Chapter 10 Flashcards
What did the FDIC do to solve bank panics in regard to the government safety net?
The Federal Deposit Insurance Corporation introduced deposit insurance, where they guarantee depositors will be paid off in the first $250,000 they have deposited in a bank if it fails (this is known as the payoff method)
As well as the payoff method, what else did the FDIC do to combat bank panics?
Purchase and assumption method, where the FDIC reorganises the bank, typically by finding a willing merger partner who takes over the failed bank’s liabilities so no depositor loses a penny.
What is another form of the Government Safety Net?
another method is support through lending from the central bank to troubled institutions, like seen during the financial crisis by the Federal Reserve. Referred to ‘lender of last resort’.
What are 4 drawbacks of the government safety net?
- Moral Hazard
- Adverse Selection
- “Too Big to Fail”
- Financial Consolidation
Describe what is meant by “Too Big to Fail”
a problem arises in which regulators are reluctant to close down large financial institutions and impose losses on the institution’s depositors and creditors because doing so might precipitate a financial crisis. This increases moral hazards from these institutions knowing they’ll be bailed out.
Describe Financial Consolidation.
proceeding at a rapid pace leading to both larger and more complex financial organisations, Financial Consolidation poses challenges to financial regulation due to the safety net. Firstly, increased the “too big to fail problem” because of more large institutions.
Secondly, the government safety net may be extended to new activities, such as securities underwriting, insurance, or real estate activities. This creates greater incentive for risk in these activities, which can weaken the financial system.
List 6 types of financial regulation?
- Restrictions on Asset Holdings
- Capital Requirements
- Financial Supervision: Chartering and Examination
- Disclosure Requirements
- Consumer Protection
- Restrictions on Competition
What are Capital Requirements?
By forcing a financial institution to hold a large amount of equity capital, it means they have more to lose if it fails and thus less likely to pursue risky activities.
Capital requirements take two forms. Firstly leverage ratio, the amount of capital divided by the banks total assets. this must exceed 5%. Lower ratios, especially <3%, trigger increased regulatory restrictions on the bank.
Secondly, which combats off balance sheet activities. The Basel Accord requires banks to hold as capital at least 8% of their risk-weighted assets
What is a limitation of the Basel Accord?
Measures of bank risk, as stipulated by the risk weights, can differ substantially from the actual risk the bank faces. This has resulted in regulatory arbitrage, where banks will keep on their books assets which are relatively risky, such as loans to a company with a poor credit rating, while taking off their books low risk assets, such as a loan to a company with a very high credit rating.
explain chartering?
A method to prevent adverse selection. Through chartering, proposals for new institutions are screened to prevent undesirable people from controlling them.
A commercial bank will obtain a charter from either the comptroller of a currency, or from a state banking authority. then people planning to organise the bank must submit an application of how they intend to operate the bank. Once the bank is chartered, it needs to file periodic call reports that reveal its assets and liabilities, income and dividends, ownership, foreign exchange operations and other details.
What are disclosure requirements?
regulators can require financial institutions to adhere to certain standard accounting principles and disclose a wide range of information that helps the market assess the quality of an institution’s portfolio and the amount of its exposure to risk.
