4.4 The financial sector Flashcards
What is the stock market
Enabling the buying and selling of shares on listed stock
markets. Firms can use stock markets to issue more shares and raise
finance.
What is the bond market
This involves buying and selling government bonds, to
fund public sector borrowing. As well as government bonds, there are
also private sector bond markets for firms.
What is commercial banking
Offering firms the chance to save and borrow for
investment.
What is a personal bank
Offering individuals the opportunity to save and
borrow
What are money markets
means for lenders and borrowers to meet their short term financial needs.
· Assets bought and sold usually have a maximum maturity of a year (24 hours-365 days) and are easily convertible into cash.
What are the main roles of financial markets
- Saving - gain interest through bonds/bank to transfer spending power to future
- Lending –> fund investment
- Facilitate the Exchange of Goods - creation of a payments system
-
Reducing Risk –> enables companies to hedge (swaps, forwards, options)
e.g. Forward Market in Commodities -
Shares –> raising finance for investment
e.g. Eurotunnel financed by selling shares to investors
What is the money supply
money supply measures the total amount of money in the economy at a particular time. It includes actual notes and coins and also any deposits which can be quickly converted into cash.
What is M0 to M4
M0 = This is the level of notes and coins in circulation + banks operational balances at the Bank of England. (This is the most liquid form of money)
· M4 = This is notes and coins in circulation plus private sector deposits in banks and building societies.
How do you increase the money supply
· Print more money
· Quantitative easing – electronic creation of money by Central Banks
· Increased bank lending – banks lending higher % of their deposits
* Central Bank purchasing bonds from private individuals which can be spent.
What are financial markets
where financial assets (eg loans) or securities (stocks/bonds/treasury bills) are traded.
What are capital markets
Shares and bonds are issued to raise medium and long term financing for both firms and government
divided into the primary market, newly issued, and the secondary market, second-hand securities
What is the foreign exchange market
market in which different currencies are bought and sold.
traded on either the spot market (immediate exchange) or the forward market.
What is the relationship between the price of a bond and the yield
there is an inverse relationship between the price of the bond and the interest, it is the coupon that remains fixed.
What are the main functions of Commercial Banks (High Street Banks)
· Accepting deposits
· Lending to economic agents
Providing efficient means of payment (bills etc)
Provide foreign currency
Offer other functions-give advice, insurance etc.
Banking is private, what does this imply
· Need to be profitable to provide a return for shareholders
· There needs to be certain level of liquidity to meet the needs of depositors
· There is a balance that needs to be found between liquidity and profitability
What is the balance sheet of a Commercial Bank
Assets - cash, balances at the BofE, Loans (advances), securities (e.g. bonds), fixed assets
Liabilities - customer deposits, money owed to bond holders, money owed to other banks
How do banks create credit
When a bank makes a loan, for example to someone taking out a mortgage to buy a house, or a business taking out a loan to finance their expansion it credits their bank account with a bank deposit of the size of the loan/mortgage.
At that moment, new money is created.
’ Bank making loans and consumers repaying them are the most significant ways in which bank desposits are created and destroyed in the modern ecnonomy’
What are the benefits of a bank attracting fresh deposits
- By attracting new deposits, the bank can increase its lending without running down its reserves.
