of financial regulators has been to:
A) Prevent banks from growing too big and powerful.
B) Minimize the competition that banks face.
C) Encourage banks to grow as large as possible.
D) Discourage small rural banks.
Answer: A LOD: 1 Page: 363
A-Head: Regulation and Supervision of the Financial System.
66. Bank mergers require government approval because banking officials want to make sure:
A) That the merger will create a larger, more solid bank.
B) That the merger will not create a monopoly in any geographic region.
C) That if a merger has a small community bank taken over by a larger regional bank, that the customers of the small town will still be well-served.
D) a and c
E) b and c
Answer: E LOD: 2 Page: 363
A-Head: Regulation and Supervision of the Financial System.
67. Which of the following statements is most correct?
A) Financial regulators do everything possible to encourage competition in banking.
B) Financial regulators work to prevent monopolies but also work to minimize the strong competition in banking.
C) Financial regulators discourage competition in banking.
D) Financial regulators prefer banks to have monopoly power in their geographic markets.
Answer: B LOD: 2 Page: 363
A-Head: Regulation and Supervision of the Financial System.
68. Banking regulations:
A) Prevent banks from holding more than 10 percent of their assets in common stock of companies.
B) Prevent banks from owning corporate jets.
C) Prevent banks from owning common stocks of corporations.
D) b and c
Answer: C LOD: 2 Page: 364
A-Head: Regulation and Supervision of the Financial System.
69. One reason that financial regulations restrict the assets that banks can own is to:
A) Combat the moral hazard that government safety nets provide.
B) Limit the growth rate of banks.
C) Prevent banks from being too profitable.
D) Keep banks from spending lavishly on perks for executives.
Answer: A LOD: 1 Page: 364
A-Head: Regulation and Supervision of the Financial System.
70. Financial regulators set capital requirements for banks. One characteristic about these requirements is:
A) Every bank will have to hold the same level.
B) The riskier the asset holdings of a bank, the more capital they will be required to have.
C) The more branches a bank has, the more capital they must have.
D) The amount of capital required is inverse to the amount of assets the bank owns.
Answer: B LOD: 2 Page: 364
A-Head: Regulation and Supervision of the Financial System.
71. The Basel Accord is:
A) The basic set of guidelines the Federal Reserve applies in regulating domestic banks.
B) A set of guidelines for basic capital requirements for internationally active banks.
C) An agreement between state and federal regulators to try to have one standard set of guidelines for all banks.
D) A set of guidelines applied only to international banks operating with U.S. boundaries.
Answer: B LOD: 2 Page: 366
A-Head: Regulation and Supervision of the Financial System.
72. Banks are required to disclose certain information. This disclosure is done to:
A) Enable regulators to more easily assess the financial condition of banks.
B) Allow financial market participants to penalize banks that carry additional risk.
C) Allow customers to more easily compare prices for services offered by banks.
D) All of the above.
Answer: D LOD: 1 Page: 365
A-Head: Regulation and Supervision of the Financial System.
73. The supervision function of banks includes:
A) Requiring bank officers to attend classes on an annual basis.
B) On site examinations of the bank.
C) Extensive background checks of all bank officers.
D) All of the above.
Answer: B LOD: 1 Page: 365
A-Head: Regulation and Supervision of the Financial System.
74. One reason a bank officer may be reluctant to write off a past-due loan is:
A) It will increase their liabilities.
B) It will decrease the banks assets and capital.
C) It will increase their liabilities and assets, requiring more capital to be held.
D) Bank officers are not reluctant to write-off past due loans.
Answer: B LOD: 2 Page: 366
A-Head: Regulation and Supervision of the Financial System.
75. The acronym CAMELS, which is the criteria used by supervisors to evaluate the health of banks, includes the following, EXCEPT:
A) Asset quality.
B) Losses.
C) Management.
D) Earnings.
Answer: B LOD: 1 Page: 366
A-Head: Regulation and Supervision of the Financial System.
76. The CAMELS ratings are:
A) Made public monthly to the financial markets so people can judge the relative quality of banks.
B) Published once a quarter in banking journals issued by the Federal Reserve.
