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Week 9 - Regulation & Central Banking Flashcards

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1
Q

Are bank runs rational or irrational?

A

They begin irrationally, then become rational

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2
Q

What is one consequence of a bank run?

A

Fire sales depress asset prices, especially if multiple banks face runs at the same time

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3
Q

What types of assets are worst affected by fire sales and why?

A

Opaque/illiquid assets like ABSs & CDOs, because they’re difficult to value

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4
Q

What was a major factor in the failure of Lehman Brothers?

A

Fire sales of ABSs & CDOs

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5
Q

How can bank runs be mitigated?

A

Deposit insurance

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6
Q

What is a limitation of deposit insurance?

A

Only covers up to set amount - most valuable depositors still run

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7
Q

Why are bank runs an even more serious risk today?

A

Online banking = rapid withdrawals

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8
Q

Why doesn’t regulation seek to eliminate risk?

A

Risk transfer is a key function & source of profit for FIs

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9
Q

What is the aim of regulation?

A

To stabilise the banking system by protecting public confidence, which prevents runs

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10
Q

What is the difference between regulation & supervision?

A
  • Regulation = establish rules
  • Supervision (monitoring) = verifies compliance
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11
Q

What are the types of banking regulation?

A
  1. Macro-prudential
  2. Micro-prudential
  3. Conduct-of-business
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12
Q

What is the purpose of macro-prudential regulation?

A
  • Combat moral hazard
  • Internalise costs to reduce system risk
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13
Q

What effect did the GFC have on banking regulation?

A

Revealed micro-prudential was inadequate – macro is needed too

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14
Q

How does macro-prudential regulation work?

A

It creates a financial safety net system to ensure a country’s financial stability & minimise risk of banking crisis

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15
Q

What does macro-prudential regulation involve?

A

Three pillars:
1. Deposit insurance
2. Lender of last resort
3. Resolutions laws / cooperation & resolution process

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16
Q

What is an example of deposit insurance in action?

A

When SVB had its run in ‘23, the Fed removed upper limit, which was expensive but somewhat effective

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17
Q

What is the drawback of deposit insurance?

A

Creates moral hazard so must be saved for emergencies

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18
Q

What is the purpose of resolutions laws / cooperation & resolution process?

A

Allow inefficient banks to exit the market in an orderly way

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19
Q

What is the purpose of micro-prudential regulation?

A

Control liquidity, solvency & riskiness of individual financial institutions

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20
Q

What is micro-prudential regulation concerned with?

A
  1. Asset quality (NPL) – are banks allocating funds efficiently?
  2. Capital adequacy (min capital requirements) – are banks capitalised enough to cover risks?
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21
Q

How did micro-prudential regulation change in response to GFC?

A

Become less focused on liability side (e.g. diversified deposits)

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22
Q

What is one benefit of micro-prudential regulation?

A

Reduces information asymmetry – helps customers judge safety & soundness

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23
Q

Is bank capital regulation macro- or micro-prudential?

A

Micro

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24
Q

What is the main focus of conduct-of-business regulation?

