Bank failure/financial market failure

Question 1

reasons for bank failure

Answer 1

bank run - not enough liquid short term assets to meet short term liabilities
(occurs when a large number of depositors simultaneously withdraw their money from a bank due to concerns about the bank’s solvency or stability.)

insolvency - where theres not enough capital to offset losses in asset values, liabilities>assets

Question 2

chain of analysis for how bank run leads to bank failure

Answer 2

• During a bank run, many depositors withdraw their money simultaneously
• The bank runs out of liquid cash to meet these withdrawal demands
• To raise cash, the bank sells assets quickly, often at a loss
• Losses from selling assets reduce the bank’s capital and financial stability.
• As the bank’s liabilities exceed its assets, it becomes insolvent, leading to bank failure.
• The failure of one bank can lead to a loss of confidence in other banks, potentially triggering more bank runs and causing systemic risk throughout the financial system.

Question 3

how does insolvency lead to bank failure, chain of analysis

Answer 3

• Insolvency occurs when a bank’s liabilities exceed its assets, meaning it cannot meet its financial obligations, including paying back depositors and creditors.
• Stakeholders, including depositors, creditors, and investors, lose confidence in the banks
• Depositors rush to withdraw their funds, and creditors demand repayment, creating a liquidity shortage. The bank, unable to liquidate assets quickly enough or at favorable prices, struggles to meet these demand

-To raise cash, the bank is forced to sell assets rapidly, often at a loss,

• If the bank is unable to restore solvency or secure emergency funding, regulators or the bank itself may declare failure
• e failure of the bank can cause wider financial instability, potentially leading to panic, contagion effects in other banks, and broader economic disruption if the failing bank is large or interconnected with other financial institutions.

Question 4

tools to reduce the risk of bank failure

Answer 4

• cash ratio - forcing commercial banks to hold enough cash assets to meet their short term liabilities - If a bank holds a high level of cash relative to its liabilities, it can better withstand a sudden surge in withdrawals during a bank run
• liquidity ratio - forcing commercial banks to hold enough short term liquid asssets to meet their short term liabilities
• The leverage ratio measures a bank’s core capital relative to its total assets or its total exposure,A higher leverage ratio indicates that the bank has a larger cushion of equity capital relative to its assets. This capital buffer can absorb losses during economic downturns or financial shocks, preventing the bank from becoming insolvent.
• capital ratio measures the proportion of a bank’s capital to its risk-weighted assets (RWAs). It is an indicator of a bank’s financial strength and its ability to absorb lossess,

Question 5

how do reserve requirements reduce the risk of bank failure

Answer 5

• By requiring banks to hold a certain percentage of their deposits as reserves, reserve requirements ensure that banks have sufficient liquid assets to meet withdrawal demands and other short-term obligations. This helps prevent liquidity shortages that could otherwise lead to a bank run or insolvency

Question 6

how do banks maximise profit

Answer 6

• borrowing short term with low interest and lending long term with higher interest
• taking more risk using less secure loans(charge more interest)

Question 7

bank failure consequences - systemic risk

Answer 7

Systemic risk - the risk that the failure or distress of one financial institution, or a group of institutions, could trigger a widespread collapse across the entire financial system

Question 8

bank failure consequences - recession

Answer 8

A bank failure often leads to a credit crunch, where banks become more conservative in lending, or credit dries up entirely. Businesses that rely on loans for operations, expansion, or working capital find it difficult to secure financing. This reduction in available credit slows down investment, consumption, and economic growth.

Question 9

bank failure consequences - lost jobs

Answer 9

• Without access to necessary financing, many businesses, particularly small and medium-sized enterprises, may be forced to downsize or close entirely. This leads to significant job losses as companies reduce their workforce to cut costs.
• As businesses lay off workers, unemployment rates rise. The increase in joblessness can lead to further reductions in consumer spending, as unemployed workers have less income to spend, deepening the economic downturn.

