W2

Question 1

Give 2 examples of narrow banking as a measure to bank runs.

Answer 1

Minimum reserves with the Central Bank

Liquidity Coverage Ratio (Basel III, HQLA / Total Net cash outflows over the next 30 days > 100%)

Question 2

What is the regulatory instrument used when a bank crisis suddenly occurs. It’s an “emergency tool”?

Answer 2

Suspension of convertibility

Question 3

Claim: empirically, banks tend to rise equity.

Answer 3

FALSE

Question 4

An alternative solution to moral hazard created by deposit insurance is to have a …

Answer 4

…deposit rate ceiling.

Question 5

A governmental institution (i.e. the Central Bank) can lend money to banks with liquidity problems but too hight will lead to …

Answer 5

…moral hazard

Question 6

A governmental institution (i.e. the Central Bank) can lend money to banks with liquidity problems but if int. rate is too low (cheap money) it will lead to …

Answer 6

…banks reducing their own capital as CB loans are cheaper!

Question 7

If one bank has liquidity problems, the others could lend to it (Interbank Market) but there are 2 problems:

Answer 7

1. Coordination/trust: if some banks refuse to lend, liquidity problems become solvency problems.
2. Systemic risk: Banks tend to all have problems at the same time.

Question 8

Interbank Market can solve bank runs only if…

Answer 8

▪ There is no systemic shortage of liquidity

▪ There is no crisis of confidence

▪ There is no solvency crisis (𝑅 as expected)

▪ Assets’ illiquidity does not increase (L as expected)

Question 9

Which crisis created the FED?

Answer 9

the Panic of 1907

Question 10

Which crisis lead to the creation of the Federal Deposit Insurance Corporation (FDIC)?

Answer 10

the Great depression of ‘29

Question 11

In a series of steps from late 70s to early 2000s, the Glass- Steagall act was repealed. Why?

Answer 11

1. Business found easier and easier to self-finance without intermediaries→lower returns from traditional banking
2. Investment banking in the meantime soared in returns
3. Some post-2008 new rules partially “repealed the repealing” (e.g., Volcker rule)
4. Current development is once again toward de-regulation

Question 12

Which crisis lead to the creation of the Basel Committee (1976)?

Answer 12

Bankhuis Herstatt (1974)

Question 13

What are some Amplification Mechanisms in a banking crisis?

Answer 13

Liquidity-driven crises: When market prices drop, banks need to sell assets to get cash. This selling pressure leads to further price drops, creating a cycle of more selling.

Market freezes: interbank markets freeze because banks become reluctant to lend to each other due to uncertainty about the health of other banks.

Coordination failures and runs: Banks and financial institutions can become fragile if there’s a lack of coordination among their creditors

Question 14

Countercyclical means…

Answer 14

counteracting the flactuations of the economics cycle.

Question 15

Countercyclical capital buffers are introduced to …

Answer 15

…smoothen the leverage cycle.

Question 16

Measures to address amplification mechanisms include…

Answer 16

1. extending deposit insurance,
2. changes in lending of last resort frameworks, and
3. the use of stress tests.

Question 17

Challenges in regulating systemic risk include …

Answer 17

…discouraging herding behavior and addressing the too-big-to-fail problem.

Question 18

What happens if the CB lends too high or too low interest rate?

Answer 18

Too high: moral hazard, they will increase risk

Too low: banks reduce own capital as CB loans are way cheaper to finance their capital

Question 19

Interbank markets can solve bank runs only if:

Answer 19

• there is not a systemic reduction in liquidity
• there is not a crisis of confidence
• there is not a solvency crisis

Question 20

‘Solutions’ for bank runs and its problems: Interbank market

Answer 20

Does not really solve the problem due to bank liquidity shortages

Question 21

‘Solutions’ for bank runs and its problems: Narrow banking

Answer 21

kills the positive effect of banking

Question 22

‘Solutions’ for bank runs and its problems: Deposit insurance

Answer 22

Distorted incentives for banks

Question 23

‘Solutions’ for bank runs and its problems: Lender of Last Resort

Answer 23

Distorted incentives for banks

Question 24

What are the pros and cons of separating commercial and investment banking:

Answer 24

Pro’s separation:
- investment banks use their own capital for proprietary trading (which is a risky type of trading)
- volatile securities are on the investment bank’s balance sheets, not commercial bank
- before, banks could sell their own securities to their own customers
- incentive for banks could push lemons to their retail customers if they wanted to get rid of them
- Before separation, you could create huge banks which were too big to fail. Due to TBTF and deposit insurance, moral hazard could exist
- Before, the a bank which is both a commercial and investment bank has excessive control of the credit market
- if a bank both originates loans and sells bonds to investors, you are either way (debt or equity) dependent on the bank for getting capital

Cons separation:
- a combined bank has more asset classes, and is thus more diversified
- combined banks can provide a full range of financial services
- a combined bank can give a loan to a firm and be one of the main shareholders of a
firm. So: banks are both lenders and shareholders, this mitigates conflict of interest
- combined banks have economies of scope, which results in cheaper banking