A

Mandatory information disclosure to customers

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25
What are some secondary concerns of conduct-of-business regulation?
1. Honesty & integrity 2. Competence 3. Fair business practices 4. Marketing
26
What are the limitations of regulation in general?
1. Moral hazard 2. False confidence 3. Innovations like securitisation / regulatory arbitrage 4. Compliance costs -> cost to customers
27
How does regulation benefit markets?
Creates trust
28
What does FSA stand for?
Financial Services Authority
29
What was unique about the FSA?
Handled all regulation for all UK FIs – innovative / efficient
30
How did UK regulation change after the GFC?
FSA replaced with Twin Peaks system
31
What are the 'twin peaks'?
PRA + FCA + FPC
32
What does PRA stand for?
Prudential Regulation Authority
33
What does FCA stand for?
Financial Conduct Authority
34
What does FPC stand for?
Financial Policy Committee
35
What does the PRA do?
Micro-prudential regulation for large banks & insurers
36
What does the FCA do?
- Micro-prudential regulation for smaller firms - Conduct-of-business regulation for all FIs
37
What does the FPC do?
- Macro-prudential regulation (monitors + responds to systemic risks) - Part of the Bank of England
38
What is the EU's financial regulation system?
ESFS (European System of Financial Supervision)
39
What does ESFS include?
1. ESMA (Securities & Markets Authority) 2. EBA (Banking Authority) 3. EIOPA (Insurance & Occupational Pension Authority) 4. ESRB (Systemic Risk Board)
40
What is another name for bank capital regulation?
Basel regulation
41
What is Basel regulation?
Risk-based micro-prudential regulation focusing on capital adequacy
42
Where does Basel regulation come from?
The Basel Committee on Banking Supervision
43
When & why was the Basel Committee set up?
80s, in response to globalisation, to prevent "race to the bottom"
44
What is the aim of the Basel Committee?
- Improve banking supervision worldwide - Provide "level playing field" for banks to compete internationally
45
How can emerging economies legitimise themselves?
First pass Basel I regulations into law, then II and III
46
What is the starting point of Basel regulation?
The riskier the asset, the greater the cushion of capital funds required to avoid insolvency
47
What are the basic forms of capital adequacy?
1. Minimum capital requirements in proportion to risk 2. Non-risk-based leverage ratio
48
What is the rationale for regulating non-risk-based leverage ratio?
Risk modelling leaves space for manipulation
49
What credit risk classes are included in Basel I?
- 0% - 20% - 50% - 100%
50
Under Basel I, what on-balance-sheet assets carry 0% assumed potential losses?
- Cash (& equivalents) - OECD government bonds
51
Under Basel I, what off-balance-sheet assets carry 0% assumed potential losses?
- Unused portion of loan commitments
52
Under Basel I, what on-balance-sheet assets carry 20% assumed potential losses?
- Short-term claims maturing within a year - Bonds issues by agencies of OECD governments
53
Under Basel I, what off-balance-sheet assets carry 20% assumed potential losses?
- Letters of credit
54
Under Basel I, what on-balance-sheet assets carry 50% assumed potential losses?
- Mortgages
55
Under Basel I, what off-balance-sheet assets carry 50% assumed potential losses?
- Revolving facilities
56
Under Basel I, what on-balance-sheet assets carry 100% assumed potential losses?
- Commercial loans - Non-OECD bank/government debts
57
Under Basel I, what off-balance-sheet assets carry 100% assumed potential losses?
- Standby letter of credit
58
Under Basel regulation, what is the minimum RAR?
8%
59
How is RAR calculated?
eligible capital / risk-weighted assets
60
What does RAR stand for?
Risk-asset ratio
61
How are risk-weighted assets calculated?
assets x risk weight
62
What capital regulated was introduced after the GFC?
Basel III
63
What characterises Basel III?
- Beyond credit risk (market, operational, liquidity etc.) - More risk classes – sensitivity - Refined methodologies to assess risk weights, using rating agencies & internal models - Broad definition of eligible capital
64
True or false: liquidity was not regulated before the GFC
True
65
What does LCR stand for?
Liquidity coverage ratio
66
What does LCR require?
High-quality liquid assets to cover net cash outflows over 30-day stress period
67
What does NSFR stand for?
Net stable funding ratio
68
What is NSFR?
Requires appropriate sources of stable funding for long-term liquidity
69
What does a '30 day stress period' involve?
No access to interbank market or central bank lending
70
What is a 'stable funding source'?
Core deposit business
71
What is a central bank?
Financial institution which oversees a nation's monetary systems
72
What is a central bank's aim?
Fostering economic & financial stability
73
What are a central bank's main functions?
1. Control issue of legal tender 2. Direct & indirect control of credit, liquidity & money created by FIs 3. LOLR to prevent crises 4. Government's banker 5. Official agent for FX matters & gold
74
What does LOLR stand for?
Lender of last resort
75
What is legal tender?
Notes & coins
76
Is LOLR micro- or macro-regulatory?
Macro – prevents financial panics/crises
77
How does LOLR avoid moral hazard?
Limited to solvent banks with good collateral
78
What is monetary policy?
Macro-economic policy conerned with availability & cost of credit (interest rates)
79
How does monetary policy work?
Influences rates, inflation & credit availability by changing supply of money (liquidity)
80
What are some monetary policy tools?
- OMOs - Discount window - Reserve requirements
81
What are OMOs?
Open market operations
82
How do OMOs work?
- Sell government securities -> credit/money supply decreases - Buy government securities -> credit/money supply increases
83
What is the discount window?
Interest paid on banks' deposits with the central bank
84
How does the discount window work?
- High discount rate: banks deposit more, lend less - Low discount rate: banks deposit less, lend more
85
How do reserve requirements work?
- High RRR: less funds available to banks - Low RRR: more funds available to banks
86
What is quantitative easing?
Buying private assets from FIs to directly inject money into economy

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