CH 14 Long Answers

What is the difference between a bank that is insolvent and one that is illiquid?

A bank that is insolvent is in a position where the bank's assets are less than its liabilities, so it has negative bank capital. A bank that is illiquid may be solvent, meaning it has assets that exceed its liabilities, but it may not have sufficient reserves, marketable assets and capital to meet all of the depositors' demand for withdrawals.

Besides regulating banks, the government also regulates nondepository financial institutions, such as insurance companies. Consider a property casualty insurance company; why would the government need to regulate them?

The insurance company takes premiums from people and makes the promise to pay claims should certain events occur. In the case of property insurance, often times these events could be widespread and quite severe, like a hurricane or an earthquake. When a loss like this occurs, it is similar to a liquidity crisis for banks, the insurance company faces a run in the sense that it will need to be liquid and quickly. Regulators then want to ensure at least three things, one is that the insurance company is solvent, meaning its assets exceed its liabilities. It also want to make sure that the assets are liquid and that the value stated reflects market value, and third, that the company has adequate capital to withstand fluctuations in asset value should it have to get liquid at a time when asset prices may be depressed.

How does the lender of last resort potentially create a moral hazard problem?

The lender of last resort function provided by a central bank will have a bank turning to the central bank for a loan after all other options are exhausted. The bank manager knows that the central bank will want to avoid a widespread bank panic and will be generous in evaluating the value of the bank's assets and to grant a loan even if it suspects the bank may be insolvent. Knowing this, bank managers will tend to take too many risks.

What is the link between the safety net provided by the government to the financial industry and the relatively heavy regulation of the same industry by the government?

The link is that the safety net provided, like FDIC insurance, too-big-to-fail, and lender of last resort, while very valuable also creates strong moral hazard and adverse selection problems. As a result, to minimize these problems governments have developed different strategies to manage the risks created by the safety net.

Why is it that a run on a single bank can turn into a widespread financial panic, or what the text identified as contagion?

The reason for the spread of panic or contagion is information asymmetries. It is due to the fact that most depositors cannot tell a healthy from an unhealthy bank. As a result, the safest thing for individuals to assume is their bank is unhealthy and to withdraw their funds.

Why are banks restricted in the assets that they can own? For example, why do you think banks are prohibited from owning common stock?

There are a few reasons for this; one, many of these assets are relatively illiquid and can cause wide swings in the value of assets. If the value of these assets were to decrease significantly, the institutions' capital would be negatively impacted putting the institution and the system at risk. Another reason is the problem of moral hazard. The government is providing a safety net, which by itself would cause a bank to want to seek a higher return by taking on more risk. To combat this problem, regulators restrict the institution in the types of assets it can hold.

How do banks potentially make economic downturns more severe and how do economic downturns contribute to the increased failure of banks?

When an economy begins to slow some people lose their jobs and/or their incomes are reduced. As a result, these individuals may default on their loans, reducing the value of a bank's assets and also reducing the bank's capital, especially if the loans are in default. As bank capital is reduced lending will also be reduced which will further slow the economy as consumer durable good spending will fall, as will investment spending. But the slowing of the economy will also continue to push more loans into default and further reduce bank capital leading to even more bank failures.

What was the primary motivation behind the creation of the 1988 Basel Accord?

banks. The problem was that often times the foreign banks would be operating under different regulatory restrictions that would provide them with a competitive advantage. The Basel Accord is an attempt to place minimum capital requirements on financial institutions that are internationally active.

Explain how bank regulators seem to face a bit of a paradox regarding preventing monopoly power by banks and spurring competition

effectively becomes a monopoly in its geographic market. Monopolies are inefficient and are seldom of benefit to consumers. On the other hand, while we usually think of competition as being beneficial to consumers because it results in low prices and new products, within the financial industry competition can cause banks to seek other ways to earn profits, which may expose the bank to greater risk, and threaten the integrity of not just one institution but the entire system.

If we lived in an economy where interest rates were highly volatile, would you expect the maximum asset to capital ratio that a regulator would allow to increase or decrease and why?

