《货币银行学》课程授课教案（英文讲义）Chapter 09 Regulating the Financial System

Chapter9Problems and Solutions1.Explain how a bank run can turn into a bank panic.Answer: Bank runs occur when people fear that their bank has become insolvent.Depositorsrushtotheirbanktowithdrawtheirfunds.Depositorsatotherbanksbecome concerned about their own bank's solvency, so they also hurry to withdraw theirfunds.Bank runs can turn into system-wide bank panics because customers have adifficult time distinguishing insolvent banks from solvent ones.2. In analyzing data from around the world, a researcher observes that countrieswhose governments offer deposit insurance are more likelyto havefinancial crisesthan other countries.Why?Answer: When depositors'funds are insured by thegovernment, depositors do not careabout risks being taken by the bank's managers, because they know that no matter whathappens,theywill beabletogettheirfundsback.Because they are not being monitoredby depositors, bank managers take on additional risk, if the risky investments areprofitable, the bank gets the benefits, while ifthe investments fail, the governmentassumes the costs.The additional risk means that individual institutions are more likelyto fail, increasing the likelihood of a financial crisis.3.Will knowing about the too-big-to-fail policy affect your choice of where to opena bank account?Why orwhynot?Answer: For a small depositor, knowing about the too-big-to-fail policy is unlikely affectwhere the depositor chooses to open an account.Becausehis account is covered bydepositinsurance.thedepositorwillgetallhismoneybackevenifthebankdoesfailNevertheless,having ones bank fail could create an inconvenience. So if given a choicebetween a bank that you know will not be allowed to fail, and one that could, you mightchoose the larger bank.4. Discuss the regulations that are designed to reduce the moral hazard created bydeposit insurance.Answer: Regulators can restrict competition so that banks are not under as much pressureto engage in risky investments. They can also prohibit banks from making certain typesof risky loans and from purchasing particular securities.U.S.banks are not allowed tohold common stock or bondsthat arebelow investmentgrade.Theirbond holdingsfrom a single issuer cannot exceed 25 percent of their capital.Likewise, they cannotmake loans to single borrowers that exceed 25 percent of their capital.Regulators havealso developed minimum capital requirements.5.How does the existence of a lender of last resort create moral hazard?133Instructor'sManual t/a Cecchetti:Money,Banking,andFinancial Markets

Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 133 Chapter 9 Problems and Solutions 1. Explain how a bank run can turn into a bank panic. Answer: Bank runs occur when people fear that their bank has become insolvent. Depositors rush to their bank to withdraw their funds. Depositors at other banks become concerned about their own bank’s solvency, so they also hurry to withdraw their funds. Bank runs can turn into system-wide bank panics because customers have a difficult time distinguishing insolvent banks from solvent ones. 2. In analyzing data from around the world, a researcher observes that countries whose governments offer deposit insurance are more likely to have financial crises than other countries. Why? Answer: When depositors’ funds are insured by the government, depositors do not care about risks being taken by the bank’s managers, because they know that no matter what happens, they will be able to get their funds back. Because they are not being monitored by depositors, bank managers take on additional risk; if the risky investments are profitable, the bank gets the benefits, while if the investments fail, the government assumes the costs. The additional risk means that individual institutions are more likely to fail, increasing the likelihood of a financial crisis. 3. Will knowing about the too-big-to-fail policy affect your choice of where to open a bank account? Why or why not? Answer: For a small depositor, knowing about the too-big-to-fail policy is unlikely affect where the depositor chooses to open an account. Because his account is covered by deposit insurance, the depositor will get all his money back even if the bank does fail. Nevertheless, having ones bank fail could create an inconvenience. So if given a choice between a bank that you know will not be allowed to fail, and one that could, you might choose the larger bank. 4. Discuss the regulations that are designed to reduce the moral hazard created by deposit insurance. Answer: Regulators can restrict competition so that banks are not under as much pressure to engage in risky investments. They can also prohibit banks from making certain types of risky loans and from purchasing particular securities. U.S. banks are not allowed to hold common stock or bonds that are below investment grade. Their bond holdings from a single issuer cannot exceed 25 percent of their capital. Likewise, they cannot make loans to single borrowers that exceed 25 percent of their capital. Regulators have also developed minimum capital requirements. 5. How does the existence of a lender of last resort create moral hazard?