- Longer-term savings deposits therefore typically offer a higher rate of interest for savers, a reward for the inconvenience of sacrificing some of their liquidity
What are the limits to money creation by commercial banks
- Market forces – the scale of profitable lending opportunities
- Regulatory policies e.g. capital reserve requirements
- Behaviour of consumers and businesses e.g. decisions about how much debt to repay
- Monetary policy - level of policy interest rates influences the aggregate demand for loans
Evaluate the role of banks
- Banks are not the only source of finance, may turn to private investors, stock market, government grants or personal savings
- In times of recession, banks may not be willing to lend e.g. 2008
- Poorest consumers often do not have access to bank account
What are Bank Stress Tests
- Put in after 2008, test the liqudity and capital of a bank in simulations of an ecnomic crisis
Banks that fail stress test mistake steps to rebuild capital reserves
EU stress tests cover 70% of banking institutions,US Banks with over 50 billion pounds or more in assets are required to undergo
What are the criticisms of Bank Stress Tests
- Stress tests are over-demanding, and require too much capital
- Thus there is an under provision of credit to the private sector; which many argue led to the relatively slow pace of economic recovery after 2008
- Timing is hard to know making banks overly cautious during normal fluctuations
What is a Hedge Fund and it’s goal
- Pool contributed to by a limited number of partners and operated by a professional managers
- Only open to qualified investors ( over a million net wealth or annual income over 200,000)
- Common goal is market direction neutrality; make money despite market fluctuations
What is the structure of a hedgefund and what is the issue with this structure
- 2 and 20 fee structure: gives the hedge fund manager 2% of the assets and an incentive fee of 20% of the profits each year
- But even if the hedge fund loses money, the manager get sa good amount ( moral hazard )
What are the type of Hedgefunds
1) Macro hedge funds try to maximise on changes in macroeconomic variables; biggest busts and highly leveraged
2) Equity hedge funds is maintying ‘long’ positios in stocks you own and ‘short’ positions in stocks you don’t tha you believe will decrease
3) Relative value arbitrage hedge fund buy securities that are expected to appreciate while simultaneously shorting a similar security that is expected to depreciate in value
4) Distressed hedge fund help companies turn themselves around by buying some of the securities in hopes they will appreciate
What is a building society
a mutual organisation; all elligible customers are known as members
· They have rights to vote and speak at meetings
· Each member always has one vote and there is a board of directors
· Societies have no shareholders requiring dividens; allowing lower costs, cheaper mortgages, better interest rates
· Building societies have a limit on what proportion of their funds that building societies can raises from the wholesale money markets ( can only raise 30%)
What makes the longer length of a bond give it a higher yield
Longer length of the bond makes it more risky as there can be more factors ( raising IR value, default)
e.g. SVB collapse from purchasing longer length bonds for a higher yield
What is a bond default
- Occurs when an issuer fails to make an interest payment or pincipal payment
- usually a last resort and is often solved by restructuring
- In case of coporate bands the bondowner usually recieves a compensation, in a high yield market the avergae recovery rate from 19577-2011 was 42%
How do distressed debt investors utilise defaulted bonds
- When bonds default they continue to trade as sharply reduced prices, attracting distressed debt investors who believe they will be able to recover more than the disperal of the company’s assets than the price of the bond reflects
In the 42 year period till 2011 how many AAA rated municipal and coporate bonds paid out interest and principal
- In the 42 year period through 2011, 100% of AAA rated municipal bonds paid alll of the epexcted interest and principal payments
From 1920-2009, only 0.9% of AAA rated coporate bonds default
What are derivatives
Financial securities with a value that is reliant upon an underlying assert or a group of assets
- Derivatives can be used to hedge, speculate or give leverage
What is the difference between over the counter (OTC) derivatives and exchange based
- Over the counter derivatives have counterparty risks - the danger that one of the parties involved in the transaction might default; this is private and unregulated
Exchange based derivatives are standardised and heavily regulated
What are futures
- Agreement between 2 parties for the purchase and delivery of an asset at an agreed upon price at a future date; obliged to fufill
- Can undwide (sell) before expiration
- Requires Margin Payments
- Market has high liquidity; exchange based
What are forwards
- Only over the counter; greatter counterparty risk but customised
- Parties in a forward contract can offset their position with counterparties
- To reverse you have to go to same counterparty who has monopoly over you
- No margin required
What are swaps
- Used to exchange one kind of cash flow with another e.g. interest rate swap to switch from variable to fixed
- Swaps can also be used to exchange currency exchange rate risk or the risk of default on a loan
- swaps on the cash flow and the potential defaults of mortgage bonds led to the counterparty risk that caused the credit crisis of 2008
What are options
- Similar to futures to but buyer has no obligation to exercise the agreement
- Options are used to hedge or speculate on future prices
