Mishkin The Economics of Money, Banking, and Financial Markets, Eleventh Edition, GE 97

Chapter 10
ANSWERS TO QUESTIONS

1. Why are deposit insurance and other types of government safety nets important to the health
of the economy?
A government safety net can short-circuit runs on banks and bank panics, and overcome
reluctance by depositors to put funds in the banking system. This helps to eliminate a
contagion effect, in which both good and bad banks could become insolvent in the event of a
bank panic. Without confidence in the banking system, such panics could result in a collapse
of the financial system and severely inhibit investment and economic growth.

2. If casualty insurance companies provided fire insurance without any restrictions, what kind of
adverse selection and moral hazard problems might result?
There would be adverse selection, because people who might want to burn their property for
some personal gain would actively try to obtain substantial fire insurance policies. Moral
hazard could also be a problem, because a person with a fire insurance policy has less
incentive to take measures to prevent fire.

3. Do you think that eliminating or limiting the amount of deposit insurance would be a good
idea? Explain your answer.
Eliminating or limiting the amount of deposit insurance would help reduce the moral hazard
of excessive risk taking on the part of banks. It would, however, make bank failures and
panics more likely, so it might not be a very good idea.

4. How could higher deposit insurance premiums for banks with riskier assets benefit the
economy?
The economy would benefit from reduced moral hazard; that is, banks would not want to take
on too much risk, because doing so would increase their deposit insurance premiums. The
problem is, however, that it is difficult to monitor the degree of risk in bank assets because
often only the bank making the loans knows how risky they are.

5. What are the costs and benefits of a too-big-to-fail policy?

The benefits of a too-big-to-fail policy are that it makes bank panics less likely. The costs are
that it increases the incentives for moral hazard by big banks that know that depositors do not
have incentives t -taking activities. In addition, it is an unfair policy
because it discriminates against small banks.

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Mishkin The Economics of Money, Banking, and Financial Markets, Eleventh Edition, GE 98

6. What types of bank regulations are designed to reduce moral hazard problems? Will they
completely eliminate moral hazard problems?
Regulations that restrict banks from holding risky assets directly decrease the moral hazard of
risk taking by the bank. Requirements that force banks to have a large amount of capital also
now have more to lose if they
fail. Such regulations will not completely eliminate the moral hazard problem, because
bankers have incentives to hide their holdings of risky assets from the regulators and to
overstate the amount of their capital.

7. Why does imposing bank capital requirements on banks help limit risk taking?
Because with higher amounts of capital, banks have more to lose if they take on too much risk.
Thus capital requirements make it less likely that banks will take on excessive risk.

8. At the height of the global financial crisis in October 2008, the U.S. Treasury forced nine of
the largest U.S. banks to accept capital injections in exchange for nonvoting ownership stock,
even though some of the banks did not need the capital and did not want to participate. What

If the banks that did not need or want the capital injections were not forced to take the capital,
then only the weakest banks would be the ones that would have received the needed capital
injections to avoid insolvency. This could have started a run on those banks, which then
would have accelerated their insolvency problem and created a contagion effect on the rest of
the financial system, harming all banks. By forcing all banks to accept capital, this helped to
reduce sending unnecessarily adverse signals to investors and depositors of the weakest banks.

9. What special problem do off-balance-sheet activities present to bank regulators, and what
have they done about it?
Because off-balance-sheet activities do not appear on bank balance sheets, they cannot be
dealt with by simple bank capital requirements, which are based on bank assets, such as a
leverage ratio. Banking regulators have dealt with this problem by imposing an additional
risk-based bank capital requirement that banks set aside additional bank capital for different
kinds of off-balance-sheet activities.

10. What are some of the limitations to the Basel and Basel 2 Accords? How does the Basel 3
Accord attempt to address these limitations?
The original Basel Accord takes into account the riskiness of capital, but in practice the risk
weights can differ substantially from the actual risk the bank faces. The Basel 2 Accords were
created to address this limitation; however, addressing these shortfalls greatly increased the
complexity of the accord, and there was substantial delay with countries adopting and
implementing the regulations. More specifically, Basel 2 did not require banks to hold adequate
capital to survive financial crises. Moreover, risk weights were dependent on credit ratings,
which can be unreliable, particularly in financial crises. In addition, Basel 2 implies

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Mishkin The Economics of Money, Banking, and Financial Markets, Eleventh Edition, GE 99

procyclical capital requirements, whereas countercyclical capital requirements would be more

prudent. Also, there is not a sufficient focus on the need for liquidity, which is necessary
particularly during financial crises. Basel 3 attempts to address these shortfalls by increasing the
quality and quantity of capital requirements, making capital requirements less procyclical,
establishing rules on the use of credit ratings, and requiring firms to have access to more
stable funding to increase liquidity.

