Financial Systems

Question 1

What are the allocations of funds in time?

Answer 1

allow investors to choose optimal time for consumption and allow firms to choose the time for investment and repayment

Question 2

What is the allocation of risks?

Answer 2

Allocation of risk to less risk average agents and allows elimination of risk through diversification and hedging.

Question 3

Is risk allocation perfect or imperfect? Why?

Answer 3

Imperfect. Misallocation of capital is often overinvestment in real estate, evergreening, and insufficient capital. Also, with derivatives,
it is possible to have larger insurance than risk, which is flawed in many ways. Two potential risks, contracts are not used to ensure pour to take risks, and banks deal with those interests swamp without ever canceling them.

Question 4

Why are people choosing to place their money?

Answer 4

They expect returns of their money + interests in the future. Hence, people tend to place to ensure a larger return in the future.

Question 5

Let’s compare Germany and the USA. Which one has the largest banking system? Which one has the largest trading system?

Answer 5

USA banking is 3 times larger than Germany, despite Germany having 2 times more banks. As for the trading systems, the Germany system is 10 times larger than Germany one.

Question 6

Why is the US banking system not as strong as the one from Germany or other EU countries?

Answer 6

1. Banking regulations are much larger in the US, than in the EU. Those regulations influenced for a very long time the banking systems in the US that didn’t develop during that time.
2. Civil law vs common law

Question 7

What are Acts of regulations that influenced the US baking system?

Answer 7

1. The Glass Steagall Act: investment banks are not allowed to offer deposits, commercial banks are not allowed to invest in shares of on-financial companies and insurance companies
2. Deregulation: The McFadden Act: Creation of a financial holding company that is allowed to invest in equity of nonfinancial companies which can own an investment bank
3. Gram Leach Biley Act: prohibiting banks from branching across state lines (only allowing banks to be in one state)
   4.Deregulation Riegle-Neal Interstate Banking and Branching Efficiency: allow bank holding companies to acquire banks in any other states, and allow mergers between banks located in different states.

Question 8

What is the meaning of ‘‘blocked companies’’?

Answer 8

Blocked companies are large orders of the same security that are bought or sold by institutional or other large investors.
a. In the US and in the UK, several regulations protect minority investors.

Question 9

What is the meaning of ‘‘multiplicator’’ in finance?

Answer 9

The banking system multiplies money. Hence, you can pretty much make an infinite amount of money. (This, however, breaks when someone doesn’t give the money back + interest.)

Question 10

Is it riskier to place your money in big or smaller banks?

Answer 10

The bigger the bank, the better chances you have to be paid back, and the bigger diversification. (in theory).

Question 11

What is an assets management company?

Answer 11

Assets management companies are business that offers different types of funds to investors. (Today, the largest assets management companies own up to 7% of the equity of most companies.)

Question 12

What is a hedge fund?

Answer 12

The hedge fund is simply a term for unregulated funds typically investing in rather liquid assets. The only common denominator is the remuneration system of the fund manager who often receives a 2% management fee + 20% return participation.

Question 13

What is the impact of the 2008 crisis on banks?

Answer 13

In particular, the largest banks have been growing very strongly since 2008, with today several banks exceeding $2 trillion in assets. large banks have also been riskier, with a larger fraction of large banks failing or suffering severe financial distress in the financial crisis. Despite being riskier, however, larger banks can borrow at lower interest rates, because in case of distress, they are more frequently supported by governments.

Question 14

Are banks heavily regulated in comparison with trading operations? How come?

Answer 14

Banks are the most heavily regularized industry in which most of the regulations are in place to stabilize banks. Financial ratios banks had to respect included, liquidity ratios, ratios measuring interest rate risk, and also, but not always, capitalization ratios.

Question 15

Explain what is the Base 1?

Answer 15

The Base I is a “regulatory capital ratio” the “Cooke Ratio” that is calculated as Regulatory Capital/ Risk Weighted Assets.

Question 16

Explain what is Base II?

Answer 16

Base 1 was overruled and developed what then became the Basel II regulations. Instead of relying only on capital adequacy, the regulation was supposed to stand on three “pillars”:
a. Capital adequacy.
b. Regulatory supervision and.
c. Disclosure.
However, the first pillar turned out to be by far the most important one.
* The biggest change was the new possibility to use either external ratings (standard approach) or the bank’s internal ratings (Internal ratings-based approach IRB) to measure the risk-weighted assets related to credit risk.

