Mishkin 13th ed

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Fordham University *

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Economics

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May 7, 2024

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Chapter 10 ANSWERS TO QUESTIONS 1. Why are deposit insurance and other types of government safety nets important to the health of the economy? A government safety net can short-circuit runs on banks and bank panics, and overcome reluctance by depositors to put funds in the banking system. This helps to eliminate a contagion effect, in which both good and bad banks could become insolvent in the event of a bank panic. Without confidence in the banking system, such panics could result in a collapse of the financial system and severely inhibit investment and economic growth. 2. If casualty insurance companies provided fire insurance without any restrictions, what kind of adverse selection and moral hazard problems might result? There would be adverse selection, because people who might want to burn their property for some personal gain would actively try to obtain substantial fire insurance policies. Moral hazard could also be a problem, because a person with a fire insurance policy has less incentive to take measures to prevent fire. 3. Do you think that eliminating or limiting the amount of deposit insurance would be a good idea? Explain your answer. Eliminating or limiting the amount of deposit insurance would help reduce the moral hazard of excessive risk-taking on the part of banks. It would, however, make bank failures and panics more likely, so it might not be a very good idea. 4. How could higher deposit insurance premiums for banks with riskier assets benefit the economy? The economy would benefit from reduced moral hazard; that is, banks would not want to take on too much risk, because doing so would increase their deposit insurance premiums. The problem is, however, that it is difficult to monitor the degree of risk in bank assets because often only the bank making the loans knows how risky they are. 5. What are the costs and benefits of a too-big-to-fail policy? The benefits of a too-big-to-fail policy are that it makes bank panics less likely. The costs are that it increases the incentives for moral hazard by big banks that know that depositors do not have incentives to monitor the banks’ risk-taking activities. In addition, it is an unfair policy because it discriminates against small banks. 6. Suppose that you have $300,000 in deposits at a bank. After careful consideration, the FDIC decides that this bank is now insolvent. Which method would you like to see the FDIC apply? What if your deposit were $200,000? If you have deposited $300,000 at the failed bank, it would be better for you if the FDIC uses the purchase and assumption method. This way, the bank never closes, and you do not lose a penny. If the payoff method was used, you will get a check for $250,000 and you will have to wait a few years

to get around 90 cents per dollar of the remaining $50,000. If your balance was $200,000, you are indifferent as to which method the FDIC would use to handle this failed bank. 7. Would you recommend the adoption of a system of deposit insurance, like the FDIC in the United States, in a country with weak institutions, prevalent corruption, and ineffective regulation of the financial sector? You probably would not recommend the adoption of a system of deposit insurance in a country with weak institutions, prevalent corruption, and ineffective regulation of the financial sector. The main reason not to implement such a system is that its adoption solves the bank runs problem, but creates moral hazard incentives for banks to engage in risky lending. Decreasing the moral hazard incentives for risky lending requires stringent financial regulation and supervision, which requires strong (and honest) institutions. 8. At the height of the global financial crisis in October 2008, the U.S. Treasury forced nine of the largest U.S. banks to accept capital injections in exchange for nonvoting ownership stock, even though some of the banks did not need the capital and did not want to participate. What could be the Treasury’s rationale for doing this? If the banks that did not need or want the capital injections were not forced to take the capital, then only the weakest banks would be the ones that would have received the needed capital injections to avoid insolvency. This could have started a run on those banks, which then would have accelerated their insolvency problem and created a contagion effect on the rest of the financial system, harming all banks. By forcing all banks to accept capital, this helped to reduce sending unnecessarily adverse signals to investors and depositors of the weakest banks. 9. What special problem do off-balance-sheet activities present to bank regulators, and what have they done about it? Because off-balance-sheet activities do not appear on bank balance sheets, they cannot be dealt with by simple bank capital requirements, which are based on bank assets, such as a leverage ratio. Banking regulators have dealt with this problem by imposing an additional risk-based bank capital requirement that banks set aside additional bank capital for different kinds of off-balance-sheet activities. 10. What are some of the limitations to the Basel and Basel 2 Accords? How does the Basel 3 Accord attempt to address these limitations? The original Basel Accord takes into account the riskiness of capital, but in practice, the risk weights can differ substantially from the actual risk the bank faces. The Basel 2 Accords were created to address this limitation; however, addressing these shortfalls greatly increased the complexity of the accord, and there was substantial delay with countries adopting and implementing the regulations. More specifically, Basel 2 did not require banks to hold adequate capital to survive financial crises. Moreover, risk weights were dependent on credit ratings, which can be unreliable, particularly in financial crises. In addition, Basel 2 implies procyclical capital requirements, whereas countercyclical capital requirements would be more prudent. Also, there is not a sufficient focus on the need for liquidity, which is necessary particularly during financial crises. Basel 3 attempts to address these shortfalls by increasing the quality and quantity of capital requirements, making capital

requirements less procyclical, establishing rules on the use of credit ratings, and requiring firms to have access to more stable funding to increase liquidity. 11. How does bank chartering reduce adverse selection problems? Does it always work? Chartering banks helps reduce the adverse selection problem because it attempts to screen proposals for new banks to prevent risk-prone entrepreneurs and crooks from controlling them. It will not always work because risk-prone entrepreneurs and crooks have incentives to hide their true nature and thus may slip through the chartering process. 12. Why has the trend in bank supervision moved away from a focus on capital requirements to a focus on risk management? With the advent of new financial instruments, a bank that is quite healthy at a particular point in time can be driven into insolvency extremely rapidly from risky trading in these instruments. Thus, a focus on bank capital at a point in time may not be effective in indicating whether a bank will be taking on excessive risk in the near future. Therefore, to make sure that banks are not taking on too much risk, bank supervisors now are focusing more on whether the risk-management procedures in banks keep them from excessive risk-taking that might make a future bank failure more likely. 13. Suppose that after a few mergers and acquisitions, only one bank holds 70% of all deposits in the United States. Would you say that this bank would be considered too big to fail? What does this tell you about the ongoing process of financial consolidation and the government safety net? If only one bank holds 70% of all deposits in the United States, it would be a financial catastrophe if this institution fails. We can expect that the FDIC and any other competent office to do everything to prevent this institution to go bankrupt. However, as banks keep merging (with the consequence of a reduction in the number of banks but an increase in their size), this is precisely the type of problem that regulators might have to face in the future. It is a real challenge for actual and future financial regulations to deal with the problem of huge financial institutions and the potential negative effects that their failure might have in the economy. 14. Suppose Universal Bank holds $100 million in assets, which are composed of the following: Required reserves: $10 million Excess reserves: $ 5 million Mortgage loans: $20 million Corporate bonds: $15 million Stocks: $25 million Commodities: $25 million Do you think it is a good idea for Universal Bank to hold stocks, corporate bonds, and commodities as assets? Why or why not? Probably not. Since these assets are relatively high risk, the bank is subject to fluctuations in the values of these assets, which can be substantial. This could result in a significant decrease in the value of its assets to the point where it can no longer cover its immediate liabilities, and would

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