Question

1. Suppose that a bank makes a loan to a firm and that the loan contract specifies that the firm is not to engage in certain lines of business. Why would the bank make such a provision?

2. Why do we need government regulations of the financial system with respect to the information problem?

Answer 1

The bank would make such a provision in order to prevent the firm from undertaking investments or business ventures which are more prone to losses and because of which the firm might not be able to repay its loan. So, eventually any loss making or risky decision taken by the firm would impact the bank directly in the form of repayment of its loan, the bank makes certain guidelines on what not to engage in

Government regulation of the financial system is needed so as to ensure the banks and other financial institutions are not undertaking loss making decisions or indulging in illegal activities. Since these financial institutions control the money supply in the economy, any incorrect decision on their part would affect the whole economy adversely. Also, it helps in increasing consumer confidence in the economy and financial institutions otherwise they would stop depositing their money and the investments in the economy would drop.

Also, we are well aware what happened to the US banking system in 2008 when it was left unregulated by the government. It led to the Great Depression of 2008.