REGULATING THE

FINANCIAL SYSTEM

CHAPTER 14
INTRODUCTION
- The painful effects of the global crisis of 2007–2009 brought
home the importance of the financial system in our lives.
Millions of people lost their jobs, their homes, and their wealth.
Healthy firms needing to borrow temporarily to pay their
employees or suppliers faced ruin. As the crisis peaked in the
fall of 2008, the global economy suffered its deepest and
broadest downturn since the Great Depression, and policy-
makers took unprecedented action to keep the crisis from
precipitating a second Great Depression. In 2010, after financial
conditions stabilized, the U.S. government enacted the most
ambitious financial reforms since the 1930s. The Dodd-Frank
Wall Street Reform and Consumer Protection Act aims to
prevent another crisis and to limit the moral hazard from the
government’s interventions during the global crisis.
The Sources and Consequences

InofaRuns, Panics, and

market-based Crises the
economy,
opportunity to succeed is also an
opportunity to fail. New restaurants open
and others go out of business. Only 1 in
10 restaurants survives as long as three
years. In principle, banks should be no
different from restaurants: new ones
should open and unpopular ones close.
- Bank run can cause a bank to fail. In short, a bank run can be the
result of either real or imagined problems. No bank is immune to the
loss of depositors’ confidence just because it is profitable and sound.
In practice, runs often start with shakier banks and then spread to
healthier ones as confidence erodes.
- During a bank run is not whether a bank is solvent, but whether it is
liquid. Solvency means that the value of the bank’s assets exceeds
the value of its liabilities—that is, the bank has a positive net worth.
Liquidity means that the bank has sufficient reserves and
immediately marketable assets to meet depositors’ demand for
withdrawals. False rumors that a bank is insolvent can lead to a run
that renders a bank illiquid.
- When a bank fails, depositors may lose some or all of their deposits,
and information about borrowers’ creditworthiness may disappear.
For these reasons alone,government officials work to ensure that
all banks are operated in a way that minimizes their chance of
failure. But that is not their main worry. The primary concern is that
a single bank’s failure might cause a small-scale bank run that
could turn into a system-wide bank panic . This phenomenon of
spreading panic on the part of depositors in banks (or of creditors to
shadow banks like MMMFs) is called contagion
There are three reasons
The Government for the
Safety Netgovernment to get involved in the financial system:
1. To protect investors. The government is obligated to protect small investors, many
of whom are unable to judge the soundness of their financial institutions.

2. To protect bank customers from monopolistic exploitation. The tendency for

small firms to merge into large ones reduces competition, ultimately ending in
monopolies.

3. To safeguard the stability of the financial system. The combustible

mix of liquidity risk and information asymmetries means that the
financial system is inherently unstable.
Government officials employ a combination of
•

