chap014 - Chapter 14 Regulating the Financial System...

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Chapter 14 Regulating the Financial System Chapter Overview In this chapter the sources and consequences of financial fragility are examined, with the emphasis on banking crises. Next, the chapter looks at the institutional safeguards, like deposit insurance, that the government has built into the system in an attempt to avert financial crises. Finally, the regulatory and supervisory environment of the banking system is examined. Reading this chapter will prepare students to: Explain the fragility of banks and the risks to the financial system from bank runs and failures; Assess the role of the government in ensuring the stability of the financial system; and Understand that government policies intended to ensure such stability can actually have the opposite effect (citing the example of deposit insurance). Important Points of the Chapter Banking crises are not a new phenomena; the history of commercial banking over the last two centuries is replete with period of turmoil and failure. By their very nature, financial systems are fragile and vulnerable to crisis. When financial crises occur, governments step in and put financial intermediaries back on track. They often do so by assuming responsibility for the banking system’s liabilities, so that depositors won’t lose their savings. But the clean up can also require the injection of capital into failed institutions, which can be very expensive. Such crises can also have a tremendous negative impact on a country’s growth. Application of Core Principles Principle #3: Information (page 332) Information asymmetries are the reason that a run on a single bank can turn into a bank panic that threatens the entire financial system. People cannot assess the quality of the bank’s balance sheet, and so can’t tell the difference between a good or a bad bank. So when the rumors begin, depositors worry about their own bank’s condition. Principle #5: Stability (page 333) The financial system is inherently unstable as a result of liquidity risk and information asymmetries. Principle #5: Stability (page 346) The goal of financial stability does not mean the stability of individual financial institutions; this would defeat the purpose of competition. Rather, regulators should strive to prevent large-scale catastrophes. Teaching Tips/Student Stumbling Blocks 196 Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets
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Chapter 14 Regulating the Financial System Chapter 14 is your students’ first substantial exposure to Core Principle 5: stability improves welfare. As you discuss regulation keep reminding students that the point is to avert financial crises. An effective way to present the material in this chapter is with an outline of bank balance sheets displayed on the board or on a handout. Since many, though not all, of the problems faced by regulators in assuring a stable financial system revolve around the various items on the balance sheet, this will provide a useful structure for student
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This note was uploaded on 02/12/2012 for the course ECON 101 taught by Professor Abrams during the Spring '11 term at Adams State University.

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chap014 - Chapter 14 Regulating the Financial System...

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