Problem Set #8
1) Bankers face informational problems on both sides of their business. On one hand, they know more about their business than their depositors (or potential depositors) do. On the other hand, lenders (and potential lenders) know more about their situation than the bank does.
a) Explain the adverse selection and moral hazard problems that arise between a bank and its depositors. How are these problems dealt with?
b) Explain the moral hazard and adverse selection problem that arises between a bank and its borrowers. How are these problems dealt with?
2) There exist two primary “safety nets” for the banking industry. First, the Federal Reserve is the “lender of last resort”. This means that the Fed is required to lend money to failing banks. Second is federal deposit insurance, which guarantees the first $100,000 of an account holders funds.
a) Explain why these “safety nets” are important.
b) Explain how these “safety nets” exacerbate the moral hazard problem in the banking industry.
3) Recent years have seen significant changes in the banking industry. First, due to mergers and buyouts, the total number of banks has fallen dramatically. Further, with the effective repeal of the Glass-Steagall act, banks are now able to engage in many types of financial services. Explain the pros and cons of these changes in the banking industry.
4) What is the Eurodollar market? How is it important to commercial banks? How is it important to the Federal Reserve?
5) What is regulation Q? Why was regulation Q imposed on the commercial banking sector? Explain how regulation Q was partially to blame for the shortage of commercial credit in the 1960s.