Question

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.

Minium capit

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

Moral hazard is a situation in which one agent decides on how much risk to take, while another agent bears (parts of) the negative consequences of risky choices

a) At the point when an organization ends up bankrupt, leasers to that organization will for the most part lose an extent of their cash. On account of a bank, this would include contributors just getting a level of the full estimation of their record. This assurance on the cash in a financial balance is known as 'deposit insurance'. In a nation with deposit insurance, in case of bankruptcy the ruined bank will have its advantages sold off. Any assets brought up along these lines are utilized to repaid contributors, with any shortage being made up with deposits from citizens.

Deposit insurance depends on the possibility that if contributors realize that the administration will repay their deposits in the aftereffect of a bank disappointment, at that point they won't try endeavoring to pull back their deposits regardless of whether they discover the bank is bankrupt. This is expected to forestall keeps running on banks that are reputed to be ruined or encountering money related trouble.

b) To reduce the moral hazard problem, banks are regulated via BASEL I &BASEL II

BASEL I :- Loans to private borrowers must be financed by at least 8% equity.

BASEL II :-  higher equity and more efficient risk management, lower probability of banking crises, reduced moral-hazard effects, reduced risk arbitrage.