An environment where interest rates are highly volatile means that the value of a firm's assets would also be volatile. For example, if interest rates significantly rise unexpectedly, the value of a bank's assets would fall unexpectedly. This would put a strain on the capital of the bank, especially in the sense that the bank's capital is the cushion that it would fall back on should it face a liquidity crisis. The bank could find itself insolvent if interest rates rise a lot and its capital was inadequate. As a result, we would expect regulators to insist on a lower asset to capital ratio.

Why do bank runs usually have people rushing to their bank instead of waiting for the lines to taper off so they do not have to wait so long?

Banks promise to satisfy depositors' withdrawal requests on a first-come-first-served basis. As a result, people thinking the bank has limited cash (which is usually true) want to get theirs before the bank runs out and so rush to the bank to be first in line.

We saw in the text that regulations, specifically deposit insurance and the Basel Accord (of 1988), can create moral hazard. Explain.

Deposit insurance creates moral hazard for bank managers. Knowing that any gains from risky assets will go to owners but any losses will be covered by the insurance fund, managers have an incentive to take on added risk. Similarly, with the 1988 (first) Basel Accord, the system that was developed failed to distinguish among assets with different default risks (such as the Treasury bonds of the United States and bonds of emerging-market countries like Turkey). This gave banks an incentive to shift their holdings toward riskier assets in ways that did not increase their required bank capital.

Imagine a situation where the deposits at state chartered banks would be insured by a state insurance fund and deposits at nationally chartered banks would be insured by FDIC. How would you expect both depositors and banks would react?

Depositors would quickly learn that no state insurance fund can withstand a run on all banks in its state. As a result, they would seek to withdraw their funds and place them in a nationally chartered institution. The owners of the state chartered banks would then seek to change their charters to national charters and pick up FDIC insurance. The reason people do not fear the FDIC running out of funds is that it is backed by the U.S. Treasury and as a result can withstand a deep crisis.

Explain why depository institutions receive a disproportionate amount of attention from government regulators (compared to most other industries).

Depository institutions receive this attention because of their central role in the economy and their unique problems. We all rely heavily on banks for access to the payments system and this makes them unique among financial institutions. Furthermore, banks are prone to runs because they hold illiquid assets to back up liquid liabilities. This again makes banks unique compared to other financial institutions. Finally, banks are linked to each other both on their balance sheets and in their customers' minds. Bank failures can be contagious

The FDIC used to charge all banks the same rate for insurance on deposits. From what you have learned, what problems did this create for not only the FDIC but for well-run banks?

For FDIC the immediate problem is adverse selection. The average rate would have attracted more low quality, or in this case, high-risk banks. Now the FDIC could get around the adverse selection problem by simply asking for a regulation requiring all banks to purchase insurance through them. This is similar to an insurance provider providing group insurance to an employer but insisting the employer get most if not all of the employees to purchase coverage and it not be voluntary. The FDIC cannot escape the problem of moral hazard, however; here the presence of insurance will have some banks wanting to take on more risk. In fact, the well-managed (low risk) banks will be at a disadvantage, actually subsidizing the high-risk banks. The only way to address the problem of cross-subsidization is through a premium that is risk based so that the lower risk company will pay a lower premium, which would in theory allow it to offer lower rates on loans and/or higher rates to depositors.

Briefly describe the combination of strategies used by government officials to protect investors and ensure the stability of the financial system.

Government officials employ a combination of strategies to protect investors and ensure the stability of the financial system. First, they provide the safety net to insure banks that face sudden deposit outflows. This consists of operating as the lender of last resort and the provider of deposit insurance. However, this safety net can result in moral hazard (bank managers have an incentive to take on too much risk), therefore the government must also engage in regulation and supervision.

What three strategies are employed by government officials to ensure that the risks created by the government safety net are contained?

Governments have developed three strategies to manage the risks created by the safety net. First, government regulation establishes a set of specific rules for bank managers to follow. Second, government supervision provides general oversight of financial institutions. And third, formal examination of banks' books by specialists provides detailed information on the firm's operation.

Discuss the ramifications of the FDIC reducing deposit insurance limits to $25,000.

