Finance 462

Solutions to Problem Set #8

1)       

a)      A depositor can’t observe the quality of a bank before prior to making a deposit.  Therefore, banks with excellent management and safe investment strategies are not rewarded for their good behavior (adverse selection).  Further, once a deposit is made, a depositor can’t guarantee that those funds will be invested wisely (moral hazard).  These problems are primarily handled through government regulation and supervision.

b)     A banker can’t observe the quality (credit risk) of the borrower.  Hence, low credit risk borrowers will be overcharged for their loans (adverse selection).  Further, once the loan has been mode, a banker will be concerned how those funds are actually used (moral hazard). These problems are dealt with through credit scoring, credit limits, collaterals, and proper diversification.

2)       

a)      These safety nets are important in that they alleviate the adverse selection between banks and depositors.  With assurance that their deposits are safe, depositors don’t have to worry about the quality of a bank.

b)     While these safety nets alleviate adverse selection, they actually exacerbate moral hazard.  Without safety nets, bankers know that if they invest in excessively risky projects and lose their depositor’s money, they will have to “face the fire” (hordes of angry depositors). With their deposits insured, bankers know that they are protected.  This lowers the cost of investing in risky assets.  The most notable example if the problem created by government backing of banks is the Asian financial crisis of the late 90’s.

3)      Pros: The primary pro is the increased ability to diversify.  The larger a bank gets, the bigger its loan portfolio becomes.  With a large number of customers, a bank not only is able to improve diversification, it is able to collect more data to use in credit scoring.  Further, with the repeal of Glass-Steagall, banks can diversify across several activities.  This increased diversification creates improved stability of the banking sector.

Con: The primary con is that while larger banks allow better diversification against idiosyncratic risk, it leaves us more susceptible to system (overall market) risk.  With lots of small banks, if one or two go out of business, the overall sector is unaffected.  However, with a very small number of very large banks, one bankruptcy creates an enormous problem for the sector (the “too big to fail” argument).

4)      The Eurodollar market is a general term for bank deposits which are not denominated in the home currency of the bank (for example, Peso denominated deposits in a German bank).  However, the term Eurodollar typically refers to dollar denominated deposits located outside the United States .  These deposits are not under US jurisdiction and, hence, not subject to US banking regulation (reserve requirements, etc).  They are useful for commercial banks because without the regulatory burden, they provide a cheaper source of credit.  For the Fed, this pool of unregulated credit makes it more difficult for the fed to control the money supply (i.e. if the Fed tries to tighten domestic credit, banks can turn to the Eurodollar market for funds.

5)      Regulation Q was a regulation limiting the interest a commercial bank could pay no deposits (for example, zero interest on a checking account).  Regulation Q had two important arguments:

a)      Regulation Q kept the interest cost on deposits low for commercial banks.  This allowed banks to maintain a competitive edge in credit markets – this insured that a majority of commercial loans would be done in the banking sector under the supervision of the fed.

b)      By capping interest rates, regulation Q restricted the competition between commercial banks (ie. Giving a degree of monopoly power to commercial bank).  Monopolies tend to engage in safer activities.

When interest rates rose in the late 60’s, banks couldn’t compete with non-bank firms for deposits.  Without deposits, banks had no credit to loan out.