Lecture 4 Flashcards
How does Systemic risk arise?
Direct contagion
Information spillovers
Liquidity-Spirals
Finance- Economy feedbacks
Analyze direct contagion
Systemic risk arises because banks are directly linked. Directly linked through : Intermidiated transaction, Derivatives, Credit lines
How can regulators solve the direct contagion? What did they choose?
De-centralized approach , Centralized approach
They chose the centralized approach
What is the de-centralized approach?
Governmental institutions step in to ensure inter-bank transactions. Pros: reduses risks of bank-run Cons: moral hazard, monitoring free-riding
What is the centralized approach?
Centralized Clearing Counterparties for inter-bank transactions. Pros: knowledge of the network Cons: CCP can also become too big to fail
Direct: CCP are mandatory
Indirect: non-cleared OTC instruments are penalized
What can create information spillovers?
Asset commonality (banks hold similar assets) , Counterparty risk (direct contagion), Poor governance (Not good management of the banks) , Liquidity shortage
What are the types of illiquidity?
Funding liquidity: How easily financial institutions can get financing to buy long-term assets. Affected by roll-over risk, redemption risk, haircut risk.
Market liquidity: How easily financial institutions can sell an asset without significant change on its price.
Explain an asset spiral
Value of the assets go down so banks need to reduce their balance sheet and therefore they need to sell their assets, but if there is market illiquidity then prices go down and sell assets at a loss. If there are no funding illiquidity problems they can raise new capital instead of selling at a loss. For the occurance of an asset spiral market and funding illiquidity need to coexist.
Why can funding/ market illiquidity happen?
Excess supply (many institutions try to raise their capital at the same time) , Asymmetric information (only uninformed investors are willing to buy-> lower prices), Self-fullfiling prophecy (investors waiting for prices to decrease to buy-> lower prices)
Explain haircut spirals
When assets value decreases then in order to rebalance your balance sheet banks try to reduce their leverage
What can regulators do for the spirals?
For the haircut spiral they can limit the regulation-driven procyclicality. For assets spirals , CB can become Lender of Last Resort or they can use asset purchasing programs like quantitative easing
Why was Basel 2 procyclical?
It increased systemic risk during cirisis because:
1. Steady capital requirements (banks need more capital above the minimum required)
2. Historical volatility to compute VaR
3. Hedging positions in IRB method
4. The use of ratings in the standardized approach (raise capital in the worst time period)
What are the methods for countercyclical regulation?
- Countercyclical capital requirements
- Contigent Convertible Bonds (CoCo Bonds)
Why do banks need countercyclical capital requirements?
Credit crunch effect. Under-capitalized banks are forced to sell assets and stop lending. This leads to
asset spirals and real economy negative feedback. For this reasons, regulators allow banks to go below the
normal level of capitalization during a crisis; this reduces the pressure for banks to sell assets/stop
lending.
Insurance effect. Regulators can introduce a systemic insurance scheme. Under such scheme, banks pay
a contribution to a dedicated fund during good times; the fund can be used to deal with a systemic crisis
when the latter occurs.
Loanable funds effect. During booms, more credit available → more projects funded → average risk of
funded project increases (since marginal returns on projects are decreasing). Higher capital requirements
during a boom mitigate the potential formation of bubbles and the creation of hidden systemic risk.
Describe CoCos
Can be used as additional Tier 1 capital. COCOs become equity when national supervisions think a bank is under-capitalised or when Tier ratios are below the threshold