If deposit insurance limits were reduced to $25,000 a few things would happen. First, many people would have more at risk by saving at their banks (their balances above $25,000 would no longer be insured). The result may be for people to either keep less on deposit at the bank; this will reduce the funds available to banks or will require the banks to offer higher interest rates to depositors to attract funds since the depositors will now face greater risk, increasing the cost of acquiring funds. Another likely outcome is that banks may actually put out more information to the public advertising how safe and well run a particular bank is; this would be done to again attract depositors who now are seeking a relatively safe place to put their funds. There may be less of a moral hazard incentive on the part of bank managers. Any decrease in bank returns or any increase in risk has the manager facing the widespread withdrawal of funds by depositors who face a higher cost of bank failure. There could also be more innovation. For example, savers could still get the U.S. government to guarantee their principal by purchasing U.S. Treasury securities. We would likely see greater use of saving vehicles where all funds are placed in Treasury securities and savers have convenient ways to access these funds (much like many current money market accounts.) Banks seeking to attract deposits would have to offer products and/or higher returns to compete with the Treasury securities. It also will increase the incentive of depositors to monitor their banks' health.

Why is the financial industry inherently more unstable than most other industries?

In most other industries the failure of one participant does not put the other participants and the industry at risk. The same cannot be said of the financial industry. The failure of one bank or financial institution, through contagion, can put the entire system at risk. This is due to information asymmetries that can have depositors assuming their bank is going to also fail and seeking to withdraw their funds. This then leads to liquidity risk, because most banks would lack the liquidity to withstand the run.

You have a retirement account in a bank that has failed. The balance in your account is $330,000. Does it make a difference to you if FDIC uses the payoff method or the purchase-and-assumption method for resolving this insolvency? Explain.

It does make a difference. Under the payoff method, the FDIC simply pays off the depositors the balance in their account up to the legal limit, which is currently $250,000. You would potentially lose $80,000. Under the purchase-and-assumption method, the FDIC will find a firm to take over the failed bank and your account will stay intact.

The text points out that there is an inverse relationship between the fiscal cost of a bank crisis and real GDP growth. What are some of the reasons that can explain this inverse relationship?

One obvious cost is that funds that have to be used to "clean-up" the crisis must be diverted from some other use, so there is the opportunity cost that is faced. Another reason is that the process of channeling funds from savers to borrowers is disrupted or inefficient. If savers become leery of banks, they may not save or they may not channel these funds through banks so the economy is not as efficient as it could be. Also, investment projects that should be funded will not be, and those that shouldn't be may receive funding since financial intermediation is not working as it should. Another, and perhaps the largest cost, is that if investment is curtailed the ability to produce output in the future will be harmed leading to a lower standard of living not just for the current year but for many years.

Identify at least two problems a borrower would face if banks were not required to disclose the information that they are currently required to make available.

One problem that quickly comes to mind would be all of the hidden fees that a bank could charge for a checking account or a loan application. In addition, the customer would face very high search cost in the sense that they would have to ask a lot of questions of each institution to uncover these hidden costs. Another problem is the way that interest is calculated for savings accounts and loans. For example, is the interest being paid on a savings account based on the average balance or is it based on the balance that exists at the beginning or end of the month? Also, the interest rate charges on the loan, is it expressed as an annual rate or is it calculated using some other formula? The disclosure laws that banks face are designed to reduce these costs to customers and make the comparing of prices across banks easier.

Discuss the case for a "super-regulator" in the context of what you have learned about "regulatory competition."

Regulatory competition describes the current situation in which banks can effectively choose their regulators by choosing whether to be a state or national bank and whether or not to belong to the Federal Reserve System. If one regulator allows an activity that another prohibits, a bank's managers can threaten to switch, or argue that a competitor who answers to a more permissive regulator has an unfair advantage. This has two consequences: first, regulators force each other to innovate, improving the quality of the regulations they writing. This is a positive outcome because it ensures that regulators and banks follow current best practice. But there is also a less desirable outcome in that bank managers can "shop" for the most lenient regulator. This was compounded in the 1990s when Congress removed the functional (and geographic) barriers that one separated commercial banking from other forms of financial intermediation (and which had outlawed interstate branching). It is likely that in the future regulators and supervisors will have no choice but to combine forces, either cooperating or merging, and the creation of a "super-regulator" would have the advantage of making the process more uniform and coherent.

