Question

In: Economics

15. [2] Why do bank failures persist despite a diverse variety of rules and laws designed...

15. [2] Why do bank failures persist despite a diverse variety of rules and laws designed to prevent them from failing?

Solutions

Expert Solution

Bank failures often result from over exposure of banks that face the moral hazard of taking more risks in business to earn more gains. Usually, small local banks extend their loans at higher interest rates to those, who find it increasingly difficult for them to get loans from top end banks. When the value of the pledged assets falls too much, it leads to the bank failing to exist.

There have been numerous cases throughout depressions, in which banks have taken higher risks and have believed that they will be able to manage their liabilities as they were too big to fall. This led them into believing that government intervention would save their case. Even though the governments do support big banks, smaller ones remain exposed to default risk, whereby those that have taken loans risk being at a default.

The core reason as to why, banks fail is their over exposure in the market place which is prone to cyclical fluctuations. For example, the recent Corona Virus crisis has led to a depression in almost all major sectors to which banks were exposed. The resultant from that is that the bad loans are said to accumulate for banks and they would find a hard time selling their assets in the market of depression.

The market in which banks operate remains volatile at all times, and the risk of default at the same time is possible because of their over exposure to such market types. This results in a situation wherein macro-economic factors such as recessions impact banks much more than any other industry due to their systematic investments in almost all market types.

Please feel free to ask your doubts in the comments section.


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