LS16 - Failure in Financial Markets

Question 1

Fractional reserve banking + what is a bank’s reserves

Answer 1

• Bank accepts deposits from customers (savings)
• Makes loans to borrowers (lending)
• Holding in reserve only a fraction of the deposit liabilities
• Reserves are held as cash in the bank or as balances in the bank’s account at the central bank
• Reserve requirement/ratio - Minimum amount of cash that bank has to hold, determined by central bank

Question 2

2008 Financial Crisis Background

Answer 2

1. Securitisation - process of pooling types of securities (fin assets such as bonds/shares/mortgages) - package debt as securities
2. Mortgages were securitised - Mortgage Backed Securities (MBS)
3. MBS come with varying risk profiles based on creditworthiness of mortgage holder/borrower
4. Subprime lending - lending to people who are likely to have difficulty maintaining repayment schedules
5. Credit Rating Agencies (CRAs) rated safe MBSs as AAA and subprime ones as BBB/CCC
6. Trillions of $ of MBSs were issued in run upto the crisis
7. Mortage issuers were benefitting as they eanred higher profits from issuing mortages and pooling them in MBSs; investords were also happy as they profited from holding and trading MBSs; borrowers were also happy as it was easier to obtain a mortgage; CRAs were earning more as they got commission from rating MBSs
8. Over time, creditworthy people became harder to find, and no one wantred the housing/MBS boom to end, so mortgages were given to riskier borrowers - more subprime mortgages were issued

Question 3

Why did number mortgage defaults increase from 2005?

Answer 3

Econ growth in China and India –> drove up oil demand and so oil price –> inflation –> interest rates were increased –> mortgage repayments got more expensive –> more defaults

Question 4

Why did value of MBSs crash in 2007?

Answer 4

Most of later MBSs were subprime and wrongly rated, risky borrowers defaulted on their houses, mortgages lost their value, no more repayments, so MBSs value crashed

Question 5

Market Rigging/Manipulation

Answer 5

Deliberate attempt to interfere with market forces - leads to less efficient allocation of resources and distrust in financial system

Question 6

Insider trading

Answer 6

Using information not available to the general public for personal gain - market manipulation to make more money or prevent loss of money

Question 7

Moral hazard

Answer 7

When someone increases their exposure to risk when insured, taking on more risks becuase someone else bears the cost of the risk

Question 8

Financial Bubble

Answer 8

Price of an asset exceeds its intrinsic value by a large factor, due to speculative demand, which fuels the inflated price resulting in the bubble eventually popping - price crashes