Preview•The financial system is one of the most heavily regulated industries.•Here we’ll focus on “depository institutions”, main type being commercial banks.•We develop an economic analysis of why regulation of banking takes the form that it does.–Asymmetries of information–“safety net” regulation (ex-post: after bank failure): deposit insurance and implicit states bailouts.–“prudential” regulation (ex-ante: before bank failure): Basel I and II regulation.2
Asymmetric Information and Bank Regulation1.Government Safety Net: Deposit Insurance•Prior to deposit insurance, bank failures meant depositors lost money, and had to wait until the bank was liquidated to receive anything. •“Good” banks needed to separate themselves from “bad” banks, which was difficult for banks to accomplish.•The inability of depositors to assess the quality of a bank’s assets can lead to panics. If depositors fear that some banks may fail, their best policy is to withdraw all deposits, leading to a bank run, even for “good” banks. Further, failure of one bank can hasten failure of others (contagion effect).•Liquidityrisk for banks (see previous lecture).3
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Asymmetric Information and Bank Regulation 1.Government Safety Net: Deposit Insurance•In the US, the FDIC handles failed banks in one of two ways so that depositors are never left alone and FDIC does not bear all costs of the guarantee on deposits:•the payoff method, where the banks is permitted to fail,•the purchase and assumption method, where the bank is folded into another banking organization.•Additional implicit insurance from the government is available should the FDIC be insufficient.•In some countries where no explicit insurance organization exists, the state is directly involved implicitly.•Whether Implicitly or explicitly, depositors should have their deposits guaranteed so to avoid a general bank run and the subsequent banking system general failure.4