Financial Markets and Institutions (2-downloads)

http://www.bbt.com/bbt/

about/investorrelations/default.html

. Does BB&T

have more or less of its portfolio in loans than the aver-

age bank? Which type of loan is most common?

2. It is relatively easy to find up-to-date information

on banks because of their extensive reporting

requirements. Go to 

www2.fdic.gov/qbp/

. This

site is sponsored by the Federal Deposit Insurance

Corporation. You will find summary data on finan-

cial institutions. Go to the most recent Quarterly

Banking Profile. Scroll down and open Table 1-A.

a. Have banks’ return on assets been increasing or

decreasing over the last few years?

b. Has the core capital been increasing, and how 

does it compare to the capital ratio reported in

Table 17.1 in the text?

c. How many institutions are currently reporting to

the FDIC?

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Financial Regulation

Preview

As we have seen in the previous chapters, the financial system is among the

most heavily regulated sectors of the economy, and banks are among the most

heavily regulated of financial institutions. In this chapter, we develop a frame-

work to see why regulation of the financial system takes the form it does.

Unfortunately, the regulatory process may not always work very well, as

evidenced by the recent 2007–2009 and other financial crises, not only in the

United States but in many countries throughout the world. Here we also use

our analysis of financial regulation to explain the worldwide crises in banking

and to consider how the regulatory system can be reformed to prevent

future disasters.

425

18

C H A P T E R

Asymmetric Information and Financial Regulation

In earlier chapters, we have seen how asymmetric information—the fact that dif-

ferent parties in a financial contract do not have the same information—leads to

adverse selection and moral hazard problems that have an important impact on our

financial system. The concepts of asymmetric information, adverse selection, and

moral hazard are especially useful in understanding why government has chosen

the form of financial regulation we see in the United States and in other countries.

There are nine basic categories of financial regulation: the government safety net,

restrictions on asset holdings, capital requirements, prompt corrective action, char-

tering and examination, assessment of risk management, disclosure requirements,

consumer protection, and restrictions on competition.

Government Safety Net

As we saw in Chapter 7, financial intermediaries, like banks, are particularly well suited

to solving adverse selection and moral hazard problems because they make private

loans that help avoid the free-rider problem. However, this solution to the free-rider

problem creates another asymmetric information problem, because depositors lack

information about the quality of these private loans. This asymmetric information prob-

lem leads to several reasons why the financial system might not function well.

Access

www.ny.frb.org/

banking/supervisionregulate

.html

to view bank

regulation information.

G O   O N L I N E

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426

Part 6 The Financial Institutions Industry

Bank Panics and the Need for Deposit Insurance

Before the FDIC started oper-

ations in 1934, a bank failure (in which a bank is unable to meet its obligations to

pay its depositors and other creditors and so must go out of business) meant that 

depositors would have to wait to get their deposit funds until the bank was liquidated

(until its assets had been turned into cash); at that time, they would be paid only a frac-

tion of the value of their deposits. Unable to learn if bank managers were taking on

too much risk or were outright crooks, depositors would be reluctant to put money

in the bank, thus making banking institutions less viable. Second, depositors’ lack of

information about the quality of bank assets can lead to bank panics, which, as we

saw in Chapter 8, can have serious harmful consequences for the economy.

To see this, consider the following situation. There is no deposit insurance, and

an adverse shock hits the economy. As a result of the shock, 5% of the banks have

such large losses on loans that they become insolvent (have a negative net worth and

so are bankrupt). Because of asymmetric information, depositors are unable to tell

whether their bank is a good bank or one of the 5% that are insolvent. Depositors

at bad and good banks recognize that they may not get back 100 cents on the dol-

lar for their deposits and will want to withdraw them. Indeed, because banks oper-

ate on a “sequential service constraint” (a first-come, first-served basis), depositors

have a very strong incentive to show up at the bank first, because if they are last in

line, the bank may run out of funds and they will get nothing. Uncertainty about

the health of the banking system in general can lead to runs on banks both good

and bad, and the failure of one bank can hasten the failure of others (referred to as

the contagion effect). If nothing is done to restore the public’s confidence, a bank

panic can ensue.

