Econ of Banking and Finance Flashcards
(94 cards)
1
Q
What are the three types of banks?
A
Commercial banks, investment banks, universal banks
2
Q
What are the advantages of universal banking?
A
- Economies of scale
- Economies of scope
- Risk diversification
3
Q
What are the disadvantages of universal banks? Which are specifically related to policy?
A
-Potential conflict of interest
- Management more difficult
- Use funding protected by deposit insurance (policy)
- Bank may become ‘too big to fail’ = costly bailout (policy)
4
Q
What is one way to resolve the conflict of interest of universal banks?
A
Banks build a reputation for only issuing good securities, which is valuable for the bank.
5
Q
What is fee income share?
A
Share of non-interest income in total operating income, can be used as a proxy for w (weight of investment banking activities)
6
Q
What are the indexes of bank returns and bank risks?
A
- ROA = pre-tax profits / assets
- Z-score = [E(ROA) + Bank equity/Assets] / SD ROA, interpreted as the number of SDs that return on assets has to fall below expectation for the bank to become insolvent.
7
Q
Which banks have the lowest Z-score?
A
Banks with fee income shares close to 1, so investment banks.
8
Q
What are the main empirical conclusions regarding universal banks with regards to their choice of allocation of investment and commercial banking activities?
A
- Investment banking tends to increase expected returns
- Some small share of investment banking activity in total banking activity may reduce risk
- It is optimal for investment banking models to be allowed, but regulation may be necessary to limit risk.
9
Q
What are capital requirements? What is the capital ratio?
A
The capital requirement is a minimum amount of capital or equity which a bank should have. The capital ratio is Equity/Assets = lambda. The capital requirement imposes minimum level of lambda.
10
Q
What is the purpose of capital requirements?
A
- Reduce risk-taking behaviour by banks
- Reduce probability of bank failure for bank liability holders, bank lending customers and public treasure as bailout may be costly.
11
Q
What is the point of international capital adequacy standards?
A
- Eliminate international competition in the area of capital regulation, particularly eliminating competitive reductions in standards to gain market share.
- Reduce compliance costs for banks
- Reduce incentives for banks to engage in international regulatory arbitrage by relocating
- Make it easier to compare banks internationally
12
Q
What is a risk based capital ratio? What do the weights reflect?
A
The nominator is a measure of capital and the denominator is a measure of risk-weighted assets. Weights reflects how risky assets are, there is a clear bias towards gov finance, showing that politics are important in banking regulation.
13
Q
What is regulatory capital arbitrage?
A
Banks may rebalance their assets to have have low-risk assets on paper but that are actually riskier in practice (think of mortgage VS blue chip company). This means that capital requirements decrease while risk actually increased.
14
Q
What are the three pillars of Basel II
A
- More sophisticated calculation of RCBR by taking into account more risks
- Guidelines for bank supervision to assess bank risks not accounted for by Pillar 1
- Public disclosure requirements for banks
15
Q
What is Value at Risk (VAR)?
A
The minimum k such that P(L >k) < 1 -q. In other words, k is the minimum value such that the probability of higher losses than k is equal or less than 1 - q. Where 1 -q is the probability of ‘high’ losses, and implies the level of risk tolerance
16
Q
What were the main changes from Basel II to Basel III?
A
- Higher quality capital and higher minimum capital ratios under Pillar 1
- Additional risks considered
- Introduction of a leverage requirement
- Additional disclosure requirements
- New liquidity requirements
17
Q
How are capital requirements privately costly for banks?
A
- Lower interest tax deductibility
- Lower implicit subsidies through reduced prospect of bailout in case of failure
18
Q
What are the social costs/benefits of higher capital requirements?
A
- They lead to higher loan interests, lower loan growth and GDP growth.
- Reduction in the probability of a crisis in a year multiplied by the average cost of a crisis if it occurs.
19
Q
What is Tobin’s q? What does it measure?
A
- q = market value of bank assets / book value of bank assets
- It measure whether assets are over or under valued. If q <1, then assets are overvalued.
20
Q
What is the purpose of deposit insurance?
A
- Reduce the probability of bank failure, reduce cost of bank failure.
21
Q
What makes banks fragile?
A
- Short-term debt (susceptible to bank runs)
- Average maturity of assets tends to be larger than the average maturity of liabilities
- Fire sales (sell assets quickly at a lower place to become liquid)
- Small proportion of cash relative to assets
- High leverage
22
Q
What are ex post and ex ante deposit insurace premiums?
