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Chapter 25: Problem 9

In a speech delivered in June 2008 , Timothy Geithner, then president of the Federal Reserve Bank of New York and later U.S. Treasury secretary, said: The structure of the financial system changed fundamentally during the boom.... [The] nonbank financial system grew to be very large.... [The] institutions in this parallel financial system [are] vulnerable to a classic type of run, but without the protections such as deposit insurance that the banking system has in place to reduce such risks. a. What did Geithner mean by the "nonbank financial system"? b. What is a "classic type of run," and why were institutions in the nonbank financial system vulnerable to such a run? c. Why would deposit insurance provide the banking system with protection against runs?

Short Answer

Expert verified
The nonbank financial system refers to financial institutions that are not regulated as banks but provide similar services. A classic type of run is when numerous depositors withdraw their money from an institution at the same time, fearing its insolvency- a vulnerability for nonbank institutions due to their lending and borrowing structure and lack of central bank funding. Deposit insurance protects against runs by guaranteeing a certain amount of deposits, increasing depositor confidence and reducing the likelihood of abrupt mass withdrawals.

Step by step solution

01

Understanding the Nonbank Financial System

The term 'nonbank financial system' refers to financial institutions that do not hold a banking license, yet are engaged in the business of loans and credit. These can include insurance companies, hedge funds, money market funds and private equity funds. They provide similar services to banks but under different regulatory oversight.
02

Defining and Applying a 'Classic Type of Run'

A 'classic type of run' in the financial realm refers to a situation where a large number of customers withdraw their deposits from a financial institution simultaneously, due to fears of the institution's insolvency. Nonbank financial institutions are vulnerable to such runs because they don't have access to central bank funding and because they lend long-term while borrowing short-term (maturity transformation).
03

Role of Deposit Insurance in Protecting Against Runs

Deposit insurance provides the banking system with protection against runs as it guarantees a certain amount of deposits even in case the bank fails. It increases confidence among depositors who then have less incentive to withdraw their funds abruptly and cause a run.

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