Complete Flashcards
Give an Historical insight of Bank Runs
1620: Thirty Years War
* German city-states minted imitations of rival cities coins using lesser metals
1772: Financial Haggis (UK)
* Scottish bank had lost customer money in risky speculation. Triggered chaos that took down almost all of the country’s private banks. Inspired the parliament to pass the Tea Act.
1873: The Great Freakout
* Customers demanded gold for cash. Economic crisis. US sent army to war with Native Americans in area with gold
1914: Schwenk Ban run (New York)
* State banking regulators seized three banks owned by Schwenk, due to dodgy accounting.
1930s: The Great Depression
* Over 9,000 banks collapsed
1980: Savings-and-Loan Crisis (US)
2001: Great Depression of Argentina (Malos Aires)
* Not enough dollar to cover all deposits. Had to put restrictions on withdrawal
2011-present: Greece (EuroBlown)
* High public spending, big debt
* A quarter of all deposits have been pulled from Greek banks over two years
What happened after stock market crash of October 1929 in US
- Wealthy people pulled out money from banks
- Less capital available = less capital for businesses and individuals
- Less capital for businesses and individuals = decline in production and employment
- Wave of Bank runs
What will a bank have to do in the case of a bank run?
The bank needs to come up with the necessary cash:
a) Liquidate loans (sell the loans, securitize them, borrow from a central bank)
b) Sell assets (often at rock-bottom prices)
Who was the president during the Great depression, and what did he do to end it?
Franklin D. Roosevelt
a) National Bank Holiday (Temporarily closure to access their solvency)
b) New Banking Legislation: The Emergency Banking Act of 1933 (aimed to separate good and bad banks)
c) The New Deal. For employment
d) Spoke on Radio: Public confidence “fireside chats”
Lehman Brothers. Size and timeline
- Fourth largest U.S Investment Bank
1. Buying the Bubble: Aimed to profit from booming housing market. Acquired several mortgage lenders.
a) Subprime Loans: offered to those with low creditworthiness
b) Alt-A Loans: A Type of mortgage loan. Lower income and less documentation required. Slightly better than Subprime, but still risky
2. Securitizing Mortgage Loans: Pooled them and sold them
3. Big profits from 2005 – 2007 - 2007: Underwrote more mortgage-backed securities than any other firm
- BNC: A Subprime mortage lender that was a subsidiary of Lehman. Known for its aggressive lending practices – offering many subprime mortgages – Which was pooled together and sold.
4. Increased its leverage.
5. Crisis:
a) Heavy investments in subprime mortgage market
b) High degree of leverage
6. Measures after crisis
a) Shut down BNC
b) Closed offices of Alt-A lender Aurora
c) Positive Public messages from CFO
7. After Korean Bank
a) Big plunge in Stock
b) Big increase in credit-default swaps on the company’s debt (shows investors confidence)
c) Hedge Fund clients started to withdraw their investments
d) Short-term creditors cut credit lines
Bankruptcy in September 2008
How to stop a Bank Run or Panic (Explanation, Example, Disadvantage)
(BLESIC)
a) Suspension of Convertibility
* Example: Roosevelt, 1933: National Bank Holiday
* Disadvantages:
Stops people who genuinely need money to withdraw.
Not easy to do today (digital banking)
b) Coalition of Private Banks
* Example: Northern Rock, 2008 – Barclays, Lloyd, Royal Bank of Scotland)
- “clearinghouse loan certificates”: Short term loans or promissory notes backed by the collective resources of the coalition banks
* Disadvantage: If all banks are suffering from common shock, it does not work
c) Government Deposit Insurance
* Example: 1934: Federal Deposit Insurance Corporation (FDIC)
- The government insure the people that they will give the people their money in case of bankruptcy
* Disadvantage:
Moral Hazard: Depositors feel that they don’t have to monitor the banks. So banks are not restricted from taking higher risks. Hence, the bank can take higher risk by lending out more money.