Question 10

bank failure consequences - lower output and incomes

Answer 10

• Decline in Production: With businesses scaling back operations or shutting down, overall production in the economy decreases. This reduction in output can lead to shortages of goods and services, further slowing economic growth.
• Lower Incomes: As companies reduce wages, cut jobs, or close down, household incomes fall. Lower incomes reduce purchasing power, leading to decreased consumer demand, which further impacts businesses and the broader economy.
• Multiplier Effect: The reduction in income and output has a multiplier effect, where the initial economic impact spreads and amplifies throughout the economy. For instance, when one industry suffers, related industries also face downturns, leading to widespread economic difficulties.

Question 11

broad impacts of bank failure

Answer 11

• Financial Market Turmoil: The failure of a significant bank can lead to loss of confidence in the financial system, causing stock markets to plunge and further eroding wealth and consumer confidence.
• Government Intervention: In severe cases, government intervention may be required, such as bailouts, increased unemployment benefits, or fiscal stimulus. While these measures can mitigate some damage, they also place additional strain on public finances and can lead to long-term economic challenges.

Question 12

consequences of bank failure - bank bailouts

Answer 12

• A bailout can prevent the failure of one bank from spreading to others, thus stabilizing the financial system. By injecting capital into the failing bank or providing guarantees, the government reassures depositors and investors, reducing the risk of a bank run.
• Bailouts are often funded by taxpayer money, which can lead to significant public expenditure. This use of public funds can lead to increased government debt and may require future tax increases or cuts in public services to balance the budget.
• Bailouts can create a moral hazard, where banks and other financial institutions might take on excessive risks, knowing that they could be bailed out if things go wrong. This can encourage reckless behavior in the financial sector, leading to future crises.
• In some cases, the increased debt burden from bailouts can lead to austerity measures, where governments cut public spending or increase taxes to manage their debt. These measures can further slow economic growth and exacerbate social inequalities.
• Bailouts can distort financial markets by propping up failing institutions, potentially leading to misallocation of resources. This can stifle competition and innovation, as weaker institutions are kept alive at the expense of healthier, more competitive ones.

Question 13

how can banks prevent bank failure

Answer 13

• holding sufficient liquid assets, such as cash, government securities, or reserves with the central bank. These assets can be quickly converted into cash to meet withdrawal demands or other short-term obligations
• Risk Management: Implementing robust risk management practices, including credit risk assessment, market risk monitoring, and operational risk controls, helps banks identify and mitigate potential threats before they lead to significant losses.
• Cybersecurity: With the increasing reliance on digital banking, robust cybersecurity measures are essential to prevent fraud, data breaches, and other cyber threats
• come at the price of profit

Question 14

role of the central bank

Answer 14

• to implement monetary policy, eg meet inflation target
• acts as a banker to the government, eg open market operations(buying+sell govt bonds)
• acting as a banker to other banks(“lender of last resorts”) - preventing bank run
• regulate financial system

Question 15

why is financial stability important

Answer 15

• to prevent panic and bank runs
• to reduce financial instability and systemic risk
• to advise govt of bank bailouts

Question 16

what is moral hazard

Answer 16

when a decision is made and if that decision goes wrong, the cost affects a 3rd party

Question 17

consequences of banks being the “lender of last resort”

Answer 17

moral hazard: The availability of emergency support from the central bank might encourage financial institutions to take on excessive risks, believing that they will be rescued in times of trouble. This can lead to reckless behaviour.

• Knowing that they can rely on the central bank as a lender of last resort, banks might be less motivated to maintain higher levels of liquidity. Instead, they may choose to allocate more resources towards higher-yield but less liquid investments, reducing their cash reserves and liquidity buffers

Regulatory capture- Banks that anticipate central bank bailouts may exert influence over regulatory bodies to shape regulations in their favor. They might push for favorable policies or less stringent oversight, knowing that they can rely on emergency support if needed.