A
- Ex ante is regular insurance premium
- Ex post is that banks who survived have to pay for banks that went under
23
Q
What is market discipline?
A
- Market discipline exists if the cost of bank funding reflects the riskiness of bank’s assets portfolio; if so, it potentially constrains a bank risk tanking.
24
Q
How does deposit insurance potentially undermine market discipline? Which paper showed this?
A
It makes deposit interest rate in theory less dependent on bank risk. (low interest rate could be offered even when banks take high risk, making the bank potentially act recklessly). ‘Market discipline and deposit insurance” (JME,2004)
25
How does deposit insurance affect bank stability ?
Ambigous:
- Prevents bank runs
BUT
- Reduces market discipline
26
How can the effect of explicit deposit insurance on the probability of a crisis be mitigated?
With a higher quality of supervision, which prevents banks from taking excessively risky strategies.
27
What incentive do TBTF institutions have?
Incentive to take on more risk (moral hazard), incentive to become too large and complex
28
How does TBTF affect competition?
It distorts competition. It allows TBTF firms to gain market share and additional profits at the expense of smaller firms that are not TBTF.
29
What was testified in September 1984?
The Controller of the Currency testified before congress that some banks were simply TBTF, and that total liability insurance would be provided for those. This would apply to the 11 largest banks.
30
What are the positive wealth effects for TBTF banks?
- Liabilities are riskless, reducing cost of funds, allowing banks to take more risks
31
How do O'Hara and Shaw investigate wealth effects? What do they find?
They investigate the effect of the controller of the currency's announcement on the returns of TBTFs. They find that al bank experienced returns above market average the following day. More specifically, the 10 largest and insolvent banks gained, while in a group of 53 smaller banks, the larger and insolvent ones lost.
32
What characteristics matter in determining the excess returns of banks?
- Size measured as a log of assets
- Solvency ratio
33
What is the solvency ratio?
((nonperforming assets + latin American debt) / book value of SE) x 100
34
How can the subsidy on TBTF banks be measured?
- Measure of subsidy used by Ueda and Weder di Mauro, it measures reductions in interest cost of bank bonds that occurs because bank can obtain state support in case of distress. It is measured by first looking at how credit rating depends on a variable that represents likelihood of state support. Then, a greater likelihood of support should give rise to better credit rating, calculate change in credit rating if state support is increased from small to high, translate change in credit rating into change in interest rate on bank liabilities.
35
How can TBTF disproportionate positive effects be corrected with taxes?
Impose a tax on bank liabilities equal to the subsidy that would take away the advantage of TBTF institutions, this is called a bank levy (tax on liabilities). The tax base would be the bank liabilities minus the insured deposits.
36
What else could be done to prevent TBTF banks?
- Higher capital requirements
- Force large banks to split up or downsize
- Use merger policy to prevent large banks from emerging (Dodd-Frank Act)
37
What is the difference between TBTF and TBTS?
TBTF means that bank creative large negative externalities, but the government is able to bail them out. TBTS means that banks creative large negative externalities but the government is not able to bail them out. In practice since the 2008-09 crisis, banks may have become TBTS.
38
What empirical evidence is there for banks being TBTF/TBTS?
Study by Demirguc-Kunt and Huizinga (JBF, 2013). Log of assets and relative bank size (L/GDP) were used as a measure of size. Market value of equity relative to book value of equity, and credit default swaps used to measure the impact on shareholders and liability holders respectively. They then regressed these two measures on the measures of size + controls in separate regressions. They found evidence that banks are TBTS. This indicates that banks have grown too large, and specifically to large for the interest of shareholders.
39
What are some reasons for banks growing too large?
- Executive compensation increases with size
- Prestige and power of banks executive rise with size
- This suggests that it is a problem of corporate governance (agency proeblem)
40
What is the key issue with respect to international banks?
Countries may have lower incentives to bail out international banks than purely domestic banks, affecting the operations of international banks.
41
What financial functions do large financial conglomerates combine? What incentives to banks have to become G-SIBS?
i) banks
ii) securities firms
iii) insurance
Economies of scale and scope, attempt to become TBTF.
42
What are the main regulatory models of international banks?
- Complete integration as a universal bank (combines underwriting, banking and insurance)
- Parent bank with non-bank operating subsidiaries in the areas of underwriting and insurance
- Holding company with bank and non bank affiliates in the areas of banking, underwriting and insurance (most common in US)
43
How does corporate complexity affect financial stability and safety?
