class 7 Flashcards
what is a government safety net?
a collection of programs that help banks if they are in trouble
are banks firms that need funding?
yes
what are the 3 problems between banks and depositors?
asymmetric information problems
potential adverse selection among banks
potential moral hazard by banks
should depositors need to screen and monitor banks?
yes
why should depositors need to screen and monitor banks?
to make sure they do not make poor decisions
how do banks deal with people withdrawing?
they have a first-come-first-serve feature to withdraw deposits
what does the first-come-first-serve feature cause?
it causes a strong incentive to withdraw deposits in case of doubt
what are the 3 potential consequences that the first come first serve withdrawal feature causes?
bank run
bank failure
bank panic
what is a bank run?
massive withdrawals of deposits from a bank that can cause a bank failure
what is a bank failure?
when a bank is unable to meet its obligations so they must go out of business, this can cause a bank panic
what is a bank panic?
massive withdrawals from multiple banks, even good banks can fail in a liquidity crisis, so expectations of bank failures can be self fulfilling prophecies
what are the 2 companies that provide deposit insurance?
federal deposit insurance commission (FDIC) US
canada deposit insurance corporation (CDIC) canada
what are the 3 other forms of government safety net?
lender of last resort (by central banks)
crisis support of financial institution:
capital injections
nationalize troubles institutions
what was diamond-bybuig?
in 1983 they wrote a paper that gave solid evidence that needed we needed deposit insurance
what is lender of last resort?
when the bank of canada lends emergency funds to avoid banks runs and financal instability
what are capital injections?
when a bank is in trouble, the government gives bank additional cash in exchange for ownership in the bank
what is nationalize troubled institutions?
the government covers all liabilities of a bank that cannot but takes full ownership in a bank that can’t meet its liabilities
will the central bank help insolvent banks?
no
what is an insolvent bank?
when a bank has more liabilities than assets
is the government safety net a mixed blessing?
yes
what are the 3 drawbacks to the government safety net?
insured depositors have less incentive to screen the banks
moral hazard
some banks are to-big to fail
why is it a drawback that the government safety net makes insured depositors to screen the bank?
insurers have less incentive to screen the banks but the government doesn’t impose market discipline to make them act any different
why Is moral hazard a draw back of banks having a government safety net?
the banks will have a greater incentive to take on greater risk due to them knowing that they have insurance and that they are unmonitored by insured depositors
why is some banks being to-big-to-fail a drawback of banks having a government safety net?
since some banks are so big regulators are reluctant to close down large financial institutions and impose loses to their creditors because doing so might trigger a financial crisis
what explains the reason for the need for financial regulation?
the drawbacks of government safety net explain the need for financial regulation
what are the 8 types financial regulations?
restrictions on asset holding
capital requirements
prompt corrective action
financial supervision
assessment of risk management (new focus)
disclosure requirements
consumer protection
restrictions on competition
what are 2 examples of restrictions on asset holding?
when banks cannot hold ownership in a company that they lend to
a banks overall lending cannot exceed more than 50% mortgages
what are capital requirements?
when there are regulations that state how much capital a bank has to hold
why is it important for capital requirements?
capital functions as a cushion when bad shocks occur, the capital adds to the safety and soundness of financial institutions
what is the leverage ratio?
capital divided by total assets
what are the 2 kinds of capital requirements?
leverage ratio
risk-based capital requirement
what is the risk-based capital requirement?
the Basel accord requires banks to hold capital at lest 8% of their total risk-weighted assets
what is the Basel accord?
requires banks to hold capital at least 8% of their total risk weighted assets
what are the 4 different categories assets are allocated in to?
zero weight
20% weight
50% weight
100% weight
what do the 4 different categories of assets reflect?
each weight reflects the degree of credit risk of each asset
what assets are in the zero weight category?
reserve and government securities
what assets are in the 20% weight category?
claims on banks (holdings of bonds issued by other banks)
what assets are in the 50% weight category?
municipal bonds and residential mortgages
what assets are in the 100% weight category?
loans to consumers and companies
what is Basel II?
it was supposed to be implemented in 2007 but it was not after the financial crisis
what is Basel III?
fully implemented in cananda in 2023, this made capital counter secular, making banks have higher capital ratios and lend less in good economies and have lower capital ratios and lend more in poor economies
it also made big banks have a higher capital, 10%-11% instead of 8%
how do you get risk-weighted capital ratio?
capital/ the sum of all assets times their risk category
(check note 7 slide 10)
what is prompt corrective action?
when there is large capital loss, the CDIC will intervene to stop further capital loss
what are the 2 kinds of financial supervision?
regulatory filing
on-site examinations
what are regulatory filing?
evert month, every bank needs to submit what loans they made to OSFI to pass on to the BOC
what are on-site examinations?
OSFI regularly visits large banks to check on them
when did assessment of risk management become the new focus?
after the 2007 financial crisis
what are the 2 kinds of assessment of risk management?
internal risk control process
stress tests
what are internal risk control process?
they control what risk is being taken
what are stress tests?
when the regulators create bad scenarios and see if the bank can still survive
what is an example of a stress test?
when the regulators see if a bank can survive the housing market dropping by 30%
what are disclosure requirements?
when banks need to report securitization
what is consumer protection?
when regulators protect the interest of consumers and make sure consumers are not mislead
what is an example of consumer protection?
when Wells Fargo created accounts under peoples names to benefit the tellers, the regulators would intervene here
what are restrictions on competitions?
when regulators do not want to many banks in a country and need banks to receive a charter to open