During the Great Depression, the American people were convinced that the FDIC wa
ID: 1163507 • Letter: D
Question
During the Great Depression, the American people were convinced that the FDIC was a necessary regulatory institution. The opponents of the FDIC claim that the institution creates a moral hazard. Briefly explain what FDIC is and the function it performs for the banking system. Then explain how it creates a moral hazard. Now suppose a world without deposit insurance, what are some of the mechanisms that would arise to “punish” bank managers who acted irresponsibly? Now think about how the likelihood of a major economic depression would change if federal deposit insurance were eliminated. Explain. During the Great Depression, the American people were convinced that the FDIC was a necessary regulatory institution. The opponents of the FDIC claim that the institution creates a moral hazard. Briefly explain what FDIC is and the function it performs for the banking system. Then explain how it creates a moral hazard. Now suppose a world without deposit insurance, what are some of the mechanisms that would arise to “punish” bank managers who acted irresponsibly? Now think about how the likelihood of a major economic depression would change if federal deposit insurance were eliminated. Explain.Explanation / Answer
The US financial services are the most regulated industry and many authorities supervise and regulate the US economy. Among these, FDIC is an independent body created by Congress to maintain stability and confidence in the financial sector via insuring deposits and supervising financial deposits. The main task was to maintain stability in the banking system and to protect the interest of depositors.
The advantage of deposit insurance is that it protects small depositors as they lack the expertise to assess the risk associated or performance of individual banks. The small depositors are better off in the sense that deposited assets are insured against illiquidity of the holding bank. Without deposit insurance, banks borrow money from depositors but have to pay a risk premium
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