Question

9. Why is the bank sector a possible source of instability in the economy? Explain how the incentives of the owners of banks act to increase this instability. How can banking regulation reduce this problem?

Answer 1

A fall in house prices can cause a negative wealth effect – householders see a decline in their net worth, leading to lower confidence and less spending. It can also cause financial losses for banks. Banks starts to lose money on failed mortgage payments. This leads to economic instability.
At the time of instability, the incentives being given to the owners further adds to the problem.
Banking regulations can reduce this problem by freezing certain minimum amount and by cutting off incentives, etc.