Financial Crises Flashcards
Why was the probability of suffering a crisis in 2008 higher for countries with the following characteristics: i) higher debt to deposit ratio; ii) lower net interest margin; iii) low bank concentration; iv) fewer restrictions of bank activity; v) less private monitoring
i) Reliance on unstable non-deposit funding from the interbank market. The drying up of this market triggered the crisis
ii) To achieve a certain level of revenue, they had to lend more. Less incentive for banks to undertake traditional activities (e.g. loans) instead of riskier activities (e.g. securities trading)
iii) Monopoly position means higher interest margin. Raise risk due to “too big to fail” policies
iv) Lax regulation = riskier behaviour = diminishes financial stability
v) Issue of how much interest do shareholders take in monitoring the bank’s practices? Less monitoring = riskier behaviour to gain profits
What are the costs and benefits of bank capital adequacy?
+supposed to improve monitoring in banks
+limit how many loans bank can make relative to its capital
+capital = buffer, hence if bank fails it is cheaper for the gov
+ensuring bank has sufficient net worth influences owners’ incentives. Higher net worth = less likely to take excessive risks
- moral hazard if gov injects capital in normal times
- shareholders may not be capable to effectively monitor the bank
Why can capital adequacy lead to pro-cyclical problems?
Banks are required to hold more capital against increased credit risk in an economic downturn, they will partly pass on their increased costs of capital to their borrowers. In a boom, asset prices rise so capital increases, hence lending increases. Lending is pro-cyclical, but bad lending can trigger a crisis. Therefore capital adequacy can lead to pro-cyclical problems.
Describe and state the arguments for and against Counter Cyclical Capital Buffers
The amount of capital bank holds relative to assets
+reduces amount of lending they can do in good times +increases capital they can use in bad times
+moderate the cycle
-encourages risk
-ineffective if risk weights are not accurate
Describe and state the arguments for and against Sectoral Capital Requirements
Determines how much liquidity is required to hold for a certain level of assets
\+prevents risk taking behaviour \+gets to source of risk \+restrains lending in booms, encourages lending in downturns -displaces risk -hard to implement
Describe and state the arguments for and against Maximum Leverage Ratios
Maximum lending and borrowing a bank can do
+less susceptible to arbitrage
+maximises the amount a bank can lend and borrow
-no penalty for risk
Describe and state the arguments for and against Loan-to-Value restrictions
Only borrow up to a certain proportion of an asset you own
+limits risky lending
-asymmetric information problems
Describe and state the arguments for and against Loan-to-Income restrictions
Assesses the ability of an individual to repay their debts
+limits risky lending
-asymmetric information and moral hazard problems
Does maturity transformation make banking fragile?
It is the practice of banks borrowing money on shorter timeframes than they lend money out. It is one of the bank’s core functions.
Banks take retail deposits, which can be accessed on demand, and make long-term loans to gain profit.
Bank’s liabilities (deposits) are more liquid than their assets (loans), therefore banks are inherently fragile.
Bad loans can result in bank runs as deposit holders are unsure of liquidity of banks in general. 100% reserve:asset ratios would result in no bank failures, but credit would be limited as banks would not lend. Hence there is a need for bank regulations to prevent bad loans caused by maturity transformation.
Is it necessary to regulate banks?
Asymmetric information
- moral hazard: banks can take big risks with the depositors’ money (ex post)
- adverse selection: depositor lacks information to choose between strategies (ex ante)
Negative externality. Bank failures can threaten the system, and so the macroeconomy:
-unemployment, falling output etc (social cost > private cost)
Maturity transformation (banks are inherently fragile)
Reduce systemic risk
Does regulation create moral hazard?
+ Financial regulation causes moral hazard, which encourages too much risk-taking on the part of the financial institutions. For example, the gov provides support to the domestic banks as ‘lender of last resort’. The banks follow risky policies in accordance to ‘too big to fail’ and ‘too important to fail’.
+ Capital adequacy standards can cause moral hazard if the gov injects capital in normal times.
- Capital adequacy ensures that banks have sufficient net worth, which influences the owner’s incentives to take less risks (reduces moral hazard)
+ Deposit-insurance can cause moral hazard, because banks can always stay in business simply by paying marginally over the odds for extra deposits, regardless of the bank’s reputation, character, or conduct.
What is financial fragility?
Financial fragility is high level gearing (debt to assets) makes an economy susceptible to crisis due to:
1) high level of debt defaults (adverse effect on creditors)
2) consumption and investment may be cut back (AD falls)
3) fall in capital adequacy leads to fall in credit (credit rationing)
4) distress sale of assets leads to asset price volatility
5) bank runs (fear of insufficient reserves)
6) borrowing costs increase
How do economies become financially fragile?
Excessive debt
-heavy borrowing in boom raises leverage and interest rates therefore asset prices rise due to consumption rising. Higher i creates fragility, hence distress sales and debt deflation. Value of assets start to fall, which deflates the economy
Rational bubbles
-current prices depend on future prices (expectations). Speculation can drive prices even higher, causing instability = fragility
Uncertainty
-unpredictability leads to herding
Why is financial fragility a problem?
Can lead to bank runs and a systemic crisis, with large social and macroeconomic costs (2008 crisis)
What is macro prudential regulation?
Regulating banks in way that makes a crisis less likely (reducing systemic risk) and less costly to the state
