chapter 5

• Free banking

  financial system with no central bank, no financial regulator, no government intervention. Market operates freely.
• adv of free banking

  system is stable as banks need to reassure depositors under such system by disclosing information and holding high levels of capital which will lead to stability.

  competition forces banks to maintain reputation of their liabilities
• disadvantage of free banking

  Many problems : counterfeiting, fraudulent banking, over-issue of bank notes and over expansion by banks. unstable because market failures, monopolies, information symmetry. banks subject to liquidity risk. risk can lead to systemic problems in the banking system. banks need to be regulated to stop banks from taking excessib=ve risk, hold sufficient capital and provide reassurance to depositors
• arguments for bank regulation

  Fragility: vulnerable to bank runs

  systemic risk: contagion effect by asymmetric info, one bank run can lead to solvent banks to run due to asymmetric information

  depositor protection: protects depositors and ensure payment systems are safe
• consequences of bank failure

  very costly to bank depositors, bond holders, stockholders and other bank(systemic risk) . Depositors also hv no expertise or information to differentiate between safe and risky banks
• arguments against bank regulation

  costly , unstable and may have negative effects. Excessive regulation can lead to a raise in compliance cost, reduction in competition, discourage financial innovation and moral hazard
• conclusion

  main justification is to reduce systemic risk, however as costs increase, this reduces competition and increases moral hazard. Problems can be minimised by regulation but will always exist. Can be seen as the "price to pay" for low systemic risk as benefit outweighs the cost.
• Bank supervision, CAMELS

  regulators use CAMELS to examine and evaluate the banks
• Government safety net : central bank as lender of last resort

  CB provides liquidity support to solvent banks in times of financial crisis (hard to differentiate)

  WHY: liquidity is most important source of instability for banks. If banks run short of liquidity and unable to obtain it through normal mechanism , they need it to be supplied externally (2008)

  BUtTTTTT creates moral hazard, banks expects CB to provide liquidity whenever it hv financial difficulty.

  SOOO banks can provide liquidity at a higher rate (penalty rate) in non-crisis period so they can better manage their liquidity
• Government safety net

  Deposit insurance
• Deposit insurance

  1. Banks pay a premium to deposit insurance companies

  2. Depositors are compensated in event of bank failure
• Deposit insurance

  • Increases depositor's confidence in their bank
  • Reduces systemic risk as depositors have assurance they can get money back
• FDIC was implemented and was effective in stabilising banks as bank failure declined from 28.16% to 0.37% from 1933 to 1934


  Great Depression
• 100% deposit assurance

  Moral hazard as depositors will place money in high risk banks as they are protected if bank fails, they also have no incentive to monitor banks activity
• Banks have 100% deposit assurance

  Banks will take more risk
• Least cost approach

  Using risk-based deposits insurance premiums
• Co-insurance approach

  Deposit insurance is less than 100% but must not be too low so depositors have incentives to not join a run
• Direct funding

  payoff method : Fdic pay off deposits up to 250000 limit

  purchase and assumption method: finds a merger partner to