11. How does bank chartering reduce adverse selection problems? Does it always work?
Chartering banks helps reduce the adverse selection problem because it attempts to screen
proposals for new banks to prevent risk-prone entrepreneurs and crooks from controlling them.
It will not always work because risk-prone entrepreneurs and crooks have incentives to hide
their true nature and thus may slip through the chartering process.

12. Why has the trend in bank supervision moved away from a focus on capital requirements to a
focus on risk management?
With the advent of new financial instruments, a bank that is quite healthy at a particular point
in time can be driven into insolvency extremely rapidly from risky trading in these
instruments. Thus, a focus on bank capital at a point in time may not be effective in indicating
whether a bank will be taking on excessive risk in the near future. Therefore, to make sure that
banks are not taking on too much risk, bank supervisors now are focusing more on whether
the risk-management procedures in banks keep them from excessive risk taking that might
make a future bank failure more likely.

13. How do disclosure requirements help limit excessive risk taking by banks?
More public information about the risks incurred by banks and the quality of their portfolio
helps stockholders, creditors, and depositors to evaluate and monitor banks and pull their
funds out if the banks are taking on too much risk. Thus, in order to prevent this from
happening banks are likely to take on less risk, and this makes bank failures less likely.

14. Suppose Universal Bank holds $100 million in assets, which are composed of the following:
Required reserves: $10 million
Excess reserves: $ 5 million
Mortgage loans: $20 million
Corporate bonds: $15 million
Stocks: $25 million
Commodities: $25 million
a. Do you think it is a good idea for Universal Bank to hold stocks, corporate bonds, and
commodities as assets? Why or why not?

Probably not. Since these assets are relatively high risk, the bank is subject to fluctuations

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Mishkin The Economics of Money, Banking, and Financial Markets, Eleventh Edition, GE
100

in the values of these assets, which can be substantial. This could result in a significant
decrease in the value of its assets to the point where it can no longer cover its immediate
liabilities, and would become insolvent. It is for this reason that the government places
restrictions on the types and amounts of assets that financial institutions can hold.
b. If the housing market suddenly crashed, would Universal Bank be better off using a mark-
to-market accounting system or the historical-cost system?
If the housing market crashed, it is likely that many of the mortgage loans would default,
and the value of collateral on those loans (the market price of the house) would decline
dramatically. If the collateral from the nonperforming loans were valued at historical cost,
these would likely be much higher than current or near future mark-to-market values
ff under a
historical-cost accounting system.
c. If the price of commodities suddenly increased sharply, would Universal Bank be better
off using a mark-to-market accounting system or the historical-cost system?
If the price of commodities spiked, this would lead to a significant increase in the value of
-to-market valuation would be better. The
original price paid for the commodities would be lower, hence a historical valuation would
indicate a lower capital position than would be reflected by the actual current liquidation
value of the commodities.
d. What do your answers to parts (b) and (c) tell you about the tradeoffs between the two
accounting systems?
Although mark-to-market rules can be more efficient in that they generally provide a more
accurate
experienced during the 2007 2009 crisis they can propagate poorly functioning financial
markets by reducing the value of collateral, making access to liquidity more difficult. On
the other hand, using historical cost can provide more capital stability for banks; however,
as noted, historical-
position.

15. Why might more competition in financial markets be a bad idea? Would restrictions on
competition be a better idea? Why or why not?
With more competition in financial markets, there are more firms making less profits. Thus,
there is greater incentive for financial firms to take on greater risk in an effort to increase
profits. Although restrictions on competition would decrease the incentive for risk by financial
firms, it may not be altogether beneficial. It is likely that lower competition would result in
higher fees to consumers and decreased efficiency of banking institutions.

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Mishkin The Economics of Money, Banking, and Financial Markets, Eleventh Edition, GE
101

ANSWERS TO APPLIED PROBLEMS

16. Consider a failing bank. How much is a deposit of $290,000 worth if the FDIC uses the payoff
method? The purchase and assumption method? Which method is more costly to taxpayers?
If the FDIC uses the payoff method, a deposit of $ 290,000 is worth $ 261,000. If the FDIC
uses the purchase and assumption method, a deposit of $ 290,000 is worth $ 290,000. The
purchase and assumption method would be costlier to taxpayers.

17. Consider a bank with the following balance sheet:

Assets Liabilities
Required Reserves $9 million Checkable deposits $90 million
Excess reserves $2 million Bank capital $6 million
T-bills $46 million
Commercial loans $39 million
The bank makes a loan commitment for $15 million to a commercial customer. Calculate the
-weighted assets
before and after the agreement.
Before the commitment, the bank's capital ratio equals 6.25 %. After the commitment, the
bank's capital ratio equals 6.25 %. Before the loan commitment, the bank's risk-weighted
assets are$ 39 million. After the loan commitment, the bank's risk-weighted assets are $ 54
million.