- Potential conflict of interests:
1. International exchange of relevant info (withheld by one regulator)
2. Time of intervention (principal VS domestic)
3. Which country's laws and proceedings to use?
4. Contrasting views of wether a bank is systematically important or not internationally
5. Who pays for bailout?
44
What is the problem with recapitalisation in an international setting?
Under provision, (coordination problem) domestic cost may exceed domestic benefits, even if overall benefits are bigger than costs.
45
What does Freixas (2003) find?
Recapitalisation and no recapitalisation can both be equilibria.
46
What do Betray, Demirguc-Kunt and Huizinga (2016) explore?
Do international banks face a higher cost of fund? (because of less certainty of bailout)
They regresses the ratio of interest expenses/interest bearing liabilities on different controls.
They find that more international banks face higher costs of funds, consistent with expectations. This effect is less strong at times of higher world GDP growth, and stronger in countries experiencing a fiscal deficit.
Overall we can conclude that depositors exercise market discipline especially on international banks.
47
How should financial sector taxation be according to the IMF report of 2010?
Fair: beneficiaries of previous bailouts should pay more
Efficient: not endangering the current economy
48
How did taxpayer money support banks in 2007-09?
- Capital injections
- Lending to banks by treasuries
- Asset purchases and protection schemes
- Guarantees of bank liabilities
- Provision of liquidity
- Expanded deposit insurance
49
How is taxation an alternative to regulation?
- In perfect textbook world, regulation and taxation can be equivalent (just set t such that banks choose a given capital asset ratio)
BUT
- If regulation is not accompanied by lump sum taxation, then buffer is accumulated in banking sector not public sector.
- taxation regime allows banks wider room to respond (think of short term investment opportunities)
- Regulation can be made dependent on soft information, but provides more discretion and gives rise to regulatory capture.
50
What are the available tax instruments?
- Bank levies: cover net fiscal cost of financial support and discourage risk taking. However this could also lead to moral hazard. The base of the levy would be a balance sheet measure, such as a measure of liabilities.Equity, insured deposits should be excluded from tax base. The tax base could also be the risky component of funding.
- Financial transaction taxes: tax on the value of trades (raise revenue and reduce speculative trading). BUT this is not good because there is no clear relationship between trading volume and need to rely on safety net. Does not take into account risk. Could also be easy to avoid this tax through financial engineering, incidence is unclear.
- Financial activities tax: tax base is the sum of profits and labor remuneration of banks (kinda like a VAT). This tax does not exist yet (hard to assess effect). But it would raise a lot of revenue while being not that distortionary, it would also reduce the size of the banking sector.
51
What do Huizinga, Voget and Wagner (2014) explore?
Impact of corporate income tax on banking, exploiting the large international variations in it. This is used as an indication of FAT effects.
They find that banks subject to taxation pass it on to consumers. They find that taxation is highly distortionary, as it reduces tax activity sharply in cause of international double taxation. This could provide evidence that FAT would significantly reduce financial activity (incidence mostly on customers).
52
What has accelerated integration between financial markets and banks led to?
- Deregulation and taxation have increased competition among banks both domestically and internationally
- Competition between banks and the financial market has also increased.
53
How are banks and financial markets intertwined?
- Through instruments such underwriting and securitisation
- This creates potential conflict of interests
- These were particularly exposed during the 2007 and 2008 crisis
54
How do banks as information intermediaries?
- Banks specialise in monitoring and evaluating borrowers, overcoming information asymmetries.
- Qualitative asset transformation: banks invest in illiquid, risky loans with liquid, risk-less demandable deposits.
- This makes banks essential for credit allocation but vulnerable to liquidity shocks.
55
Why are banks better than markets at solving informational asymmetries?
- Closer proximity and better information to borrowers
- Borrowers may reveal proprietary information to banks but not to the market
- Banks have better incentive to invest into information acquisition and a banking relationship
56
What is the difference between relationship banking and market borrowing?
-Relationship banking: contractual flexibility, discretionary contracts ex ante leave room for ex post adjustments. Timely intervention, bank can call back loan when it i sufficiently high priority.
- Market borrowing: More severe information asymmetries, bondholders are more disperse, thus they are ill-suited for an early intervention.
57
What is the effect of competition on relationship banking?
