Chap 26

220 CHAPTER 10
F. Financial Regulation, Deregulation, and Innovation
1. Depository institutions face two types of regulations: deposit insurance and balance sheet
rules.
2. Deposits at banks, S&Ls, savings banks, and credit unions are insured by the Federal
Deposit Insurance Corporation (FDIC).
a) This insurance guarantees deposits of up to $100,000.
b) Banks benefit from deposit insurance because the risk of a bank run is minimized.
c) This guarantee gives depository institutions the incentive to make risky loans because
the depositors believe their funds to be perfectly safe; because of this incentive balance
sheet regulations have been established.
3. There are four main balance sheet rules:
a) Equity capital requirements — regulations setting the minimum amount of the owners’
financial wealth that must be at stake in the depository institution.
b) Reserve requirements — rules listing the minimum percentages of deposits that must be
held in currency or in other safe assets.
c) Deposit rules — restrictions on the type of deposits that an intermediary may accept.
d) Lending rules — restrictions on the type and size of loans that can be made by a
depository institution.
G. Deregulation in the 1980s and 1990s
1. The 1980s were marked by considerable financial deregulation, when federal legislation and
rule changes lifted many of the restrictions on depository institutions, removing many of
the distinctions between banks and others, and strengthening the control of the Federal
Reserve over the system.
2. In 1994 the Riegle-Neal Interstate Banking and Branching Efficiency Act was passed, which
permits U.S. banks to establish branches in any state. It led to a wave of mergers.
H. Financial Innovation
1. The 1980s and 1990s have been marked by financial innovation—the development of
new financial products aimed at lowering the cost of making loans or at raising the return
on lending.
2. Financial innovation occurred for three reasons:
a) The economic environment, especially of the 1980s, featured high inflation and high
interest rates, which created risk for intermediaries. Some innovations, such as variable
rate mortgages, were aimed at lowering this risk.
b) Massive technological change, especially reductions in the cost of computing and longdistance
communication, brought other innovations.
c) Much innovation was directed at avoiding regulation.
I. Deregulation, Innovation, and Money
The combination of deregulation and innovation has produced large changes in the composition
of money, both M1 and M2.
III. How Banks Create Money
A. Reserves: Actual and Required
1. The fraction of a bank’s total deposits held as reserves is the reserve ratio.