strategies to protect investors and ensure the

stability of the financial system. First, they provide
the safety net to insure small depositors.
Authorities both operate as the lender of last
resort, making loans to banks that face sudden
deposit outflows, and provide deposit insurance,
guaranteeing that depositors receive the full value
of their accounts should an institution fail
The Unique Role of Banks and
Shadow Banks
-As the key providers of liquidity, banks
ensure a sufficient supply of the means
of payment for the economy to operate
smoothly and efficiently. This critical
role and the problems associated with it
make banks a key focus of attention for
government regulators. Shadow banks
are also major providers of liquidity,
and following their role in the financial
crisis of 2007–2009, they also have
attracted intense attention from
regulators around the world
The Government as
Lender of Last Resort
- The best way to stop a bank failure from
turning into a bank panic is to make sure solvent
institutions can meet their depositors’ withdrawal
demands. In 1873 the British economist Walter
Bagehot suggested the need for a lender of
last resort to perform this function. Such an
institution could make loans to prevent the
failure of solvent banks and could provide
liquidity in sufficient quantities to prevent or end
a financial panic
 Government
Deposit Insurance
-
Congress’s response to the Federal Reserve’s inability to stem the
bank panics of the 1930s was to create nationwide deposit
insurance. The Federal Deposit Insurance Corporation
guarantees that a depositor will receive the full account balance up
to some maximum amount even if a bank fails. Bank failures, in
effect, become the problem of the insurer; bank customers need not
concern themselves with their bank’s risk taking. So long as a bank
has deposit insurance, customers’ deposits are safe, even in the
event of a run or bank failure.
-
When a bank fails, the FDIC resolves the insolvency either by
closing the institution or by finding a buyer. The first approach,
closing the bank, is called the payoff method. The FDIC pays off all
the bank’s depositors, then sells all the bank’s assets in an attempt
to recover the amount paid out. Under the payoff method, depositors
whose balances exceed the insurance limit, currently $250,000,
suffer some losses.
 Government
Deposit Insurance
-
In the second approach, called the purchase-
and-assumption method , the FDIC finds a firm
that is willing to take over the failed bank.
Because the failed institution is insolvent—on
the balance sheet, its liabilities exceed its assets
—no purchaser will do so for free. In fact, the
FDIC has to pay banks to purchase failed
institutions. That is, the FDIC sells the failed
bank at a negative price.
Problems Created by the
Government Safety Net
-
We know that insurance changes people’s
behavior. Protected depositors have no incentives
to monitor their bankers. Knowing this, bankers
take on more risk than they would normally,
because they get the benefits while the
government assumes the costs. In protecting
depositors, then, the government creates moral
hazard.
-
Some intermediaries are treated as too big to fail
or too interconnected to fail. Means too big or
too complex to shut down or sell in an orderly
fashion without large and painful spillovers.
Regulation and Supervision
of the Financial System
-
Government officials employ three strategies to ensure that the
risks created by the safety net are contained.
-
Government regulation establishes a set of specific rules for
intermediaries to follow.
-
Government supervision provides general oversight of financial
institutions.
-
And formal examination of an institution’s books by specialists
provides detailed information on the firm’s operation.
Disclosure Requirements
Many intermediaries are required to provide information, both
-

to their customers about the cost of their products and to the

financial markets about their balance sheets. Regulation
regarding disclosures to customers are responsible for the
small print on loan applications and deposit account
agreements; their purpose is to protect consumers.

A bank must tell you the interest rate charged on a loan

-

and must do so in a standardized way that allows you to

compare interest rates at competing banks.
The bank must also tell you the fees it charges to
-

maintain a checking account—the cost of check clearing,

the monthly service charge, the fee for overdrafts, and the
interest rate paid on the balance, if any. Disclosure of
accounting information
Supervision and Examination
The government enforces banking rules and regulations
through an elaborate oversight process called supervision ,
which relies on a combination of monitoring and inspection.
Supervision is done both remotely, using the detailed reports
banks are required to file, and through on-site examination.
All chartered banks must fi le quarterly reports known as call
reports.
Largest institutions, examiners are on site all the time. They
follow a process known as continuous examination, which
is a bit like bridge painting—once they get to the end of the
process, they go back to the beginning and start over.
Supervision and Examination
Supervisors use what are called the CAMELS
criteria to evaluate the health of the banks they
monitor. This acronym stands for Capital
adequacy, Asset quality, Management,
Earnings, Liquidity, and Sensitivity to risk.
Micro-Prudential Versus Macro-Prudential Regulation

Micro-prudential had been the sole focus of regulators, but it

is insuffi cient to prevent systemic risks. That is the goal of
macro-prudential regulation.

It treats systemic risk taking by an intermediary as a kind of

pollution that spills over to other financial institutions and
markets. To limit such costly spillovers, or externalities,
regulators can use an evolving set of macro-prudential tools
that work like the taxes and fees that governments use to
limit pollution.
Two types of externalities that pose systemic risks requiring
regulatory intervention:

Common Exposure When many institutions have an exposure to the

same specific risk factor, it can make the system vulnerable to a shock
to that factor. The shock may be small, but the institutions with an
exposure to it can all be brought down at once.

Pro-cyclicality How do the cyclical patterns in finance and other

economic activity pose systemic risks? As the crisis of 2007–2009
illustrates, financial activity is prone to virtuous and vicious cycles. The
interaction between financial and economic activity can be mutually
reinforcing—recall the concept of adverse feedback mentioned on page
364—leading to unsustainable booms and busts.
Regulatory Reform: The Dodd-Frank Act
of 2010
The Act’s Goals and Means Dodd-Frank has four primary goals:
Strengthening the Financial System Dodd-Frank encourages transparency and simplification
throughout the financial system and improves its resilience. Reminiscent of limits imposed
on banks before 1999, Dodd-Frank forbids depositories from engaging in a variety of risky
activities such as trading securities for their own accounts (see footnote 17)

Preventing Crises Through Systemic Risk Management Led by the Treasury Secretary,
Dodd-Frank’s new super-committee of top U.S. regulators, the Financial System Oversight
Council (FSOC), aims to identify and forestall threats to the system.