Too-Big-To-Fail: Banks covered by Deposit Insurance. Failure of a covered bank can trigger a chain reaction. Banks owe money to each other
d) Capital Requirement and Cash Requirement (always)
- A bank has to hold an amount of reserves. Often as a ratio of equity that must be held as a percentage of risk-weighted assets.
i) Bank cannot take too much leverage
ii) Bank have liquid funds in times of financial distress
* Disadvantage: Reduces the efficiency of a bank’s use of money and hence increases the costs of credit for the entire economy
e) Lender of Last Resort
* Example: Reichsbank, 1914: Schwenk. Also, many in 2008)
- Bank run will stop if people are not afraid that the bank will run out of money. Hence, central banks can back up private banks.
* Disadvantage:
Moral Hazard: Banks might take higher risks (can rely on central)
Financial Risk: Central Bank can be exposed to significant financial risk
Blurring the Boundaries: Blur boundary between monetary and fiscal policy. By giving money, gets involved in fiscal matters
f) Government Bailouts (2008: Several governments, U.S: TARP)
- Government aims to raise Credit Availability:
i) Liquidity injection: Asset purchase, Debt guarantee or Direct Debt (Provide immediate funds to address short term liquidity)
ii) Equity Injection (Acquiring ownership by buying newly issued preferred stocks)
* Disadvantage: Too-Big-To-Fail creates Moral Hazard. Signals to market that risky banks will be saved regardless of risky behaviour
g) Equity Injections
* Example: 2011: Government and International institutions provided equity to Greece)
How did they raise Credit Availability in 2008?
(CRID)
a) Removing Poisonous Assets:
* Programs like TARP, where government bought troubled assets, like mortage-backed securities from financial institutions
b) Debt Guarantee:
* Government pays debt for another party. Makes it easier for banks to do liquidity things.
c) Relaxing the requirement of collateral
* Bank gets to access funding by using a broader range of assets as collateral (also those who might have lost value)
d) Increase Borrowers Net Worth:
* Individuals and Businesses. Financial Assistance
What is the Diamond Dybvig Model
- Model of bank runs and related to financial crises.
- Shows how a mix of these components may create panics by depositors:
a) Illiquid assets (like mortgage loans)
b) Liquid liabilities (deposits which may be withdrawn at any time)
What are the General Principles of Bank Regulation
(MLM)
a) Licensing and supervision
Banks usually need banking license from national bank.
The regulator supervises licensed banks
b) Minimum Requirements
National bank imposes requirements for banks, often closely tied to the level of risk exposure.
Most important: Maintaining minimum capital ratios
c) Market Discipline
Banks must publicly disclose financial statements
What are the Instruments and Requirements of Bank Regulation
(FCC CARL)
a) Capital Requirement
- How banks must handle their capital in relation to their assets
b) Reserve Requirement
- Lost the role it had, as the emphasis has moved to capital adequacy
c) Corporate Governments (Encourage bank to be well managed)
- Legal entity, number of directors, organization structure
d) Financial reporting and disclosure requirements
- Requirement of disclosure of banks finances
e) Credit Rating Requirement
- May be required to obtain credit rating given by credit rating agency
f) Large exposures restrictions
- Prevent banks from having overly large financial exposures to specific individuals or groups of related individuals
g) Activity and Affiliation
- Limit activities banks can engage in and the relationship they can have with other financial institutions
FED Controversy
- Lending to private firms, hence putting taxpayers money at risk
- Could avoid these problems by not lending to private firms
What was BNC
A Subprime mortage lender that was a subsidiary of Lehman. Known for its aggressive lending practices – offering many subprime mortgages – Which was pooled together and sold.
How much involved did Lehmann get in the mortgage market in 2007
In 2007 they underwrote more mortgage-backed securities than any other firm
Why has Europe never had to use the Suspension of Convertibility?
Banks have not ran out of money because of Lender of Last Resort. Commercial banks have borrowed money from the European Central Bank.
What is a clearinghouse?
A “middle-man” between buyer and seller.
What is “clearinghouse loan certificates”?
Short term loans or promissory notes backed by the collective resources of the coalition banks
Why did central banks emerge?
