Lecture 6 - Incentive Problems in Banking Flashcards
what is the meaning of credit risk?
the probability of a financial loss resulting from a borrower’s failure to repay a loan.
what is the meaning of liquidity risk?
when a bank is unable to meet short-term financial obligations due to insufficient cash or the inability to convert assets into cash without significant loss.
what is the definition of return on equity?
- measures how effectively a company is using its equity to generate profit
- net income/shareholders’ equity
- indicates how well a bank has utilised its shareholders’ money
- It shows how much profit is generated for each dollar of equity invested by shareholders. A higher ROE indicates more efficient use of shareholders’ capital
what does a too leveraged bank mean?
a bank with too little equity capital relative to assets
- a highly leverage ratio indicates that a bank has a large amount of assets financed by a relatively small amount of equity thus it relies heavily on debt (Liabilities - deposits, borrowed money) to finance it assets (Loans, securities, etc.)
Banks are considered to be ran in a risky way when they are:
- too leveraged
- have too many risky investments
- have too much short-term non-deposit funding, rely on things like borrowed money
- banks do not take their “negative externalities” into account
Lower capital-assets ratio:
produces profits and has a high return on equity
- means the bank is highly leveraged: it has a high credit risk and liquidity risk but also make profit
A highly-leveraged bank is taking on more risk.
it has more credit risk (more loans that could go bad) and more liquidity risk (funds from international money markets could dry up if things go wrong). But it also makes profits
The higher credit and liquidity risk
the higher bank profits
Capital-to-Asset Ratio
= capital (/total equity)/total assets
- It assesses the financial leverage of the company, indicating how much of the company’s assets are funded by equity versus debt.
- A higher ratio means the company relies more on equity than debt for financing
systemic risk
how a bank may be perceived as “too big to fail” because its failure can bring down the whole financial system
what type of ratio (high//low) does a bank that is highly leveraged have?
a high ratio of assets to equity
why do banks have an incentive to grow bigger in size over time
the bigger they are the more likely the state will intervene to save them if things go wrong
Many problems with mortgage-backed securities(MBS) - This crisis was partly due to various parties having incentives that aligned badly with the MBS being of good quality
- Appraisers: Many mortgages came with reports appraising the properties as having higher value than they were worth
- Originators: The banks that made the original loans would then sell these mortgage assets to the underwriters, large investment banks that would bundle the mortgages together and create the MBS. They made money off fees from the originators and cared about those fees, not whether the mortgages were poor quality
- Underwriters: They made money from selling the MBS to investors and did not always care much about the quality of the product
- Ratings Agencies: These got paid by the underwriters and so they had incentives to claim the MBS were safer than they actually were
The capital-assets ratio is often discussed in reverse terms as what?
as the assets-capital ratio which is called the leverage ratio
Capital-to-assets ratio
- Capital(/total equity) / total assets
- if a bank has lower capital relative to its assets, it means that most of its assets are financed by debt including deposits and other borrowings), rather than its own capital
- this indicates that the bank has less equity to absorb potential losses on its assets, which increases financial risk
- the bank is relying heavily on borrowed money, making it highly leveraged