Ending “Too Big to Fail” and Reducing Moral Hazard One leading motivation for Dodd-Frank
was the desire to eliminate government bailouts of institutions whose failure would be
deemed too risky for the financial system.
CENTRAL BANKS
IN THE WORLD
TODAY
CHAPTER 15
INTRODUCTION
- Central banks neither foresaw nor prevented the crisis of 2007–2009. Even long after
the tempest began, they did not see how menacing it would become. Yet, as the
expanding storm continuously poked new holes in the financial boat, policymakers
developed new tools to plug the holes.

- The central bank of the United States is the Federal Reserve (widely known as the Fed
for short). The people who work there are responsible for making sure that our
financial system functions smoothly so that the average citizen can carry on without
worrying about it.

- This chapter begins to explain the role of central banks in our economic and financial
system. It describes the origins of modern central banking and examines the
complexities policymakers now face in meeting their responsibilities. It also highlights a
central question that has become politically controversial following the crisis actions of
the Fed, the ECB, and other central banks; namely, what is the proper relationship
between a central bank and the government?
The Basics: How Central Banks Originated
and Their Role Today
The central bank started out as the
government’s bank and over the years added
various other functions. A modern central
bank not only manages the government’s
finances but provides an array of services to
commercial banks. It is the bankers’ bank.
Let’s see how this arrangement came about.
 The Government’s Bank
As the government’s bank, the central bank occupies a privileged position: It has a
-

monopoly on the issuance of currency. The central bank creates money. Historically,
central bank money has been seen as more trustworthy than that issued by kings,
queens, or emperors.
The ability to print currency means that the central bank can control the availability of
-

money and credit in a country’s economy. As we’ll see in later chapters, most central
banks go about this by adjusting short-term interest rates. This activity is what we
usually refer to as monetary policy.
Central banks use monetary policy to stabilize economic growth and inflation. An
-

expansionary or accommodative policy, through lower interest rates, raises both

growth and inflation over the short run, while tighter or restrictive policy reduces them.
The Bankers’ Bank
The political backing of the government,
together with their sizable gold reserves, made
early central banks the biggest and most
reliable banks around. The notes issued by the
central bank were viewed as safer than those of
smaller banks, making it easier for holders to
convert their deposits into cash. This safety and
convenience quickly persuaded most other
banks to hold deposits at the central bank as
well.
The Bankers’ Bank
The important of day-to-day jobs of the central bank are to

(1) provide loans during times of financial stress. The central bank’s ability to create
money means that it can make loans even when no one else can, including during a
crisis.

(2) manage the payments system. Every country needs a secure and efficient payments
system. People require ways to pay each other, and financial institutions need a cheap
and reliable way to transfer funds to one another.

(3) oversee commercial banks and the financial system. As we saw in our discussion of
banking regulation, someone has to watch over commercial banks and nonbank
financial institutions so that savers and investors can be confident they are sound.
Those who monitor the financial system must have sensitive information.
Stability: The Primary Objective
of All Central Banks

- The central bank is essentially part of the government. Whenever we see an

agency of the government involving itself in the economy, we need to ask
why. What makes individuals incapable of doing what we have entrusted to
the government? In the case of national defense and pollution regulation, the
reasons are obvious. Most people will not voluntarily contribute their
resources to the army. Nor will they spontaneously clean up their own air. To
put it slightly differently, government involvement is justified by the presence
of externalities (the uncompensated impact on one entity from the actions of
another; see page 383) or public goods (those that the public cannot be
excluded from using and whose use does not limit use by others).
Central bankers work to reduce the volatility of the economic and financial
systems
by pursuing five specific objectives:
1. Low and stable inflation. An official of the International Monetary Fund (the
closest thing there is to a world central bank) once summarized virtually every
economist’s view when he said, “ Uncontrolled inflation strangles growth, hurting the
entire populace, especially the indigent.” That is why many central banks take as their
primary job the maintenance of price stability . As a practical matter, that means
keeping inflation low and stable. The consensus is that when inflation rises for any
extended period, the central bank is at fault.

