Financial System Reform Flashcards
Goals of Financial Reform
- Discourage excessive risk taking
- Make financial system more resilient to losses
- Without impairing the system’s function of providing credit
Dealing with the financial sector
- Regulation
Rules that financial institutions need to follow - Supervision
Monitoring of financial institutions’ adherence to rule and risk taking - Regulation has become tighter and supervision has become more intrusive, and extended to a wider range of institutions
- Note: “The regulators” often refers to both those whose design regulation and supervise it
- Stress tests are used to see how resilient banks are in stressful in situations
- Regulators May encourage banks to create capital by issuing shares
Micro v “Macro-prudential” supervision
- Traditionally: only “micro” supervision of individual banks
- Since crisis: also “macro-prudential” supervision of the system as a whole
- Usually banks have had own regulators/supervisors
FPC - macro
PRA - micro
Compensation reform
- Traditional structure of compensation
Base salary + asymmetric bonus based on annual performance -> recipe for extensive risk taking - Incentives not aligned with shareholders/taxpayers
Fully participate on the upside - sheltered on the downside
Short-term vision - Guidelines for reform
Less asymmetric
Less based on short-term performance - Example:
Claw-back clauses based on long-term performance -> if something bad happens which is traced back, can demand money back - Aside:
Overall level of compensation also a hot topic but fairly irrelevant to excessive risk taking
Constraints on asset allocation
- Some commercial banks got in trouble by trading risky securities
Risky: bitcoins, no backing, speculative)
Traditional: Bonds, Mortgages, Backed - Volcker rule (USA); Ring-fencing (UK)
Deposit-taking institutions restricted from trading in risky assets
-Why focuses on commercial banks?
Depositors economically more vulnerable
Critical for loans to small and medium firms
Taxpayers on the hook through deposit insurance
Bail-in Rule
- Implicit bailout guarantee fro banks “Too big to fail”
This makes them safer compared to non-financial or small firms
Cheap bank funding encourages high leverage, risk taking and further growth - Bailout = Gov buys banks that fail -> moral hazard -> risky investments -> paid for by gov (taxpayers
- Bail-in Rules
Public recapitalisation conditional on losses imposed on bond holders
E.g. new Eurozone bank resolutions mechanisms
Bank expected to pay first - Solutions:
Break up banks/size limit
But, banking lobby resistance
Scale of economies for large banks = cheaper lending
Cheaper and more effective securities (little evidence)
Capital Requirements
- Minimum buffers that financial institutions must have
- Example:
Leverage ratio: compares equity to total assets - How much should be increases?
Makes banks safer so less fall in lending due to crises
Bank lobby: increased cost of funding and hence less lending in normal times - Also:
Increase capital requirement -> reduce lending
Leverage is where profits come from?
Housing Price Bubbles: Originate and Distribute
Some lenders buy bonds (to generate loans) with the intention of selling them to other people, instead of holding them until maturity
- Contributed to the crisis as borrowers had strong incentives to issue large quantities of loans once they could sell them after insurance
- Boosted lending and borrowing activities; people were just passing time bombs around
- Lending and borrowing amplified the house prices since borrowing was easier, and it leads to an increase in demand
TLDR; There are financial institutions that buy loans, and repackage to sell them in secondary loan markets, and booms when the bombs explode
Banks Balance sheet
Asset: Reserves, Loans, Securities, Residential Mortgages
Liabilities and Equity: Deposits, Debts (ST, LT), Capital
Terminology (solvency)
Solvent: Asset >= Liabilities (able to to back loans)
Insolvent: Asset < Liabilities
Insolvent does not equal liquidity; but illiquid assets can lead to insolvency
- They are not causal: you can have illiquid banks that are solvent (mor illiquid assets, and higher liabilities) or liquid banks that are insolvent
Liquidity of Assets
The liquidity of an asset: how easily is the asset converted to cash => the easier it is to convert the asset, the mor liquid it is considered
E.g.
Liquid: Currencies, commodities, stocks, shares, equity traded in major exchanges - a lot of buying and selling going on frequently
Illiquid: Mortgages (houses), arts, collectibles, debts and equity from private loans
How can Illiquidity crash the financial system?
1) Insolvency: Fall in asset prices, and it is harder to convert houses into cash. For fast sales, banks probably reduce the prices of assets
2) Bank-run: If everyone wants to withdraw their deposits, withdrawals have to be match in cash. For example, houses are hard to convert into cash overnight
Capital (Equity)
Raise capital - Issuing shares
- Shares is an investment and it is not risk-free: so it should have a positive rate of return by divided (a compensation for taking risk)
- However, share’s dividend is costlier than bank deposits (i.e., deposits pay interest that is usually lower than a share’s dividend), so issuing shares to raise capital is an expensive thing to do!
High Capital Requirement
Why is it good?
- Limit the damage of balance-sheet shrinkage
- Allows bank to honour its liabilities even in times of asset losses
- Prevent the bank from going bankrupt (i.e., capital = 0), bankrupt when all capital is gone
- Makes a bank less likely for a failure in financial crises
Why can having high capital be bad?
- Reduce the amount of lending by banks: Cost to issue loans is high (Capital can still be landed by just at a higher cost, less supply of capital to loan)
- Opportunist cost for holding more capital is high (could be used for other investments), banks make profits by lending out
- High Capital requirement may mean banks might engage in riskier activities to increase return - may not result in safer investments
- Generally inefficiency to the economy and can harm growth
