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
why night more and intense competition in financial markets be a bad idea?
because the banks would lower interest they charge on loans to attract customers and would have to take higher risks to make up for the loss of profit from their lower interest
what is a financial crisis?
a major disruption in financial markets, with the result that financial frictions increase sharply and financial markets stop functioning
what are 4 results of a financial crisis?
sharp declines in asset prices
failures of many financial and non-financial firms
high unemployment rate
high interest rates
what are financial frictions?
asymmetric information problems
what happens if financial markets stop functioning?
broad economic activity can collapse
what was the biggest financial crisis?
the great depression
how much did the stock market drop during the Great Depression?
90%
how much did the canadian and US GDP drop during the great depression?
US GDP dropped 30%
canadian GDP dropped 25%
how many banks failed during the Great Depression?
more than one third of US commercial banks failed
what lead to prolonged economic contraction during the great depression?
the decline in net worth and worsening credit
how much did unemployment rise in canada and the US during the Great Depression?
US unemployment rose by 25%
canada unemployment rose by 20%
how much did the stock market drop during the financial crisis in 2007?
dropped by 50%
how much did the GDP decline during the 2007 financial crisis?
GDP fell at -1.3% annually in the third quarter of 2008
then fell at -5.4% and -6.4% in the next 2 quarters
how much did unemployment increase during the 2007 financial crisis?
US unemployment increase from 4.6% in 2007 to 10% in 2009
canada increased to 8.7%
what are the 6 causes of the 2007 financial crisis?
bursting of the US housing bubble and subprime mortgage crisis
change in lending model: MBS
credit default swaps
inaccurate credit ratings
government policies
global financial integration: crisis spread to global financial markets
what are subprime mortgages?
when the borrower of the mortgage has a credit rating lower than 610
how did the the housing market react before the 2007 financial crisis?
from 2002 - 2006 the housing market prices increased by 40% in 4 years
how did the housing market react during the financial crisis in 2007-2009?
house prices dropped by over 30%
what is a recourse mortgage?
when the bank can go after any assets the borrower has to recover the cost of their outstanding debt
what is a non-recourse mortgage?
when the bank cannot go after any asset besides the house in the event the borrower defaults
what are the 2 reasons for the US housing bubble?
easy credit supply
high mortgage demand
what were the 3 reasons for easy credit supply during the US housing bubble?
low interest rates
large inflows of foreign funds
change of banking lending practices
what caused the low interest rates that caused easy credit supply?
the us federal reserve continuously lowered interest rates to maintain the domestic economy since 2001, that 6 years of constantly lowering rates
what caused large inflows of foreign funds that caused easy credit supply?
lots of government bonds and government agency bonds and stock was being bought by foreign countries and their funds where entering the banking system
what caused a change in lending practices cause easy credit supply?
the increase of mortgage baked securities caused lending standards to decline so they firms could benefit from the MBS but this made it easy for people to get mortgages with bad credit
what are the 5 reasons that mortgage demand went up during the US housing bubble?
longterm trend of rising prices
lower lending standards
increase in loan incentives
easy refinancing
increase in speculation in real estate
how did long term trends of rising housing prices cause mortgage demand to go up?
because the media pushed this idea that if you don’t get a house now it will only be come more and more expensive in the future
how did lower lending standard cause mortgage demand to go up?
it was a lot easier for people to get a mortgage so they wanted to get them just because it was easy
how did an increase in loan incentives cause mortgage demand to go up?
they offered 0 down mortgages and adjustable rates so it made it easier to get a mortgage, this was done so firms had more MBS to sell
how did an increase in speculation in real estate cause mortgage demand to go up?
because it made people want to get houses before it got even more expensive
how did the housing bubble impact refinancing on homes?
it caused many home owners to refinance their homes at lower interest rates or taking out a second mortgages to use for consumer spending
how much was personal spending responsible for debt in 2007?
127% of debt was from personal consumer spending and 40% of credit cards had an unpaid balance on them
what are the 6 causes of the bursting of the US housing bubble?
oversupply of housing
increased interest rates
declining house prices
difficulty refinancing for subprime borrowers
mortgage default and foreclosure
downward pressure on housing prices
what is the originate to distribute model?
when the credit risk of the mortgage is transferred to investors through mortgage backed securities. securitization created a secondary market for mortgages and meant that the issuer did not have to hold them till maturity
what are mortgage backed securities?
when the risk is shifted from the mortgage issuer to investors, the issuer could repeatedly relend a given sum and keep increasing their fee because they would sell off their mortgages
how much money can from the securitization market?
10 trillion
how much the the share of subprime mortgages increase in MBS?
from 54% in 2001 to 75% in 2006
what is a credit default swap (CDS)?
a swap contract in which the buyer of the CDS makes a series of payments to the seller and in exchange, the buyer receives a payoff if a credit instrument (Bond or loan) goes in to default or the company goes bankrupt
who is typically the seller of a credit default swap?
insurance companies
how would investors use credit default swaps?
they would buy them if they had some speculation regarding the failure of somthing in the market
how much did the volume of outstanding credit default swaps increase from 1998-2007?