Chapter9RegulatingtheFinancial SystemAnswer: Because bank managers know that the government will lend to them if they needit,theyaremorelikelytotake onadditional risk.6.Distinguish between illiquidity and insolvency.Why is it difficult for a lenderof lastresortto tell insolvencyfrom illiquidity?Does the distinction matter?Answer: Illiquidity is when a bank does not have enough reserves to meet depositorswithdrawals.Insolvency is when a bank's assets do not cover its liabilities.Duringcrisis,itisdifficultforalender oflastresorttodetermineif abankis solventbecausecomputing thevalue ofthebank's assets is almost impossible.The distinction betweenilliquidity and insolvency is important, a bank that is illiquid is facing a temporaryproblem and will be able to recover, while a bank that is insolvent will repeatedly need toborrow.7.A government is considering changing its deposit insurance system from one inwhich deposits are implicitly guaranteed (that is, if a bank fails, people trust thegovernment to put enough resources into the bank so that depositors will losenothing) to one with an explicit ceiling. What would be the impact of such a changeondepositors?Onbankers?Answer: This can go both ways.If, with implicit guarantees, everyone really believesthat there deposits are guaranteed with no limit, then the change will induce moremonitoringbyborrowers, reducingmoral hazard.Alternatively,if the explicit ceilingmakes depositors whose account values are below the ceiling feel even more confident inthe security of their funds, while depositors whose accounts are above the ceiling seekoutwaystoensurethatalloftheirfundsareinsured(forexample,dividingtheirdepositsinto different accounts), then the change could increase moral hazard.8.Why do regulators insist that banks hold a minimum level of capital?Answer: Capital cushions banks against a decline in the value of their assets, and alsoreducestheproblemofmoral hazardby ensuringthat owners havean interest in thebankremaining solvent.9. Many of the people the government employs to supervise and monitor bankseventually leave the government in order to work for the banks.Is this revolvingdooraproblem?Why orwhy not?Answer: This could be a problem because the former supervisors could give banks adviceon how to work around existing regulations to take on more risk.However, bankemployees who formerly worked for the government probably help banks to maximizetheir returns while keeping risk at an acceptable level.10. Before the Federal Reserve's creation, banks tried banding together against thethreat of bank runs. Under what circumstances would such an approach work?When would it not work?134Instructor's Manual t/a Cecchetti:Money,Banking,and Financial Markets

Chapter 9 Regulating the Financial System Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 134 Answer: Because bank managers know that the government will lend to them if they need it, they are more likely to take on additional risk. 6. Distinguish between illiquidity and insolvency. Why is it difficult for a lender of last resort to tell insolvency from illiquidity? Does the distinction matter? Answer: Illiquidity is when a bank does not have enough reserves to meet depositors’ withdrawals. Insolvency is when a bank’s assets do not cover its liabilities. During crisis, it is difficult for a lender of last resort to determine if a bank is solvent because computing the value of the bank’s assets is almost impossible. The distinction between illiquidity and insolvency is important; a bank that is illiquid is facing a temporary problem and will be able to recover, while a bank that is insolvent will repeatedly need to borrow. 7.A government is considering changing its deposit insurance system from one in which deposits are implicitly guaranteed (that is, if a bank fails, people trust the government to put enough resources into the bank so that depositors will lose nothing) to one with an explicit ceiling. What would be the impact of such a change on depositors? On bankers? Answer: This can go both ways. If, with implicit guarantees, everyone really believes that there deposits are guaranteed with no limit, then the change will induce more monitoring by borrowers, reducing moral hazard. Alternatively, if the explicit ceiling makes depositors whose account values are below the ceiling feel even more confident in the security of their funds, while depositors whose accounts are above the ceiling seek out ways to ensure that all of their funds are insured (for example, dividing their deposits into different accounts), then the change could increase moral hazard. 8. Why do regulators insist that banks hold a minimum level of capital? Answer: Capital cushions banks against a decline in the value of their assets, and also reduces the problem of moral hazard by ensuring that owners have an interest in the bank remaining solvent. 9. Many of the people the government employs to supervise and monitor banks eventually leave the government in order to work for the banks. Is this revolving door a problem? Why or why not? Answer: This could be a problem because the former supervisors could give banks advice on how to work around existing regulations to take on more risk. However, bank employees who formerly worked for the government probably help banks to maximize their returns while keeping risk at an acceptable level. 10. Before the Federal Reserve’s creation, banks tried banding together against the threat of bank runs. Under what circumstances would such an approach work? When would it not work?

