Question

How could government prevent banks from failing due to insolvency and illiquidity?

Answer 1

Banks are extremely limited in what they can do to reduce the number of bank failures. We are barred from other forms of financial transactions and practices which are deemed too risky. Banks are expected to maintain a net worth minimum as a fraction of the total assets. FDIC regulators conduct audits and other reviews of individual banks on a regular basis to ensure they operate safely. , The authorities must be attentive to the interest of the franchise. Needless to say, banks should not be allowed to take undue risks or treat clients unfairly to increase their franchise value

Nor would it be good public policy to weaken banking competition with a view to increasing franchise prices. At the other hand, when regulators place excessive burdens at banks, it is not only a matter of cost, but also of financial stability.

Regulatory costs are a particularly big problem for smaller banks, since regulatory functions almost certainly provide economies of scale. There is also the critical argument that inadequate regulation that discriminates against banks in favor of shadow banks can damage financial stability in two ways: shadow banks can become loci of instability; and it can make their insolvency more likely by undermining the franchise value of regulated institutions.

It is about time we went past a more or less sterile discussion on legislation. No rational person should argue that insufficient supervision has led to what happened in 2008, or believe that market restraint is enough to prevent excessive risk-taking in the financial sector. At the same time, not all regulatory changes are beneficial and in certain cases stricter regulation may be detrimental for financial stability if it decreases productivity without offsetting gain, interferes with bank diversification or causes regulators to become excessively identified within regulated institutions.