LS16 + LS20 - Failure In Financial Markets, Role Of Central Banks Flashcards
Fractional reserve banking + what is a bank’s reserves
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
2008 financial crisis background
Securitisation - process of pooling types of securities (fin assets such as bonds/shares/mortgages) - package debt as securities
Mortgages were securitised - Mortgage Backed Securities (MBS)
MBS come with varying risk profiles based on creditworthiness of mortgage holder/borrower
Subprime lending - lending to people who are likely to have difficulty maintaining repayment schedules
Credit Rating Agencies (CRAs) rated safe MBSs as AAA and subprime ones as BBB/CCC
Trillions of $ of MBSs were issued in run upto the crisis
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
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
Why did number of mortgage defaults increase from 2005
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
Why did the value of MBSs crash in 2007
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
Market rigging
Deliberate attempt to interfere with market forces - leads to less efficient allocation of resources and distrust in financial system
Insider trading
Using information not available to the general public for personal gain - market manipulation to make more money or prevent loss of money
Moral hazard
When someone increases their exposure to risk when insured, taking on more risks becuase someone else bears the cost of the risk
Financial bubble
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
What are financial markets and what do diff institutions do
Financial markets are where buyers and sellers can buy and trade a range of goods and services or assets that are fundamentally monetary in nature
§ Range of different financial institutions. Retail banks provide services to households- payment of direct debits, saving accounts, loans and mortgages
§ Commercial banks provide services to businesses.
§ Investment banks trade in foreign exchange, commodities, bonds, shares and derivatives for speculation purposes as well as giving advice to firms on how to raise finance and on mergers. Some smaller companies also
take part in speculation.
§ Savings vehicles exist to help individuals save, for example pension schemes, trusts, hedge funds and assurance companies, whilst insurance companies insure against a range of risks.
§ The central bank is a financial institution that has direct responsibility to control the money supply and monetary policy, to manage the country’s gold and foreign currency reserves and to issue government debt.
Role of financial markets
Facilitate savings, which allows people to transfer their spending power from the present to the future. It can be done through a range of assets, such as storing money in savings account and holding stocks and shares.
§ Lend to businesses and individuals which allows consumption and investment- financial intermediary, the step between taking money from one person to give to another since money from savings is used for investment.
§ Facilitate the exchange of goods and services by creating a payment system. Central banks print paper money, institutions process cheque transactions, companies offer credit card services and banks and bureau de changes buy and sell foreign currencies.
§ They provide forward markets . This is where firms are able to buy and sell in the future at a set price - exists for commodities and in foreign exchange and helps to provide stability.
§ Provide a market for equities company’s shares. Issuing shares is an important way for companies to finance expansion but people would be unlikely to buy shares if they were unable to sell them on in the future. Financial markets provide the ability for shares to be sold on in the future, making the asset more appealing.
Reasons for commercial bank failire
Liquidity Crisis. A commercial bank does not have enough S/T liquid assets to meet its S/T liabilities. This could happen if commercial banks run down their liquid cash assets from savings to make l/t loans where there’s greater profit to be made or if they borrow s/t in the money markets and use this to increase less liquid assets, lending long term- consequence is that if S/T liabilities need to be met e.g. if savers come to the bank and demand their savings- commercial bank won’t be able to meet this obligation causing panic and a run on the bank, known as a liquidity crisis.
§ Insolvency. This is where a commercial bank does not have enough capital (shareholder’s funds or retained profit) to offset any losses in longer term asset values. For example if excessive risk is taken by banks and any mortgages or other loans default they will be underwritten, cancelled out by a reduction in capital. However if the level of capital is large enough, the bank will owe more than it owns - not a long run sustainable position. Overall liabilities will be greater than assets, an unbalanced balance sheet, culminating in the failure of the commercial bank
Consequences of bank failure
Systemic Risk. Bank failure can increase systemic risk in the economy where the collapse of one commercial bank can ripple through the industry leading to further banking collapses and eventual meltdown of the entire industry. This is because as one bank fails, assets held by another bank may become worthless and will need to be offset by a reduction in capital. If capital is not enough to offset this loss this bank = insolvent and fail causing problems for other banks in the same way.
§ Recession. Given imp of financial industry for growth- bank failure/ systemic risk = lead to deep recession or depression = increases U/E and reduces incomes and SOL not just for those who work in industry but negative multiplier effects occur - create job losses throughout entire economy. Businesses, individuals and governments = reliant on commercial banks and financial markets to borrow and spend. Businesses and individuals = directly affected - risk averse banks = unwilling to lend, reducing borrowing for investment and consumption hampering AD significantly. Financial sector collapse= limit borrowing by GOV for GOV spending to stimulate recovery deepening crisis, heightening U/E.
