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 [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
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
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
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 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…
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
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
- Margin funding risk: margins/haircuts can change
- Rollover risk: risk is impossible to rollover in the ST
- 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
