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.
What do the Basel Committee say on Banking Supervision?
- Basel accord as international agreements in response to the financial crisis.
What is the minimum level of capital a bank has to have?
- Greater or equal to 8%
Risk Weighted Capital Adequacy Formula
Capital/risk weighted assets greater than or equal to 8%
What are Risk Weighted Assets (RWA)?
- Proxy for potential to generate unexpected losses.
What are the three types of capital under Basel III?
- Common Equity Tier 1 (CET1)
- Additional Tier 1 (AT1) (Tier 1 = CET+AT1)
- Tier 2
What is Common Equity Tier 1 (CET1)?
- Common equity, retained earnings
- Best quality of capital.
What is Additional Tier 1?
- Preference shares perpetual subordinated debt.
- Second best quality of capital.
- Credit Suisse AT1 Bonds
What are the basic requirements of capital under the CRD IV and the CRR?
- Common equity tier 1 (4.5%)
- Additional Tier 1 (1.5%)
- Tier 2 (2%)
- Values can be higher
What is the extra cushion of CET1 capital under the CRD IV and the CRR?
Capital conservation buffer (2.5%); can be higher
What is the extra cushion of CET1 capital in boom times under the CRD IV and the CRR?
Countercyclical capital buffer (0-2.5%)
What is the extra cushion of CET1 capital for systemically important institutions and for macro prudential risk under the CRD IV and the CRR?
Higher of systemic risks, G-S11 and O-S11 buffers (0%-5%)
What are the extra capital for other risks under the CRD IV and the CRR?
- Pillar 2 (0%-2%)
- Banks own capital buffer (1%-2%)
Basel III Liquidity Regulation Measures
- Banks are required to hold a minimum level of liquid assets and stable funding.
Liquidity Coverage Ratio (LCR) formula
High Quality Liquid Assets/Total Net Cash Outflow over next 30 days greater than or equal to 100%
Net Stable Funding Ratio (NSFR) formula
Available stable funding over next 1 year/Required stable funding over next 1 year greater than or equal to 100%
Level 1 Assets that Qualify as Liquid Under the LCR
- Most Liquid/Best
- Cash, Government and central bank debt issued by countries with a strong credit rating.
- Central bank reserves
- No upper limit, can be 100% of stock
Level 2 assets that qualify as liquid under the LCR
- Second most liquid/best
- High quality non-financial corporate bonds
- High quality third-party covered bonds
- Max 40% of stock
NSFR More Stable Funding (Liabilities)
- Capital and Long-Term Debt (Factor 100%) (Least Liquid)
- ‘Stable’ short-term deposits (90%)
- ‘Less Stable’ short-term retail deposits (80%)
- Unsecured short-term funding from non-financial corporates (50%)
- All other liabilities and equity categories (0%) (Most Liquid)
NSFR More Stable Funding (Assets)
- Long Term Assets (Other than those in 65% bucket) (Factor 100%) (Least Liquid)
- Short-Term Loans to Retail Clients (85%)
- Long-term loans with Basel II standardised risk weights of 35% or below
- Listed equity securities, single A-rated corporate and covered bonds. Short term loans to non-financial corporate clients (50%)
- Highly rated corporate and covered bonds (20%)
- Sovereign Debt (5%)
- Off balance sheet enquiries: undrawn amount of committed credit and liquidity facilities (5%)
- Cash and short-term securities (0%)
What can regulators do to assess stability of bank capital?
- Stress tests.
What are types of financial regulations?
- Restrictions on asset holdings.
- Capital requirements
- Prompt corrective action.
- Chartering and examination.
- Assessment of Risk Management
- Disclosure Requirements.
- Consumer Protection
- Restrictions on Competition
- Macroprudential Regulation
What can the existence of deposit insurance increase?
- Banks with deposit insurance are likely to take on greater risks than they otherwise would.
- Moral Hazard, Adverse Selection
What is the Bank Run Effect?
The possibility that the failure of one bank can hasten the failure of other banks.
Too-Big-To-Fail Policy
It increases the incentives for moral hazard by big banks.
Why do Banks not want to hold too much capital?
- They do not bear fully the costs of bank failures.
- Higher returns on equity are earned when bank capital is smaller, all else equal.
What does it mean for Bank Capital under the Basel plan?
- Assets and off-balance sheet activities are assigned to various categories to reflect the degree of credit risk.
- Bank’s total capital must equal or exceed 8% of total risk-weighted assets.
What does microprudential regulation focus on?
- Safety and soundness of individual financial institutions.
What does Macroprudential regulation focus on?
- The safety and soundness of the financial system in aggregate.
