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
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)
3
Q
What is the Leverage Ratio? Give the equation
A
- Leverage: The use of borrowed funds to amplify returns
- Leverage Ratio = Assets / Equity
4
Q
What is the formula for the maximum sustainability loss?
A
- Max. Sustainability loss = Equity / Assets
5
Q
What is the Return on Equity? Given the equation
A
- Profitability measure in relation to equity
- RoE = Net Profit After Tax / Equity
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
7
Q
What happens to changes in asset prices on the balance sheet?
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
8
Q
What is the leverage cycle? How does it 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
9
Q
What happens if an asset price increases?
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
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
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)
12
Q
What is Wholesale Funding?
A
- Wholesale Funding = funding obtained by other Fiscal
- 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…
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
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
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
