Question 1 1. An important issue that has arisen recently has been exactly what institution(s) the U.S. government should place in charge of regulating the nations banking system. To examine how having multiple regulators might (or might not) lead to bad outcomes, we have considered a simple model of competition among bank regulators

.a. (11points) Suppose that a bank with fixed deposits can either (i) take an action a0to allocate those funds to holding assets that yield a return > 1 with probability p0or a return -< -1 with probability 1-p0or (ii) take an action a1to allocate those funds to holding assets that yield a return 1 with probability p1or a return -1 with probability 1-p1. The relationship between the probabilities associated with the two actions is p0< < p1. What are the expected returns associated with each action? Are they positive or negative? If deposit insurance protects the banks depositors from experiencing any losses and p0> p1, which action will the bank choose? Explain briefly but fully. Write words and sentences.

b. (11points) Draw a rough diagram in which , the deposit insurance premium, is measured along the horizontal axis and , the probability that any given bank will be examined by the regulators staff, is measured along the vertical axis. Assume that the deposit insurer/regulator knows that all banks are of the same type. Explain in words the shape of both the budget constraint faced by the regulator and the shape of the incentive-compatibility constraint. What is the efficient point on the diagram, and why is this so? Explain briefly but fully. Write words and sentences. (Hint: If you really want to do so, you can use algebra to assist, but none is necessary.)

c. (11points) Draw a rough diagram in which two bank regulators that have no deposit insurance responsibilities operate with different unconsolidated budget constraints. Explain why, if both regulators desire to maintain clienteles of banks to regulate, a regulatory race to the bottom could take place. Along the way, be sure to explain the meanings of the ideas of unconsolidated and race to the bottom. Explain briefly but fully. Write words and sentences.