Question

1. [1] What is contagion in financial markets and why worry about it?

2. [1] Why are banks regulated?

3. [1] What are the forms of the government safety nets in the financial sector?

4. [1] What are the pros and cons of reducing deposit insurance from $250,000 to $10,000?

5. [1] What are the costs and benefits of a too-big-to-fail policy?

6. [1] What are the costs and benefits of increasing competition in financial markets

7. [1] Why does imposing bank capital requirements on banks help limit risk taking?

Answer 1

Answer 1

Financial contagion refers to the spread of market disturbances mostly on the downside from one country to the other, a process observed through co-movements in exchange rates, stock prices, sovereign spreads, and capital flows.Financial contagion can be a potential risk for countries who are trying to integrate their financial system with international financial markets and institutions. It helps explain an economic crisis extending across neighboring countries, or even regions.

Financial contagion can create financial volatility and can seriously damage the economy and financial systems of countries.Financial Contagion can result in spillover effects and financial crisis.Spillover effects can happen either globally, heavily affecting many countries in the world, or regionally, affecting only neighboring countries.Some examples that can cause contagion related to financial crisis are increased risk aversion, lack of confidence, and financial fears. Under the correlated information channel, price changes in one market are perceived as having implications for the values of assets in other markets, causing their prices to change as well .

Answer 2

Banks perform very essential functions as mentioned below:

• Banks are trusted with a significant potion of the liquid assets of households.
• Banks provide maturity, denomination, risk inter-mediation services to saves & borrowers.
• Bank are the primary conduit for monetary policy.

Banks Regulations is necessary to:

• Prevent disruption of the economy

1. Prudential regulation to ensure safety and soundness
2. Preventlarge scale failures that would affect economic activity
3. Reduce systemic risk wherein bank failures are potentially contagious. Such shocks could be domestic or international in scope.

• Guard against deposit insurance losses

1. Protect small depositors by providing government deposit insurance (FDIC) -- $250,000 per account.
2. Moral hazard problem of deposit insurance causes banks to have incentives to take risks with potential losses borne by the government.

• Achieve desired social goals

1. Prevent discrimination in lending, support housing finance, community development, etc.
2. Help fight crime (Bank Secrecy Act of 1970 to create paper trail of large currency transactions).

Answer 3

In banking,’ safety nets’ refer to government guarantees provided to depositors and sometimes to all bank creditors. When some banks are considered to be ‘too big to fail’, and therefore are given assistance, the safety net covers all of the bank’s stakeholders, including customers, employees, and (usually to a lesser extent) stockholders.

A financial safety net is meant to protect you and your family, at least in part, from losing your financial security or derailing your long-term financial goals because of some unexpected event like a catastrophic illness or other personal tragedy.

Today, Social Security is the largest safety net program in the U.S. In 2017 it reachi an estimated 62 million Americans with $955 billion in benefits.

Forms of government safety net are as follows:

Federal Reserve lending to financial institutions (lender of last resort).

1.One way governments provide support is through leading from central bank to troubled intuitions as the federal revere did during global finance crisis.

2. Also government can also take over nationalized troubled institution and guarantee that all creditors will be repaid their loan in full

Moral hazard and the government safety net

1.With a safety net, the depositors and creditors know they will not suffer losses if a financial institution fails, so they do not impose the discipline of the marketplace on these institutions by withdrawing funds when they suspect that financial institution is taking on too much risk.

2.The existence of insurance provides increased incentive for taking risk that might result in an increase pay off.

Adverse selection and the government safety net

1.The people who are most likely to produce the adverse outcome insured against are most want tot take advantage of insurance

2. Risk loving entrepreneurs might find the financial industry a particularly attractive on to enter they know that they will be able to encourage in highly risk activities.

Answer 4

The amount of deposit insurance is an important part in the determination of risk. The amount of deposit relates with moral hazard and level of risk. The deposit insurance increases moral hazard for banks because insured depositors would have incentives to keep the banks for taking too much risk. However, deposit insurance would give guarantee that depositor would not suffer from any losses.

Eliminating or reducing amount of deposit insurance from $250000 to $10000 is a good ideas for banking institutions. This would be helpful to decrease moral hazard problem of banks excessive risk taking activities. Hence, limiting or eliminating amount of deposit insurance decreases the ability of taking excessive risk.

Limiting or reducing amount of deposit insurance reduces the excessive risk taking ability of the banks and thereby protects the interest of the investors and depositors.

The higher deposit insurance premium for banks with riskier assets would be beneficial to the economy. The increasing amount of deposit insurance premiums helps to minimize moral hazard and adverse selection issues.The riskier assets result from issuing of loans. The increasing deposit insurance premiums put control on the degree of risk that banks take. This reduces the percentage of riskier assets and ultimately benefits the economy.

However, explicit deposit insurance might have unintended consequences for bank stability: First, deposit insurance weakens market discipline on banks by reducing the incentives of depositors and debt holders to monitor banks and thus results in higher bank risk. Second, banks will be reluctant to maintain sufficient capital levels if explicit deposit insurance exists because additional bankruptcy costs will be borne by the deposit insurance fund if an adverse shock hits the bank.