- Borrowers are more prone to switching banks, so there is less of an incentive to invest in the relationship
- Competition may also increase relationship orientation, as it may be seen as a competitive edge
- More competition does not eliminate relationship banking, it just adapts it.
58
How do banks and markets compete with/complement each other?
- Compete at the expense of each other (US = more market, EU = more banks).
- Presence of prioritised bank debt is also valuable for bondholders.
59
How do banks create liquidity and how are they fragile?
- Banks make loans (illiquid), and finance them with highly liquid deposits. This creates liquidity in the economy.
- However, this exposes banks to withdrawal risk and become fragile.
60
What are the main implications of bank/markets integration?
- Harder to isolate banking risk from financial markets risk (banks are more and more involved in it)
- Bail out of uninsured investors increases moral hazard
61
What are the reasons for banks being increasingly involved in securitization?
- For originators: raise funding, reduce financing costs, diversify sources of financing.
- For investors: pooling of assets results in risk diversification
62
What were the lessons of the financial crisis in the context of securitisation?
- Over-reliance on credit ratings
-Increasing opacity and difficulty to valuate
63
How have bank capital/assets ratios evolved between 1847 and 2001? What can this trend be attributed to?
- Capital assets ratios have been steadily declining
- This reflects the increasing leverage of banks (more debt is used to finance assets)
- This same trend was not present for non-financial capital ratios
- This is due to moral hazard (implicit and explicit guarantees), perverse incentives of taking more risk and reducing bank capital, bond holders have no incentive in monitoring and disciplining the bank, short term bonus-schemes.
64
What are the two components of market discipline?
Flannery argues that it has two components:
- Monitoring: if investors accurately monitor their bank's condition, prices and liability choices will accurately reflect that market information
- Influencing: investors' reactions to bank's credit developments must influence how the firms behaves.
65
What were the main components of Basel I?
- Risk Based Capital Requirements (weighted by risk)
- Also capital requirements for off balance sheet exposures
66
What is contingent capital?
- Bonds that mandatorily convert into equity if necessary
- They offload some burden from the taxpayer as they raise capital.
67
What are resolution schemes and PCA? What does PCA provide?
It establishes capital/asset zones:
- Above 10%: limited supervision
- Below 10%: greater supervision and requirement to submit business plan
- Below 8%: Direct monitoring and supervision
- Below 2%: take over and restructure bank
PCA provides legal basis for intervention and resolution. This could be harder for global banks, but they could be forced to draw up 'wills'.
68
How can compensation schemes be changed to encourage less risky behaviour?
- Long term compensation instead of short term
- Claw back clauses (claim bonus back if risk rematirialises)
- Encourage stability focused culture.
69
What were the main problems with Basel II?
- Complexity and regulatory burden
- Too much reliance on self-regulation (Benink's view) --> Bank could abuse/manipulate their risk models
- Failed at raising regulatory capital
- Too much focus on the single institution (micro prudential instead of macro)
- Pro-cyclicality
- No focus on bank liquidity
70
What were the main innovations of Basel III?
- Capital Adequacy: establishing countercyclical buffers, increasing quantity + transparency of banks capital base (focus on tier 1 capital)
- Liquidity rules: introduction of minimum international liquidity standards (liquidity was not managed properly during the crisis). 30 day stress resilience (liquid coverage ratio). Promote long time stability by requiring banks to fund activities with more stable sources of funding (net stable funding ratio).
- Leverage Ratio: minimum Tier 1 leverage ratio of 3% of non-risk based assets.
- Additional capital charges fro SIBs (up to 3.5% RWA) to be met with Tier 1 only.
71
What is Tier 1 capital? What is additional Tier 1 capital?
-Shares, retained earnings plus items such as stock surplus.
- Contingent capital instruments classified as liabilities but having principal cost absorption (conversion to common shares, write-down mechanism)
72
What is tier 2 capital?
Subordinated to depositors and general creditors, minimum five year maturity, can only be replaced by the same or better quality capital.
73
Assess Basel III Capital Requirements
- Complexity and supervisory burden is not reduced
- Capital levels are raised but most likely not enough
- Leverage ratio should play a more central role (15% proposed by Beninnk and Benston (2005))
- Market discipline is not credible due to limited allowance for use of contingent capital.
74
What is Systemic risk characterised by?
-High correlation and clustering of failures across institutions
- One failure triggers another
75
Which type of shocks can systemic risk originate from?
