7. Regulation of Financial Intermediaries (I) Flashcards
Why does the nature of banking imply frangibility?
- Mismatches of maturity and liqudity: Bank run
- Highly leveraged: solvency
Jacob Frenkel 2008 on Balance Sheet
Left side of the balance sheet has nothing right and the right side of the balance sheet has nothing left. But they are equal to each other. So accounting wise we are fine.
Bank Run Definition
- Large amount of depositors (and creditors) rush to withdraw their deposits (and lending) because they expect the bank ceases to function.
Stakeholder Roles in a Bank Run
- Banks maintain normal liquidity (fractional reserve) to meet the withdraw demand.
- If depositors/creditors believe the bank would fail, they would withdraw their lending early.
- They rush to secure their payment.
- Everyone withdrawing early will force the bank to liquidate their assets (fire sale) that triggers further run.
- Creditors withdraw more than they would have, had they had full information. Some bank runs are no more than self-fulfilling crisis.
Northern Rock 2007 Bank Run
- Were the country’s 5th largest mortgage lender, asked BoE for liquidity support.
- Triggered first major run on British bank since 1866.
- Feb 2008 bank was nationalised
Characteristics of a Bank Panic
- Asymmetric Information: inability of depositors to assess the quality of a bank’s assets can lead to panics.
- Many banks fail simultaneously.
- May provide rationales for financial regulations.
Negative Externalities of a Bank Failure
- Information Contagion: One bank failure may trigger bank runs on other solvent banks.
- Balance Sheet Contagion: Risk spillovers developing into systematic risks.
- Disruption of economic activities: from financial to economic crisis.
Characteristics of Large Exposures Between UK banks
- Large exposure one that >10% of lending banks eligible capital at end of period.
- Eligible capital defined as tier 1 and tier 2 minus reg deductions.
What is Deposit Insurance?
- The government safety net to prevent bank panics.
US perspective on Deposit Insurance
- Deposit insurance is provided by the Federal Deposit Insurance Corporation (FDIC) with the limit of $250k
- Between 1930-1933, average number of bank failures exceeded 2000 per year.
- After FDIC founded in 1934, annual bank failures on average fell lower than 15 until 1981.
UK Deposit Insurance
- Provided by Financial Services Compensation scheme (FSCS) with current limit at £85k, increased from £75k in 2017.
How can Deposit Insurance bring about unintended consequences?
- Creates moral hazard: incentives for banks to take on greater risk.
- Creates adverse selections: no incentives for screening and monitoring borrowers.
- Too big-to-fail problem
What is the Too-Big–To-Fail Problem?
- Regulators reluctant to let large/systematically important banks to fail
- Greater problems of moral hazard and adverse selection as above.
- Financial consolidations generate more large banks and complex firm structure mixing with other non-banking business.
Relationship Between Capital, Leverage and Return on Equity
When capital increased, Equity Multiplier decreased and ROE decreased
Return on Asset Formula
Net Profits/Assets
Return on Equity Formula
Net Profits/Equity or Return on Assets * Equity Multiplier
Equity Multiplier Formula
Assets/Equity Capital
What is the trade off of holding bank capital?
- Higher capital increases the buffer for insolvency.
- High capital (relative to asset) increases opportunity cost of profit.