Chapter 7 Flashcards
Why are banks special?
A high proportion of their liabilities have a fixed value
Their liabilities comprise a high proportion of the money supply of a country
They are involved in running major payment systems in a country
How do bank raise funds?
Deposits
Issuing bonds
Short-term securities
Equity shares
Banks lend to who?
Household firms
Governments
Other banks
Credit risk transformation by banks is partly a result of what?
Creating liabilities which use priority of claims
Diversification of assets
Maturity transformation results from what ?
A willingness by a bank to increase the liquidity of its customers by creating an illiquid balance sheet for itself
On what basis do banks price loans ?
Probability of the loan defaulting and their probable loss given default
What are expected losses met from?
Revenues
Banks are unable to lend profitably to AAA companies because of what?
AAA companies can borrow at a lower rate than most banks
What can banks provide credit for?
The expansion of real investment
High value asset transfer
To enable some households to consume more than their after-tax income b
Dis-intermédiation in finance is a result of what?
A reduced need for intermediaries in finance and a reduced ability to intermediate profitably
What are the key types of intermediaries in any economy?
Central banks
Most commercial banks have what banking operation?
A retail and a wholesale
What does the whole sale banking operation do?
Involved in large scale lending including cross border lending
Are mutual fund holdings fixed or variable value assets ?
Variable
What type of funds do not benefit from deposit insurance ?
Mutual funds
What is an insurance fund?
Scheme by government or private sector which pays back deposits to customers in case bank fails
What are the features of banks that make them special in any economy?
Fixed nominal values
Instant redeemability
Money supply
Essential credit
Payments system
A sharp fall in credit provision could lead to What?
Lack of credit availability to lubricate the wheels of the economy
What is the purpose of regulation ?
To minimise the likelihood of collapse and hence the need for tax payer support
What does the liability side of the balance sheet involve?
Issuing liabilities for investors, savers and other banks to hold to finance banking
What does the asset side of the balance sheet do?
Creates household and business liabilities to provide financin*
How are consumer loans, mortgages and corporate loans securitised ?
They are taken off the bank balance sheet and sold to other financial institutions
What is size transformation?
Pooling services
The fixed value liabilities that banks offer are usually what?
Nominally riskless assets
What is credit transformation?
Lowering the risk of risky loans being offered
How is credit transformation achieved ?
Portfolio diversification
Creating liabilities on balance sheet which use priority of claims
What is idiosyncratic risk?
The risk that one large borrower creates a large percentage loss on the portfolio
What type of risk is reduced by portfolio diversification ?
Idiosyncratic
Between senior, junior debts and deposits, what takes the first loss?
Junior then senior then deposits
Modigliani and Miller’s capital structure irrelevance theorem suggests what?
Average cost of financing the asset book of the bank cannot be lowered if there is no tax deductibility of interest and no costs involved in bankruptcy
How can maturity transformation be achieved?
Through the banks ability to offer long term loans despite short term deposits
How is credit intermediation achieved?
By borrowing at short maturity and providing risky loans at long term maturity
Banks take one which type of risks?
Credit risk
Interest rate risk
Rollover risk or liquidity risk
What is interest rate risk?
Cost of liabilities above the yield
The two main type of risks banks are subject to are?
Solvency risk
Liquidity risk
What are the two mechanisms available to banks to control risks?
A viable business model
A social contract with society
What does viable business model include:
Pooling of funds
Skill in assessing risk of loans
Independent risks
Subordination
What does a social contract with society include:
Stand by liquidity
Deposit insurance
Bank examiners
Market discipline
What are the social contract and viable business model designed to do?
Minimise the risk of insolvency or illiquidity
What is the too big to fail doctrine?
If financial institution is large, it cannot be allowed to fail impact on economic stability is too great
What is the loan agreement?
Contract between borrower and lending bank
What is the Great Moderation?
A period of low volatility in markets a low loan losses in the banking world
On what two things do banks make an estimate of expected loss of loans?
Probability of default
Loss given default
What is expected loss?
Percentage of assets of this type that it expects to lose in the year ahead as a cost of doing business
Who is unexpected loss taken by?
Shareholder funds
What does more equity capital at bank mean for the bank?
More protection for other capital providers
Order of losses if bank has a loss greater than shareholder funds
Shareholders preferred share holders subordinate debt holders mezzanine debt holders senior debt holders depositors
How does a bank generate a higher return than targeted?
By having fewer write off charges
What basis are loans priced on in the fixed income markets?
A spread above the treasury yield for a government bond
What is floating rate?
The rate of interest changes every 1, 3, 6 or 12 months
What are investment grade loans?
Loans made to high grade corporations which have relatively high credit rating
What is the average bank rated as?
AA
Why are AAA banks not willing to pay the AA rate?
They can go straight to the capital market without and intermediary
What are leveraged loans?
Loans to companies with relatively low credit rating as result of high debt to equity ratio.
What is a syndicated loan?
One which the funds supplied to the borrower come from a group of lenders rather than simply one bank
