Chapter 20
Banking Regulation
◼ Multiple Choice Questions
1. During the boom years of the 1920s, bank failures were quite
(a) uncommon, averaging less than 30 per year.
(b) uncommon, averaging less than 100 per year.
(c) common, averaging about 600 per year.
(d) common, averaging about 2000 per year.
2. When one party to a transaction has incentives to engage in activities detrimental to the other party,
there exists a problem of
(a) moral hazard.
(b) split incentives.
(c) ex ante shirking.
(d) pre-contractual opportunism.
3. Moral hazard is an important consequence of insurance arrangements because the existence of
insurance
(a) provides increased incentives for risk taking.
(b) impedes efficient risk taking.
(c) causes the private cost of the insured activity to increase.
(d) both (a) and (b) of the above.
(e) both (b) and (c) of the above.
4. Since depositors, like any lender, only receive fixed payments while the bank keeps any surplus
profits, they face the _________ problem that banks may take on too _________ risk.
(a) adverse selection; little
(b) adverse selection; much
(c) moral hazard; little
(d) moral hazard; much
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5. The existence of deposit insurance can increase the likelihood that depositors will need deposit
protection, as banks with deposit insurance
(a) are likely to take on greater risks than they otherwise would.
(b) are likely to be too conservative, reducing the probability of turning a profit.
(c) are likely to regard deposits as an unattractive source of funds due to depositors’ demands for
safety.
(d) are placed at a competitive disadvantage in acquiring funds.
6. Although the FDIC was created to prevent bank failures, its existence encourages banks to
(a) take too much risk.
(b) hold too much capital.
(c) open too many branches.
(d) buy too much stock.
7. When bad drivers line up to purchase collision insurance, automobile insurers are subject to the
(a) moral hazard problem.
(b) adverse selection problem.
(c) assigned risk problem.
(d) ill queue problem.
8. Deposit insurance
(a) attracts risk-prone entrepreneurs to the banking industry.
(b) encourages bank managers to take on greater risks than they otherwise would.
(c) reduces the incentives of depositors to monitor the riskiness of their banks’ asset portfolios.
(d) does all of the above.
(e) does only (a) and (b) of the above.
9. The possibility that the failure of one bank can hasten the failure of other banks is called the
(a) bank run effect.
(b) moral hazard effect.
(c) contagion effect.
(d) adverse selection effect.
10. If the FDIC decides that a bank is too big to fail, it will use the _________ method, effectively
ensuring that _________ depositors will suffer losses.
(a) payoff; large
(b) payoff; no
(c) purchase and assumption; large
(d) purchase and assumption; no
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11. If the FDIC uses the purchase and assumption method to handle a failed bank,
(a) all deposits will suffer losses.
(b) small deposits will be paid in full but deposits over the insurance limit will not.
(c) all deposits will be paid in full.
(d) none of the above.
12. One problem of the too-big-to-fail policy is that it _________ the incentives for _________ by big
banks.
(a) reduces; moral hazard
(b) increases; moral hazard
(c) reduces; adverse selection
(d) increases; adverse selection
13. The result of the too-big-to–fail policy is that _________ banks will take on _________ risks,
making bank failures more likely.
(a) small; fewer
(b) small; greater
(c) large; fewer
(d) large; greater
14. The too-big-to–fail policy
(a) exacerbates moral hazard problems.
(b) puts large banks at a competitive disadvantage in attracting large deposits.
(c) treats large depositors of small banks inequitably when compared to depositors of large banks.
(d) does only (a) and (c) of the above.
15. The primary difference between the “payoff” and the “purchase and assumption” methods of
handling failed banks is that the FDIC
(a) guarantees all deposits, not just those under the $100,000 limit, when it uses the “payoff”
method.
(b) guarantees all deposits, not just those under the $100,000 limit, when it uses the “purchase and
assumption” method.
(c) is more likely to use the “payoff” method when the bank is large and it fears that depositor
losses may spur business bankruptcies and other bank failures.
(d) both (a) and (b) of the above.
(e) both (b) and (c) of the above.
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16. The primary difference between the “payoff” and the “purchase and assumption” methods of
handling failed banks is that the FDIC
(a) guarantees all deposits, not just those under the $100,000 limit, when it uses the “payoff”
method.
(b) guarantees all deposits, not just those under the $100,000 limit, when it uses the “purchase and
assumption” method.
(c) is less likely to use the “payoff” method when the bank is large and it fears that depositor losses
may spur business bankruptcies and other bank failures.
(d) both (a) and (b) of the above.
(e) both (b) and (c) of the above.
17. Regulators attempt to reduce the riskiness of banks’ asset portfolios by
(a) limiting the amount of loans in particular categories or to individual borrowers.
(b) prohibiting banks from holding risky assets such as common stocks.
(c) establishing a minimum interest rate floor that banks can earn on certain assets.
