Week 8: Lectures 14-15 - Banking Reforms Flashcards
(26 cards)
Why are banks essential for the economy?
- Banks receive deposits and make loans
- Loans are used to finance entrepreneurs or buy goods or expand businesses
- Banks keep only a fraction of deposits as reserves in order to provide liquidity to the economy
- If banks stop the economy stops
What does how much a bank chooses to lend or invest depend on?
- Lend or invest depends on the capital a bank holds
- The more capital a bank has, the more losses it can take in case loans cannot be returned
What happens to banks in a downturn?
- Banks’ capital is eroded by loan losses
- Banks now require more capital which is difficult to source in a downturn
- Banks are forced to cut back on their lending which worsens the downturn
What was the housing bubble in 2007?
The 2007 housing bubble was a period of rapid and unsustainable growth in real estate prices, ultimately leading to a crisis when the bubble burst
What three main reasons are used to explain why the 2007 housing bubble crisis ocurred?
1- Complex financial instruments + Network effects (interconnection)
2- Wrong incentives (moral hazard)
3- Underestimation of risks
What is the main reason as to why the 2007 housing bubble crisis ocurred?
- Traditionally banks used to handle the whole mortgage process (writing the loans, collecting payments and holding them in portfolios to maturity)
- This meant they took the full risk of default
Explain why the 2007 housing bubble crisis occurred in terms of complex financial instruments and network effects
- Banks used asset backed securities which involved them pooling several mortgages and selling them to investors through Special Purpose Vehicles (SPVs) which reduced the bank’s risk
- The banks resorting to risk packaging rather than risk holding meant the risk was passed onto ultimate investors which led to the risk-shifting problem
- Network effects: Investors throughout the world could invest in US mortgages & choose their return-risk combination
Explain why the 2007 housing bubble crisis occurred in terms of wrong incentives and moral hazard
- Moral hazard is the idea that when an individual is insured they may take greater risks than if they are not insured
- Bank managers had huge salaries in good years and good salaries in bad years even if the bank lost money therefore this led to them taking excessive risks
Explain why the 2007 housing bubble crisis occurred in terms of underestimation of risks
- Banks created complex instruments and diversified risks which led to the increase in value of financial instruments and the prices of real estate
- Buyers and sellers underestimated the fact that rising prices would eventually lead to the bubble bursting
Explain the event of the ‘Great panic’ after the bubble had burst
- The financial system became interconnected in complex ways increasing vulnerability
- Housing prices decreased and this spread to other assets as well
- Confidence vanished
- There was an unexpected and sudden freezing of the entire securitization industry
Explain the effects on Europe of the 2007 housing bubble crisis and the policies that were used to alleviate the effects
- In Europe there were bank failures, decreases in stock indexes and market values of equities
- Central Banks in Europe and US imposed a liquidity injection into the credit and bailouts
- This involved buying $2.5 trillion of government debt and raising the capital of their national banking systems by $1.5 trillion
Explain the problems of Too big to fail (TBTF) banks
- The liabilities (debts) of some TBTF banks are larger than the GDP of their home country
- If an EU bank knows that it is too big to fail then in the case of excessive turndown it will be subsidized by the leading to excessive risk taking by the bank (Moral Hazard problem)
- Hence we need controls and regulations for TBTF banks
Explain who the Basel reforms were carried out by in response to the 2007 housing bubble crisis
- The Basel reforms were carried out by the Basel Committee on Banking supervision (BCBS)
- They oversee prudential regulation of banks and cooperation on banking supervisory matter
- The BCBS is not a supranational authority. Its decisions do not have legal force, they only make recommendations on banking laws and regulations
What is the main goal of the Basel Committee of Banking Supervision (BCBS)?
- The main goal of the BCBS is to reduce bank exposure to credit risk by holding enough capital using the capital adequacy ratio
- The capital adequacy ratio is the minimum capital a bank must keep in case of losses from their loans
What was the limit on the losses that banks could take set by the Basel reforms
The losses a bank can take are equal to the adequate capital for a bank as a percentage of its assets
What are today’s consequences of the financial crisis?
Taxpayers have paid a huge bill to keep banks afloat after the financial crisis including:
- University fees
- Reductions in public health provision
- Unemployment
- Reductions of public services
Explain the first stage of the Basel reforms (Basel 1 -1988)
The relationship between capital and risk-weighted assets for banks had to be 8%
Explain the index of risk-weighted assets
- Cash and home country debt had a risk weighting of 0%
- Securitisations such as mortgage-backed securities (MBS) with the highest AAA ratings had a risk weighting of 20%
- Municipal revenue bonds and residential mortgages had a risk weighting of 50%
- Most corporate debt had a risk weighting of 100%
Explain the second stage of the Basel reforms (Basel 2 - 2004)
- The first pillar was to establish minimum capital requirements for credit risk (borrowers), operational risk (fraud, theft of information and natural disasters), and market risk (changes in interest rates, exchange rates)
- The second pillar was the establishment of supervisory review. Banks were required to use models to determine their own probability of default and in case the losses they would occur due to a given default
- The third pillar involved disclosures in that banks were now required to disclose any underlying problems
Explain the third stage of the Basel reforms (Basel 3 - 2019)
- Risk weightings became more cautious from 2019
- Banks were required to have a minimum capital level of 7% with buffers
- This buffer meant that in crisis, banks were allowed to let their capital ratio drop temporarily to 4.5% and were not allowed to pay any bonuses or dividends until this ratio returned to 7%
What are some potential problems of the third stage of the Basel reforms (Basel 3 - 2019)
The minimum capital requirements might not reduce risks in crisis times
What are the aims of the third stage of the Basel reforms (Basel 3 - 2019)
The aims are to induce banks to do the following in order to meet the new capital rules:
- Issue new shares
- No dividends
- Reduce lending and risky investments
Explain the role of the Financial Policy Committee after the 2007 housing crisis
- Financial Policy Committee (FPC) identifies and monitors risks in the financial system
- FPC is part of the monetary policy
committee of the bank
Explain the role of the Prudential Regulation Authority (PRA) after the 2007 housing crisis
The Prudential Regulation Authority (PRA) is responsible for prudential regulation and supervision of banks, building
societies, credit unions, insurers and major investment firms