C) Included in the annual report of publicly owned banks.
D) Not made public.
Answer: D LOD: 1 Page: 366
A-Head: Regulation and Supervision of the Financial System.
77. In the 1980's, regulators let a large number of insolvent savings and loans continue to operate. They allowed this because:
A) They didn't know they were insolvent.
B) To close them down may have bankrupted the deposit insurance fund.
C) Regulators did not want to admit they might have been wrong.
D) a and c
E) b and c
Answer: E LOD: 2 Page: 368
A-Head: Regulation and Supervision of the Financial System.
78. In the 1980's, many managers of insolvent institutions actually made a bad situation worse by:
A) Closing their institution before regulators did.
B) Offering higher interest rates on deposits depleting healthy institutions of these funds.
C) Dramatically reducing the loans they were making.
D) Cutting the interest rate they would pay for deposits.
Answer: B LOD: 1 Page: 368
A-Head: Regulation and Supervision of the Financial System.
79. Forbearance in the regulations of savings and loans had regulators:
A) Closing many institutions that were actually quite healthy.
B) Taking a far more stringent interpretation of banking regulations.
C) Deliberately ignoring or taking a loose interpretation of regulations.
D) Ultimately saving the deposit fund for savings and loans from insolvency.
E) b and d
Answer: C LOD: 2 Page: 369
A-Head: Regulation and Supervision of the Financial System.
80. A regulatory change that has resulted from the savings and loan crisis is:
A) Assets are now accounted for at market value.
B) The deposit insurance premiums charged are the same for all institutions.
C) Assets are now accounted for at book value rather than market value.
D) Regulators put institutions whose capital levels are less than two percent of assets on a watch list.
Answer: A LOD: 2 Page: 369
A-Head: Regulation and Supervision of the Financial System.
81. As a result of the failure of many financial institutions in the 1980's:
A) Deposit insurance premiums are now risk based.
B) Regulators must immediately close institutions whose capital falls below two percent of assets.
C) Assets must be accounted for at book value rather than market value.
D) a and c
E) a and b
Answer: E LOD: 2 Page: 369
A-Head: Regulation and Supervision of the Financial System.
Short Answer Questions
82. The text points out that there is an inverse relationship between the fiscal cost of a bank crisis and real GDP growth. What are some of the reason that can explain this inverse relationship?
Answer: One obvious cost is that funds that have to be used to "clean-up" the crisis must be diverted from some other use, so there is the opportunity cost that is faced. Another reason is that the process of channeling funds from savers to borrowers is disrupted or inefficient. If savers become leery of banks, they may not save or they may not channel these funds through banks so the economy is not as efficient as it could be. Also, investment projects that should be funded will not be, and those that shouldn't be may receive funding since financial intermediation is not working as it should. Another, and perhaps the largest cost, is that if investment is curtailed the ability to produce output in the future will be harmed leading to a lower standard of living not just for the current year but for many years.
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A-Head: The Sources and Consequences of Runs, Panics and Crises.
83. Why is it generally assumed that there is a trade-off between a bank's profitability and its safety?
Answer: The assets that tend to bring the bank the highest return tend to be the least liquid. Highly liquid assets have relatively low returns. So if a bank seeks high profits it is likely to invest in relatively illiquid assets. On the other hand, a bank needs to be liquid, especially in situations where customers may desire to withdraw their deposits. If a bank does not have liquid funds or if they cannot convert illiquid assets to a liquid form without taking significant losses, they may fail.
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A-Head: The Sources and Consequences of Runs, Panics and Crises.
84. Why do bank runs usually have people rushing to their bank instead of waiting for the lines to taper off so they do not have to wait so long?
Answer: Banks promise to satisfy depositors' withdrawal requests on a first come first served basis. As a result, people thinking the bank has limited cash (which is usually true) want to get theirs before the bank runs out and rush to the bank to be first in line. LOD: 1 Page: 352
A-Head: The Sources and Consequences of Runs, Panics and Crises.
85. What is the difference between a bank that is insolvent and one that is illiquid?
Answer: A bank that is insolvent is in a position where the bank's assets are less than their liabilities, so they have negative bank capital. A bank that is illiquid may be solvent, meaning it has assets that are exceed its liabilities, but it may not have sufficient reserves, marketable assets and capital to meet all of the depositors' demand for withdrawals.
