3.8. Deposit insurance and the need to regulate

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Capital Markets and Financial Institutions – How to Survive Them

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Moscow Institute of Physics and Technology

Capital Markets and Financial Institutions – How to Survive Them

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Cours 1 sur 5 dans Specialization Understanding Modern Finance

Capital markets and financial institutions are all around us. This is an enormous industry in which powerful players oftentimes challenge investors and the public at large and expose them to significant risks. This Course provides for the deep understanding of the core ideas, concepts, and mechanisms of the modern capital market in a learner-friendly way. We will analyze the market’s most fundamental problems, realize the intrinsic interests of the market participants, reveal the true meaning of certain financial terms, and uncover credible signals of the likely behavior of economic agents – all that with little math and a lot of fun. The learners will be much better positioned with respect to the financial environment. They will see through the financial news, reveal the risks of the financiers’ wishful thinking promises, and protect themselves against dangerous adventures. The learners will get the opportunity to use the obtained knowledge, skills, and understanding for the successful professional career in the financial and other business areas, as well as in their day-to-day life.

À partir de la leçon

Banks (2) – Asset Transformation and Liquidity Creation. Banks’ Vulnerability with Respect to Runs

Week 3 of the Course is devoted to the analysis of creation of liquidity – namely, we do answer the question of how a bank attracts depositors. You will get introduced to asset transformation and will learn how the presence of banks in capital markets makes the money circulation in the economy more efficient. You will analyze the market participants’ preferences and the “safety cushion” of a bank. We will study the mechanism of bank runs and feel how vulnerable the bank is with respect to runs. You will learn what methods of fighting bank runs have been used in centuries, and realize why the role of government in regulating of the banking business is so important. We will discuss deposit insurance as a universal and effective mechanism of preventing runs.

3.1. How to induce depositors?4:19

3.2. Liquidity creation (1) – the model of liquidity11:27

3.3. Liquidity creation (2) – the mechanism10:16

3.4. Banks’ vulnerability with respect to runs15:56

3.5. Ways to fight bank runs (1) – suspension of convertibility4:46

3.6. Ways to fight bank runs (2) – deposit insurance9:03

3.7. Problems of deposit insurance12:00

3.8. Deposit insurance and the need to regulate6:04

Rencontrer les enseignants

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

We're approaching the end of a third week of course.

And it's now time to wrap up what we did so far in this week,

and to see how from here we proceed.

And that is the central point

of the course for now because see what we did throughout this week.

We said in the beginning that we have a problem how to

force or to induce depositors to lend through the bank,

and we invented a red triangle.

We showed that the invention of the red triangle sets up

the whole scheme for banking business to proceed and make money.

But then, we unfortunately said that the whole system is

vulnerable with respect to the uncertainty of the people,

of the cash needs,

and with the respect with the fact that the people are just frightened,

and they sometimes by their behavior can result in the fact that the bank fails.

And we're said that poses a huge problem of bank runs,

and they have to somehow be dealt with,

and we offered a universal remedy which said this is deposit insurance.

And as we've seen already in this course,

the deposit insurance is great,

and it solves a lot of problems but unfortunately,

it results in the fact that

the moral hazard problem goes up one level or even more if you will.

And now, banks have adverse incentives to behave imprudently,

and to use insured money to engage in risky projects.

And we said that the way to fight the VAT is regulation.

Well, you might think about introducing coinsurance.

You can tell the depositors,

you know what, only part,

let's say the major part of the deposit is insured,

but the remainder is not.

Now, this approach does not work here because the majority of small investors say,

why should I lose this part?

And that does not prevent them from running at point one in their scheme,

so coinsurance doesn't work here.

So the only way is the complete insurers to a certain level.

Again, we have to cover with

deposit insurance older people who cannot protect themselves,

because for example, even now if someone

has a deposit in the bank that is 50 million dollars,

the major part of that is not insured.

But the logic here goes that if someone has that significant amount of money,

that someone can somehow protect herself,

maybe not by her own moves but by hiring a

professional or group of professionals who will advise on what is good,

and what is not so good to do.

Now, and we said that to those people who cannot do that by themselves, remember,

when we started with delegated monitoring,

we said that small people cannot monitor by the same token.

Small people cannot engage in actions that protect themselves in most cases,

that is why the need, but these people do provide the majority of money.

And therefore, they must be protected.

And we said that to the extent that the government does provide this insurance,

we now have to somehow decide what we will do with that.

What kind of payment will we impose on the banks to be able to enjoy deposit insurance.

And that is the story of a banking regulation that would study next week.

For now, I will say just a few things about that.

I would say that it's been quite a while since

the introduction of deposit insurance in the early 30's of the 20th century,

and for quite a few decades everything was going on sort of okay.

And as always to engage in massive regulatory actions,

you have to face some fundamental large scale problem.

And we will start next week with the analysis of

this problem that indeed occurred in the 80's,

and that is widely known as the crisis of the savings and loan associations.

We will see that was the final straw that broke the camel's back,

and that pushed the regulatory bodies to

start regulating banks not on their geographical level as was before,

not that was sort of the legacy of regulation from the old good old days,

but the regulation of that was specifically aimed at the prevention of

the moral hazard problem of that cost

a lot to the taxpayers as a result of the SNL crisis.

So, we are all prepared to study bank regulation,

and this is one more time at the very end of the third week,

to tell you that although many things that we're discussing here seem to be very trivial,

we do not use more than just some most simplistic algebra and sometimes arithmetic,

but the actual understanding of what's going on

arrives only when you solve some of these problems.

Again, I am telling that to you not to just push,

but this is based on my 20 plus years of experience in that.

As long as the people start to solve some of these things and see them,

how they calculate that, then understanding comes, and stays.

So good luck with your assignments,

and I see you next week.

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