Money and Banking Chapter 12

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 who 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. What types of bank regulations are designed to reduce moral hazard problems? Will they
completely eliminate the moral hazard problem?

Regulations that restrict banks from holding risky assets directly decrease the moral
hazard of risk taking by the bank. Requirements that force banks to have a large amount
of capital also decrease the banks’ incentives for risk taking, because banks now have
more to lose if they fail. Such regulations will not completely eliminate the moral hazard
problem, because bankers have incentives to hide their holdings of risky assets from the
regulators and to overstate the amount of their capital.

7. Why does imposing bank capital requirements on banks help limit risk taking?

Because with higher amounts of capital, banks have more to lose if they take on too much
risk. Thus capital requirements make it less likely that banks will take on excessive risk.

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 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.
4. How can the S&L crisis be blamed on the principal agent problem?

The S&L crisis can be blamed on the principal agent problem because politicians and regulators
(the agents) have not had the same incentives to minimize costs of deposit insurance as do the
taxpayers (the principals). As a result, politicians and regulators relaxed capital standards,
removed restrictions on holdings of risky assets, and engaged in regulatory forbearance, thereby
increasing the cost of the S&L bailout.
2. Consider a bank with the following balance sheet:

Assets Liabilities
Required Reserves $ 8 million Checkable Deposits $100 million
Excess Reserves $ 3 million Bank Capital $ 6 million
T-bills $45 million
Commercial Loans $50 million

The bank commits to a loan agreement for $10 million to a commercial customer. Calculate
the bank’s capital ratio before and after the agreement. Calculate the bank’s risk-weighted
assets before and after the agreement.
Solution: Before the agreement, the capital ratio  6/106  5.66%. Since the loan
agreement has no accounting transaction, the capital ratio is the same after.
For risk-weighted assets:
Reserves and T-bills have a zero weight. So, $56 million has zero weight.
Commercial loans carry a 100% weight. RW Assets  $50 million.
Total risk-weighted assets  $50 million.
After the loan agreement, risk-weighted assets:
Reserves and T-bills have a zero weight. So $56 million has zero weight.
Commercial loans carry a 100% weight. RW Assets  $50 million.
Commercial loan commitments are at 100%. RW Assets  $10 million
Total risk-weighted assets  $60 million.
The actual risk-weighted assets for the loan commitment may vary depending on
the terms of the commitment and other factors. However, under the idea of risk-
weighted assets, the $10 million would be correct.