Chapter 10 - Problem Set.pdf

In 1970s the oil boom in western canada created

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Briefly discuss the banking crisis in Canada during the 1980s. In 1970s, the oil boom in western Canada created several western banks. They excessively concentrated in a few borrowers in western Canada and placed a large percentage of their total loans in real estate. The existence of deposit insurance increased moral hazard for some of these banks. When they pursued rapid growth and took on risky projects, attracting the necessary funds by issuing large denomination certificates of deposit with high interest rates. Depositors would normally expect higher risk with higher interest rates and would think twice without deposit insurance. But deposit insurance covers their downside risk and they were more than happy to jump on the risky bandwagon. The managers of these banks did not have the required expertise to manage risk in the permissive atmosphere of western Canada. Also, rapid credit growth may outstrip the available information resources of the banking institution, resulting in excessive risk taking. The lending boom meant that the activities became more complicated, but regulators of chartered banks had neither the expertise nor the resources that would have enabled them to sufficiently monitor the activities of these banks. The combinations of sharp increases in interest rates from late 1979 until 1981 and a severe recession in 1981-1982. The rapidly rising costs of funds for the banks that were not matched by higher earnings on their principal assets (long-term residential mortgages with rates fixed at lower levels). The recession collapsed the prices of energy and farm products led to defaults on many loans. These banks became insolvent. The regulators adopted a stance of regulatory forbearance (they refrained from exercising their regulatory right to put the insolvent banks out of business) because (i) the CDIC did not have sufficient funds in its insurance fund to close the insolvent banks and pay off their deposits. (ii) bureaucrats do not like to admit that their own agency is in trouble, the regulators preferred to sweep their problems under the rug in the hope that they would go away. The loss of public confidence in the Canadian banking system led to financial reforms and the consolidating of financial supervision under OSFI .
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ECO349 2011 Winter Chapter 10 Problem Set Michael Ho 7/12 3. Briefly discuss the political economy of a typical banking crisis. The key to understanding the political economy of a typical banking crisis is to recognize that the relationship between voter-taxpayers and the regulators and politicians creates a particular type of moral hazard problem principal-agent problem for regulators and politicians. Regulators and politicians are ultimately agents for voter-taxpayers (principals) as taxpayers bear the cost of any losses by the deposit insurance agency. The principal- agent problem occurs because the agent (a politician or regulator) does not have the same incentives to minimize costs to the economy as the principal (the taxpayer).
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  • Fall '09
  • H
  • Fractional-reserve banking, Bank run

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