- Investors buy a put ( sell ) or call (buy) option at a strike price to buy at a date in the future - the expiration date
Options have time decay; value of assets decline over time and severely reduce profitability
What are the advantages of derivatives
- Mitigate risk
- Lock prices
- Hedge
- Can be purchased on margin to make less expensive
What are the disadvantages of derivatives
Buffet describes them as ‘financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal’
- Difficult to value because based on prices of another asset
- Counterparty risks that are difficult to value
- Sensitive to changes in amount of time to expiration, cost of holding asset and interest rates; hard to value
- Leverage can have externalities e.g. 2008
- difficult for regulators to maintain oversight to the market since they are so hard to value
What 2 sections is the financial market split into
- Money Markets - assets w a maturity of less than a year
e.g. Bonds, Interbank Lending
Capital Markets - assets w a maturity of more than a year
What is the quantity theory of money
- Theory that links growth in money supply, to growth in inflation
- Embarced by Monetarists; it is the reason for inflation
1) M (money supply)
2) V (velocity of circulation; no. of transactions given an amount of money)
3) P (Avg. Price Level - Inflation )
4) Q (Quantity of Goods/services sold) i.e. real gdp
Fischer Equation:
MV (what is bought ) = PQ ( what is sold )
P = MV / Q
But V and Q are fixed in the long run or their changes are negligible
Therefore only M can influence price
Evaluate the Quantity Theory of Money
- Assumptions of V and Q same
- Recession
- Doesn’t hold
- Big increases in money supply doesn’t translate due to liquidity traps
What do investment banks do
- Proprietary Trading - taking any excess capital and investing it to get a better rate of return
- Market Making - a place where markets can be made; where you can buy shares + bonds but also issue bonds and shares
Advisory Roles:
* Mergers and Acquisitions: Companies might go through an investment bank for advice: when? Structure? Due diligence? Paperwork? Media? Regulation?
* New Issues and IPO’s
Underwriting IPO’s: buying all the shares up and then charging a higher price to sell to the market
What is systemic risk
most banks like hsbc and barclays are nor pure commercial or investment. Thus it makes them vulnerable to black-swan events to bring down the entire financial system
What is capital on the banks balance sheet
Shareholder’s Funds + Retained Profit (reserves)
- since you need to pay them back to the shareholder
What is SONIA
reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial instiutions
How is insolvency caused on the balance sheet
- If any loans go bad, capital - specifically retained profit - will take the hit
- Thus banks need enough capital to offset bad loans
If there isnt enough capital, there will be an unsustainable position on the balance sheet where the bank owes more than they own which is bank failure/insolvency
What is a liquidity crisis and how is it shown on the balance sheet
There may also be a position where the bank can’t meet short-term borrowing with short term assets ( Cash, reserves at BoE, Money at Short Notice (Near Money), Short term investments) therefore they are in a liquidity crisis and there will be a run on the bank; another form of bank failure
What is a liquidity crisis and how is it shown on the balance sheet
There may also be a position where the bank can’t meet short-term borrowing with short term assets ( Cash, reserves at BoE, Money at Short Notice (Near Money), Short term investments) therefore they are in a liquidity crisis and there will be a run on the bank; another form of bank failure
What are the 2 types of bank failure
Insolvency - unsustainable position on the balance sheet
Illiquidity- unable to meet short term borrowing with short term assets
What is the Money Multiplier
- Through frational reserve banking, new money is created by loans which comes back into the bank as the form of a deposit
Money Multiplier equation comes from 1/reserve ratio
What are the types of market failure in the financial sector
- Assymetric Information - struggle to know how reliable the loan is
- Moral Hazard - bank bailouts £45.8 billion for RBS
- Speculation and Market Bubbles
- Market Rigging - Libor
- Externalities - opp. cost of bailouts
How is assymetric information in Financial Markets a market failure
- financial institutions often have more knowledge so they can sell them products that they do not need
e.g. PPI costed over £53 billion
FInancial Crisis sub-prime mortgages
How are externalities a market failure in the financial sector
- Bailouts are a burden on the tax payer
e.g. 2008 total bailout cost of £700 Billion - Profit maximisation can be contrary to social objectives
e.g. Madoff fraud estimated around £65 billion
How is Moral Hazard a market failure of the financial sector
- individual workers take adverse risk in order to increase their salary
e.g. Mortgage brokers gained from increased risk as the burden was shifted to investors - Central Bank is lender of last resort, some banks such as Credit Suisse are categorised as of structural damage to the economy
How is speculation and market bubbles a market failure in the financial sector
all trading in financial markets is speculative and this leads to the creation of market bubbles due to herd behaviour
e.g. 2008, Dot.Com Bubble, Wall Street Cash 1929
How is market rigging a market failure in the financial market
- Group or individual collude to fix prices - insider trading
e.g. Libor Scadal of 2008
How much did Citibank make from a 1% fall in the LIBOR rate
$1,935 million if they were to fall by 1 percentage point instantaneously
How did the Housing bubble affect the Irish House prices
Irish house prices rose 30% in just two years, but fell 35% when the housing bubble ended.