Question 17

Explain what is Base III?

Answer 17

Basel III consists of a series of additions to the previous regulation, leaving most of the existing regulations unchanged. Essentially, there are 3 new features in Basel III;
1. Stronger requirements for common equity (i.e. more “Core Tier 1” capital instead of “lower Tier 1” or Tier 2 capital)
2. Liquidity ratios
3. a “leverage ratio” that does not depend on risk weights.

Question 18

What are the 3 concerns listed with Base 3?

Answer 18

1. a new risk-weighted ratio of 4.5% common equity + three additional “buffers”,
2. Unlike capital adequacy ( = solvency) ratios, liquidity ratios cannot ensure the long-term survival of the bank. Liquidity ratios can only make sure that even in a very severe stress scenario the bank does not immediately collapse. - The long-term ratio is similarly targeted at a 1 year stress situation.
3. The new leverage ratio of 3% is, unlike all other capital adequacy ratios, not determined with “regulatory capital” and “risk-weighted assets” but as “common equity” over “assets”, similar to the simple balance sheet ratios that were used before the Basel I regulation came in place.

Question 19

What is the definition of shadow banking?

Answer 19

Shadow banking refers to financial activities conducted by non-bank financial institutions or entities outside the traditional banking system. These activities include lending, borrowing, and investing, and are often performed by hedge funds, private equity firms, money market funds, and other financial intermediaries. Shadow banking activities are typically characterized by high levels of leverage and risk-taking, and they may not be subject to the same regulations as traditional banks. This can lead to potential systemic risks and financial instability if the shadow banking system experiences a crisis.

Question 20

What is a credit rating?

Answer 20

In broad terms, a credit rating is an opinion of the relative credit risk of financial obligations. Ratings are an opinion on Credit Risk, but they do not value Market Risk. They can change from one day to another, they can upgrade or downgrade from one day to another.

Question 21

What is the difference between a short-term and a long-term rating?

Answer 21

Short-term ratings: obligations with an original maturity of thirteen months or less and reflects the likelihood of a default on contractually promised payments.
Long-term ratings: assigned to issuers or obligations with an original maturity of one year or more and reflect both on the likelihood of a default on contractually promised payments and the expected financial loss suffered

Question 22

What is the purpose of credit rating?

Answer 22

There are two principal objectives to ratings: accuracy and stability. Most companies are rated BAAA3 and BAA1. To obtain the rank order, we must compute the cumulative default rates of the fundamental rate universe. The transition matrix gives us an idea of how the ratings move and change over time.

Question 23

What is the rating process?

Answer 23

• Analytical team assigned.
• Collection of information
• Analysis
• Rating committee
• Rating notification
• Rating dissemination`
• Surveillance

Question 24

What is the rating structure?

Answer 24

A baseline credit assessment must be done, which means establishing a macro-profile, a financial profile, and qualitative factors all influenced the output of the BCA as well as establishing an analysis of the loss given profile.

Question 25

What is the difference between P&C insurance from life insurance?

Answer 25

P&C is mainly insurance that is not life insurance such as fire, motor, homeowner, property, etc.
Life insurance: health, savings, and retirement

Question 26

How is the balance sheet of an insurance company different from other companies?

Answer 26

Insurance companies have very different balance sheets than normal companies as it is often reversed. In the property and liability sector, clients pay insurance premiums at the beginning of the period over which they want to be insured. These show up as “unearned premiums” if the policy is not expired. During the contract, however, the premiums are invested in the financial markets, hence the assets of insurance

Question 27

Is insurance a regulated type of business?

Answer 27

Insurance was not a regulated business. This all changed with the introduction of Solvency II in the EU in 2019. The Solvency II regulation allows insurance companies to entirely base their equity level on a self-assessment of risk under the supervision of the regulator.
a. Instead of risk weighting assets, it requires insurance companies to develop a full Value at Risk model of the entire balance sheet including assets and liabilities as well as financial and economic.
b. If an insurance company’s equity falls below the SCR level, they will have to explain to regulators how they intend to recapitalize the company.