Evolved as a response to the inability of the commercial banks to cope with panics
Where can you find Deposit Insurance today, and how does it work?
Most countries in Europe.
(But also USA I believe (?))
Similarities between collapse of Lehman Brothers and “normal” bank runs?
- Underlying reasons are similar
1. Institutional investors stops funding the bank
2. Due to liquidity problems Bankruptcy
What is one solution that has been proposed to the risk of Deposit Insurance?
Deposit insurance backed by the whole eurozone.
Taxpayers of Germany would have to pay for financial stability in Greece.
How will Capital Requirement usually be expressed?
As a ratio of equity that must be held as a percentage of risk-weighted assets.
Why are Capital/Cash requirements put into place?
Often as a ratio of equity that must be held as a percentage of risk-weighted assets.
This is good because:
a) Bank cannot take too much leverage
b) Bank have liquid funds in times of distress
Bank ru: Liquidity injection through ….?
Asset Purchase
Debt Guarantee
Direct Debt
What is the main argument for Bank Regulation?
Too-Big-To-Fail
certain banks, due to their size, complexity, or interconnectedness with the financial system, pose a significant risk to the overall economy if they were to fail
What are the different types of banks
a) Central Banks
b) Commercial Banks
c) Investment Banks
Main Tasks of Central Bank
a) Control the nations money supply
b) Oversee the commercial banks
What are the different Banking Services
a) Individual Banking - help people to manage their finances
b) Business Banming - Business gets different type of service
c) Digital Banking - Digital services
What are the Main Policy Tools of Central Banks (in controlling money supply)
a) Open market operations
* Buy and sell securities in the open market.
- Buying securities = injecting money
- Selling securities = withdrawing money
b) Lender of Last Resort:
* Central bank’s role as a source of funding for banks and other financial institutions during times of financial stress or crisis
c) Minimum reserve requirements:
* Amount of money that banks are required to hold in reserve.
- By adjusting, central banks can control the amount of money banks have available to lend
d) Monetary Policy (Interest rate etc.)
* The rate which banks can borrow from the central bank
- Courage or discourage banks from borrowing, which in turn affects amount of money in economy
What is the interbank market? Purpose & rates
A Debt market among banks. Is used to:
a) Manage liquidity (may need to borrow from other banks on a short-term basis to meet liquidity needs)
b) Satisfy regulations (such as reserve requirements)
Uses FED-rate, Euribor or LIBOR
Credit Unions / Mutual Banks
- Not-for-profit organizations, but not for charity. Offer many of the same services as banks.
- When you invest in a credit union, you get an ownership in the union. Banks are normally owned by investor, which does not need to have money in that bank.
Commercial versus Investment Banking
a) Deposits
* IB does not take deposits
b) Risk:
* IB has freedom to take more risk.
* Commercial are governed, so less freedom. To protect the customer
c) Insured
* Commercial often insured by central bank
Revolving lines of credit
Allows you to borrow money when you need it and pay interest only on what you borrow. Then, if you pay back any of the borrowed funds before the end of the draw period, you can borrow that money again.
Commercial & industrial (C&I) loan market
- Collateral loans made to a business or corporation either to provide working capital or CAPEX (operational purposes)
- Always collateral.
Role of Investment Banks
Function as a underwriter/agent in the issuance of securities. To help corporations, governments and individuals by raising capital. Mainly serve businesses. Often involved in M&A and IPOS.
What has Information Technology done for banking
Has facilitated the harnessing of economies of scale in the banking industry during the last decades (increased production or operational efficiency)
Give an insight of the FED-rate before the 2008 crisis. Why was it so low, and what did it lead to?
- FED-rate:
* FED lowered funds rate from 6.5% to 2% in 2001, and kept it at 1% until 2004. With 2% inflation, this gave a negative real rate.
* The rate was so low because of:
a) Dot-com bubble busted in 2001
b) Concerns about Japanese stagnation in the 90s and deflation - Cheap Liquidity:
* Businesses and households borrowed. Big increase in both household debt and house prices
What is Subprime Lending?