(d) doing all of the above.
(e) doing only (a) and (b) of the above.
18. One way for bank regulators to assure depositors that a bank is not taking on too much risk is to
require the bank to
(a) diversify its loan portfolio.
(b) reduce its equity capital.
(c) reduce the size of its loan portfolio.
(d) do both (a) and (b) of the above.
(e) do both (b) and (c) of the above.
19. Banks do not want to hold too much capital because
(a) they do not bear fully the costs of bank failures.
(b) higher returns on equity are earned when bank capital is smaller.
(c) higher capital levels attract the scrutiny of regulators.
(d) all of the above.
(e) only (a) and (b) of the above.
20. The increased integration of financial markets across countries and the need to make the playing
field equal for banks from different countries led to the Basel agreement to
(a) standardize bank capital requirements internationally.
(b) reduce, across the board, bank capital requirements in all countries.
(c) sever the link between risk and capital requirements.
(d) do all of the above.
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21. Under the Basel Plan,
(a) assets and off-balance sheet activities are assigned to various categories to reflect the degree of
credit risk.
(b) a bank’s total capital must equal or exceed 8 percent of total risk-adjusted assets.
(c) both of the above.
(d) none of the above.
22. Of the following assets, the one which has the highest capital requirement under the Basel Accord is
(a) municipal bonds.
(b) residential mortgages.
(c) commercial paper.
(d) securities issued by industrialized countries’ governments.
23. Which of the following is not true regarding the Basel 2 proposal to reform the original 1988 Basel
Accord?
(a) It attempts to link capital requirements more closely to actual risk by expanding the number of
risk categories.
(b) It focuses on assessing the quality of risk management in banking institutions.
(c) It attempts to improve market discipline by requiring increased disclosure of pertinent
information about banks.
(d) It has been well received by banks and national regulatory agencies.
24. Ways in which bank regulations reduce the adverse selection and moral hazard problems in banking
include
(a) a chartering process designed to prevent crooks from getting control of a bank.
(b) restrictions that prevent banks from acquiring certain risky assets, such as common stocks.
(c) high bank capital requirements to increase the cost of bank failure to the owners.
(d) all of the above.
(e) only (a) and (b) of the above.
25. The chartering process is especially designed to deal with the _________ problem, and regular bank
examinations help to reduce the _________ problem.
(a) adverse selection; adverse selection
(b) adverse selection; moral hazard
(c) moral hazard; adverse selection
(d) moral hazard; moral hazard
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26. The chartering process is especially designed to deal with the _________ problem, and restrictions
on asset holdings help to reduce the _________ problem.
(a) adverse selection; adverse selection
(b) adverse selection; moral hazard
(c) moral hazard; adverse selection
(d) moral hazard; moral hazard
27. Regular bank examinations and restrictions on asset holdings indirectly help to reduce the
_________ problem because, given fewer opportunities to take on risk, risk-prone entrepreneurs will
be discouraged from entering the banking industry.
(a) moral hazard
(b) adverse selection
(c) ex post shirking
(d) post-contractual opportunism
28. Regular bank examinations and restrictions on asset holdings indirectly help to _________ the
adverse selection problem because, given fewer opportunities to take on risk, risk-prone
entrepreneurs will be _________ from entering the banking industry.
(a) increase; encouraged
(b) increase; discouraged
(c) reduce; encouraged
(d) reduce; discouraged
29. The legislation that separated commercial banking from the securities industry is known as the
(a) National Bank Act.
(b) Federal Reserve Act.
(c) Glass-Steagall Act.
(d) McFadden Act.
30. The Depository Institutions Deregulation and Monetary Control Act of 1980
(a) approved NOW accounts nationwide.
(b) restricted the use of ATS accounts.
(c) imposed interest rate ceilings on bank loans.
(d) did all of the above.
31. The Depository Institutions Deregulation and Monetary Control Act of 1980
(a) approved NOW accounts nationwide.
(b) imposed uniform reserve requirements.
(c) mandated the phase out of interest rate ceilings on deposits.
(d) did all of the above.
(e) did only (a) and (b) of the above.
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32. As a way of stemming the decline in the number of savings and loans and mutual savings banks, the
Garn-St. Germain Act of 1982 allowed
(a) money market certificates.
(b) money market mutual funds.
(c) money market deposit accounts.
(d) negotiable order of withdrawal accounts.
33. An impact of the Garn-St. Germain Act of 1982 has been to
(a) put savings and loans at a competitive disadvantage.
(b) make the banking system more competitive.
(c) give money market mutual funds a competitive advantage.
(d) do both (a) and (b) of the above.
(e) do both (a) and (c) of the above.
34. Moral hazard and adverse selection problems increased in prominence in the 1980s
(a) as deregulation opened up more avenues for savings and loans and mutual savings banks to take
on more risk.
