Question

6. Minimum capital requirements for banks are an extremely important financial regulation.

a. Explain how deposit insurance creates a moral hazard problem in the banking sector.

b. Explain how requiring banks to hold more equity capital helps reduce the moral hazard problem created by deposit insurance.

c. How does a larger capital cushion make banks more resilient during a financial crisis?

d. Why is it important for capital requirements to be adjusted by regulators to allow for the business cycle?

Answer 1

6)a) Deposit Insurance is an insurance cover to depositors to ensure them their money is safe and they will get back the whole money in case of indebtness of financial Institutions.

however , this creates a situation of moral hazard in the minds of banker as they are insured and feel thenselves safe so arhat they can undertake more risky ventures .

B) Requiring banks to hold more equity capital reduces moral hazard problem because deposit insurance. Encourages banks to take more risk and to go for debentures . Increasing requirements for equity can create buffers and banks can sell them at time they are in any financial crisis.

C) financial crisis in bank occurs only when they are unable to pay back the money due to insufficient funds and to pay that they have to sell assets at lower prices .

Therefore, to increase liquidity , there should be a large cushion of capital which can be easily converted to cash .

D) capital requirements mean restrictions to bank to give loans . It should be adjusted in repose to three cycle includes , boom recession recovery .

If economy is under boom and banks increase their capital requirement, there will not be money flow in market . Therefore it should be adjusted by regulators