§ Negative Externalities and Moral Hazard. Bank failure -significant impact on tax payers if GOV feel systemic risk is too great a possibility and thus agree on bank bailouts. Tax payers money used to fund bailout BUT if funds do not currently exist at level required to cover the bailout, gov =substantially increase borrowing, creating a L/T burden of debt repayment and debt interest servicing, impacting current/ future gens with higher tax rates.
§ The deeper consequence of bank bailouts is that it incentivises further excessive risk to be taken by commercial banks either by not holding enough liquid assets, deciding instead to convert cash assets into loans or by a bank deciding to offer more risky loans for profit seeking purposes. Banks take such risks knowing that if they fail as a result, either becoming insolvent or suffering a liquidity crisis, the gov will bail them out to continue operating= moral hazard, where excessive risk is taken due to third parties paying the consequences of decisions going wrong as banks believe there are too big to fail. Despite the gov being able to regulate bank decisions and operations after a bail out, if a bail out is expected, this will not stop excessive risk taking with the tax payer suffering the most as a result of more likely bank failure.
Role of the central bank
To implement monetary policy through manipulation of interest rates, the money supply and the exchange rate to meet an inflation target. -In times of deep economic turmoil central bank can place other macroeconomic objectives above inflation targeting in aim of achieving macroeconomic stability.
To act as a banker to the government where gov bonds can be bought and sold on behalf of the gov and debt interest can be managed down with the central bank also offering advice to the gov on various economic matters.
A banker to the banks acting as a lender of last resort. When commercial banks suffer liquidity problems. where they do not have enough short-term liquid assets to meet needs of depositors and other short-term liabilities, the central bank (Bank of England) can step in and provide emergency liquidity, either emergency or non-emergency to prevent a full blown liquidity crisis and bank failure. Financial stability. GFC- banks not lending to each other- xcredit crunch, no transparency between banks
§ Conditions needs to be met for banks to be eligible for these funds and strict regulations will be imposed once liquidity has been transferred, with money being paid back with interest, but objective of this function is to prevent bank failure and reduce systemic risk in the economy maintaining the stability of the financial sector. In this sense, the central bank acts as a lender of last resort to banks facing a liquidity crisis
Regulator of the financial system. Both Financial Policy Committee (FPC) and Prudential Regulation Authority (PRA) are regulatory bodies within the BOE whose job is to look out for risks to financial stability, prevent bank failure and thus negate systemic risk in the financial sector. Since the financial crisis of 2008, the regulatory role of the BOE has become much more important.
Lender of last resort pros for a central bank
Prevent a liquidity crisis actually resulting in bank failure thus preventing systemic risk and potential for full financial sector collapse. Individual savers know that their money is safe and panic does not surface- crucial for confidence in the banking sector to remain, otherwise growth and living standards would suffer as the economy experiences deep recession. Liquidity provision comes with strict regulatory conditions from BOE and repayments with I/R above market levels, therefore the chance of such a crisis happeningagain should in theory be limited.
§ This role for the Bank of England allows them to advise the government on where a bailout might be necessary. The Bank can identify where serious concerns in the banking sector lay and therefore where state intervention may be necessary to prevent systemic risk sector collapse and the disastrous consequences that accompany it
Lender of last resort cons for a central bank
The biggest issue with liquidity assurance schemes is that they promote further excessive risk by commercial banks the central bank will be there to provide emergency funds. This is known as moral hazard, where excessive risk is taken due to third parties paying the consequences of decisions going wrong. Despite the central bank being able to regulate bank decisions and operations after a liquidity provision, this may not stop excessive risk taking
Strong argument to question why banks should be treated differently to any other business. In a market economy losses and failure signal shut down and a transfer of FOP into other areas. This is true for any other private business where no central or gov support is available. Despite regulation after liquidity provision, moral hazard is likely to increase with banks believing they are too big to fail.
There is a risk of regulatory capture with such intervention by central bank- managers of commercial banks in the industry form close relationships with central bank regulators influencing decision making over liquidity provision and conditions imposed thereafter to favour the commercial bank rather than doing what is in the best interests of society. Consequently there is significant gov failure, and risk of liquidity crisis going forward could remain high. The likelihood of this happening is strong as often regulators were themselves managers and CEOs of banks in previous careers and therefore have good working relationships with those who remain in the sector.
