Chapter 7 Q&A Flashcards
- What are the main reasons for financial sector regulation?
To ensure systemic stability; to provide smaller, retail clients with protection; and to protect consumers against monopolistic exploitation
- What are the arguments of the so-called ‘free banking school’?
Advocates of this school argue that the financial sector would work better without regulation, supervision and central banking. In absence of regulation, banks would have greater incentives to prevent failures (see p.161).
- What is the relation between bank contagion, bank runs and systemic risk and to what extent this is a rationale for regulation?
Bank contagion occurs when due to interconnectedness of banks, the failure of one bank can immediately affect others and this may lead to bank runs. Systemic risk is the risk that problems in one bank will spread through the whole sector. Regulation might be needed to ensure consumer’s confidence in the financial sector (see p.162).
- What is the relation between financial regulation and supervision, moral hazard and government safety net arrangements? Explain.
Financial regulation and supervision are needed because moral hazard can be associated with government safety net arrangements that are designed to protect the banking and financial system.
- How the moral hazard arises in the financial system and how this moral hazard problem can be mitigated? Explain.
Moral hazard arises if banks all believe that they have access to the ‘lender-of-last-resort’ they may be inclined to take on excessive risks knowing that in the event of trouble they will be bailed out by the authorities. To mitigate this moral hazard problem the authorities need to establish a regulatory framework that assures access to the lender-of-last resort facility is by no means guaranteed for banks (see p.165).
- Why do you think banks become reluctant to deposit money with other banks during the global financial crisis of the late 2000s?
The concern was the exposure of other banks to so-called ‘toxic assets’. Therefore, banks were fearful that if they deposited money with other banks that these other banks might not be able to pay the money back, i.e. they would default on payment.
- What is meant with securitization and what is the benefit of sellers of securitized products?
Securitization involves a financial institution selling some of its assets to financial investors, often other financial institutions. Future cash flows are turned into marketable securities, such as bonds. The sellers get cash immediately and can use it to fund loans to customers. Hence, securitization facilitates the provision of credit
- Does securitization necessarily involve a moral hazard problem?
Not if banks are no longer convinced that the risks will be born by other banks, who themselves may get into difficulties. Once such risks are underwritten by the central bank, however, the problem of moral hazard can become serious unless accompanied by tighter regulation to prevent banks taking undue risk.
- Why may supplying of extra liquidity to the banks not necessarily be successful in averting a slowdown in borrowing and spending?
If banks choose to hold a lower liquidity ratio, they may still be reluctant to lend unless the rise in liquidity is substantial. Also if they are concerned about the state of the economy, again they may be reluctant to lend, fearing a rise in defaults as firms fail and individuals lose their jobs. At the same time the demand for loans may decrease if people rein in spending, fearing that their future income may fall.
- Why is there a potential ‘moral hazard’ in supporting failing banks? How could the terms of a bailout help to reduce this moral hazard?
Because it might encourage banks to carry on with risky behaviour, knowing that in the last resort the ‘tax payer’ will bail them out. Tough terms of the bailout will help to keep the moral hazard to a minimum. The central bank may only be willing to lend to the banks in return for tighter control over the banks’ activities, such as insisting that bonuses for senior management are cut substantially. The bailout may come in the form of full or partial nationalisation, as in the case of the Royal Bank of Scotland and the Lloyds Banking Group – something that bankers and their shareholders would much rather avoid.
- What are the global banking trends after the global financial crisis and what is the impact of the this crisis on the rationale of regulation?
Re-regulation of the industry; ownership structures are shifting towards heavier state involvement;
investor scrutiny is rising strongly; equity ratios will be substantially higher and as a result growth and profitability are likely to decline; banks may be lacking major growth drivers such as securitization; consolidation to continue but with a different focus (more domestic deals, less cross-border mergers);
internationalization of EU banks is likely to slow: more re-nationalization and a re-orientation towards domestic markets rather than financial globalization and market integration.
- Name the most important types of supervision and regulation?
Systemic, prudential and conduct of business regulation and monetary supervision (p.162-163).
- What are implications of the Second Banking Directive for banking activities in the EU?
A single European license; home country supervisors (mutual recognition of each other’s banks); minimum levels of capital required before authorization can be granted (BIS-ratio = 8%); supervisory requirements in relation to major shareholders and banks’ participation in the non-banking sector; accounting and internal control requirements
- What are the advantages and disadvantages of Basle-I comparing to Basle-II accord?
Basle-I is a ‘one-size-fits all’ approach with limited risk differentiation whereby collateral and derivates are not used to minimize capital requirements.
Basle-II uses more risk-weighted assets based on standard or IRB risks taking into account default, market and operational risks and on- and off-BSA.
- What are the main financial risks involved in the Basle-II accord? Explain these risks.
Default or credit risk: risk of the inability to ultimately fulfill a contractual obligation when it falls due.
Market risk: risk that value of investments will decrease due to movements in market prices.
Operational risk: risk associated with the potential for systems failure.
- What are the main features of the three pillar system of Basle-II accord?
First pillar (minimum capital requirement): deals with the qualification of new capital charges and relies heavily on banks’ internal risk-weighting models and on external rating agencies. Second pillar (supervisory review): aims to ensure that a bank’s capital adequacy position is consistent with its overall profile (qualitative judgments by supervisors on the ability of each bank to measure and manage its own risks). Third pillar (market discipline): encourage effective disclosure about risk exposure, capital adequacy and risk management techniques.
- What is the difference between the standard and IRB-approach and ‘foundation and advanced’ IRB-approach?
Standard approach refers to external credit assessment through credit rating agencies;
IRB-approach: banks are allowed to use their own internal credit risk assessment methods in a less (fundamental) or more advanced way (with the use of more statistical methods to assess risks).
- Mention two potential ‘winners’ and two potential ‘losers’ under the Capital Accord Basel II.
Winners: large prudent banks; retail banks; highly credit-rated corporations etc.
Losers: weak OECD credits; high-yield loan market; credit derivatives etc. (see p.187)
- What is meant with ‘pro-cyclical effects’ of Basle-II and how can banks reduce these effects?
Capital adequacy rules may exacerbate downturns in the business cycle. Banks should put a larger percentage of their retained profits in their reserves.
The purpose of the ‘counter cyclical capital buffer’ in Basel III is to reduce pro-cyclicality and to take into account inter-linkages and common exposure among financial institutions.
- What are the four major adjustments proposed for Basel III (to be phased by 2019)?
Calculation of Tier 1 capital (more core capital: common equity and retained earnings); risk weightings for exposure to certain securitized assets; leverage ratios (as measured by equity/assets); liquidity ratios (global liquidity standards).