100% mortgages were common
What was the Big Bang and it’s consequences
The reform program focused on the elimination of the city’s major problems: overregulation and the widespread practice of old-boy networks.
the concentration of power was focused on the big companies that took over long-standing firms
Now, companies that are “too big to fail” dominate financial cities. This characteristic has turned financial centers fragile, as seen in 2008,
What are the types of market bubbles
- Market Bubble - When a particular market sees a rapid increase in price
- Commodity bubble e.g. price of gold, e.g. in the 1970s and 1980.
- Credit bubbles- a rapid growth in consumer and business credit to finance higher consumer spending
-
Economic boom/bubble- AD grows faster than LRAS
*
What are some examples of market bubbles
- Tulip mania of the 1630s. When the price of tulips rose to over 500 times their previous price before collapsing when buyers stopped entering the market.
- Dot Com Bubble
- House Price Bubbble- Between 2000 and 2006, house prices rose 80% and house price to earning ratios rose above long-term averages. This was partly fuelled by a growth in mortgage lending to subprime customers
What are the main causes of market bubbles
- Irrational exuberance investor buy assets because of strong psychological pressures which encourage them to ignore the fundamental value of the asset
- Herding behaviour.
- Short-termism
- Cognitive dissonance – filtering out of the bad news and looking for views which reinforce their beliefs.
- Financial instability hypothesis. The theory that periods of economic prosperity cause investors to be increasingly reckless leading to financial instability.
- Monetary policy. Excess liquidity can more easily lead to bubbles because people need somewhere to put their money.
e.g. Low IR 2000 –> fuelled 80% rise in house prices 2000-6
What are the varying effects of market bubbles
- stock market crashes don’t always cause a recession.
e.g. 1987, the stock market crash didn’t cause any slow down in economic growth
- But 1929 one was a major factor to the Great Depression
- Bubble in housing market is most damaging since it affects consumers
e.g. housing crash of 1991 contributed to UK recession. The house price bubbles and bust were a strong factor behind recessions in Ireland and Spain.
- Breaking bubbles in oil and commodities can help net importers
What is financial instability Hypothesis by the economist Hyman Minsky
financial crisis are endemic in capitalism because periods of economic prosperity encouraged borrowers and lender to be progressively reckless
Success breeds excess which leads to crisis
Or
Economic stability itself breads instability.
How do economies go from stability to instability
- Higher asset prices –> increrase confidence –> irrational exuberance –> speculatie lending –> Ponzi Borrowing to keep asset prices rising
- Regulaters + Credit rating agencies get caught in irrational exuberance
- Unsustainable and cannot be maintained, until stop rising and realisation that there isnt enough credit to meet repayments
What is the Minsky Moment
point where the financial system moves from stability to instability. It is that point where over-indebted borrowers start to sell off their assets to meet other repayment demands.
Can lead to a balance sheet recession
What is a balance sheet recession
occurs when the private sector is focused on paying down debt and unwilling to borrow and spend, despite 0 IR
In a balance sheet recession the banking sector is unwilling to lend because it needs to improve its balance sheet and increase bank reserves.
Features
- Liquidity Trap
- Falling Asset Prices
- Deflationary Pressure; falling asset prices and stagnant economy
- Higher saving rates
- low bond yields
What is irrational Exuberance
Irrational exuberance refers to a situation where economic agents develop overconfidence in the economy and financial markets that is misplaced
- Rapid asset price inflation
- Increased risk willingnesss
- Tendency to ignore potential for asset to fall
- Growth in Speculative or Ponzi Lending
What are the main roles of the Central Bank
- Monetary policy - IR, QE, OMO, Currency
- Banker to the Government
-
Lender of Last Resort - providing liquidity to government + financial system
e.g. Liquidity Assurance Scheme, BOfE buying government bonds after Truss disaster - Printing Money
- Regulation of Financial System - maintaing reserve ratios + preventing Rigging
What are open market operations
When the Federal Reserve buys or sells securities from its member banks, it’s engaging in what’s known as Open Market Operations.