- Macro shock: an event having an effect on the entire financial system (e.g. ECB raises interest rates)
- Micro shock: 1. The probability that the failure of one bank causes the failure of others. 2. Spillover from an exogenous external shock which does not involve direct causation
76
What are the main impacts of banking crises?
- Loss of confidence in the payment system
- Pressure on fiscal deficits, public debt and domestic interest rates
- Reduction in market discipline (if banks are rescued)
- Reduction in bank credit and higher interest rates
- Worsening of information and adverse selection
- Constraints on the ability to raise interest rates
77
What is the early history of banking crises?
- 10 yearly recurrence in 19th century
- Exceptional stability post WW2, due to high economic growth and regulations that restricted banking competition
- Later, regulations became unsustainable due to communication tech and financial innovation
- This liberalisation of the system combined with increasingly volatile macroeconomic conditions resulted in return of banking crises.
78
What is the root cause of crises?
- Bad banking and bad policies:
1. New instruments lead to excessive risk taking without considering down side
2. Liberalisation can lead to bank failure in countries with weaker governance and information institutions
3. More competition = dangerous
79
What is the role of over-optimism?
1. Dynamic instability in widely held
expectations about macroeconomic and business prospects has played a major role in many systemic banking crises
2. Disaster myopia
3. 'As long as the music plays you have to get up and dance'- Chuck Prince (Citigroup CEO 2007)
80
What happened in Norway, Sweden and Finland in 1980s-90s?
- Deregulation (regulatory balance sheet restraints) induced a more competitive and efficient banking system --> rapid raise of asset and real estate prices
- Nordics moved into a recession, with a combination of tight monetary policy many banks had to be rescued
81
What happened to Japan in the 1990s?
- Real estate bubble burst in early 90s
- No sense of urgency and public resistance to use tax payer money
82
What happened in East Asia 1997?
- Thailand floated the Baht after failing to protect the currency from speculative attack
- The following economic collapse also spread to South Korea and Indonesia
- Sharp contractions in GDP and bank failures
-
83
How did the EU zone cause moral hazard?
- Created perception of guarantee and bail outs
- German bond perceived about as risky as a Greek bond
- Minister of finance had an incentive to reduce Germany's anchor role
84
How did the EU arrive to the 2007 crisis?
- Violation of the Growth and Stability Pact with no consequences (shows weakness)
- High budget deficits and debt levels
- Lack of enforcement of structural reforms
- All this put EU in a weak position bty 2007
85
What was created at the Eurozone council of 29 June 2012?
- Permanent European rescue fund, called European stability mechanism (ESM), which replaced the European financial stability facility (EFSF)
- Still interest rates of Italy and Spain peaked shortly after (July)
86
What did Draghi announce on 26th July 2012?
- 'Whatever it takes to preserve the euro'
- Later introduced OMT- scheme to buy the bonds of countries in ESM --> lead to reduction in interest rates in problem countries
87
What are the pillars/main components of the European banking union?
- Single supervisory mechanism (SSM)
- Single resolution mechanism (SRM)
- Deposit guarantees schemes (DGS)
- Higher capital and liquidity requirements
88
What is the SSM?
- ECB acts as a direct supervisor to banks with more than 30B assets, ECB has power to require banks to take remedial action
- Active involvement of international supervisors in SSM
89
What is the SRM?
-Bank recovery and resolution directory (BRRD), this includes a bail-in debt mechanism and a requirement for banks to draw up living wills.
- Established harmonised procedures for the restructuring of banks (also BRRD)
- SRM also introduced the single resolution board
- Build-up of single resolution fund
90
What are DGS?
- Relies on the existing networks of national DGSW
91
What are the main 'solutions' the ECB took part in since 2012?
- Stronger enforcement of structural economic reforms
- Urgent action needed to prevent a deflationary spiral
- Jan 2015, QE of 1140bn
- March 2020 Pandemic Emergency Purchase Program
- July 2020 Pan-european Corona rescue fund
92
What is the Draghi report?
- Draghi advocated for massive investments (5% of GDP) such as:
Digitalise and decarbonise the economy
Radical change to become more productive
- Dependencies on other countries have become weaknesses
- Missed out on the digital revolution
93
How does Draghi suggest to raise the funds for investments?
- Private sector will not be able to do it alone, EU needs to be willing to reform itself to increase productivity. Use joint-funding
- Also advocates for the advancement of capital markets unions instead of banks
94
What were the recent new rules for economic governance?
- Make governance simpler, put more emphasis on medium term plans, and impose stricter enforcement.
