2.2 EU/UK reforms Flashcards
What is a balance sheet - how does it show how banks work?
Shows the balance of assets to liabilities
Assets include investments, liquid cash, loans, bonds and other debtors
Liabilities include deposit interest, capital and bonds
Say there is £10m in savings at a 5% interest rate - bank returns £500,000
SAy there is £9m in investment at 10% - bank receives £900k
Bank profits are 900,000
- Cash and reserves risk free
Bank capital - risky investments e.g. restaurants - first evaluate the chance of success, but keep bank capital in case of failure
Why are banks essential for the economy?
- Receive deposits, make loans
- Loans used to fiannce capital and business, leads to more deposits
- Banks keep a fraction of deposits on reserves -> providing liquidity to the economy
Providing liquidity - this leaves banks vulnerable as if everyone wants the money back this will be impossible
- If banks stop, the economy stops
What is the cpaital of a bank?
- Capital is its own funds: money loaned or invested minus all the money borrowed (assets - liabilities)
- Lending or investments depend on the capital a bank holds
- The more capital a bank has, the more losses it takes in case loans cannot be returned
What is bank instability?
During downturns:
- Capital eroded by loan losses
- Borrowers downgraded
- Banks require more capital, difficult in a downturn
- Banks cut back on lending, worsens the downturn
Liabilities of entire banking sector in the US is about 100% of US GDP - in the UK it is about 530%
- Banking sector in the EU is nearly 350% of EU GDP.
What is TBTF? What is the effect in Europe?
Moral hazard:
- Some banks TBTF and always saved by bailouts
Liabilities of some banks larger than the GDP of their home country
- If a big spanish bank fails, germany taxpayers liable to bail out spanish savers due to European Stability mechanism; creates conflict across countries
Europeam banks are too big for their individual sovereigns to protect credibly
- If an EU bank knows it is too big to fail and it will be protected, leads to excessive risk taking and weaker controls - moral hazard problem
- As a result, need for controls and regulation
What is the effect of the GFC today?
Taxpayers pay huge bill to keep banks afloat after crissi
- Increased uni fees
- reduced health provision
- Unemployment
- Reduction of public services
What was the housing bubble?
Housing bubble:
- Complex financial instruments and network effects (interconnected)
- Wrong incetives - moral hazard
- Underestimated risks
- Vulnerable financial system
Traditionally, banks handled mortgage process
- Didn’t lend money to risky borrowers
- Took full risk of default
- Had large reserves in case of defaults
To reduce risk, banks use the house itself as collateral - bank give out loans for mortgage, receive interest payment on mortgage
What were the effects of complex financial instruments and networks?
Complex financial instruments and network effects:
-Asset and mortgage backed securities - pooling mortgages and selling to investors through Special Purpose Vehicles - led to rise in diversification, fall in risk
- In theory, some loans less risky than others but on average the risk to loan is lower overall
- Risk packaging rather than holding - ultimately risk on investors
- In practice nobody technically holding risk of mortgage, as goes to investors
Credit agencies rated these instruments - credit agencies are paid by issuers, not investors
- Highest rates even for junk funds
Network effects:
- Investors throughout the world could invest in US mortgages and choose risk return combination
What was the effect of wrong incentives?
- Risk shifting problem
- Risk neutral investors can choose between safe assets and risky assets
- Investors tend to prefer safer asset. However, if investor needs to borrow funds at rate r, limited liability and choice of asset unobserved by lendon, investors may choose the risk asset - moral hazard problem - Moral hazard:
- Individual insured he may take greater risks if not insured:
- Limited liability: e.g. bank managers - huge salaries in good years and bank years even if bank loses money, leads to excessive risks
- Creditors did not watch over major banks, allowing large banks to fail
Underestimation of risk: housing bubble
- Banks complex instruments, diverse risks - rise of value of financial instruments and price of real estate
- Feedback loop and rating agencies - buyers/lenders convinced prices continue to rise, until unsustainable
As a result, prices gained intrinsic value - based off assumptions - difficult to accurately know
What was the great panic?
Financial system interconnected, too complex and vulnerable
- Housing price spread to other assets and the interbank market
Sep/Oct 2008 confidence fell - senior and super senior trancehs no longer perceived as safe
- Lehmann Brothers collapsed Sep 2008
- Unexpected and sudden freezing of entire securitisation and industry - credit crunch
What was the effect of contagion?
Contagion
- Bank failures, falling stock indexes and falling market value of equities
Savings moved to safety - rising money stock
Central banks in Europe and US - liquid injection into credit market and bailouts:
- Bought $2.5tn of government debt and private assets from banks.
- Raised capital of national banking systems by $1.5tn (new stock)
Summarise banks before GFC?
Banks undercapitalised
- Moral hazard problem even higher than before crisis - no consequence if lossess
- Risks hidden, financing chains complex
- Banks complacent, assumed marekts always work
Banks took high risks paid by citizens - needed financial regulation - creating supporting institutions and regulation to curb opportunistic and exessive risk taking
What were the banking reforms in 1988
Basel Reforms:
Prudential regulation of banks and cooperation on banking supervisory matter
- Decisions do not have legal force - recommendation based
Main goal was to reduce bank exposure to credit risk by holding enough capital:
- Capital adequacy ratio is the minimum capital a bank must keep in case there are losses from loans
The adequate capital for a bank as a percentage of its assets (losses banks take):
- Regulators risk weigh assets to calculate ratio
- Ignore safe investments (cash), consider risky ones e.g. loans from struggling companies.
What is the realtionshipi between capital and risk weighted assets?
8%
What are risk weighted assets:
- 0 % cash - home country debt
- 20% securitisation e.g. mortgage backed sucurities with highest credit rating
- 50% municipal revenue bondsl residential mortgages
- 100% most corporate debt
Many assets are very risky instead of low risk
What were the bankin reforrms in 2004?
Basel reforms:
Pillar 1:
- Minimum capital requirements for:
Credit risk (borrowers)
Operational risk (fraud, natural disasters)
Market risk (interest and exchange rates)
Pillar 2:
Supervisory review - models to determine own probability of default in case losses of given default - internal ratings based approahc
Pillar 3:
Disclosures - many assets risky, instead of low risk and internal calculation of risk weighted assets and internal supervisory review may generate wrong incentives