When the Fed wants interest rates to rise, it sells securities to banks. This is known as contractionary monetary policy –> reduces bank credit –> higher interbank rate
What will the Bank do when OMO’s are not enough
- In extreme scenarios OMOs may not be enough, the CB can create more money by extraordinary market operations in which it buys riskier longer govt securities or assets known as QE
What are the effects of negative interest rates
Negative interest rates are designed to:
* Get banks lending – they will pay the central bank interest for holding money on deposit with them
* Bring about a reduction in real interest rates – which might in turn stimulate increased business investment
* Negative rates are partly designed to cause an outflow of hot money thereby depreciating the exchange rate
* * Main aim of negative rates is to lower the risks to output, profits, employment & wages from deflation
What are the Risks from negative interest rates
- lower bank profitability by narrowing the interest-rate margins between savings and loans rates – threat to their long run stability
- Pension and insurance companies may struggle to meet their long term liabilities if long term interest rates (yields) are close to zero or below
- May become dependent on ultra-low IR and cheap money
Why are there doubts about the effectiveness of QE
doubts about the effectiveness of quantitative easing – bank lending has struggled to recover since the end of the last recession. In the summer of 2015, QE in the UK totalled £375bn
Evaluate the Lender of Last Resort Funtion
- Liquidity from the central bank isn’t without conditions or interest. More emergency the liquidity is the more stringent these conditions and interest
BUT
1) Promotion of moral hazard
2) Banks are incentivised to take more risky deals and not hold sufficient liquidity
3) Regulatory Capture
4) Why should banks have this luxury and not other firms?
e.g. 85,000 of individual savings back by Gov.
What is the countercyclical capital buffer (CCyB)
The FPC sets the level of the UK CCyB rate. If the Committee thinks risks are growing, it sets a higher UK CCyB rate. This means that banks are required to have an additional cushion of capital to absorb potential losses
e.g. Current Rate is 1%, upcoming rate from 5th July 2023 will be 2%
How does the FPC (Financial POlicy Committee) utilise its reccomendation power to stop risky mortgages growing
The FPC uses it recommendation power to restrict the proportion of risky mortgages banks take on. This helps us to reduce the risks to the financial system from high levels of household debt, particularly if the economy suffers a downturn.
For example, we have put a limit on the amount of new mortgages that lenders can approve that are 4.5 times or more the size of a borrower’s income.
What does resolution involve
- Doesn’t require agreement of management/shareholders/creditors or recourse to taxpayers money
- Ensure customers have access to services they require
- Costs of failures fall on the shareholders + creditors of failed bank not taxpayers
- Senior Executives take blame and are replaced
- Transfer most important partss of bank to another bank
- If no purchaser then can be transferred to bridge bank
- Insure consumer deposits returned through the Compensation Scheme or transfered to another firm
Whats a bail in
- repairing balance sheet using the firms own resources e.g. losses of failing firm is absorbed by the shareholders
- Creditors converted to shareholders; debt for equity swap
How did the BOfE deal with the fallout of SVB bank in the UK
- Got HSBC to buy SVB’s UK unit in a rescue deal
- Avoids taxpayer being needed to protect deposits of over 10 billion
How did the FED deal with the fallout of SVB
- Insured all consumer deposits
- Took it over and utilised firm’s assets to repay depositors; investors will not be made whole
*
How is the FED trying to prevent contagion from the fall of SVB
The Federal Reserve also announced a new lending facility that other banks can draw on to help them meet demands from depositors.
Fed’s lending reduces the risk that banks’ paper losses, estimated to be above $600bn at the end of 2022, will crystallise into actual losses.
How is the failure of SVB partly down to poor regulatory oversight from the Central Bank
- US dual banking system meant things were lost in co-ordination
- 96% of SVB deposits were not covered by the FDIC insurance
- SVB was reliant on the Federal Home Loan Bank of San Francisco
- Financial policies had begun to pile up from long-term fixed bond rates
To what extent was the failure of SVB down to a loosening of regulatory policies by the government
- 2018 rollback of the Dodd-Frank act, the biggest deregulatory effort since the 2007-08 financial crisis, exempted some banks with assets of up to $250bn from the Fed’s toughest supervisory measures, including stress tests as well as capital and liquidity requirements.
