Financial Flashcards
What would be the effects of an increase in risk perceptions by banks?
1) Mark up rises
2) Lending rate rises
3) Move up along IS curve - recession
4) bank treats as a negative demand shock
5) forecasts fall in inflation below target
6) find desired point on MR curve constrained by new PC, calculate policy rate required to achieve
7) lower interest rates
What is narrow money?
central bank money or high—powered money
notes
and coins and the reserve balances of banks held at the central bank
What is broad money?
central bank money plus commercial bank money
What affects demand for money?
Higher income = more demand (more transaction)
Higher interest rate = less money (bonds earn more and become more attractive)
Inflation = less money
structural changes in financial sector
What affects demand for money?
Higher income = more demand (more transaction)
Higher interest rate = less money (bonds earn more and become more attractive)
Inflation = less money
structural changes in financial sector and payment technology
Lower confidence = higher demand
What does the demand function for money look like?
there is no well-defined and stable downward sloping money demand function
Do changes in phi (structural factors, technolog etc) affect the CB’s ability to achieve its objectives
No
By keeping the policy rate unchanged, any shift in the money demand function affects the money supply but does not feed back to influence real economic activity
Why is the lending rate close to the policy rate?
Opportunity for arbitrage between short term interbank lending rates ($ market rates) and the rate paid on reserves
What are some factors that affect the mark up
1) risk perceptions
2) risk tolerance
3) ability to bear risk (depends on equity, capital cushions
4) competitiveness of banking sector
What is credit risk?
Cresdit risk relates to the fact that there si no guarantee that loans will be repaid or the principle will be paid back in full when repayment is due
securitised loans still carry credit risk as houses that are foreclosed sell at a loss
What is an example of moral hazard? How does it contribute to credit rationing
Following the signing of the contract, banks do not observe how much effort the agent exerts. IF a project fails it can be unclear whether this was due to bad luck or a lack of effort.
This affects the bank’s willingness to lend and contributes to credit rationing as the more wealth the agent invests, the better aligned their incentives are so those with little wealth may be unable to get loans
What is an example of asymmetric information and how does this contribute to credit rationing
Agent knows more about their financial situation than the banks
Charging higher interest rate to those with safe but low returning projects may not gain credit (adverse selection) so banks instead respond by rationing credit
What are the 3 main functions of a bank in a fractional reserve system?
1) maturity transformation
2) aggregation
3) risk pooling
What is liquidity risk?
risk that a bank in a fractional reserve system has inadequate reserves to
meet the demand by depositors to withdraw money from their accounts.
How can liquidity risk be dampened?
back-stop provision of central bank money through the Lender of Last Resort facility so no ‘first in queue’ incentive and deposit guarantees
What is the risk with LoLR and deposit guarantee schemes
need to balance protecting public from spillovers of banking crisis and avoiding moral hazard which makes the banks to behave less prudently
When is a bank bankrupt?
Value of assets < liabilities
What happens in the banking sector when there is an investment boom?
1) banks make new loans to households and firms and therefore need to replenish reserves a the CB
2) higher incomes generated by boom leads to higher household deposits and m more bonds
3) because some $ goes to bonds, increase in deposits doesn’t cover new lending so banks borrow from money market
4) CB raises policy rate to bring inflation to target
5) raises bank funding costs so banks pass on increase so interest sensitive spending declines
what happens to returns on bonds when the interest rate rises?
price of bonds fall so capital loss
What is the downswing of the house price cycle?
house prices decline
lower value of collateral
household borrowing falls
purchases fall
What is the downswing of the bank cycle?
asset prices decline
weaker balance sheets
bank borrowing falls
purchases of securitised assets fall
banks insolvent when assets < liabilities
Why is there special treatment for the banking sector?
economy depends on the provision of banking services, spillovers of a single bank to system as a whole due to complexity and interconnections of the sector
What is mark to market?
Asset value in the bank’s balance sheet reflect market prices
What are the 4 main types of crises?