- Loans to borrowers with poor credit scores or low income
- these loans had
a) Lower credit standards (To people with poor credit scores)
b) Lower down payment requirement (not required to provide a significant upfront payment when purchasing a property, EGENKAPITAL)
c) More flexible term than traditional mortgages (interest rates, longer loan terms etc.)
Government Housing Policy before 2008
a) Fannie Mae and Freddie Mac
* Were Government Sponsored Enterprises (GSEs) created by U.S government. They bought mortage loans from banks and other lenders, providing them liquidity. Fannie Mae and Freddie Mac would then package these loans into mortgage-backed securities (MBS) and sell them to investors in the form of securitized packages
b) Lending to Minorities
* Congress started program to expand mortage lending to minorities and low and moderate income groups.
c) Subprime lending: Loans to borrowers with poor credit scores or low income
i) Lower credit standards (To people with poor credit scores)
ii) Lower down payment requirement. Declined from 20% to 3.5% (not required to provide a significant upfront payment when purchasing a property, EGENKAPITAL)
iii) More flexible term than traditional mortgages (interest rates, longer loan terms etc.)
Main reasons for financial crisis 2008
a) The Low Federal Funds Rate
* After dot-com 2000 and concerns about deflation and japanese stagnation, FED lowered the rate from 6.5& to under 2% in 2001
b) Government Housing Policy
* Fannie Mae and Freddie Mac
* LMIs
* Subprime Loans
c) Soaring Risk from Securitazation
* Mortages where packaged into complex securitization packages, which were sold to investors. Often highly rated, but in reality, of poor quality
What is Securitization
When assets are pooled so that they can be repackaged into interest-bearing securities.
Problem with Securitization during the 2008 crisis
Securitization to manipulate credit ratings
- Lower tranches were put together with tranches from other pools that carried lower risk. By combining them, the overall risk of the pool was distributed over a large number of loans, making it appear less risky.
- The borrowers was diversified across geographical regions and economics, making it appear as “reasonably safe securities”
LIBOR Scandal
2012.
Banks manipulated the interest rates. Falsely inflating or deflating their rates. They did this because they wanted to:
a) Profit from trading
b) Impression of creditworthiness
TARP
Troubled Asset Relief Program.
Created by U.S Treasury to stabilize the financial system.
TARP bought troubled companies assets and stocks
What happens during a bank run
- Many bank customers withdraw their deposits
- This increases probability of default
- This makes even more people withdraw money
- In extreme cases, the bank reserves might not be enough to cover the withdrawals
“Repo” and “run on repo”
a) Repo
* Repurchase agreement. Financial transaction where one party (usually a borrower) sells a security to another party (usually a lender) with an agreement to repurchase the security at a later date and at a slightly higher price.
b) Run on Repo:
* A run on repo occurs when lenders or investors lose confidence in the borrower’s ability to repurchase the securities in a repo agreement.
* Can lead to a situation where lenders demand their securities back, and the borrower may struggle to fulfill those demands, potentially causing a liquidity crisis
“Repo” and “run on repo” in the financial crisis 2008
- Some Banks, IBs relied heavily on repo financing to fund their activities, using mortgage-backed securities (MBS) and other collateral as the basis for these transactions
- Banks would pledge these MBS as collateral in repos, receiving cash in return, which they could then use for lending or other purposes.
- Crisis unfolded, housing market down, mortgage backed securities dropped in value
- “run on repo” – investors fearing declining value of collateral:
- Lenders and investors did not want to participate more in repo transactions, specially MBS-backed collateral
- The collapse of Lehman Brothers triggered a run on repos in the interbank market and a run in the stock market
- Both market collapsed
Historical insight of Fintech
1950s - Credit Cards - Ease the risk and burden of only carrying cash
60s - First ATMs
70s - Electronic Stock Trading
80s - Rise of bank computers
90s - Internet and e-commerce models flourished, online stock brokerage websites aimed at retail investors
How did many financial institutions survice during/after the financial crisis?