- decision was predicated on the view that large regional banks were not “systemic” and “don’t need close regulatory and supervisory scrutiny”.
What can the lender of last resort role be divided into
· the routine provision of liquidity
· the emergency provision of liquidity to a bank that has cash flow problems or there is a systemic issue
How does the BOfE prevent abuse of the liquidity assurance schemes
- Requires high quality collateral
- Premium over Bank Rate to access emergency funds with stringent conditions
How does the BOfE change the supply of money
1) Reserve Requirements
2) Discount Rate - rate at which commercial banks borrow from the central bank to meet their liquidity needs in the short-run
3) Open-Market Operations - buying and selling of gov bonds
What is the impact of increasing the money supply on interest rates
Usually, an increase in the money supply will lead to a fall in interest rates.
However, in a liquidity trap, an increase in the money supply may have no effect on reducing interest rates.
What are the main 3 regulators of the financial system
- Tripartite regulation; 3 major organisations
2 work for BoE and one with the treasury
BOfE
Financial Policy Committee (Macro-Prudential Regulation)
Prudential Regulation Authority (Micro-Prudential Regulation Authority)
Treasury:
Financial Conduct Authority (also micro-prudential authority)
What is macro-prudential regulation
This identifies, monitors and acts to remove risks that affect the **stability of the financial system as a whole.
**
The FPC is primarily responsible for macroprudential regulation.
What is micro-prudential regulation
· Focuses on ensuring the stability of individual banks and other financial institutions.
It involves identifying, monitoring and managing risks that relate to individual firms.
PRA and FCA are mainly responsible for microprudential regulation.
What is the Financial Policy Committee (FPC): macro-prudential
primary objective is to mitigate/remove systemic risk, secondary objective is to support the economic policy of the government.
· The FPC has two main powers: it can issue mandatory directions to the PRA and the FCA, and it can make recommendations to anyone, including the government
It has the power to make comply-or-explain recommendations to the PRA and FCA
e.g. 2 annual stress tests from 2017. Liquidiity Assurance Scheme
What is the Prudential Regulation Authority (PRA): mirco-prudential
· It sets standards and supervises financial institutions at the level of the individual firm to enhance stability
* The PRA may require individual institutions to maintain specified capital and liquidity ratios.
* However, the PRA does not seek to operate a ‘zero-failure’ regime. Instead, the PRA tries to ensure that if a financial firm fails it does so in a way that avoids significant disruption to essential financial services.
What is the Financial Conduct Authority (FCA): micro-prudential
- Protect consumers + increase confidence in financial institutions/products by:
1) Supervising conduct of firms being legal ( no market rigging )
2) Promote competition so consumers get better deals - deregulate to reduce red tape
3) Banning financial products against interest of consumers - stopping PPI scandal and getting over 50 million paid back
4) Banning or changing mis-leading adverts for financial products - loan sharks e.g.
mandatory APR and terms and conditions
What did the CMA say abut challenges to the clearing bank
The Competition and Markets Authority report on UK banking in August 2016 said that “the older and larger banks, which still account for the large majority of the retail banking market, do not have to work hard enough to win and retain customers and it is difficult for new and smaller providers to attract customers.”
What are SIFI financial instiutions
The Financial Stability Board, an international body that monitors and makes recommendations about the global financial system, every year since 2011, identified a list of G-SIBs. Any financial institution that is a SIFI is considered “too big to fail” and according to regulators poses a serious risk to the economy if it were to collapse
“Both Credit Suisse and Deutsche Bank are designated as systemically important financial institutions (SIFI): i.e. they are ‘too big to fail.’”
