Essay Example on Reckless Driving, Moral Hazard, and Adverse Selection

Introduction

Moral hazard occurs when drivers with automobile collision insurance engage in reckless driving as the insurance company will pay a considerable amount for the repairs and damages in case of an accident (Mishkin & Eakins 419). An adverse selection may happen when reckless drivers insure their vehicles against accidents.

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Adverse Selection in Fire Insurance

Individuals who have a high likelihood of causing fire to their property either due to the nature of their work or for possible gain as they would acquire significant insurance policies, which causes adverse selection. Moral hazards may result from the individuals with fire insurance taking little or no measures to prevent fire hence increased incentive to take risks as the insurance company will meet the costs of damages caused.

FDIC and its Role in Promoting Economic Growth

FDIC promotes economic growth by ensuring that people make deposits which are used to give loans to those interested in making viable investments but lack adequate capital. In doing so, the financial institutions earn interest on the amount loaned, which is used to expand the service delivery of these institutions. Besides, the depositors receive a dividend, which is an addition to their income.

FDIC should apply "the purchase and assumption method," which entails getting a partner who is willing to take over the liabilities of the insolvent bank such that no depositor will lose their money, if I had $300,000 in the bank ((Mishkin & Eakins 418). The implication is that all deposits and liabilities are guaranteed without any limitations on the amount. For the payoff method, the bank would pay deposits up to $250,000 insurance limit and give 90 cents on the dollar for the amount above this limit, whereby the payment could take a long time to actualize. If my deposit were $200,000, I would still recommend the use of a purchase and assumption method.

Benefits and Costs of FDIC's Policies

The policy is beneficial in that it has made banking institutions viable as many depositors take their deposits to the bank without fear of losing them in case the bank becomes insolvent; hence, reducing bank failure. Attaining this requires that FDIC employs the purchase-and-assumption method to ensure that no creditor or depositor suffers a loss. Besides, it has lessened the bank panics that may result from the depositors having inadequate information regarding the quality of bank assets (Mishkin & Eakins 416). The cost is that the substantial financial institutions where they may engage in activities that attract high risks resulting in inefficiency and instabilities of the institutions hence bank failure. Non-bank financial institutions may also be enticed to this moral hazard.

"Off-balance-sheet activities" pose a problem because they cause financial institutions to engage in risky business, which entails the creation of returns from selling loans, which would augment the gains of the institutions but are never recorded (Mishkin & Eakins 422). For this reason, regulators execute the Basel Accord, which aids in lessening the uncertainties caused by these activities.

Deposit Insurance in Weak Institutional Environments

I would not recommend the adoption of deposit insurance in the United States in a country that has weak institutions, prevalent corruption, and ineffective regulation of the financial sector. In such a state, deposit insurance will result in a decrease in the stability of the industry. Besides, the deposit insurance will enhance retardation in the financial development of the nation as such a state lacks a stable institutional environment, which is vital for reducing moral hazard incentives that would prompt the banks to engage in risky activities.

Bank supervision entails close monitoring that enables in determining if institutions in the banking industry follow specified guidelines on capital and limitations on asset holdings, which is crucial in lessening moral hazard. The process takes the forms of "capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk." These forms are usually shortened to the acronym CAMELS. Besides, they promote a safe and sound banking system by undertaking the measures to modify the conduct of the institution or terminate its operations if its CAMEL ratings go low thus, making banks avoid moral hazards of taking high risks (Mishkin, and Eakins 423). Also, the supervision lessens adverse selection as reduction of chances for risk-taking, then entrepreneurs who love risks will resist venturing into the banking industry.

FDICIA Legislation and Corrective Actions

The FDICIA legislation of 1991 employed provisions that require the engagement of the government insurance policy on time and more active, especially after engaging in moral hazards (Mishkin & Eakins 423). According to the act, FDIC has to effect corrective actions for financial institutions such as limiting asset growth, submission of a capital restoration capital and seeking regulatory approval before developing new lines of business or opening new branches. In doing this, these institutions will lessen their engagement in risky activities as the insurance premiums will increase.

The increased technological advancements and innovation in banks have resulted in current instruments and markets that ease the making of quick and fast bets by the financial institutions and their staff. In doing so, the institution may get insolvent due to engaging in risky activities that make it trade in losses (Mishkin & Eakins 426). Risk management procedures are vital in reducing uncertainties in the banking industry.

If only one bank holds 70% of all deposits, it would be considered as too-big-to-fail due to the prevailing government safety net, which results in difficulties in financial regulation. Financial consolidation enhances this problem as a failure of the merged institutions may cause systemic risk to the financial system (Mishkin & Eakins 421). Besides, the government may have to widen its safety net and incorporate services like securities underwriting, real estate activities, and insurance.

Consumer Protection Regulations and Impact on Financial Institutions

Regulations on consumer protection ensure that borrowers have adequate information about the loans, and they restrict bias on lenders. Financial intermediaries may suffer losses if details of their missed chances and lending rich people are exposed to borrowers. Besides, a lack of prejudice may benefit them by attracting potential clients.

Yes. It will boost the productivity of banks and make the financial system healthy as financial institutions will aim at diversification of their loan portfolios and lessen moral hazards.

The banks would lower their level of moral hazard hence reducing the rate of bank failure as they would not engage in risky activities due to the high premiums, thus enhancing the economic performance of the country. More people will continue making deposits, which will be given to the lenders as loans, and the banks will earn interests.

Conclusion: Challenges and Impact of the Dodd-Frank Act of 2016

The Dodd-Frank Act of 2016 was quite a challenge. Lobbyists held that the new regulation had the potential of raising costs for the financial institutions resulting in a decline in their gains (Mishkin & Eakins 437). Besides, it has not dealt with the challenge of a too-big-to-fail problem as it does not address future regulation.

Work Cited

Mishkin, Frederic S., and Eakins, Stanley G. Financial Markets And Institutions. 9th ed., Pearson Education Inc., 2018, pp. 415-440.