Chapter 11

Chapter 11 - Chapter 11-Economic Analysis of Financial...

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Chapter 11 - Economic Analysis of Financial Regulation Asymmetric Information and Bank Regulation: Government Safety Net •Bank panics and the need for deposit insurance: –FDIC: short circuits bank failures and contagion effect. –Payoff method. –Purchase and assumption method (typically more costly for the FDIC). •Other form of government safety net: –Lending from the central bank to troubled institutions (lender of last resort). Government Safety Net •Moral Hazard –Depositors do not impose discipline of marketplace. –Financial institutions have an incentive to take on greater risk. •Adverse Selection –Risk-lovers find banking attractive. –Depositors have little reason to monitor financial institutions. Government Safety Net: Too Big to Fail •Government provides guarantees of repayment to large uninsured creditors of the largest financial institutions even when they are not entitled to this guarantee •Uses the purchase and assumption method •Increases moral hazard incentives for big banks Government Safety Net: Financial Consolidation •Larger and more complex financial organizations challenge regulation –Increased “too big to fail” problem –Extends safety net to new activities, increasing incentives for risk taking in these areas (as has occurred during the subprime financial crisis in 2007-
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Chapter 11 - Chapter 11-Economic Analysis of Financial...

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