What potential problems are created by regulatory competition?

Regulatory competition often allows a financial institution to select who will regulate it by selecting who charters it. One problem is that this will encourage the institution to select the regulator(s) that they believe will be the most lenient.

What were the positive effects of the 1988 Basel Accord? What were its shortcomings?

The Basel Accord of 1988 was an attempt to place minimum capital requirements on financial institutions that are internationally active. It had several positive effects: first, by linking minimum capital requirements to the risk a bank takes on, it forced regulators to change the way they thought about bank capital. Second, it promoted a more uniform international system. Finally, the Accord provided a framework that less developed countries could use to improve the regulation of their banks. However, the Accord did have the major shortcoming that in adjusting for asset risk, there was no differentiation among bonds with different default risks (for example, the Treasury bonds of the United States versus the government bonds of an emerging-market country). This encouraged banks to shift their holdings toward riskier assets in ways that did not increase their required bank capital.

Define the components of the CAMELS criteria and explain how a CAMELS rating is calculated.

The CAMELS criteria are: Capital adequacy; Asset quality; Management; Earnings; Liquidity; and Sensitivity to risk. Examiners give the bank a rating from one to five in each of these categories (one being the best rating) and combine the scores to determine the overall rating.

Does the lender of last resort function guarantee an end to bank runs? Explain.

The Great Depression is evidence to the fact that just because a central bank has the function of lender of last resort, there is no guarantee that banks will use it or the central bank will lend freely. The experience in the early years of the Great Depression showed that banks did not take advantage of borrowing from the Fed.

Explain why the ratio of assets to capital increased dramatically for commercial banks from the 1920s to the present.

The answer to this question is simply deposit insurance. Without deposit insurance a bank would have to make sure its assets were highly liquid and that it maintained adequate capital to withstand either the shock of assets losing value or a run on the bank. With deposit insurance, the bank manager knows that the insurance fund will protect most depositors and so feels comfortable assuming more risk. While the additional return from the greater risk will belong to the bank's owners, the potential loss from the greater risk will be borne primarily by the insurance fund. This is a classic moral hazard problem.

Why might there be a trade-off between a bank's profitability and its safety?

The assets that tend to bring the bank the highest return tend to be the least liquid. Highly liquid assets have relatively low returns. So if a bank seeks high profits it is likely to invest in relatively illiquid assets. On the other hand, a bank needs to be liquid, especially in situations where customers may desire to withdraw their deposits. If a bank does not have liquid funds or if it cannot convert illiquid assets to a liquid form without taking significant losses, it may fail.

You are the head of finance for a very large corporation located in a relatively small town. At a local chamber of commerce meeting, the president of the local bank asks you why you keep the corporation's bank accounts in a very large mid-western bank and not in his local bank. From a risk reduction perspective, how could you answer his question?

You might employ the concept of too-big-to-fail. As the text points out, the likelihood of bank regulators allowing a large bank to actually fail is very remote. A small bank failure, while certainly disruptive to the bank's depositors and owners, is not likely to cause wide scale panic. If you had your company's funds in this bank and it failed, your company may only recover up to the legal limit. On the other hand, the failure of a large bank might cause wide scale panic, so realizing this, you decide to place your company's funds into a bank that you believe is in the too-big-to-fail category thus protecting your company's deposits.

In 1873, British economist Walter Bagehot proposed that the central bank function as the lender of last resort. Specifically, he suggested the central bank lend freely to banks which have good collateral at high rates of interest. Why the requirements of good collateral and a high rate of interest?

interest rates will penalize a bank for not holding adequate reserves to meet its liquidity needs. If the interest rate charged is low, the bank will have a strong incentive to seek higher returns through illiquid assets knowing it can count on the central bank in times of liquidity need.