Econ of Banking and Finance Flashcards
What are the three types of banks?
Commercial banks, investment banks, universal banks
What are the advantages of universal banking?
- Economies of scale
- Economies of scope
- Risk diversification
What are the disadvantages of universal banks? Which are specifically related to policy?
-Potential conflict of interest
- Management more difficult
- Use funding protected by deposit insurance (policy)
- Bank may become ‘too big to fail’ = costly bailout (policy)
What is one way to resolve the conflict of interest of universal banks?
Banks build a reputation for only issuing good securities, which is valuable for the bank.
What is fee income share?
Share of non-interest income in total operating income, can be used as a proxy for w (weight of investment banking activities)
What are the indexes of bank returns and bank risks?
- ROA = pre-tax profits / assets
- Z-score = [E(ROA) + Bank equity/Assets] / SD ROA, interpreted as the number of SDs that return on assets has to fall below expectation for the bank to become insolvent.
Which banks have the lowest Z-score?
Banks with fee income shares close to 1, so investment banks.
What are the main empirical conclusions regarding universal banks with regards to their choice of allocation of investment and commercial banking activities?
- Investment banking tends to increase expected returns
- Some small share of investment banking activity in total banking activity may reduce risk
- It is optimal for investment banking models to be allowed, but regulation may be necessary to limit risk.
What are capital requirements? What is the capital ratio?
The capital requirement is a minimum amount of capital or equity which a bank should have. The capital ratio is Equity/Assets = lambda. The capital requirement imposes minimum level of lambda.
What is the purpose of capital requirements?
- Reduce risk-taking behaviour by banks
- Reduce probability of bank failure for bank liability holders, bank lending customers and public treasure as bailout may be costly.
What is the point of international capital adequacy standards?
- Eliminate international competition in the area of capital regulation, particularly eliminating competitive reductions in standards to gain market share.
- Reduce compliance costs for banks
- Reduce incentives for banks to engage in international regulatory arbitrage by relocating
- Make it easier to compare banks internationally
What is a risk based capital ratio? What do the weights reflect?
The nominator is a measure of capital and the denominator is a measure of risk-weighted assets. Weights reflects how risky assets are, there is a clear bias towards gov finance, showing that politics are important in banking regulation.
What is regulatory capital arbitrage?
Banks may rebalance their assets to have have low-risk assets on paper but that are actually riskier in practice (think of mortgage VS blue chip company). This means that capital requirements decrease while decrease while risk actually increased.
What are the three pillars of Basle II
- More sophisticated calculation of RCBR by taking into account more risks
- Guidelines for bank supervision to assess bank risks not accounted for by Pillar 1
- Public disclosure requirements for banks
What is Value at Risk (VAR)?
The minimum k such that P(L >k) < 1 -q. In other words, k is the minimum value such that the probability of higher losses than k is equal or less than 1 - q. Where 1 -q is the probability of ‘high’ losses, and implies the level of risk tolerance
What were the main changes from Basel II to Basel III?
- Higher quality capital and higher minimum capital ratios under Pillar 1
- Additional risks considered
- Introduction of a leverage requirement
- Additional disclosure requirements
- New liquidity requirements
How are capital requirements privately costly for banks?
- Lower interest tax deductibility
- Lower implicit subsidies through reduced prospect of bailout in case of failure
What are the social costs/benefits of higher capital requirements?
- They lead to higher loan interests, lower loan growth and GDP growth.
- Reduction in the probability of a crisis in a year multiplied by the average cost of a crisis if it occurs.
What is Tobin’s q? What does it measure?
- q = market value of bank assets / book value of bank assets
- It measure whether assets are over or under valued. If q <1, then assets are overvalued.
What is the purpose of deposit insurance?
- Reduce the probability of bank failure, reduce cost of bank failure.
What makes bank fragile?
- Short-term debt (susceptible to bank runs)
- Average maturity of assets tends to be larger than the average maturity of liabilities
- Fire sales (sell assets quickly at a lower place to become liquid)
- Small proportion of cash relative to assets
- High leverage
What are ex post and ex ante security premiums?
- Ex ante is regular insurance premium
- Ex post is that banks who survived have to pay for banks that went under
What is market discipline?
- Market discipline exists if the cost of bank funding reflects the riskiness of bank’s assets portfolio; if so, it potentially constrains a bank risk tanking.
How does deposit insurance potentially undermine market discipline? Which paper showed this?
It makes deposit interest rate in theory less dependent on bank risk. (low interest rate could be offered even when banks take high risk, making the bank potentially act recklessly). ‘Market discipline and deposit insurance” (JME,2004)
How does deposit insurance affect bank stability ?
Ambigous:
- Prevents bank runs
BUT
- Reduces market discipline
How can the effect of explicit deposit insurance on the probability of a crisis be mitigated?
With a higher quality of supervision, which prevents banks from taking excessively risky strategies.
What incentive do TBTF institutions have?
Incentive to take on more risk (moral hazard), incentive to become too large and complex
How does TBTF affect competition?
It distorts competition. It allows TBTF firms to gain market share and additional profits at the expense of smaller firms that are not TBTF.
What was testified in September 1984?
The Controller of the Currency testified before congress that some banks were simply TBTF, and that total liability insurance would be provided for those. This would apply to the 11 largest banks.
What are the positive wealth effects for TBTF banks?
- Liabilities are riskless, reducing cost of funds, allowing banks to take more risks
How do O’Hara and Shaw investigate wealth effects? What do they find?