What is the effect of financial instability on the broader economy
Instability and confidence
* Negative impact on business investment and paradox of thrift
* High levels of debt and falling asset prices hit consumer wealth
Instability and loss of trust
* Higher interest rates on loans to businesses
Instability and inequality
* Evidence that poorer communities and families are more vulnerable during periods of financial stress/recession
* Policy response of ultra-low interest rates hits real incomes of savers
What are the Basel Reccomendations
a framework of agreements to prevent something like the GFC ever happening again. Only recommendations so no power but every developed nation adopted them apart from US which has a strong community banking lobby
What are ratios and requirement to increase liquidity
- Cash Ratio
- Liquidity Ratio
- Reserve Requirements
What is a Cash Ratio
cash assets/current liabilities
What are Liquidity Ratios
= short term current assets/ short term current liabilities
Basel Reccomendation –> 1 Jan 2015 60% and a 10% increase each year until 2019 to reach LCR
What is LCR - Liquidity Coverage Ratio
100% liquidity cover to liabilities owed in 30 days or less
How can reserve requirements be used to increase liquidity
- Fraction of deposit that must be held at the BOE
- Prevent liquidity crisis
FED puts 10% reserve requirement
What are ratios to reduce and insolvency risk (and de facto illiquidity)
- Capital Ratios
- Leverage Ratio
What are Capital Ratios
= Capital / Loans (can be specified)
- Intention is to prevent insolvency + thus bank failure/systemic risk
- Basel Reccomendation is 8%
- However its possible to specify which loans are included e.g. GFC used capital ratio that didn’t include ‘safe’ loans including mortgages
Unfavoured
What are Leverage Ratios
= Capital/ Loans + Long Term Investment
**Includes all loans **
- Intention is gains to prevent insolvency and thus …
Basel Recommendation of 3% minimum
What are some types and effects of financial market regulation
1)** Ban Market Rigging with strong enforcement**
Less market rigging/collusion which harms consumers, businesses and other financial institutions
2) Prevent sale of unsuitable products to consumers e.g. PPI
Protect consumers from products with excessive risk, charges + limited benefits
** 3) Maximum Interest Rates**
Prevent consumer exploitation whilst preventing excessively risky lending
4) Deregulation
More competition –> lower IR on borrowing and a higher IR on savings
5) Deposit insurance - up to £85,000
Protect consumer deposits in case of Bank Run –> Increases trust
6) Ring fence commercial banking away from investment banking
Lowers systemic risk e.g. Barclays split into commercial and investment
7) Set Limits on Bank Lending
8) Liquidity Assurance with conditions and punishments
What are the problems with financial market regulation
1) Moral Hazard - liquidity assurance creates bad incentives
2) Regulatory Capture - regulation is weakened by those who see through the industry’s eyes rather than the govt.
3) Assymetric Information - regulator always one step behind in product development - time lag
5) Unintended Consequences - deregulation of some can be dangerous for competition and systemic risk.
Maximum interest rates; excess demand in the market, encouraging bad borrowers and discouraging lending to reduce investment
6) Administration + Enforcement costs - PRA budget of over 600 million
What is an example of regulatory capture
When Timothy Geithner was FED president became unusually close with the scions of Wall Street banks.
Geithner engineered the New York Fed’s purchase of $30 billion of credit default swaps from American International Group (AIG), which it had sold to Goldman Sachs, Merrill Lynch, Deutsche Bank and Société Générale.
By purchasing these contracts, the banks received a “back-door bailout” of 100 cents on the dollar for the contracts. Had the New York Fed allowed AIG to fail, the contracts would have been worth much less, resulting in much lower costs for any taxpayer-funded bailout.
Evaluate the problems with Financial market regulation
i) Balance needed to protect against systemic risk but to maintain bank profitability
ii) Regulation should promote equity without damaging efficiency
iii) Costs vs Benefits; are the costs of regulation greater than the benefits?
What are the clearing banks and how much of the market do they contain
Clearing Banks - Llyods, RBS, HSBC, Barclays and Santander
FCA reported that 77% of PCA market, 85% of business current account and 90% of business loans
What are examples of UK Government and Regulatory Intervention
- Current Account Switching Service - launched in Sept 2013 to ease barriers
- Authorisation Procedures for new banks, New Bank Start-Up Unit
- Sterling Monetary Framework for all banks in 2013- provide stability and liquidity assurance
- British Business Bank- nov 2014 for finance for SME lending
How has challenger metro bank grown to how many assetts
Metro Banks now has assets of over 20 billion
How is the failure of SVB partly down to poor regulatory oversight from the Central Bank
- US dual banking system meant things were lost in co-ordination
- 96% of SVB deposits were not covered by the FDIC insurance
- SVB was reliant on the Federal Home Loan Bank of San Francisco
- Financial policies had begun to pile up from long-term fixed bond rates
