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Year 2 Money, Banking and Finance (AUT EXAM) > Liquidity and Leverage > Flashcards

Liquidity and Leverage Flashcards

Week 6

1
Q

What is a balance sheet? How can a balance sheet be used?

A
  • A balance sheet is a list of assets and liabilities, where total assets = total liabilities (equity + debt)
  • Institutions acquire funds by selling liabilities, which are sources of funds the bank uses
  • Institutions purchase income-earning assets acquired by funds from selling liabilities
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2
Q

Give some key definitions for assets, equity and debt

A
  • Asset: Money working for you (mortgages…)
  • Debt: Other people’s money (deposits, repos…)
  • Equity: Skin in the game (money of shareholders)
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3
Q

What is the Leverage Ratio? Give the equation

A
  • Leverage: The use of borrowed funds to amplify returns
  • Leverage Ratio = Assets / Equity
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4
Q

What is the formula for the maximum sustainability loss?

A
  • Max. Sustainability loss = Equity / Assets
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5
Q

What is the Return on Equity? Given the equation

A
  • Profitability measure in relation to equity
  • RoE = Net Profit After Tax / Equity
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6
Q

What are the effects of leverage increasing?

A
  • If leverage increases, the more profitable the Financial Institution
  • This also means that the firm is more vulnerable to asset price shocks
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7
Q

What happens to changes in asset prices on the balance sheet [position, not magnitude]?

A
  • Changes in asset prices only impact equity number
  • To ensure a constant leverage ratio, the bank must take on more assets or reduce equity- debt increases
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8
Q

How does the leverage impact each different agents

A
  • For households, the leverage growth rate is inversely related to an asset growth rate- via equation
  • For non financial corporate institutes/ commercial banks, there is no relation between leverage and asset growth
  • For investment banks/ broker-dealer sector, leverage is procyclical to increase RoE
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9
Q

What happens if an asset price increases with respect to equity? How can you increase the Leverage ratio?

A
  • If asset value increases, equity value will also increase, as debt is fixed in the SR
  • To increase leverage ratio, you increase purchasing assets or increasing lending
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10
Q

How can institutions manipulate their balance sheet?

A
  • Institutions actively manage balance sheets
  • If institutions hold surplus capital, they can take on more short-term debt
  • On liabilities side, they take on more short-term debt
  • On assets side, they search for potential borrowers
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11
Q

What is the Leverage Cycle? Explain what happens

A
  • Cycle due to demand/price spiral
  • Procyclicality means that a drop in asset prices
  • If asset prices increase, there is a stronger balance sheet, this adjusts leverage increases the balance sheet size (vise versa)
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12
Q

What is Wholesale Funding?

A
  • Wholesale Funding = funding obtained by other FIs
  • Short-term, active, always available funding
  • This is better than retail funding which is passive and has a limited supply
  • Wholesale financiers are considered about RoI on commercial papers repos, CoDs, MBS…
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13
Q

What are the benefits of wholesale funding?

A
  • Exploiting valuable investment opportunities without being constrained by the local deposit supply
  • Wholesale financiers to provide market discipline
  • Refinance unexpected retail withdrawals
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14
Q

What are the drawbacks of wholesale funding?

A
  • Aggressive lending & compromised credit quality
  • Wholesale financiers have limited market discipline and abruptly withdraw upon negative news
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15
Q

What is Marked-to-Market Accounting?

A
  • MTM is a measure of the fair value of accounts that can change over time (assets & liabilities)
  • MTM aims to provide a realistic appraisal of an institution’s financial situation
  • Takes into account what the firm could sell their asset/liability for today (differs from book value)
  • Allows for fluctuations
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16
Q

What are the main differences between traditional and modern balance sheets?

A
  • Traditional: Less Tradeable Assets and no repos/wholesales
  • Modern: Greater Tradeable Assets and more repos/wholesales, with less loans and mortgages
17
Q

Expand on the modern balance sheet

A
  • Loans/mortgages are securitised and made tradeable
  • Wholesale funding is used to finance loans instead of deposits and increase interconnectivity in the financial system
  • Funds (REPOs) are collateralised and usually raised on Short-Term Loans
18
Q

What are the major issues with each type of banking?

A
  • Traditional banks have information issues
  • e.g. insolvency versus illiquidity can cause bank runs
  • Modern banks risk funding mismatch as liquidity dries up
19
Q

What effect does interconnectivity have on FIs?

A
  • Banking and capital markets have become inseparable and their fluctuations have huge impacts
20
Q

What is the main effect of wholesale borrowing? What does this mean for the modern banking system?

A
  • Wholesale borrowing leads to lower equity and reduces the incentive to monitor/screen loans
  • Modern banking amplifies leverage circles
  • Liquidity risk is higher as there is a particular prone nature to bank runs
21
Q

Why are Market-Based financial institutions used?

A
  • Broker-dealers have balance sheets that are short-term, hence are highly receptive to changes in markets
  • Supply of securitised credit to the real economy is often channelled through broker-dealers B/S
  • Measure for funding conditions in a market based FS
22
Q

What does funding liquidity measure?

A
  • Funding liquidity shows how easy investors/banks can obtain funds to invest
  • Usually the repo is used as collateral & borrows against it, with the difference between security’s price and its value as collateral must be financed by intermediaries own equity
  • SR, margins can be adapted rapidly- margin lending
    a-If financial assets rely too heavily on repos, they roll over debt on a regular basis - maturity mismatch can occur
23
Q

What is funding risk? What are the 3 forms?

A
  • Funding risk captures the inability of financial institutions to service liabilities
    1. Margin funding risk: margins/haircuts can change
    1. Rollover risk: risk is impossible to rollover in the ST
    1. Redemption risk: Risk that demand depositors withdraw
24
Q

What is Market liquidity? What makes a market liquid?

A
  • Illiquidity; the inability of trading at a fair price with immediacy
  • Ease and speed at with which assets can be converted into cash without loss
  • If you can trade at short notice, markets are liquid
  • This is reduced when it is tough to raise money by selling assets or when selling assets depresses the sale price
25
Q

What is the Loss Spiral?

A
  • Shows how initial funding issues can be amplified by reduced position
  • Leverage is procyclical, so a fall in asset price amplifies losses
  • Banks are forces to sell more assets, causing a further price drop
26
Q

What is the Margin Spiral?

A
  • Margins/Haircuts spike in times of price drops, which tightens the funding constraints via their effect on leverage
  • Higher margin force de-leveraging and more sales, which furthers the margin
27
Q

Why are margins pro-cyclical?

A
  • Time varying volatility means sharp price declines
  • Adverse selection: financiers become more ‘picky’ on what they will accept as collateral
  • Risk appetite within banks, reduced and management forces banks to deleverage
28
Q

How do Repos and haircuts relate?

A
  • Repos are the primary source of funding for MBIs
  • Haircut of repos fluctuation with the funding conditions
  • Fluctuations in haircut determine the degree of available funding
  • Determibes maximum permissable leverage achievable by borrowers
29
Q

If haircuts increase, what must you do?

A
  • You have two options?
  • Raise equity
  • Sell

Year 2 Money, Banking and Finance (AUT EXAM) (8 decks)

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