C H A P T E R 10 Economic Analysis of Financial Regulation LE A RNI NG OB JE CTI VE S After studying this chapter you should be able to explain bank regulation in the context of asymmetric information problems characterize how the CDIC handles failed banks and detail recent CDIC developments outline the banking crises that have occurred in Canada and other countries throughout the world PRE VI EW As we have seen in the previous chapters, the financial system is among the most heavily regulated sectors of the economy, and banks are among the most heavily regulated of financial institutions In this chapter we develop an economic analysis of why regulation of the financial system takes the form it does Unfortunately, the regulatory process may not always work very well, as evidenced by the recent subprime meltdown in the United States and other financial crises, not only in Canada but also in many countries throughout the world Here we also use our economic analysis of financial regulation to explain the worldwide crises in banking and how the regulatory system can be reformed to prevent future disasters ASYM ME TRI C I NF ORM ATI O N AN D FI N AN CIA L REG U LAT IO N In earlier chapters we have seen how asymmetric information, the fact that different parties in a financial contract not have the same information, leads to adverse selection and moral hazard problems that have an important impact on our financial system The concepts of asymmetric information, adverse selection, and moral hazard are especially useful in understanding why government has chosen the form of financial regulation we see in Canada and in other countries There are nine basic categories of financial regulation: the government safety net, restrictions on asset holdings, capital requirements, prompt corrective action, chartering and examination, assessment of risk management, disclosure requirements, consumer protection, and restrictions on competition 225