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Interconnectedness has been an important source of market failures, leading to the recent financial crisis. Large financial institutions tend to have similar exposures and thus exert externalities on each other through various mechanisms. Regulators have responded by putting in place more regulations with many layers of regulatory complexity, leading to ambiguity and market manipulation. Mispricing risk in complex models and the arbitrage opportunities through the regulatory loopholes have provided incentives for certain activities to be more concentrated in the regulated entities and for other activities to leave the banking into new shadow banking areas. How can we design an effective regulatory framework that would perfectly rule out bank runs and TBTF and to do so without introducing incentives for financial firms to take excessive risk? It is important for financial regulations to be coordinated across regulatory entities and jurisdictions and for financial regulations to be forward looking, rather than aiming to address problems of the past.

The crisis demonstrated that microprudential regulation focusing on the risks taken by individual banks is not sufficient to prevent crises. This is because it ignores systemic risk. Six types of systemic risk are identified, namely: (i) panics – banking crises due to multiple equilibria; (ii) banking crises due to asset price falls; (iii) contagion; (iv) financial architecture; (v) foreign exchange mismatches in the banking system; (vi) behavioral effects from Knightian uncertainty. We focus on the first three as they are arguably the main causes of the 2007–9 crisis and consider regulatory and other policies to counteract them.

In September 2007, Northern Rock—the fifth largest mortgage lender in the United Kingdom—experienced an old-fashioned bank run, the first bank run in the U.K. since the collapse of City of Glasgow Bank in 1878. The run had been contained by the government’s announcement that it would guarantee all deposits in Northern Rock. This paper analyzes spillover effects during the Northern Rock episode and shows that both the bank run and the subsequent bailout announcement had significant effects on the rest of the U.K. banking system, as measured by abnormal returns on the stock prices of banks. The paper also shows that the effects were a rational response by investors to market news about the liability side of banks’ balance sheets. In particular, banks that rely on funding from wholesale markets were significantly affected, a result consistent with the drying up of liquidity in wholesale markets and the record-high levels of the London Interbank Offered Rate (LIBOR) during the crisis.

Banks have been involved with and regulated by governments for hundreds of years. Following a brief review of this history, I delineate nine reasons that could justify continued regulation, particularly in the United States. These include deposit insurance, preventing banks from obtaining excessive economic power, reducing the cost of individual bank insolvency, avoiding the effects of bank failures on the economy, protecting the payments system, serving the interests of popularly elected officials, enhancing the Federal Reserve's control over the money supply, suppressing competition, and protecting consumers. Analysis of each leads me to conclude that deposit insurance, which allows banks to hold insufficient capital, is the only public-policy-justifiable rationale for regulation. This concern can be managed with capital requirements; otherwise, banks should only be regulated as are other corporations.

This paper examines the impact of ownership structure and changes in the deposit insurance system on the market for bank time deposits in Poland. In an environment of less restrictive bank supervision and a deposit insurance policy that favored state banks, we find that depositors exacted a price for risk-taking. After a new law increasing insurance coverage for private banks went into effect, however, bank specific variables became less important in explaining differences in deposit interest rates. We report, however, that the three fully guaranteed state banks pay significantly lower rates than private banks. Moreover, other state-owned banks, with the same explicit guarantee as private banks, pay significantly lower rates than private banks, so it appears that depositors treat these state-owned banks as if they have a larger implicit guarantee.

Previous studies investigating the stock market reaction to U.S. bank failures rejected the bank run or domino hypothesis. However, if providing relevant bank information to the public is crucial to preventing bank panics, Japanese banks with limited disclosure are more vulnerable to bank runs than their U.S. counterparts. In this paper, I investigate the stock market reaction to Hyogo Bank's liquidation on August 30, 1995, which was the first bank liquidation in Japan and placed the financial burden on the general public. I find that stock market participants distinguished solvent banks from problematic banks. That is, my results, supporting the informational effect hypothesis, suggest that it is questionable even in Japan for the government to bail out an insolvent bank based on the potential risk of bank runs.

This article examines a bank's optimal capital structure and risk-taking decisions in a regulated environment. We focus on the interactive nature of the Fed's collateralized discount window lending and the FDIC's deposit insurance. Such regulatory interactions are shown to have nonlinear and nonuniform impacts on the bank's leverage and risk-taking decisions. Thus, bank moral hazard problems may persist, even when banks are charged risk-adjusted deposit insurance premia and are also subject to market discipline through subordinate debt. Our analysis yields several new policy implications about the design and pricing of bank regulations.

Resort to bank suspension is generally viewed as an unacceptable means for coping with bank panics, in part because suspension is assumed to involve unacceptably high welfare costs. In Diamond and Dybvig (1983), suspension is costly because it interferes with agents' welfare-maximizing consumption plans. Here a modified version of the Diamond-Dybvig model is used to show how suspension may have only minor welfare costs so long as bank debt is transactable and can serve as a medium of exchange.

Capital has two basic meanings that are not interchangeable, which gives rise to much confusion. Capital can refer to assets, such as plant and equipment. It also refers to the other side of the balance sheet, to claims over the assets. In banking, "capital adequacy" usually refers to stockholders' equity, although for purposes of deposit insurance, debt claims that are not guaranteed, de jure or de facto, by a federal government agency also should be considered. Indeed, as is shown below, such debt claims are superior in several important ways to equity capital. When people say that "banks a are overcapitalized" or"there is too much capital in the banking industry," they could be referring to the asset or the liability side of the balance sheet. If their concern is with the asset side, they would be calling for mergers of banks that would reduce physical plant size, loans, and investments. If they mean the equity and nongovernment insured debt portion of the liability side, they would be claiming that the federal deposit insurance agency (hereafter, the FDIC 2) is not sufficiently subject to risk, either from the point of view of the owners of banks or for social purposes (e.g., to offset externalities from bank runs or to optimize the quantity of bank money and financial intermediation). If they mean only the equity portion of the liability side of the balance sheet, they could mean that the bank should hold more debt that is de facto as well as de jure uninsured (usually called subordinated debentures) in the same sense that nonbanks are said to have suboptimal debt/equity ratios. 3 One reason that the two concepts might be confused is that they are related, as the assets in which a bank invests and regulatory restraints on these investments are important determinants of the cost of debt and equity capital. For example, laws and regulations that prevent banks from diversifying their assets efficiently increase risk and the cost of equity capital. Underpriced federal deposit insurance gives rise to an intangible asset, the deposit insurance put option. This linkage might be the source of some confusion. In the balance of the article, I first consider capital as assets and then capital as equity and uninsured debt. Capital here and throughout the paper is assumed to reflect well economic market values. As presently reported, capital is an accounting construct that often badly measures market or current values of assets and liabilities. Although a thorough discussion of market value accounting for banks is beyond the scope of this article

If banks were allowed to engage in securities activities, it is feared that the federal “safety net”-deposit insurance, the Fed's role as lender-of-last resort, and government intervention to prevent financial crises-might be strained, and possibly broken as banks' risk taking increased. An analysis of methods of controlling risk taking and bankers' present ability and propensity to take risks leads to a contrary conclusion. Nevertheless, the concern has given rise to a considerable body of empirical work. Studies on bank failures, risk-return profiles, cash flows, and profits and losses from underwriting are reviewed critically. On the whole, both the empirical and theoretical analyses provide little reason for concern about the federal safety net.