Response to the following problem:
Why are FIs regulated?
Regulation of Financial Institutions
The preceding section showed that financial institutions provide various services to sectors of the economy. Failure to provide these services, or a breakdown in their efficient provision, can be costly to both the ultimate suppliers of funds and users of funds as well as to the economy overall. The financial crisis of the late 2000s is a prime example of how such a breakdown in the provision of financial services can cripple financial markets worldwide and bring the world economy into a deep recession. For example, bank failures may destroy household savings and at the same time restrict a firm's access to credit. Insurance company failures may leave household members totally exposed in old age to the cost of catastrophic illnesses and to sudden drops in income upon retirement. In addition, individual FI failures may create doubts in savers'minds regarding the stability and solvency of FIs and the financial system in general and cause panics and even withdrawal runs on sound institutions. Indeed, this possibility provided the reasoning in 2008 for an increase in the deposit insurance cap to $250,000 per person per bank. At this time, the Federal Deposit Insurance Corporation (FDIC) was more concerned about the possibility of contagious runs as a few major FIs (e.g., IndyMac and Washington Mutual) failed or nearly failed. The FDIC wanted to instill confidence in the banking system and made the change to avoid massive depositor runs from many of the troubled (and even safer) FIs, more FI failures, and an even larger collapse of the financial system.
FIs are regulated in an attempt to prevent these types of market failures and the costs they would impose on the economy and society at large. Although regulation may be socially beneficial, it also imposes private costs, or a regulatory burden, on individual FI owners and managers. Consequently, regulation is an attempt to enhance the social welfare benefits and mitigate the costs of the provision of FI services.