LOD: 2 Page: 352
A-Head: The Sources and Consequences of Runs, Panics and Crises.
86. Why is it that a run on a single bank can turn into a wide scale financial panic, or what the text identified as contagion?
Answer: The reason for the spread of panic or contagion is information asymmetries. It is due to the fact that most depositors cannot tell a healthy from an unhealthy bank. As a result, the safest thing for individuals to assume is their bank is unhealthy and to withdraw their funds.
LOD: 2 Page: 352
A-Head: The Sources and Consequences of Runs, Panics and Crises.
87. How do banks potentially make economic downturns more severe and how do economic downturns contribute to the increased failure of banks?
Answer: When an economy begins to slow some people lose their jobs and or their incomes are reduced. As a result, these individuals may default on their loans which reduces the value of a bank's assets and also reduces the bank's capital, especially if the loans are in default. As bank capital is reduced lending will also be reduced which will further slow the economy as consumer durable good spending will fall, as will investment spending. But the slowing of the economy will also continue to push more loans into default and further reduce bank capital leading to even more bank failures. LOD: 2 Page: 353
A-Head: The Sources and Consequences of Runs, Panics and Crises.
88. Why is the financial industry inherently more unstable than most other industries?
Answer: In most other industries the failure of one participant does not put the other participants and the industry at risk. The same cannot be said of the financial industry. The failure of one bank or financial institution, through contagion, can put the entire system at risk. This is due to information asymmetries which can have depositors assuming their bank is going to also fail and seek to withdraw their funds. This then leads to liquidity risk, because most banks would lack the liquidity to withstand the run.
LOD: 2 Page: 353
A-Head: The Government Safety Net.
89. In 1873, British economist Walter Bagehot proposed the central bank function as the lender of last resort. Specifically, he suggested the central bank lend freely to banks which have good collateral at high rates of interest. Why the requirements of good collateral and a high rate of interest?
Answer: The requirement of good collateral is to ensure the loans are going to solvent banks. The high interest rates will penalize a bank for not holding adequate reserves to meet the liquidity needs. If the interest rate charged is low, the bank will have a strong incentive to seek higher returns through illiquid assets knowing it can count on the central bank in times of liquidity need.
LOD: 2 Page: 356
A-Head: The Government Safety Net.
90. Does the lender of last resort function guarantee an end to bank runs? Explain.
Answer: The Great Depression is evidence to the fact that just because a central bank has the function of lender of last resort, there is no guarantee that banks will use it or the central bank will lend freely. The experience in the early years of the Great Depression showed that banks did not take advantage of borrowing from the Fed. LOD: 2 Page: 357
A-Head: The Government Safety Net.
91. How does the lender of last resort potentially create a moral hazard problem?
Answer: The lender of last resort function provided by a central bank will have a bank turning to the central bank for a loan after all other options are exhausted. The bank manager knows that the central bank will want to avoid a widespread bank panic and will be generous in evaluating the value of the bank's assets and to grant a loan even if they suspect the bank may be insolvent. Knowing this, bank managers will tend to take too many risks.
LOD: 2 Page: 357
A-Head: The Government Safety Net.
92. You have a retirement account in a bank that has failed. The balance in your account is $180,000. Does it make a difference to you if FDIC uses the payoff method or the purchase and assumption method for resolving this insolvency? Explain.
Answer: It does make a difference. Under the payoff method, the FDIC simply pays off the depositors the balance in their account up to the legal limit which is currently $100,000. You would potentially lose $80,000. Under the purchase and assumption method, FDIC will find a firm to take over the failed bank and your account will stay intact.
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A-Head: The Government Safety Net.
93. Imagine a situation where the deposits at state chartered banks would be insured by a state insurance fund and deposits at nationally chartered banks would be insured by FDIC. How would you expect both depositors and banks would react?