100 times
what is the intended reason for financial innovation?
it is intended to redistribute and reduce risk, appears mainly to have the redistribution hidden from view
how did inaccurate credit ratings impact the 2007 crisis?
many credit rating agencies were under scrutiny for having given investment grade ratings to CDS and MBS even though they were made up of subprime mortgage loans
why did credit rating agencies give these higher ratings even when they should not have?
because the rating agencies had a conflict of interest because they were paid by investment banks and other firms that organize and sell structured securities to investors
what were the 2 ways that the 2007 crisis impacted banks?
banks faced huge losses
banks capital levels were depleted
what is reason why banks faced huge losses due to the 2007 crisis?
the mortgages they issued defaulted and their MBSs as their value and market liquidity dropped
what is the reason why banks capital levels were depleted in the 2007 crisis?
banks had high debt levels and the crash lowered their assets so they could not meet their obligations
how did the 2007 crisis impact businesses?
they had a liquidity crisis because it was harder to get loans and higher interest on loans
how did the 2007 crisis impact European banks?
they had huge bank losses and assets were down 323.3 billion dollars
how much the the IMF estimate that financial institutions around the world had to write off of their holds of subprime MBS?
1.5 trillion
what did the federal reserve do in response to the 2007 crisis?
loser federal funds rate from 5.25% to almost 0 percent
provide 1.6 trillion in short term loans to banks
help to rescue financial institutions and provided emergency loan of 85 billion to AIG insurance
3 rounds of quantitative easing ( QE1 November 25, 2008 and march 18,2009. QE2 November 2010. QE3 September 2012
how much did the banks spend during their quantitative easing?
the fed announced a 600 billion program to purchase the MBS and GSE to help lower mortgage rates
pumped an extra 1 trillion dollars in to the financial system by purchasing treasury bonds and mortgage securities
what were the 4 fiscal policy responses of the US government to the 07 crisis?
troubled asset relief program (TARP, 700 billion
recapitalize a number of banks by purchasing newly issued preferred stocks
Fannie mae and Freddie back was under government control
fiscal stimulus
why did the us government take ownership of Fannie Mae and Freddie Mac?
the us government spend 225 billion to buy them because they had more than 5 trillion outstanding dollars in MBS and debt
what fiscal stimulus did the us government do in response to the 07 crisis?
on February 13, 2009 congress passed the 787 billion economic stimulus bill
what the the economic stimulus bill do?
it provided tax credits, expansion of social welfare benefits and domestic spending on education, healthcare and infrastructure
who did the economic stimulus bill help?
it helps the us people recover and not the banks
how did economists react to the economic stimulus bill?
economists reactions differed, some said good some said bad
what is CMHC?
canada mortgage and housing corporation
what does the canada mortgage and housing corporation (CMHC) do?
they provide mortgage insurance and use securitization with MBS
how did the 07 crisis change financial regulation in 2 ways?
pre crisis the regulation was micro prudential supervision and after the crisis they changed it to macro-prudential supervision
Dodd-frank Wall Street reform and the consumer protection act of 2010
what is micro prudential supervision?
it focused on the soundness of individual financial institutions and not focused on looking at at the whole economy
was micro prudential supervision sufficient for preventing financial crises?
no
what is macro prudential supervision?
a supervision that focuses on the safety and soundness of the financial system as a whole rather than the individual institutions
how does macro prudential supervision help prevent financial crises?
it tries to short-circuit leverage cycles so there isn’t to much leverage being used at once, it makes capital requirements go up when the when the economy is doing good and lowers capital requirements when the economy is not doing good
what are the 5 things the Dodd-frank Wall Street reform and the consumer protection act of 2010 do to help prevent crises?
consumer protection
resolution authority
systemic risk regulation
Volcker rule
regulating derivatives
how does consumer protection help prevent financial crises?
the act created a new consumer financial protection bureau
what is resolution authority?
the rule that makes banks write down what they will do if there is another crisis
what is systematic risk regulation?
when the federal reserve identifies the systematically important financial institutions (SIFIs) and regulate them more tightly because if they were to fail that would cause a lot of damage in the economy
what are the 2 kinds of systematically important financial institutions?
domestic
global
how many domestic systematically important financial institutions does canada and the us have?
canada: 8
US: 20
how many global systematically important financial institutions does canada and the us have?
canada: 2
US: 6
what is the Volcker rule?
places a restriction on proprietary trading
what is proprietary trading?
when the bank is trading with their own money, this can cause them to make recommendations to customers just so it can ultimately benefit the bank
what is an example of proprietary trading?
lets so a bank is wanting to dump a bunch of bitcoin because they think it will go down so they make recommendations to buy bitcoin to their customers
how can regulating derivatives help prevent a financial crises?
they require that certain products like derivatives to be traded on certain exchanges and also require high capital requirements and higher margins of using their own money to debt when trading derivatives
what is the financial choice act of 2018?
it scales back many of the provisions of the Dodd-Frank act, like increasing the threshold for a bank to be considered a bank that’s to big too fail to be moved from 50B in assets to 250B in assets
what are the 2 banks impacted by the financial choice act of 2018?
Silicon Valley banks failure (209B in assets and the 16th largest us bank)
signature banks failure (110B in assets and the 29th largest us bank)
does the regulation process always work?
no it might not always work to prevent a global financial crisis, but it is a very important part of preventing it
what was an early symptom in canada of the 07 crisis?
the asset-backed commercial paper market was frozen (110B) worth of assets were frozen in august 2007
how did the 07 crisis impact canadian mortgages?
the high-risk, long-term 40 year 0 down payment mortgages grew in popularity in 2007 and 2008 but in the summer of 2008 this mortgages were banned and a number of rounds of mortgage rules changed
what problems did canada have during the 07 crisis?
shares fell by almost 50% and some experienced huge losses but governments did not have to bail out any banks
why was cananda spared of the worst in the financial crisis?
the canadian regulatory and supervisory framework helped shape lending practices and contributed to the resilience of Canadas housing system
