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Tutorial Solutions Week 6 - Chapter 13 Regulation of...

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Chapter 13 – Regulation of financial institutions 13.1 What is the role of financial system regulation and why is it important? Financial institutions are regulated because they provide goods and services that the economy needs to function well. In addition, they function in an environment in which asymmetric information is more the rule than the exception. Most consumers and businesses will disclose their financial affairs to a financial institution if it is a necessary condition to obtain services. However, consumers and businesses want their financial affairs to be confidential. As a result, financial institutions are required to keep the information private but in doing so it is difficult for depositors to have enough information to assess the institution’s soundness. Depositors, for example, do not know whether their financial institution has made good loans and entered into sound financial contracts. Unfortunately, because of the veil of uncertainty that exists when information is limited, banks and other depository institutions in the past have been subjected to runs and the financial system as a whole has encountered ‘panics’, in which people rush to withdraw funds because they fear their bank or the banking system is unsound. 13.2 Why are bank failures considered to have a greater effect on the economy than other types of business failures? Do you agree with this conclusion? Individual bank failures can hurt a community by shrinking the money supply and disrupting credit.
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