• ## Financial institutions, such as banks and large corporations, often receive direct bailouts or emergency liquidity, while smaller businesses and other industries might not have access to the same level of support. This selective assistance can exacerbate inequality and create an uneven playing field.

Question 18

what is financial market failure

Answer 18

when free functioning financial markets fail to allocate financial products at the socially optimum level of output

Question 19

reasons for financial market failure - excessive risk

Answer 19

• overproduction and overconsumption of risky assets
• Financial institutions, driven by the pursuit of higher profits, engage in high-risk investments
• The excessive risk-taking often leads to the creation of asset bubbles
• As more institutions engage in risky behavior, the financial market becomes increasingly unstable
• Eventually, when the bubble bursts or risky investments fail to deliver expected returns, there is a sudden market correction.
• Asset prices plummet, leading to significant financial losses for institutions heavily invested in these assets.
• The sharp decline in asset values and resulting losses lead to a loss of confidence in the financial system, triggering a broader market failure characterized by liquidity shortages, credit crunches, and potentially a systemic crisis.

Question 20

what are asset bubbles

Answer 20

where the prices of assets (such as real estate or stocks) inflate rapidly due to speculative investments.

Question 21

what is credit crunch

Answer 21

A credit crunch is a situation where there is a significant reduction in the availability of loans or credit from financial institutions, making it difficult for businesses and consumers to borrow money.

Question 22

consequences of excessive risk

Answer 22

• systemic risk
• confidence in banks reduce
• lost jobs, incomes, output throughout entire economy
• recession
• bank bailouts

Question 23

how does monopoly pricing(collusive interest rates) lead to financial market failure

Answer 23

• Banks or financial institutions may engage in collusion, agreeing to set interest rates at artificially high levels rather than competing
• restricts competition and keeps interest rates higher than they would be in a competitive market.
• Higher interest rates increase the cost of borrowing for businesses and consumers. As a result, fewer people can afford to take out loans, leading to reduced access to credit.
• This limits investment in businesses, housing, and consumer spending, slowing down economic growth.
• As defaults rise and economic activity slows, the financial system becomes increasingly unstable. The reduced access to credit, coupled with inefficiencies and higher default rates, can lead to a broader financial market failure, characterized by reduced liquidity, loss of confidence in financial institutions, and potential economic recession.

Question 24

Why did the deregulation (Big bang) of 1986 increase systemic risk in the UK - removal of reserve requirements

Answer 24

• was used to encourage people to move away from mining and move into financial sector

2. Elimination of Reserve Requirements:

• With fewer reserves required, banks could lend more aggressively, often to riskier borrowers or for speculative activities, increasing their exposure to default risks.
• As banks operated with minimal reserves, a sudden economic downturn or increase in loan defaults could rapidly deplete their available funds, leading to widespread banking failures.

Question 25

examples of excessive behaviour

Answer 25

• speculation
• market bubbles

Question 26

what is speculation and how do they lead to financial market failure

Answer 26

• speculation occurs when assets are bought at a low price and sold at a high price
• Investors buy assets, like stocks or real estate, hoping prices will keep rising, even if the assets aren’t really worth that much.
• As more people buy, prices skyrocket, creating a bubble where asset prices are much higher than their true value.
• To maximize profits, investors and companies often use leveraged deals, borrowing money to invest even more into the bubble. This leverage amplifies both potential gains and potential losses, increasing the overall risk in the financial system.
• When people realize the assets are overpriced, prices crash. Those who borrowed heavily to invest face huge losses. demand and price of assets fall
• The crash causes widespread financial trouble, leading to defaults, panic selling, and a loss of confidence, which can destabilize the entire financial market. ppl sitting on worthless assets

Question 27

explain a leveraged deal

Answer 27

• In a leveraged deal, an investor or company buys another company mostly using borrowed money, with only a small portion of their own funds.
• The debt used to buy the company is expected to be paid off using the profits or assets of the acquired company.
• Because so much of the purchase is funded by debt, there’s a high risk. If the bought company doesn’t make enough money, it can be hard to pay back the loans.
• If the deal works out, the buyer can make big profits with little investment. But if it doesn’t, the buyer could face huge losses, and the bought company might even go bankrupt.