Chapter9Regulating the Financial SystemAnswer:Ifthere is a bankrun at justonebank,theotherbanks would be able toprovideenough liquidity to thebank.However, in theevent of a system-widebanking panic, allof the banks would be facing illiquidity and would not be able to loan reserves to eachotherto stopthebank runs.11.Given the increasing complexity of the banking system, some people haveproposed that banks be required to issue uncollateralized bonds, whose marketprices could provide valuable information about banks'financial health.Whatis the logic behind such a proposal? Do you think it would work?Answer: Holders of these bonds would have an incentive to monitor the risk-takingbehavior of the bank (since, unlike depositors, they would lose their money if the bankfailed).Theprice of the bonds would provide information about thefinancial soundnessof the issuing banks.12.Could an insurance company or a pension fund be subject to a run?Why orwhy not? Does the government need to guarantee deposits in these institutions?Answer: Insurance companies and pension funds are not subject to runs because they donotallow investors to withdraw funds on demand.However,they can still mismanageinvestors'funds, so there is reasonfor government intervention to protect investors13.Current technology allows large bank depositors to withdraw their fundselectronically at a moment's notice. They can do so all at the same time, withoutanyone's knowledge, in what is called a silent run.When might a silent runhappen,and why?Answer: Depositors may have their accounts set up so that funds are automaticallywithdrawn under certain conditions.If the value of the depositors'other assetsdecreases (because of a fall in the stock market, for example), the depositors may havedifficultymeetingtheirliabilitiesandwillneedtohavefundswithdrawnfromtheirdepositaccounts.Depositorsarelikelytoneedtowithdrawfundsatthesametimeleading to a silent run.14.If you ran a large international bank headquartered in the United States, wouldyou be for or against uniform regulations for all international banks, regardlessof where they are based?What difference would it make if each countryregulated its own banks, even thosethat have operations abroad?Answer: I would be for uniform regulations.Regulations for U.S.banks are relativelystrict compared to banks in other countries; if banks were subject only to the regulationsof their country and not to a set of standardized regulations, then banks from countrieswithlaxregulationswouldhaveanadvantageoverbanksfromcountrieswithstrictregulations.135Instructor'sManualt/aCecchetti:Money,Banking,andFinancial Markets

Chapter 9 Regulating the Financial System Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 135 Answer: If there is a bank run at just one bank, the other banks would be able to provide enough liquidity to the bank. However, in the event of a system-wide banking panic, all of the banks would be facing illiquidity and would not be able to loan reserves to each other to stop the bank runs. 11. Given the increasing complexity of the banking system, some people have proposed that banks be required to issue uncollateralized bonds, whose market prices could provide valuable information about banks’ financial health. What is the logic behind such a proposal? Do you think it would work? Answer: Holders of these bonds would have an incentive to monitor the risk-taking behavior of the bank (since, unlike depositors, they would lose their money if the bank failed). The price of the bonds would provide information about the financial soundness of the issuing banks. 12. Could an insurance company or a pension fund be subject to a run? Why or why not? Does the government need to guarantee deposits in these institutions? Answer: Insurance companies and pension funds are not subject to runs because they do not allow investors to withdraw funds on demand. However, they can still mismanage investors’ funds, so there is reason for government intervention to protect investors. 13. Current technology allows large bank depositors to withdraw their funds electronically at a moment’s notice. They can do so all at the same time, without anyone’s knowledge, in what is called a silent run. When might a silent run happen, and why? Answer: Depositors may have their accounts set up so that funds are automatically withdrawn under certain conditions. If the value of the depositors’ other assets decreases (because of a fall in the stock market, for example), the depositors may have difficulty meeting their liabilities and will need to have funds withdrawn from their deposit accounts. Depositors are likely to need to withdraw funds at the same time, leading to a silent run. 14. If you ran a large international bank headquartered in the United States, would you be for or against uniform regulations for all international banks, regardless of where they are based? What difference would it make if each country regulated its own banks, even those that have operations abroad? Answer: I would be for uniform regulations. Regulations for U.S. banks are relatively strict compared to banks in other countries; if banks were subject only to the regulations of their country and not to a set of standardized regulations, then banks from countries with lax regulations would have an advantage over banks from countries with strict regulations

Chapter9RegulatingtheFinancial System15.Using the example of the Great Depression, explain why the existence of a lenderoflast resortis noguaranteeoffinancial stability.Answer: During the Great Depression, the Federal Reserve existed as a lender of lastresort. However, the Fed adopted a policy that made it very difficult for banks to obtainloans.Just because someone can bethelender of last resort, doesn't mean theywill dothe job competently.136Instructor'sManualt/aCecchetti:Money,Banking,andFinancial Markets

Chapter 9 Regulating the Financial System Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 136 15. Using the example of the Great Depression, explain why the existence of a lender of last resort is no guarantee of financial stability. Answer: During the Great Depression, the Federal Reserve existed as a lender of last resort. However, the Fed adopted a policy that made it very difficult for banks to obtain loans. Just because someone can be the lender of last resort, doesn’t mean they will do the job competently