Bailout of banks by national governments
Why was the Federal Funds Rate so low before the financial crisis?
a) Dot-com bubble busted 2001
b) Concerns about Japanese stagnation in the 90s and deflation
What was the FED real rate before the crisis?
1% until 2004, combined with 2% inflation. Hence, a negative real rate
How low did conventional down payment decline due to Subrime Loans?
From 20% to 3.5%
How were the shares of pools of mortage securitization sold as “reasonably safe securities”?
The borrowers was diversified acrss geographical regions and economics
Pros/Cons with securitization?
Makes the market more efficient
Gets more complicated and difficult to price and monitor (regulate). Hence, it is more risky
What is the “too big to fail” theory?
Certain corporations and particularly financial institutions are so large and interconnected that their failure would be terrible for the greater economic system.
Hence, they should be supported by the government when they face potential failure
2 of the different types of typical government interventions (injections)?
1) Liquidity injections (through assets purchase, debt guarantee or direct debt)
2) Equity injections
What happened to Northern Rock
was nationalized
Banks and FinTech in developing countries
Banks have not really penetraded developing countries.
Many there use payments apps. This is also getting bigger in the western world.
FinTech - The Case of China
The traditional wallet has been replaced by an electronic wallet on a smartphone.
China is today the most cash-free society of any of the worlds major economies
What are financial markets in short terms?
Market where people trade financial securities (e.g., stocks and bonds), commodities (e.g., metal or agricultural products), and other fungible assets
What are some of the different types of financial markets?
1) Loan Markets
2) Capital Markets
3) Money markets
4) Commodity markets
5) Options, futures and other derivatives
6) Insurance markets
7) Foreign exchange markets
What can capital markets be divided into?
1) Primarily markets
* Newly formed (issued) securities are bought and sold in here, such as IPOs
2) Secondary markets
* Allows investors to buy and sell existing securities
Provide an example of imperfect information between seller and buyer in regular market
Sellers often have better info about the good than the buyer (selling a car)
Example of imperfect info between workers and employers
Workers are knownledgeable about their skill, insustriousness and productivity.
Employers have limited info about the quality of prospective workers
Example imperfect info insurers and insures
Adverse: Insurers have often less info about the risk that their clients are taking
Moral: insured person might take higher risks
Example imperfect info insurers and insures
Insurers have often less info about the risk that their clients are taking.
nsurance might alter a persons behavior
Example of imperfect info between Professor and student
Ability, IQ, EQ, Exams, Student grades
Adverse selection and moral hazard are both examples of
Asymmetrical information between buyer and seller. This leads to market failure
Adverse selection
- Called “hidden types”
*Problem that occur BEFORE contract is written. E.g., trading partner cannot observe the quality of other partner
- Mitigate problem: Signaling, screening
Moral Hazard
- Problem that occur AFTER the contract is written. E.g., trading partner cannot be sure if the other is behaving OK after the contract is written
- Called “hidden actions”
- Mitigate: Monitoring
- No moral hazard in one-shot transactions: A seller does not need to worry about how a buyer treats a good after it is sold
How can adverse selection and moral hazard be related? Example in health care
Health care.
Insured person may chose to act more unhealthy due to insurance. Makes the insurance more attractive for the person that are insured.
Adverse: The person has a lot of info about his health before signing
Moral hazard: Acts different after signing
When is there no moral hazard, and why?
One shot transactions. A seller does not need to worry about how a buyer treats a good after it is sold
does moral hazard and adverse selection overlap? and why?
Every case of moral hazard has adverse selection at least to some extent.
The person who potentially will indulge in risk-taking behavior will have prior information about his/her risk-taking tendencies
How can financial institutions mitigate Risk-Shifting Moral Hazard?
1) Credit bureau: Credit information
* Company that collects info and provides consumer credit information.
2) Credit rating: Evaluation of creditworthiness
* Evaluation of the creditworthiness of a debtor, a business or a government, but not individual consumers. A credit rating agency evaluates the debtor’s ability to pay back and the likelihood of default.
3) Collateral
