MGT411 Money & Banking GDB No 2 Solution Ideas Spring 2014

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[B]MGT411 Money & Banking GDB No 2 Solution Ideas Spring 2014 Due Date: July 17, 2014

Topic for Discussion: “THE GOVERNMENT SAFETY NET"


THE GOVERNMENT SAFETY NET

There are three reasons for the government to get involved in the financial system To protect investors To protect bank customers from monopolistic exploitation To ensure the stability of the financial system Investor Protection Small investors are unable to judge the soundness of financial institutions In practice only force of law ensure the bank's integrity, thus investors rely on government to protect them from mismanagement and malfeasance Protection from monopolistic exploitation Monopolists exploit their customers by raising prices to earn unwarranted profits Government intervenes to prevent firms in an industry from becoming too large. The same mayapply to banks as wellStability of financial systemLiquidity risk and information asymmetry indicate the instability of financial systemFinancial institution can create and destroy the value of its assets in a very short period, and asingle firm's failure can bring down the whole systemGovernment officials employ a combination of strategies to protect investors and ensure thestability of the financial systemThey provide the safety net to insure small depositorsThey operate as the lender of last resort[/B]

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HE GOVERNMENT SAFETY NET

There are three reasons for the government to get involved in the financial system To protect investors To protect bank customers from monopolistic exploitation To ensure the stability of the financial system Investor Protection Small investors are unable to judge the soundness of financial institutions In practice only force of law ensure the bank's integrity, thus investors rely on government to protect them from mismanagement and malfeasance Protection from monopolistic exploitation Monopolists exploit their customers by raising prices to earn unwarranted profits Government intervenes to prevent firms in an industry from becoming too large. The same mayapply to banks as wellStability of financial systemLiquidity risk and information asymmetry indicate the instability of financial systemFinancial institution can create and destroy the value of its assets in a very short period, and asingle firm's failure can bring down the whole systemGovernment officials employ a combination of strategies to protect investors and ensure thestability of the financial systemThey provide the safety net to insure small depositorsThey operate as the lender of last resort

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The Unique Role of Depository Institutions
Depository institutions receive a disproportionate amount of attention from government regulators because They play a central role in the economy They face a unique set of problems We all rely heavily on banks for access to the payments system Banks are also prone to runs, as they hold illiquid assets to back their liquid liabilities,promising full and constant value to the depositors based on assets of uncertain value They are linked to each other both on their balance sheets and in their customers' minds;This in terconnectedness of banks is almost unique to the financial industry
The Government as Lender of Last Resort
The best way to stop a bank failure from turning into a panic is to make sure solvent institutionscan meet their depositors' withdrawal demandsThe existence of a lender of last resort significantly reduces, but does not eliminate, contagionFor the system to work, central bank officials who approve the loan applications must be able todistinguish an illiquid from an insolvent institutionIt is important for a lender of last resort to operate in a manner that minimizes the tendency forbankers to take too much risk in their operations