Indeed, bank panics were a fact of American life in the nineteenth and early twen-

tieth centuries, with major ones occurring every 20 years or so in 1819, 1837, 1857,

1873, 1884, 1893, 1907, and 1930–1933. Bank failures were a serious problem even

during the boom years of the 1920s, when the number of bank failures averaged

around 600 per year.

A government safety net for depositors can short-circuit runs on banks and bank

panics, and by providing protection for the depositor, it can overcome reluctance

to put funds in the banking system. One form of the safety net is deposit insurance,

a guarantee such as that provided by the Federal Deposit Insurance Corporation

(FDIC) in the United States in which depositors are paid off in full on the first

$250,000 they have deposited in a bank if the bank fails. With fully insured deposits,

depositors don’t need to run to the bank to make withdrawals—even if they are

worried about the bank’s health—because their deposits will be worth 100 cents on

the dollar no matter what. From 1930 to 1933, the years immediately preceding the

creation of the FDIC, the number of bank failures averaged more than 2,000 per year.

After the establishment of the FDIC in 1934, bank failures averaged fewer than 15

per year until 1981.

The FDIC uses two primary methods to handle a failed bank. In the first, called

the payoff method, the FDIC allows the bank to fail and pays off deposits up to the

$250,000 insurance limit (with funds acquired from the insurance premiums paid

by the banks who have bought FDIC insurance). After the bank has been liquidated,

the FDIC lines up with other creditors of the bank and is paid its share of the pro-

ceeds from the liquidated assets. Typically, when the payoff method is used, account

holders with deposits in excess of the $250,000 limit get back more than 90 cents

on the dollar, although the process can take several years to complete.

In the second method, called the purchase and assumption method, the FDIC

reorganizes the bank, typically by finding a willing merger partner who assumes

Access

www.federalreserve

.gov/Regulations/default.htm

for regulatory 

publications of the Federal

Reserve Board.

G O   O N L I N E

Access

www.fdic.gov/bank/

historical/bank/index.html

to search for data on bank

failures in any year.

G O   O N L I N E

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Chapter 18 Financial Regulation

427

(takes over) all of the failed bank’s liabilities so that no depositor or other creditor

loses a penny. The FDIC often sweetens the pot for the merger partner by provid-

ing it with subsidized loans or by buying some of the failed bank’s weaker loans.

The net effect of the purchase and assumption method is that the FDIC has guar-

anteed all liabilities and deposits, not just deposits under the $250,000 limit. The pur-

chase and assumption method is typically more costly for the FDIC than the payoff

method, but nevertheless was the FDIC’s most common procedure for dealing with

a failed bank before new banking legislation in 1991.

In recent years, government deposit insurance has been growing in popularity

and has spread to many countries throughout the world. Whether this trend is desir-

able is discussed in the Global box, “The Spread of Government Deposit Insurance

Throughout the World: Is This a Good Thing?”

Other Forms of the Government Safety Net

Deposit insurance is not the only

form of government safety net. In other countries, governments have often stood

ready to provide support to domestic banks facing runs even in the absence of explicit

deposit insurance. Furthermore, banks are not the only financial intermediaries that

can pose a systemic threat to the financial system, as our discussion of financial crises

in Chapter 8 has illustrated. When financial institutions are very large or highly inter-

connected with other financial institutions or markets, their failure has the poten-

tial to bring down the entire financial system. Indeed, as we saw in Chapter 8, this

is exactly what happened with Bear Stearns and Lehman Brothers, two investment

banks, and AIG, an insurance company, during the recent financial crisis in 2008.

One way governments provide support is through lending from the central bank

to troubled institutions, as the Federal Reserve did during the 2007–2009 financial

G L O B A L