Econ 2154 Ch 10 - Econ 2154: Economic Analysis of Financial...

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Econ 2154: Economic Analysis of Financial RegulationAsymmetric Information and Bank RegulationGovernment safety net: Deposit insurance andthe CDICShort circuits bank failures and contagion effectThe CDIC uses two primary methods to handle a failed bank:Payoff method: the CDIC allows the bank to fail and pays off depositsup to the $100,000 insurance limit-after the bank has been liquidated, the CDIC lines up with othercreditors of the bank and is paid its share of the proceeds from theliquidated assetsPurchase and assumption method: the CDIC reorganizes the bank,typically by finding a willing merger partner who assumes all of thefailed bank’s liabilities so that no depositor or other creditor losespennyGovernment can support banks through lending from the central bank“Lender of Last Resort” role for central bankGovernment can provide funds directly to institutions in needMoral HazardDepositors or creditors know that they will not suffer losses if afinancial institution fails, so they do not impose the discipline of themarketplace on financial institutions by withdrawing funds when theysuspect that the financial institution is taking on too much riskBanks have an incentive to take on greater risk with taxpayers payingthe bill if the bank subsequently goes belly upAdverse SelectionRisk-lovers find banking attractiveDepositors have little reason to monitor bank with government safetynetWithout government intervention, outright crooks might also findfinance an attractive industry for their activities because it is easy forthem to get away with fraud and embezzlementToo Big to FailFailure of very large financial institution makes it more likely thatmajor financial disruption will occurRegulators unwilling to let large institutions failGovernment provides guarantees of repayment to large uninsured

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Term
Winter
Professor
Boyer
Tags
Money, Chapter 10, Econ 2154, Fractional reserve banking, Deposit insurance, failed bank

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