Answer: Depositors would quickly learn that no state insurance fund can withstand a run on all banks in their state. As a result, they would seek to withdraw their funds and place them in a nationally chartered institution. The owners of the state chartered banks would then seek to change their charter to a national one and pick up FDIC insurance. The reason people do not fear FDIC running out of funds is that they are backed by the U.S. Treasury and as a result can withstand any crisis.
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A-Head: The Government Safety Net.
94. Explain why the ratio of assets to capital increased dramatically for commercial banks from the 1920s to the present.
Answer: The answer to this question is simply deposit insurance. Without deposit insurance a bank would have to make sure their assets were highly liquid and that they maintained adequate capital to withstand either the shock of assets losing value or a run on the bank. With deposit insurance, the bank manager knows that the insurance fund will protect most depositors and so feels comfortable assuming more risk. One, the additional return from the greater risk will belong to the bank's owners. The potential loss from the greater risk will be borne primarily by the insurance fund. This is a classic moral hazard problem.
LOD: 2 Page: 359
A-Head: The Government Safety Net.
95. You are the head of finance for a very large corporation located in a relatively small town. At a local chamber of commerce meeting, the president of the local bank asks you why you keep the corporation's bank accounts in a very large mid-western bank and not in his local bank. From a risk reduction perspective, how could you answer his question?
Answer: You might employ the concept of too big to fail. As the text points out, the likelihood of bank regulators allowing a large bank to actually fail is very remote. A small bank failure, while certainly disruptive to the bank's depositors and owners, is not likely to cause wide scale panic. If you had your company's funds in this bank and it failed, your company may only recover up to the legal limit. On the other hand, the failure of a large bank might cause wide scale panic, so realizing this, you decide to place your company's funds into a bank that you believe is in the too big to fail category and thus protecting your company's deposits.
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A-Head: The Government Safety Net.
96. You get married and, in doing some basic financial planning, your spouse suggests that the two of you open separate accounts so that if your total deposits exceed $100,000, your funds will be protected by FDIC. How would you respond to the suggestion?
Answer: You could respond by saying that it isn't necessary until the amount you have exceeds $200,000 since currently FDIC insurance will protect a joint account up to $100,000 for each person on the account. Once you have more than $200,000 in accounts, you may want to open another account at a different institution.
LOD: 2 Page: 362
A-Head: The Government Safety Net.
97. What is the link between the safety net provided by the government to the financial industry and the relatively heavy regulation of the same industry by the government?
Answer: The link is that the safety net provided, like FDIC insurance, too big to fail, and lender of last resort, while very valuable also creates strong moral hazard and adverse selection problems. As a result, to minimize these problems governments have developed different strategies to manage the risks created by the safety net.
LOD: 2 Page: 360
A-Head: Regulation and Supervision of the Financial System.
98. What potential problems are created by regulatory competition?
Answer: Regulatory competition often allows a financial institution to select who will regulate it by selecting who charters it. One problem is that this will encourage the institution to select the regulator(s) that they believe will be the most lenient.
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A-Head: Regulation and Supervision of the Financial System.
99. Explain how bank regulators seem to face a bit of a paradox regarding preventing monopoly power by banks and spurring competition.
Answer: One of the goals of banking regulators is to prevent any bank from growing so large that they effectively become a monopoly in their geographic market. Monopolies are inefficient and are seldom of benefit to consumers. On the other hand, while we usually think of competition as being beneficial to consumers because it results in low prices and new products, within the financial industry competition can cause banks to seek other ways to earn profits, which may expose the bank to greater risk, and threaten the integrity of not just one institution but the entire system.
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A-Head: Regulation and Supervision of the Financial System.
100. Why are banks restricted in the assets that they can own; for example, why do you think banks are prohibited from owning common stock?
Answer: There are a few reasons for this, one, many of these assets are relatively illiquid and can cause wide swings in the value of assets. If the value of these assets were to decrease significantly, the institutions' capital would be negatively impacted putting the institution and the system at risk. Another reason is the problem of moral hazard. The government is providing a safety net, which by itself would cause a bank to want to seek a higher return by taking on more risk. To combat this problem, regulators restrict the institution in the types of assets it can hold.
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A-Head: Regulation and Supervision of the Financial System.
