EconomicAnalysis of Financial Regulation:
The financial system is one of them most regulated sectors of the economy, and the most
regulated financial institutions are the banks.
Nine Basic Categories of Financial Regulation:
● Government Safety Nets
● Restrictions on Asset Holdings
● Capital Requirements
● Prompt CorrectiveAction
● Chartering and Examination
● Assessment of Risk Management
● Disclosure Requirements
● Consumer Protection
● Restrictions on Competition
Government Safety Nets: Bank Panics and the need for deposit insurance: The FDIC started
operations in 1934, but before that, a bank failure--situation in which a bank is unable to meet its
obligations to its depositors and other creditors--meant that depositors had to wait to obtain their
funds until the bank was liquidated. They would only receive a fraction of their deposits. This
made depositors reluctant to place their money in the bank because they couldn’t tell whether
banks were unscrupulous or taking too much risk, making banks less viable.Another point is
with regards to bank runs and the contagion effect.
Lack of information about the quality of bank assets led to bank panics which have harmful
effects to the economy. For example, if an adverse shock hits the economy such that 5% of banks
are insolvent--that is, have negative net worth and are bankrupt--due to asymmetric information,
depositors are unable to know whether their bank is part of or not part of the 5%. Depositors
know that they will not be able to obtain their all their funds from the bank since banks operate
on first come first serve basis. Depositors therefore have a strong incentive to show up at the
Uncertainty about the health of the banking system can lead to runs on banks both good and bad
Therefore, the failure of one bank can hasten the failure of another bank--contagion effect.
Bank panics were common between the 19th century and early 20th century. Bank panics
occurred every 20 years.Agovernment safety net for depositors can short circuit the bank runs,
provide protection for depositors, and overcome reluctance to put funds in the banking system.
One form of government safety net is deposit insurance such a the Federal Deposit Insurance
Corporation (FDIC) where depositors are paid off the first $250,000.
With deposit insurance, depositors do not need to run on banks in order to make withdrawals
irrespective of whether they are aware of the health of the general bank system The FDIC uses
two primary methods to fund a bank, and they include the payoff method in which they allow the
bank to fail first then pay off deposits up to the insurance limit. For this particular method, when
depositors own accounts in excess of $250,000, they get 90 cents on the dollar.
Nakintu1 The 2nd method is called purchase and assumption method. This involves the FDIC reorganizing
the bank by finding a willing merger to take over the bank’s liabilities so that no depositor loses a
penny. The FDIC will provide the merger with subsidized loans or by buying some of the banks
weak loans. The FDIC guarantees all the bank’s liabilities and just under the insurance limit.
Another form of a safety net is a lender of last resort. This is through the central bank. The
Central Bank lends to banks during a financial crisis.
The moral hazard associated with government safety net is that it gives financial institutions the
incentive to take on greater risks which may result into an insurance payoff. The adverse
selection associated with the government safety net is that those who are most likely to produce
an adverse outcome are the ones who seek insurance.
Go to book for “Too Big to Fail” Policy (Pgs 252-253)
Financial Consolidation and the Government Safety Net
Financial consolidation has proceeded at a rapid race due to the passage of the Riegle-Neal
Interstate Banking and Branching Efficiency Act of 1994 and the Gramm-Leach -Biley Financial
Services Modernization Act in 1999. This had led to the creation of larger and complex financial
institutions. This creates two challenges to financial regulation because of the existence of safety
net. The first one is that due to consolidation, more large financial institutions are created; this
means that more large institutions are likely to be treated as “too big to fail”. These institutions
are then given incentive to take greater risk than the financial system can handle.The second
challenge is that the financial consolidation of banks with other financial services such as
underwriting, insurance, and so on means that the government safety net may be extended to
these new activities. This also increases the incentive for greater risk in taking in these activities.
Restrictions on Asset Holdings: Moral hazard associated with government safety net encourages
financial institutions to take great risk. Bank regulations that restrict asset holdings are meant to
minimize this moral hazard. Risky assets may provide financial insti