Question 28

leveraged deal meaning

Answer 28

• borrowing to amplify the end outcome of a deal

Question 29

how does asymmetric info lead to moral hazard and ultimately financial market failure

Answer 29

• Asymmetric information occurs when one party has more or better information than the other party in a transaction.
• • In financial markets, a bank might have more information about the risks associated with a loan than the lender does.
• When one party (e.g., a bank) knows it will not face the full consequences of its risky behavior (e.g., due to government bailouts or insurance), it may engage in riskier activities.
• The party with more information might take on excessive risk, as they do not have to fully bear the negative outcomes of their actions.
• If multiple institutions engage in risky behavior, it can lead to a financial crisis, where the entire financial system becomes unstable due to the widespread exposure to high-risk activities

Question 30

What is adverse selection

Answer 30

when the most likely buyers of a financial product are not the buyers that the seller would prefer to sell to

Question 31

how does asymmetric info lead to adverse selection and ultimately financial market failure

Answer 31

• Lenders or insurers, lacking complete information, may have difficulty accurately assessing the true risk of borrowers or applicants.
• those with higher risks (who know they have more risk) are more likely to seek loans or insurance because they benefit from not disclosing their full risk level.
  - eg someone with a high risk lifestyle may purchase life or disability insurance as they know they will be more likely to collect on it
• The presence of more high-risk individuals leads to higher default rates or claims, forcing lenders or insurers to increase prices or face losses. This inefficiency reduces the availability and affordability of financial products

Question 32

how does commercial banks ignoring negative externalities lead to financial market failure

Answer 32

• eg - cost to taxpayers for bailouts, lost jobs,income,growth,savings
• : By focusing on short-term profits and ignoring potential negative outcomes, banks may engage in excessive-risk activities
• When risky practices lead to financial instability or crises, governments often intervene with bailouts or financial support to prevent widespread economic collapse.
• Taxpayers bear the cost of bailouts through higher taxes or reduced public services. Additionally, the broader economy suffers from reduced growth, lost jobs, and decreased income due to the financial crisis.
• The financial crisis triggered by risky banking practices leads to widespread job losses, reduced economic growth, and lower household savings as businesses and consumers cut back on spending.

Question 33

what is market rigging

Answer 33

where banks/intermediaries/traders collude and manipulate markets(like forex) and make huge profits

Question 34

how does market rigging lead to financial market failure

Answer 34

• Market rigging causes asset prices to deviate from their true value, as the manipulations create artificial price levels.
• If companies collude to fix prices, the artificially high prices do not reflect the true supply and demand dynamics, leading to mispricing in the market.
• Once market participants realize that the market is being manipulated, trust in the fairness and integrity of the market is undermined.
• Investors might pull out their investments or become reluctant to invest, fearing that market conditions are rigged against them.
• With distorted prices, resources are not allocated efficiently. Investments may be directed towards less productive area

Question 35

how did the big bang deregulations increase the risk of systemic risk - use of commercial bank funds for investment bank activities

Answer 35

• Investment banking involves high-risk activities, like trading and speculation, exposing commercial bank funds to significant potential losses.
• Losses from risky trades can deplete commercial banks’ capital, reducing their financial stability.
• Using commercial bank funds for investments can reduce liquidity, limiting the bank’s ability to meet depositor demands.
• Losses in one bank can create panic, leading to withdrawals and instability across the banking sector.
• Large interconnected banks failing could lead to a broader financial crisis, affecting the entire economy.

Question 36

why might a bank become insolvent

Answer 36

• bad loans or falling asset prices.
• ## Banks require a capital buffer to absorb unexpected losses, but excessive lending or risky investments can deplete these reserves.