101. If we lived in an economy where interest rates are highly volatile, would you expect the maximum asset to capital ratio that a regulator would allow to increase or decrease and why?
Answer: An environment where interest rates are highly volatile says that the value of a firm's assets would also be volatile. For example, if interest rates significantly rise unexpectedly, the value of a bank's assets would fall unexpectedly. This would put a strain on the capital of the bank, especially in the sense that the bank's capital is the cushion that it would fall back on should it face a liquidity crisis. The bank could find itself insolvent if interest rates rise a lot and their capital were inadequate. As a result, we would expect regulators to insist on a lower asset to capital ratio.
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A-Head: Regulation and Supervision of the Financial System.
102. We saw in the text that the government also regulates nondepository financial institutions, such as insurance companies. Consider a property casualty insurance company; why would the government need to regulate them?
Answer: The insurance company takes premiums from people and makes the promise to pay claims should certain events occur. In the case of property insurance, often times these events could be widespread and quite severe, like a hurricane or an earthquake. When a loss like this occurs, it is similar to a liquidity crisis for banks, the insurance company faces a run in the sense that it will need to be liquid and quickly. Regulators then want to ensure at least three things, one is that the insurance company is solvent, meaning its assets exceed its liabilities. It also want to make sure that the assets are liquid and that the value stated reflects market value, and third, that the company has adequate capital to withstand fluctuations in asset value should it have to get liquid at a time when asset prices may be depressed.
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A-Head: Regulation and Supervision of the Financial System.
103. What was the primary motivation behind the creation of the Basel Accords?
Answer: Globalization in the sense that foreign banks could enter a market and compete with domestic banks. The problem was that often times the foreign banks would be operating under different regulatory restrictions that would provide them with a competitive advantage. The Basel Accords are an attempt to place minimum capital requirements on financial institutions that are internationally active.
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A-Head: Regulation and Supervision of the Financial System.
104. Identify at least two problems a borrower would face if banks were not required to disclose the information that they are currently required to make available.
Answer: One problem that quickly comes to mind would be all of the hidden fees that a bank could charge for a checking account or a loan application. In addition, the customer would face very high search cost in the sense that they would have to ask a lot of questions of each institution to uncover these hidden costs.
Another problem is the way that interest is calculated for savings accounts and loans. For example, is the interest being paid on a savings account based on the average balance or is it based on the balance that exist at the beginning or end of the month? Also, the interest rate charges on the loan, is it expressed as an annual rate or is it calculated using some other formula. The disclosure laws that banks face are designed to reduce these costs to customers and make the comparing of prices across banks easier.
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A-Head: Regulation and Supervision of the Financial System.
105. You head up an agency where one of the services your agency provides is examination of financial institutions. Over time you notice that you are experiencing high personnel turnover and the turnover is a result of the largest bank in your area hiring the examiners at much higher salaries than they were earning. Do you see any problem here and if so, how do you address it?
Answer: In economics there is a concept called "regulatory capture" where the firm being regulated actually captures the regulator in potentially a number of ways. In this case, the examiner, knowing that the firm may hire her, potentially could extend leniency that would otherwise not be extended, or could look the other way on a number of questionable practices, hoping to land one of the high paying jobs within the firm. One way to address the problem is to move examiners around to different institutions. This does have a tradeoff to it, in that an examiner does have specific information regarding the firm and this can be valuable in examining the institution. Another way to treat the problem is to make sure that examiners are well paid and are earning salaries that are commensurate with what their skills would command in the private sector.
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A-Head: Regulation and Supervision of the Financial System.
106. The CAMELS criteria to evaluate the health of banks by supervisors is not made public. Make a case for one making this information public and a case for keeping it private.
Answer: The case for making it public would be to encourage the managers of banks to do whatever is necessary to earn a high rating to keep depositors and to attract investment capital. This information would go a long way toward treating the moral hazard problem. The case for keeping it private is to avoid a run on the bank. If a bank is having difficulty, regulators may have the opportunity to work with the management to solve the problem and avoid a bank run which is likely to push the institution into insolvency and end up costing some depositors and taxpayers more than it would have if they work the problems out without public scrutiny.
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A-Head: Regulation and Supervision of the Financial System.
