Chapter 16: ANSWERS TO "DO YOU KNOW" TEXT QUESTIONS
DO YOU UNDERSTAND?
1. Why are bank failures considered to be so undesirable that the government should try to prevent
them?
Solution: Unlike other business failures, when a bank fails the money supply is reduced which can have
an adverse affect on business activity in general if the failures are too widespread. Even if the failure is
local, local business could suffer if there was no other convenient source of liquid credit financing and the
local money supply contracted sharply. Furthermore, individual bank failures potentially could be
contagious if they caused people to lose confidence in the financial system in general and thereby
precipitated a bank “panic” with adverse consequences for the economy, as happened during the Great
Depression.
2. What has the U.S. trend in bank failures been since 1920?
Solution: In the 1920s many small unit banks failed due to depressed local conditions. The failure rate
skyrocketed from 1929 to 1933 as the Great Depression unfolded. After the advent of deposit insurance
in 1934, bank failures dropped sharply, until the 1980s when enhanced competition among financial
institutions coupled with moral hazard caused bank failures to increase somewhat. Then, after the
insurance fund was recapitalized and got tough with banks that took too much risk or held too little capital,
bank failures declined sharply in the 1990s.
3. What is the difference between a “purchase and assumption” and a “payoff” method for liquidating a
failed bank?
Solution: In a purchase and assumption, another institution purchases the assets of the failed institution
and assumes all its liabilities. Thus, all depositors and liability holders get deposits or other liability claims
on the purchasing institution in exchange for their initial deposits. In a payoff, the FDIC pays insured
depositors up to $100,000 per account, but any payment above that limit will be made in full only if the
assets of the failed bank can be sold at a high enough price to repay all uninsured depositors and liability
holders in full.
4. Why might it be unfair to small banks if all large bank liquidations were accomplished via purchase and
assumption rather than payoff transaction?
Solution: If only purchase and assumptions were used for large banks, large depositors would prefer to
place their money in such banks to ensure that all their funds would be safe—even if their deposits
exceeded $100,000. Since they wouldn’t be as sure they would get all their money back if they had large
deposits in a small bank, the large banks would have an unfair advantage in attracting large depositors
away from small banks. For that reason, the FDIC has experimented with modified purchase and
assumption policies so uninsured depositors could still lose and, thus, would still have an incentive to
monitor the riskiness of the banks in which they put their funds—even if the bank is large.
DO YOU UNDERSTAND?
1. What is moral hazard and how does deposit insurance contribute to it on the part of both depositors
and bank management?
Solution: Moral hazard occurs when insured people are less careful than they would be if they were
uninsured. Deposit insurance makes depositors less careful about depositing their funds in insured banks.
It allows bank managements to take more risk without having to compensate its liability holders for the
extra-risk taking by paying higher interest rates. Thus, unlike uninsured businesses, banks can often
increase their profits by taking extra risks as their costs of funds will not rise commensurately with the risk.
The deposit insurance fund must try to counter these problems by severely disciplining bank managements
that take excess risk.
2. How can bank capital and subordinated debt help protect deposit insurance funds against losses?
Solution: If a bank is liquidated, depositors will be repaid before capital owners or subordinated debtors.
Thus, the insurance fund will lose money only if there is insufficient capital and subordinated debt
outstanding to absorb all the losses. Consequently, those items act like a “deductible” on the deposit
insurance policy. Furthermore, since debt holders stand to lose if a bank fails, they will try to sell their
debt prior to failure—thereby depressing the market price of the debt and alerting the regulators that
something is amiss.
3. What are the arguments for and against the regulators using a “too big to fail” policy?
Solution: It’s unfair to protect depositors in large banks fully as then large depositors will only deposit
their funds in such banks. Furthermore, it creates a serious moral hazard for depositors in such banks as
they will only want to know if it is TBTF and to whether it is taking too much risk. These are the cons. The
main pro argument is that the failure of a very large bank could destabilize the entire banking system by
causing losses to the multitudinous firms and banks that did business with it and causing widespread
financial disruptions and a loss of confidence.
DO YOU UNDERSTAND?
1. In what way did the Financial Services Modernization Act of 1999 merely formalize the regulatory
interpretations of existing laws?
Solution: Over the years court and regulatory decisions had effectively, but slowly brought commercial
banking into investment banking activities. The FSMA formalized the ongoing actions. Congress is
always last in repealing regulations; markets, regulatory authorities, and court interpretations are often far
ahead.
2. What was the justification for separating commercial banking from investment banking?
Solution: In the 1930's Congress was concerned that bank credit might have fueled the stock market
boom of the late 1928's. Further, separating loans from investment banking underwriting (cheap loans for
underwriting business) provides an economic advantage so that CB would eventually own all IB. Keeping
the money supply away from the stock market was another purpose. Some evidence of actions of the
late 1990's by CB and IB uphold the concerns of 1930's Congressmen.
3. Why do bankers probably have more favorable attitudes toward the Truth in Lending Act than the
Community Reinvestment Act?
Solution: The truth-in lending act may help bankers by showing that they charge relatively low rates on
consumer credit compared to retailers, finance companies, and some other lenders. Thus, they may gain
business and profits. The community reinvestment act, however, may prevent them from merging,
branching, or obtaining other regulatory approvals unless they can show they have bent over backward to
accommodate loan requests by certain favored groups. Thus, certain community groups have threatened
to protest if bankers do not make them loans, and bankers have had to knowingly make bad loans to
keep on good terms with regulators.
4. What does it mean to say that the Federal Reserve is an “umbrella” regulator?
Solution: Under the Financial Services Modernization Act the Fed has "overall" or ultimate responsibility
for the performance of financial holding companies, but cede detailed, daily regulatory authority to
insurance regulators, the SEC, and other bank regulators (FDIC, OCC, and states). Such will require
coordination of regulatory actions and information in the future.