Question

A con artist has a great idea: he’ll open a bank without investing any capital and lend all the deposits at high-interest rates to real estate developers. If the real estate market booms, the loans will be repaid and he’ll make high profits. If the real estate market goes bust, the loans won’t be repaid and the bank will fail—but he will not lose any of his own wealth. How would modern bank regulation frustrate his scheme?

Short answer

To avoid such a problem created by bank owners, the regulators require bank owners to have assets more than the value of their deposits. Therefore, if the loans are unpaid, banks still have assets to cover and pay back to the depositors.

Step-by-step solution

Capital requirements 

The introduction of deposit insurance can give birth to a problem where bank owners may not invest capital and accept deposits. The banks might lend these deposited funds to risky investors; if such investors fail to pay the loan back, then by deposit insurance, the federal reserve or government needs to pay the depositor's money back. The bank owner bears no loss at all.

To avoid such problematic situations, the regulators came up with capital requirements. Under this, the bank owner needs to keep assets worth more than their total deposits. If some loans go bad, the bank's assets will cover them, and the government need not bear them. The excess of a bank's assets over their liabilities and net worth is the bank's capital. The bank's capital is required to be equal to 7% of the value of the bank's assets.