18. Oldhat Financial starts its first day of operations with $11 million in capital. A total of $120
million in checkable deposits are received. The bank makes a $30 million commercial loan
and another $40 million in mortgages with the following terms: 200 standard, 30-year, fixed-
rate mortgages with a nominal annual rate of 5.25%, each for $200,000. Assume that
required reserves are 8%.
a. What does the bank balance sheet look like?
Assets Liabilities
Required Reserves $10 million Checkable Deposits $120 million
Excess Reserves $51 million Bank Capital $ 11 million
Loans $70 million
b. How well capitalized is the bank?
The leverage ratio is 8.40 %, and the bank is well capitalized.
c. Calculate the risk-weighted assets and risk- first day.
The risk-weighted assets after Oldhat's first day are$ 50 million; the risk-weighted capital

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Mishkin The Economics of Money, Banking, and Financial Markets, Eleventh Edition, GE
102

ratio after Oldhat's first day is 22.00 %.

19. Early the next day, the bank invests $35 million of its excess reserves in commercial loans.
Later that day, terrible news hits the mortgage markets, and mortgage rates jump to 13%,
per mortgage.
Bank regulators force Oldhat to sell its mortgages to recognize the fair market value. What

The actual balance sheet is:

Assets Liabilities
Required Reserves $10 million Checkable Deposits $125 million
Excess Reserves $49 million Bank Capital $ 11 million
Loans $55 million

bank is in a dire capital position.

20. To avoid insolvency, regulators decide to provide the bank with $27 million in bank capital.
Assume that bad news about mortgages is featured in the local newspaper, causing a bank
run. As a result, $40 million in deposits is withdrawn. Show the effects of the capital injection
and the bank run on the balance sheet. Was the capital injection enough to stabilize the bank?
If the bank regulators decide that the bank needs a capital ratio of 10% to prevent further
runs on the bank, how much of an additional capital injection is required to reach a 10%
capital ratio?
The effect of the capital injection and bank run are shown in the balance sheet below:

Assets Liabilities
Required Reserves $ 8 million Checkable Deposits $100 million
Excess Reserves $26 million Bank Capital $ 9 million
Loans $75 million

ANSWERS TO DATA ANALYSIS PROBLEMS

1. Go to the St. Louis Federal Reserve FRED database, and find data on the number of
commercial banks in the U.S. in each of the following categories: average assets less than
$100 million (US100NUM), average assets between $100 million and $300 million

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Mishkin The Economics of Money, Banking, and Financial Markets, Eleventh Edition, GE
103

(US13NUM), average assets between $300 million and $1 billion (US31NUM), average
assets between $1 billion and $15 billion (US115NUM), and average assets greater than $15
billion (USG15NUM). Download the data into a spreadsheet. Calculate the percentage of
banks in the smallest (less than $100 million) and largest (greater than $15 billion) categories,
as a percentage of the total number of banks, for the most recent quarter of data available
and for 1990:Q1. What has happened to the proportion of very large banks? What has
-big-to-
problem and moral hazard?

and 76.5% of total commercial banks in the U.S., respectively. For the most recent quarter of

and 30.8% of total commercial banks in the U.S., respectively. Thus, the proportion of very
large banks in the banking system has increased substantially over this period while very
small banks have shrunk dramatically; because of the proportional increase in these very large
implies that
government safety nets, along with the increase in the number of very large banks can
increase moral hazard in the banking system.

2. Go to the St. Louis Federal Reserve FRED database, and find data on the residual of assets
less liabilities, or bank capital (RALACBM027SBOG), and total assets of commercial banks
(TLAACBM027SBOG). Download the data from January 1990 through the most recent month
available into a spreadsheet. For each monthly observation, calculate the bank leverage ratio
as the ratio of bank capital to total assets. Create a line graph of the leverage ratio over time.
All else being equal, what can you conclude about leverage and moral hazard in commercial
banks over time?
See graph below. In January 1990, the leverage ratio was 6.6%, and the most recent month of
April 2014, the leverage ratio was 11.0%. The graph clearly illustrates a gradual increase in
the leverage ratio over time for commercial banks, indicating that, holding everything else
constant, moral hazard in the banking system should have gradually declined over that period.

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Mishkin The Economics of Money, Banking, and Financial Markets, Eleventh Edition, GE
104

Leverage Ratio
14.00
12.00
10.00
8.00
6.00
4.00 Leverage Ratio

2.00
0.00

2008-05-01
1990-01-01
1991-09-01
1993-05-01
1995-01-01
1996-09-01
1998-05-01
2000-01-01
2001-09-01
2003-05-01
2005-01-01
2006-09-01

2010-01-01
2011-09-01
2013-05-01

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