Economic Analysis of Financial Regulation
1. Nine basic categories of financial regulation
a) Government safety net (Deposit insurance & Lender of last resort) *** b) Restriction on asset holding
c) Capital requirement
d) Prompt corrective action
e) Chartering and examination
f) Assessment of risk management
g) Consumer protection
h) Restriction on competition
2. Government safety net comes in the form of deposit insurance and lender of last resort
3. Deposit insurance is a guarantee given by organization such as Federal Deposit Insurance Cooperation (FDIC) in the United States in which depositor are paid off in full on the first $100,000 they have deposited in the bank in the event that the bank fails.
4. Deposit insurance is necessary to prevent bank run.
5. Without the deposit insurance, in the event of bank failure (in which the bank is unable to meet its obligation to pay its depositors and other creditors and must go out of business), depositors would have to wait to get their deposit until the bank was liquidated and at that time, they may not get back their deposit in full amount.
Bank creates an asymmetric information problem between the principle, the depositors and the agent, the bank itself as the depositors lack information about the quality of the private loan the bank made using the deposit they have with the bank.
Unable to learn if the bank managers were taking too much risk or were outright crooks, depositors would be reluctant to put money in the bank thus making the bank institution less viable.
The asymmetric information problem can lead to bank panics in the event of adverse shock in the economy with deposit insurance. Depositors at bad and good banks recognize that they may not get back their full deposit and will want to withdraw the deposit. Depositors have a strong incentive to show up at the bank first because the bank may run out of fund and they may not...
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