2. High and stable real growth, together with high employment. When Ben S.
Bernanke was sworn in as the 14th chairman of the Board of Governors of the Federal
Reserve System, he said “Our mission, as set forth by the Congress, is a critical one:
to preserve price stability, to foster maximum sustainable growth in output and
employment, and to promote a stable and efficient financial system that serves all
Americans well and fairly.” We just discussed the first of these; preserving price
stability requires keeping inflation low and stable. And we will look at financial stability
in a moment.
Financial System Stability. Is an integral part of every modern central banker’s job. It is
essential for policymakers to ensure that the markets for stocks, bonds, and the like continue
to operate smoothly and efficiently. If people lose faith in financial institutions and markets,
they will rush to low-risk alternatives, and intermediation will stop. Savers will not lend and
borrowers will not be able to borrow. Getting a car loan or a home mortgage becomes
impossible, as does selling a bond to maintain or expand a business. When the financial
system collapses, economic activity does, too.

Interest-Rate and Exchange-Rate Stability. If you ask them, most central bankers will tell you
that they do their best to keep interest rates and exchange rates from fluctuating too much.
They want to eliminate abrupt changes. But if you press them further, they will tell you that
these goals are secondary to those of low inflation, stable growth, and financial stability. The
reason for this hierarchy is that interest-rate stability and exchange-rate stability are means
for achieving the ultimate goal of stabilizing the economy; they are not ends unto
themselves.
Meeting the Challenge:
Creating a Successful Central Bank
- The past several decades were amazing in many ways. The Internet and cell
phones came into widespread use. Overall economic conditions improved nearly
everywhere, and especially in rapidly growing emerging economies, such as those
of Brazil, China, and India. Virtually across the globe, inflation was lower and more
stable than in the 1980s.

- To be successful, a central bank must:

(1) be independent of political pressure. The idea of central bank independence —
that central banks should be independent of political pressure—is a new one. After
all, the central bank originated as the government’s bank. It did the bidding first of
the king or emperor and then of the democratically elected congress or parliament.
(2) Make decisions by committee. Monetary policy decisions are
made deliberately, after significant amounts of information are collected
and examined. Occasionally a crisis does occur, and in those times
someone does need to be in charge. But in the course of normal
operations, it is better to rely on a committee than an individual.

(3) be accountable to the public and transparent in communicating

its policy actions. Explicit goals foster accountability and disclosure
requirements create transparency . While central bankers are powerful,
our elected representatives tell them what to do and then monitor their
progress. Technically speaking, legislatures usually grant central banks
instrument independence—the authority to use their tools as they see fi
t to achieve mandated objectives—not goal independence. That means
requiring plausible explanations for their decisions, along with
supporting data.
(4) operate within an explicit framework that clearly
states its goals and makes clear the tradeoffs among
them. We’ve seen that a modern central bank has a long list
of objectives—low, stable inflation; high, stable growth; a
stable financial system; and stable interest and exchange
rates. To meet these objectives, central bankers must be
independent, accountable, and good communicators.
Together these qualities make up what we will call the
monetary policy framework . The framework exists to resolve
ambiguities that arise in the course of the central bank’s work
Fitting Everything Together:
Central Banks and Fiscal Policy
-Fiscal and monetary policymakers share the same ultimate goal—to improve the
well-being of the population—conflicts can arise between them. Fiscal policymakers
are responsible for providing national defense, educating children, building and
maintaining transportation systems, and aiding the sick and poor. They need
resources to pay for these services. Thus, funding needs create a natural conflict
between monetary and fiscal policymakers

-Central bankers, in their effort to stabilize prices and provide the foundation for high
sustainable growth, take a long-term view, imposing limits on how fast the quantity of
money and credit can grow.

-In contrast, fiscal policymakers tend to ignore the long-term inflationary effects of
their actions and look for ways to spend resources today at the expense of prosperity
tomorrow. For better or worse, their time horizon often extends only until the next
election. Some fiscal policymakers a resort to actions intended to get around
restrictions imposed by the central bank, eroding what is otherwise an effective and
responsible monetary policy.
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