Econ 2154 Ch 10 - Econ 2154 Economic Analysis of Financial Regulation Asymmetric Information and Bank Regulation Government safety net Deposit insurance

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

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Econ 2154: Economic Analysis of Financial Regulation Asymmetric Information and Bank Regulation Government safety net: Deposit insurance and the CDIC Short circuits bank failures and contagion effect The CDIC uses two primary methods to handle a failed bank: Payoff method : the CDIC allows the bank to fail and pays off deposits up to the $100,000 insurance limit -after the bank has been liquidated, the CDIC lines up with other creditors of the bank and is paid its share of the proceeds from the liquidated assets Purchase and assumption method : the CDIC reorganizes the bank, typically by finding a willing merger partner who assumes all of the failed bank’s liabilities so that no depositor or other creditor loses penny Government can support banks through lending from the central bank “Lender of Last Resort” role for central bank Government can provide funds directly to institutions in need Moral Hazard Depositors or creditors know that they will not suffer losses if a financial institution fails, so they do not impose the discipline of the marketplace on financial institutions by withdrawing funds when they suspect that the financial institution is taking on too much risk Banks have an incentive to take on greater risk with taxpayers paying the bill if the bank subsequently goes belly up Adverse Selection Risk-lovers find banking attractive Depositors have little reason to monitor bank with government safety net Without government intervention, outright crooks might also find finance an attractive industry for their activities because it is easy for them to get away with fraud and embezzlement Too Big to Fail Failure of very large financial institution makes it more likely that major financial disruption will occur Regulators unwilling to let large institutions fail Government provides guarantees of repayment to large uninsured

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