STABILITY OF THE FINANCIAL SYSTEM

STABILITY OF THE FINANCIAL SYSTEM

Government solution for bank run and banking panics

·         Regulation and supervision

• Certain standard is given


• Supervision of compliance to those standards


• If not complied, enforcement actions are taken


• New standards can be set as per the situation

·         Lender of the last resort

• Private initiatives:


• Problem of liquidity, credibility and moral hazard


• Since government can create unlimited money, liquidity and credibility is not a problem for government


• Government create institutions which provide the banking system with the liquidity it needs in crises is the lender of last resorts


• Central bank as lender of last resort


• What should lender of the last resort do?


• Should lend only against good collateral (see book)


• Should accept all good as collateral


• Should charge penalty rate of interest on loans


• Policies should be made known to public

·         Discount window

• Borrowing from the central bank is borrowing from the discount window


• Rate charged is known as discount rate


• Discount rate is set by the central bank


• Guidelines for maximum borrowing


• Adjusted credit: for few days, available for banks facing difficulty  to meet reserve requirement


• Extended credit: for longer period to small institutions having poor access to money market

·         Government guarantee

• Government institutions providing government guarantee such as;


• Federal Deposit Insurance Corporation (FDIC): insures deposits at bank


• Bank Insurance Fund: section of FDIC that ensures deposits at commercial bank and saving bank


• Saving Association Insurance Fund: section of the FDIC that insures deposits at savings and loans


• National Credit Union Share Insurance Fund: Federal agency that insures deposits (shares) at credit unions


• Federal Saving and Loan Insurance Corporation: Federal agency that insured deposits at savings and loans

Private solution for bank run and banking panics

·         Clearing house association

• Self regulation


• Mutual aid and provision for liquidity


• Arrange other members to lend reserves to banks under pressure


• Loan certificates: certificates issued by clearing house association to be used in settling inter-bank payment


• Suspension of convertibility


• Temporary refusal of banks to convert deposits into cash on demand


• Partial suspension of convertibility


• Restricted to a certain amount per day

·         Private Guarantees

• For example: state deposit insurance system

Banks make contributions → that would be used if a member bank failed

• Problems: guarantee backed by limited reserves thus lacks credibility and problem of moral hazard

Factors affecting stability

·         Fragmentation and interdependence

• Fragmentation:


• Small size institutions → weak because, pooling is less effective and liquidity is poor


• Fragmentation → increased interdependence (inter-bank connection: deposits of one bank held at other)

↓

spread problems from one another

·         Connection between banks and securities markets:

Call loan market is formed → in banking panic bank can call market dealers for repayment of loan

↓

dealers are forced to sell their securities

↓

market price of securities decreases

↓

value of securities collapse gradually

↓

    market crash

·         Institutional investors

Financially sound and have analytical capability → their reaction has greater impact → selling of securities

↓

                                                                                                    market crash

·         Globalization:

Increased amount of international inter-bank deposits → withdrawal of foreign deposits → increase instability

↓

                                                                                                    market crash

·         Methods of managing liquidity

• Internal method:


• Rearrangement of balance sheet to provide protection


• In terms of liquidity: asset management holding cash and secondary reserve


• In terms of risk:


• matching maturity and currency denomination of assets and liabilities


• diversifying


• holding substantial equity capital


• External method:


• Liquidity and risk management relying on the resources outside the institution


• In terms of liquidity: liability management borrowing cash from other


• In terms of risk: rather than reducing its own risk, pays to others to bear risk


• In case of external method → liquidity spread and risk spread → when pooling breakdown → market failure