1) inflation
2) currency
3) sovereign
4) banking
What is a banking crisis?
crises that Iead to the closure, merging or takeover by the public sector of one or more financial institutions
Associated with the bursting of asset price and credit bubbles and the collapse of highly-indebted borrowers
What are 3 characteristics of banking crises?
1) deep and prolonged asset price collapses
2) large and persistent adverse effects on the real economy (output and employment)
3) ballooning government debt
Describe the financial cycle?
Upswing characterised by rapid growth in house prices, banks extending more credit and a positive feedback process which amplifies rising prices and debt
upswing ends with collapse in prices and a banking crisis
downswing characterised by deleveraging as indebted agents seek to reduce debt and repair balance sheets, banks less willing to make loans. public debt rises
Is teh housing sector pro or counter cyclical
pro cyclical
In PDE diagrams, what do stable, unstable and multiple equilibria look like
x axis - time
y axis time + 1
linear, start above then below 45
unstable: start below, end up above, steep
multiple: s
first left part and last right part quite flat cross 3 places
Why does demand for housing rise when prices do?
If the conviction takes hold that the price will increase further, then this leads the demand curve to shift up in the supply and
demand diagram. People expect to make a capital gain from holding them so demand rises
How do price expectations affect the PDE curve?
As more and more people come to believe the price will fall, the PDE curve shifts down.
Tipping point is reached when it is tangent to the 45 degree line as in the following period, the middle equilibrium
has disappeared and the economy is pulled toward the low price equilibrium.
What is the financial accelorator?
Some households are credit constrained
rising prices means higher collateral so more people can get loans
higher debt and consumption, including on houses which increases prices
What is a plain vanilla crisis?
1) property bubble bursts
2) houses repossessed and sold at loss
3) net worth of banks fall
4) banks become insolvent
plain vanilla crisis does not rely on the more sophisticated behaviour of banks involving novel financial instruments or the investment and shadow banking activities
How are housing prices reflected in 3 equation model?
more houses increases demand - rightward shift of IS
link to the central bank is only via the effect of the increased loans on aggregate demand and the forecast effect on CPI inflation
response of the central bank to the associated forecast rise in inflation will not necessarily prevent the continuation of the upswing
What is the risk preference of savers and banks?
savers are risk averse and investment banks are risk neutral.
What is the process for investment bank crises?
1) upswing begins with the widespread belief that risk has fallen significantly.
As demand for the financial asset goes up, the price rises. Investment banks will want
to hold more of the risky asset as long as the expected return is positive. Hence the financial assets are transferred from savers to investment banks.
2) second ’upswing period as the price of the financial asset leads to a capital gain This increases the equity of IBS because they use the mark-to-market valuation of their assets. This means that the investment banks have more equity available
to cover the worst case risk; so savers are now prepared to lend more
3) unexpected reversal of the previous optimistic beliefs about risk and consequent fall in asset prices leads to major capital IB becomes insolvent
What is the formula for the number of assets a bank will buy?
e / z - (1 + r - P)
= equity / risk - (1 + rate of return - price)
What is a balance sheet recession?
that follow the bursting of large, credit-fuelled, asset price bubbles
Households and firms deleverage and so increase their savings. This reduces
aggregate demand slowing the recovery
What are 4 reasons for the GFC?
1) incentives encouraged banks to adopt stategies that added to aggregate risk
2) regulators allowed banks to use own risk calculating models
3) deposit insurance schemes, credit rating agencies and benign macroeconomic environment encouraged view that risk was low
4) rise in subprime lending and private edbt
What were the implications of the GFC in terms of the 3 equation framework?
increased spread between money market and policy rate
increased markup (undermine transmission process)
Reached effective lower bound
What were the policy responses in GFC?
1) liquidity problem: cb made reserves available
2) solvency problem: gov ownership stakes, nationalisation, toxic asset purchases
3) cuts to interest rates
4) quantitative easing
5) fiscal stimulus
What is QE?
involves the central bank creating
creation of new central bank money to buy financial assets
Aims to support asset prices and bring down long-term interest rates (downward pivot of yield curve where nominal interest rate v time to maturity.
