The financial sector and crises - Bank behavior, cycles and crises - Bank behavior and the macro-economy

9 important questions on The financial sector and crises - Bank behavior, cycles and crises - Bank behavior and the macro-economy

Explain why banks are a special case for policymakers

1. The economy depends on the continuous provision of core banking services.
2. Problems in one bank spill over to fears about the functioning of the banking system as a whole (contagion).

Why is the bankruptcy of a bank a problem for public policy in a way that is not for a company in another industry?

The expectation that governments are likely to step in to bail out a failing bank in order to prevent the disruptive effects on the economy of a bank failure.

Describe the trade-off for policymakers when a bank is bankrupt

On the one hand, the need to maintain the continuity of core banking services (otherwise potentially a catastrophic negative demand shock).
On the other hand, the need to avoid moral hazard.
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Describe an important market failure in bank behavior

When an individual bank makes commercial decisions, it does not take into account the effect of its decisions on overall risk in the financial system, and of the costs to the economy of a financial crisis that might ensue.

How could a policymaker mitigate the market failure in bank behavior?

Impose capital regulation as a method of inducing the bank to take on less risk (and thereby to operate closer to the socially optimal level)

What are the activities of banks?

1. The provision of core banking services including mortgage lending.
2. Engagement in the creation and trading of financial assets and of contracts based on assets (derivatives)

Definition of a retail bank

Engages in traditional banking activity. Its core business is deposit taking, payment services and lending.

Definition of a universal bank

Bank that combines the activities of a retail and an investment bank

Definition of the shadow banking system

Shadow banks engage in credit intermediation and although they are often related to banks, they are not covered by banking regulation.

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