(b) following a burst of financial innovation in the 1970s and early 1980s that produced new
financial instruments and markets, thereby widening the scope for risk taking.
(c) following an increase in federal deposit insurance from $40,000 to $100,000.
(d) all of the above.
(e) only (a) and (b) of the above.
35. Moral hazard and adverse selection problems increased in prominence in the 1980s
(a) as deregulation opened up more avenues for savings and loans and mutual savings banks to take
on more risk.
(b) following a burst of financial innovation in the 1970s and early 1980s that produced new
financial instruments and markets, thereby widening the scope for risk taking.
(c) following a decrease in federal deposit insurance from $100,000 to $40,000.
(d) all of the above.
(e) only (a) and (b) of the above.
36. The Federal Deposit Insurance Corporation Improvement Act of 1991
(a) increased the FDIC’s ability to borrow from the Treasury to deal with failed banks.
(b) reduced the scope of deposit insurance in several ways.
(c) eliminated governmentally-administered deposit insurance.
(d) did only (a) and (b) of the above.
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37. The Federal Deposit Insurance Corporation Improvement Act of 1991
(a) reduced the scope of deposit insurance in several ways.
(b) eliminated restrictions on nationwide banking.
(c) allowed well-capitalized banks to do some securities underwriting.
(d) did only (a) and (b) of the above.
(e) did only (a) and (c) of the above.
38. The Federal Deposit Insurance Corporation Improvement Act of 1991
(a) reduced the scope of deposit insurance in several ways.
(b) limited the FDIC’s ability to use the “too-big-to–fail” policy.
(c) requires the FDIC to intervene earlier when a bank gets into trouble.
(d) did all of the above.
39. The Federal Deposit Insurance Corporation Improvement Act of 1991
(a) instructed the FDIC to come up with risk-based deposit insurance premiums.
(b) expanded the FDIC’s ability to use the “too-big-to–fail” policy.
(c) instructed the FDIC to wait longer before intervening when a bank gets into trouble.
(d) did all of the above.
40. Which of the following is least likely to accompany financial consolidation and the development of
large complex banking organizations?
(a) More financial institutions will be considered too big to fail.
(b) The government safety net will be extended to include nonbanking activities.
(c) Moral hazard problems will become less important.
(d) Banks will have greater incentives and opportunities to take on more risk.
41. What accounts for the problems facing China’s four largest banks?
(a) Large loans to inefficient state-owned enterprises
(b) Closing of unprofitable branches and laying off unproductive employees
(c) Selling shares in the bank overseas to raise capital
(d) All of the above
42. World Bank research on the effects of deposit insurance concludes that
(a) adoption of deposit insurance will promote stability and efficiency in the banking systems of
emerging-market economies.
(b) adoption of explicit government deposit insurance is associated with a higher incidence of
banking crises.
(c) adoption of deposit insurance has the greatest benefits in countries that have weaker institutional
environments.
(d) none of the above are true.
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◼ True/False
1. To understand banking regulation in the United States, it is helpful to understand the concepts of
asymmetric information, adverse selection, and moral hazard.
2. Because asymmetric information problems in the banking industry are a fact of life throughout the
world, bank regulation in other countries is similar to that in the United States.
3. The failure of one bank can hasten the failure of others in what is referred to as a contagion effect.
4. To be classified as a well-capitalized bank, a bank’s leverage ratio must exceed 8 percent.
5. Once a bank has been chartered, it is required to file periodic call reports that reveal the bank’s
assets and liabilities, income, ownership, and other details.
6. “Truth in lending” was mandated under the Consumer Protection Act of 1969 and requires all
lenders to reveal the annual percentage rate, or APR, on loans.
7. Probably the most important feature of FDICIA is its prompt corrective action provisions which
require the FDIC to intervene earlier and more vigorously when a bank gets into trouble.
8. According to some economists, Congress made a mistake when it passed the FDICIA of not
requiring the FDIC to assess risk-based insurance premiums.
9. The “too big to fail” policy reduces the adverse selection problem in bank regulation.
10. A better capitalized bank has more to lose when it fails and is les likely to take less risk.
11. When the payoff method is used to resolve a failed bank, both large and small depositors are
protected from suffering losses.
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◼ Essay
1. What do we learn about the causes of banking crises by comparing crises throughout the world to
those that have occurred in the United States?
2. What is the asymmetric information problem and how does it contribute to our understanding of the
structure of bank regulation in the United States and other countries?
3. Why did the United States experience a banking crisis in the 1980s?
4. How has bank regulation in the United States changed since the late 1980s? What accounts for these
changes?
5. How have bank capital requirements changed since the banking crisis of the 1980s? Explain.
6. Describe the CAMELS rating system used by bank examiners.
7. Why does the safety net created by deposit insurance increase the advere selection and moral hazard
problems in banking? How do bank regulations attempt to overcome these problems?