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In a previous episode,
we talked about deposit insurance.
And we said that this is a great measure to prevent potential and real bank
runs and to stabilize the whole financial intermediation process.
Now unfortunately, we said that the deposit insurance also has its problems.
And the fact that the people at a certain point may
not trust the government is one clear huge problem,
but luckily, it is not seen in most places.
So, we can to a certain extent ignore it.
However, there is another,
a much more significant problem here.
In order to study that,
we have to go back to our classic diagram again.
We see the people here.
These are depositors.
We know that here are the borrowers,
and we already know that here comes
the bank that serves
as an intermediary that makes the process of money traveling efficient.
Now, we know that here are contracts,
and this important exchange of cash.
This one, this is insured.
Because we know that if there is no deposit insurance here,
then depositors can run on the bank.
Now, on this diagram,
there is another big thing,
which is the government that insures depositors.
Now see what happens.
Well, here, this is a strictly commercial relationship.
So basically, these people they engage in
contracts of that kind of liquidation with the bank.
There is some monitoring here too.
So this is just a standard case.
But see what happens,
the bank has now a lot of money from depositors.
Depositors, those are covered by the government.
So they are happy. But see what happens to the bank.
The bank now has a lot of money and
has the option to invest this money in risky projects.
Because if I engage in a very risky project,
let's go back to our first weeks.
Remember these projects, one and two.
Two was sort of moderate or modest if you will,
and there was project one, which was risky.
In a good state,
it was really high in cash flow.
For the low state, it was zero.
Now, the bank has a huge incentive to engage in projects number one.
Because if the bank arrives at a high state of the future,
then the bank pockets all the money.
If however, the bank arrives to
a low state and fails to make payments through the depositors,
the bank says, "Sorry about that guys."
Now, who pays them?
The government does. Now, this is a classic set up
of a huge moral hazard problem on the part of the bank.
So, let's say if the government does not set
any specific limitation or any terms of the provision of insurance to a bank,
then clearly banks go off rails,
and the government has to somehow raise a lot of money.
Well, you can say, "Well, the government can print money."
The government may change its fiscal policy and raise taxes,
but it is not costless.
And in some cases,
the damage is huge.
On the other hand, you can see that wherever you provide a free lunch to a bank,
that induces some very irresponsible behavior.
So, unless and until the government sets
the terms of the provided deposit insurance to a bank,
that clearly provokes this moral hazard problem.
So the government basically says,
"Well, now I buy this insurance.
I provide sort of an umbrella over the bank,
but this umbrella costs some money."
Because after all, if you as a bank would like to enjoy deposit insurance,
you have to pay something for that.
And the question is first, how much?
And second, in what form?
Because clearly, the bank oftentimes cannot pay really a lot of money because,
for example, the governments can say, "Well,
you know what guys, so you have collected this amount of money from deposits.
Set aside a large percentage of this money in order to be able to
always clear your obligations with respect to crazy depositors that come earlier."
This is a way, but this is an extremely inefficient way.
Because first of all,
the bank could do that on its own,
although it wouldn't because it's really damaging its business.
But if the bank is forced to do so by the pride of deposit insurance,
then instead of promoting efficiency and
circulation of the money in the economy with a low cost of greater intermediation now,
we would see quite the opposite.
So the banks do indeed pay the formal reserves some amount of money they do
set aside to make sure that whenever some unexpected person comes,
then there is enough cash in the bank to pay to this person.
Again, in reality, this is what happens,
because the cash needs of these individuals are not known with certainty.
But there is another very important limitation set that is imposed on the bank.
The government basically says,
"You know what guys,
you better behave yourselves.
So we will provide this umbrella only,
in case and to those who do not engage
in riskier projects or excessively risky projects."
So how can that be done?
The government says, "Well,
we watch you, and we see your assets."
Because these guys are banks assets.
So, if you invested something very,
very risky, then the government can say, "Well,
you have to get out of these investments or you have to pay certain fines first,
and then you have to be forcefully restructured or you have to change your policy."
So, all that has one uniform name.
It's called bank regulation.
It's not only bank regulation because clearly,
that goes for other financial institutions,
as well to the extent they enjoy some kind of protection in
the form of deposit insurance or anything close to that.
For example, now it's time to recall
that simultaneously with the introduction of deposit insurance back in 1933,
the government passed the famous Glass-Steagall Act that by
force broke the business of major banks at that time in two parts.
They said that if you are a commercial bank,
so if you sell retail deposits or in our terms red triangles,
you can enjoy deposit insurance,
but you cannot at the same time underwrite securities.
So you cannot use this money in order to buy up issues of securities by the companies.
And this investment banking business that we'll discuss
in much greater detail in the week five of course,
that was by force broken up,
it was sort of set aside.
It is you choose,
you're either in an investment bank or a commercial bank.
And this act was the major regulatory act
of the US capital markets all the way until the very end of the 20th century.
And we will discuss in quite some detail
what that resulted in the fact that it was rethought.
And then, finally, this act is no longer enforced.
And what happened?
As a result of that,
some people say as a result of that,
the spirit has changed.
We'll discuss all that further on this course.
But for now, for us, it's important that now we see
that the existence of a huge moral hazard problem,
here on the banks side,
that sets the scheme for
the specific measures that are labeled regulation.
And you can say that here,
we talked only about bank regulation.
Actually, regulation goes over all financial institutions.
We'll study other financial institutions,
namely investment banks and some other in this course in greater detail in week five.
So, later we will also say a few words about the regulation for these institutions.
Now, let's say that we know everything about bank regulation.
So far we don't, but we will know more very,
very quickly and very soon.
Now, what we can say is that now the moral hazard problem that sort of bubbled
up to the next level is taken care of to
some extent and is dealt with by this bank regulation.
Now is this enough or doesn't solve a problem?
Jumping way ahead, we can say that
some behavior of the market showed that unfortunately the time has come,
and that's recent time,
when many of these banks became so powerful and so great,
that they said, "You know what, that's all great.
But we are so huge that if anything happens to us,
then if we fail,
we will bury the whole capital market under something that remains of us."
That is a well-known idea of too big to
fail or bulge bracket banks that again is study in greater detail here.
But I can say right away that we can see that
unfortunately that is for the first time as we see the ascent of
moral hazard from the level between
depositors and borrowers to the level between the bank and the borrowers.
And unfortunately, this central problems caused by current information
is the key set of problems that are addressed in this course.
That too many, may seem sort of descriptive.
But what we talk about here is actually the analysis of the core ideas.
That actually, they regulate,
and they set up the scheme of the whole market.
That is why, remember that the specializations is called understanding finance.
And here, we're trying to understand the setup.
So, in the next final episode of this week,
we will discuss some other problems,
and we will do a comprehensive wrap up of what's going on in the banking industry.
Konstantin KontorDirector and Professor of Finance and Strategy
