Chapter 14. Regulating the Financial System.ppt

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 C