This chapter discusses regulating the financial system. It explores sources of financial fragility like bank runs and panics. The role of government in providing a safety net through the lender of last resort, deposit insurance, regulation, supervision and examination is examined. Issues like moral hazard from deposit insurance and too-big-to-fail policies are covered. The chapter provides an overview of different components of the financial regulatory system.

1. © The McGraw-Hill Companies, Inc., 2008
McGraw-Hill/Irwin
Chapter 14
Regulating the Financial
System

2. 14-2
Regulating the Financial System:
The Big Questions
1. What are the sources and
consequences of financial fragility?
2. What is the role of the government in
the financial system?
3. How does financial regulation and
supervision work?

3. 14-3
Regulating the Financial System:
Roadmap
• Runs, Panics & Financial Crises
• The Government Safety Net
• Regulation and Supervision

4. 14-4
Financial Crisis
• Since the 1970s:
– 93 Countries
– 117 system-wide crises
– 51 smaller disruptions
– No part of the world has been spared

5. 14-5
Size of Financial Crisis
vs. Change in GDP Growth

6. 14-6
Bank Runs, Bank Panics, and
Financial Crises
• Sources of Bank Runs:
– Promise depositors withdrawal on demand
– First come, first served
• Suppose depositors lose confidence?
• Concern over insolvency can lead to
illiquidity.
• Bank run can be the result of both real
and imagined problems

7. 14-7
Bank Panics
• Run on a single bank can turn into a
system-wide panic.
• Asymmetric information:
Can’t distinguish good from bad banks.
• Concern about one bank can create
panic about all banks.

8. 14-8
Bank Panics
• Cyclical downturns are associated with
bank panics
• Look at the period prior to the
Federal Reserve, 1871-1913
– Eleven business cycles
– Bank panics during 7 recessions
– No panics without recessions.

9. 14-9
The Government Safety Net:
Why?
• Depositor protection
– Government is obligated to protect small
deposits unable to judge the soundness of
financial institutions
• Protect customers from exploitation
– Large institutions can raise prices
• Ensure financial stability
– System is inherently unstable

10. 14-10
The Government Safety Net:
Unique Role of Depository Institutions
• We rely heavily on depository institutions
(banks) for access to the payments system
• If banks disappeared, we would have a
difficult time making payments
• Furthermore, banks are prone to runs
• The result is that banks receive a
disproportionate amount of the attention of
regulators

11. 14-11
The Government Safety Net:
Component Parts
• Lender of Last Resort
• Deposit Insurance
• Regulation
• Supervision
• Examination

12. 14-12
• The SIPC insures investors from fraud
• If a brokerage firm fails and you don’t
receive the securities you purchased,
you are insured
• The SIPC does NOT insure you
against making poor investments

13. 14-13
The Government Safety Net:
Lender of Last Resort
• Lend to solvent but illiquid banks
• Can authorities tell the difference?

14. 14-14
Failure of the Lenders of Last Resort:
Federal Reserve Lending, 1914-1940
As banks became
illiquid in the early
1930s, lending
declined.
The existence of a
lender of last resort
is no guarantee it
will be used.

15. 14-15
• On Nov 20, 1985 there was a
software error at Bank of New York
• Made payments without receiving funds
• Borrowed $23 billion
• Success of Lender of Last Resort:
Problem at one bank didn’t become a
system-wide crisis

16. 14-16
The Government Safety Net:
Deposit Insurance
• Means depositors (liability holders) are
indifferent to the risk taken by the
bank’s managers
• Creates moral hazard

17. 14-17
“Each depositor insured to $100,000.”
• Insurance covers individuals
• Accounts at different banks are insured
separately
• Retirement savings are insured
separately and have a higher limit,
currently $250,000

18. 14-18
The Government Safety Net:
The Problems it Creates
• Creates moral hazard
• Before deposit insurance banks had debt
to equity of 4 to 1, today it is 13 to 1
• Too-big-to-fail policy
– Care more about the largest institutions.
– Gives banks an incentive to become large
and then take on too much risk.

19. 14-19
• Higher levels of deposit insurance are
associated with more risk-taking at banks.
• Explicit deposit insurance may make
financial crises more likely

20. 14-20
Regulation
• Banks have more than one regulator
• Creates regulatory competition

21. 14-21
Regulation:
Who Regulations Whom?

22. 14-22
Regulation
• Restrictions on competition
– Greater competition leads to more risk to survive.
• Asset holding restrictions
– Can’t hold stocks,
• Minimum capital requirements
– Capital acts as buffer, has to be big enough.
• Disclosure requirements
– Allows regulators and financial markets to assess
quality of the institution

23. 14-23
Supervision and Examination
• Regular visits from examiners
• Check that loan collateral exists
• Evaluate past-due loans to see that
banks write them off
• Rate banks (CAMELS)

24. 14-24
• Global competition requires global rules
• If one bank can hold less capital than
another, it will have an advantage
• The Basel Accord tries to make bank
regulation more uniform across countries
• Recent changes are improving the system,
but the details are complex

25. © The McGraw-Hill Companies, Inc., 2008
McGraw-Hill/Irwin
Chapter 14
End of Chapter