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The ____ allowed chartered banks to own investment banking subsidiaries.
A) Bank of Canada Act
B) Financial Institutions and Deposit Insurance System Amendment Act
C) Bank Holding Company Act
D) Monetary Control Act
Answer: B
Diff: 1 Type: MC Page Ref: 223
Skill: Recall
Objective List: 10.1 Explain bank regulation in the context of asymmetric information problems
The government safety net creates both an adverse selection problem and a moral hazard
problem. Explain.
Answer: The adverse selection problem occurs because risk-loving individuals might view the
banking system as a wonderful opportunity to use other peoples' funds knowing that those funds
are protected. The moral hazard problem comes about because depositors will not impose
discipline on the banks since their funds are protected and the banks knowing this will be
tempted to take on more risk than they would otherwise.
Diff: 2 Type: SA Page Ref: 213
Skill: Recall
Objective List: 10.1 Explain bank regulation in the context of asymmetric information problems
Banking regulation suffers from the principal-agent problem. Describe how this problem
relates to regulators and politicians.
Answer: Taxpayers are the principals, and regulators and politicians are the agents. Regulators
want to escape blame for poor performance, so they have incentives to loosen capital
requirements and practice forbearance, the opposite of what they should do. Regulators must also
please politicians, who in turn receive contributions from the banks being regulated. Thus,
politicians may pressure regulators to practice forbearance, and fail to address problems if
resolving problems conflicts with their personal interests.
Diff: 2 Type: SA Page Ref: 221 - 222
Skill: Recall
Objective List: 10.1 Explain bank regulation in the context of asymmetric information problems
What is the "too-big-to-fail" policy of the CDIC? how is it associated with asymmetric
information problems?
Answer: Students must explain that because the failure of a very large bank makes it more likely
that a major financial disruption may occur, bank regulators are usually reluctant to allow a big
bank to fail and cause losses to its depositors. Thus, the too-big-to-fail policy increases the moral
hazard incentives of big banks as they know that they can take more risk as the CDIC will try
and save them in case they encounter difficulties, instead of using the alternative payoff method
according to which depositors are paid only up to $100,000 for their deposits in the event that the
bank fails.
Diff: 2 Type: SA Page Ref: 213
Skill: Recall
Objective List: 10.1 Explain bank regulation in the context of asymmetric information problems