Quiz 9: Governments Role in Banking


The process by which cash, checks, and electronic payments flow from buyers to seller is called payment system. Most transactions are followed by on banking system, credit cards, debit cards are the electric payment system. The government supervises the banks on payment system, because there should not have any problems making payments to one another by banks. The government plays a key role in payment system in banks; it helps the payment system work well in bank during the instances of bank run. At the bank run, the banks have to provide more money, and in this situation, majority of the banks become out of cash; therefore, the government (Federal Bank) helps as a lender of last resort. A well-functioning payment system provides benefits to the banks because it decreases their costs the government gives helps to clear in timely and efficient manner. Thus, banks will follow the government systems for payments. The banks give a guaranty for the payments on their deposits at a risk factor.

According to the government's rules banks have to deposit a said amount in the Fed accounts. This savings would help banks in financial crisis. The banks, which need amount, would receive from Fed banks from their respective accounts. These transactions cost more to the banks due to the role of government. Apart from this, government makes few policies that protect the interest of depositors and borrowers of banks. For this banks have follow some procedures, which costs more to banks. Banks usually make profit by allowing loans to customer at higher rates for example 8%. These banks accept deposits only at 4% to 6%. The spread between accepting deposits and making loans are the profit to the banks.

If large banks fail in the process the Fed banking authorities do not let it fall unlike the small banks. Here the banking authorities or the federal bank provides loans to large bank to keep on. Because, large bank failure causes shortage of liquidity, and furthermore, stock prices will decline sharply. Here the authorities will agree to merge a weak bank with a stronger bank. In addition, if the bank fails then FDIC will take an action as fallows i.e. they undertake pay off or purchase and assumption. In the payoff transaction FDIC closes the bank, sells the assets, first pays to the insured depositors. Later it pays off to creditors if funds remain. In purchase and assumption transaction the FDIC, find a bank purchaser to sell. Moreover, give the good assets to the buyers and assumes transaction. The FDIC keeps pen and give the loans assistance transaction, means the stockholder loss their stake while the depositor and creditors will not lose. Furthermore, FDIC will get losses. Thus, in purchase and assumption transaction government has to absorb some losses.