Essay Questions
107. Discuss the ramifications of the FDIC reducing deposit insurance limits to $25,000.
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Answer:
If deposit insurance limits were reduced to $25,000 a few things would happen. First, many people would have more at risk by saving at their banks. The result may be for people to either keep less on deposit at the bank, this will reduce the funds available to banks or will require the banks to offer higher interest rates to depositors to attract funds since the depositors will now face greater risk, increasing the cost of acquiring funds. Another likely outcome is that banks may actually put out more information to the public advertising how safe and well run their particular bank is, this would be done to again attract depositors who now are seeking a relatively safe place to put their funds. There may be less of a moral hazard incentive on the part of bank managers. Any decrease in bank return or any increase in risk has the manager facing the widespread withdrawal of funds by depositors who face a higher cost of bank failure. There could also be more innovation. For example, savers could still get the U.S. government to guarantee their principal by purchasing U.S. Treasury securities. We would likely see greater use of saving vehicles where all funds are placed in treasury securities and savers have convenient ways to access these funds, (much like many current money market accounts.) Banks, seeking to attract deposits would have to offer products and or higher returns to compete with the Treasury securities.
A-Head: The Government Safety Net.
108. We saw in the text that government regulations, specifically deposit insurance, compounded the savings and loan crisis. But how did government regulation actually "sow the seeds" of the crisis?
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Answer:
Savings and loans originally were chartered to make home mortgage loans and accept deposits. Basically, they were regulated in what they could pay to depositors and they were limited in the form their assets could take. Their assets were long term and relatively illiquid, while their liabilities were short term and subject to withdrawal, meaning the regulations that savings and loans faced made them ripe for liquidity risk. When nominal market interest rates increased in the 1970's above the interest rates that savings and loans could offer to depositors, depositors began to withdraw their funds and the savings and loans were plunged into a liquidity crisis. At the same time the rising interest rates was severely decreasing the market value of their assets and many of these institutions were insolvent. Most were allowed to continue to operate by regulators who did not want to face either the wiping out of the insurance fund for these institutions or the admission that regulations and the regulators contributed heavily to this problem.
A-Head: Regulation and Supervision of the Financial System
109. FDIC used to charge banks the same rate for insurance on deposits. From what you have learned, what problems did this create for not only the FDIC but for well run banks?
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Answer:
For FDIC the immediate problem is adverse selection. The average rate would have attracted more low quality, or in this case, high risk banks. Now FDIC could get around the adverse selection problem by simply asking for a regulation requiring all banks purchase insurance through them. This is similar to an insurance provider providing group insurance to an employer but insisting they get most if not all of the employees to purchase coverage and it not be voluntary. FDIC cannot escape the problem of moral hazard, however, here the presence of insurance will have some banks wanting to take on more risk. In fact, the well-managed (low risk) banks will be at a disadvantage, actually subsidizing the high risk banks. The only way to address the problem of cross-subsidization is through a premium that is risk based so that the lower risk company will pay a lower premium which would in theory allow it to offer lower rates on loans and or higher rates to depositors.
A-Head: The Government Safety Net.
110. On a regular basis Congress is asked to consider raising the insurance limit on FDIC coverage. From what you learned in Chapter 14, what do you think Congress should do?
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Answer:
This is an interesting problem. Most people who would not give the matter a lot of thought would probably think this is a good idea and that it would help a lot of savers. The reality is that most savers do not have the current limit of $100,000 in a bank. Large investors or businesses who may have more than $100,000 in a bank have the tools to adequately assess the financial health of their bank and the risk they are taking. Perhaps more important, we saw the disaster brought by the last increase in coverage. There is no escaping the fact that deposit insurance creates moral hazard problems and the more insurance the greater the problem. If the goal of the insurance is to protect the savings of relatively "small" savers, even the current limit of $100,000 is likely more than enough. It is difficult to make a case for raising the limit, and given the moral hazard and regulatory problems that come with a higher limit, it probably isn't a good idea. A stronger case could be made to make sure that the financial institutions that are operating are following current regulations and have adequate capital.
A-Head: Regulation and Supervision of the Financial System.
