Macro 20: Financial Markets

Question 1

Capital ratio:

Answer 1

A CAPITAL RATIO for a bank is the amount of capital (assets-liabilities= Net Worth or Capital) expressed as a % of total assets (loans).

It is calculated by (capital/assets) x 100.

Assets - liabilities = Capital on Net Worth

Gives a percentage of loan defaults they can handle.

Question 2

Liquidity ratio:

Answer 2

A liquidity Ratio is the % of deposits that a bank must retain as liquid assets. With a liquidity ratio of 10%, for every £100 deposited, £10 must be retained by the bank as a liquid asset to meet current demands for withdrawals.

Both of these ratios serve the same purpose of forcing the bank to keep funds in reserve in case of a financial crisis such as a collapse in the housing market or significant increase in bad debt caused by a major recession.

They act to increase the security of the Financial Market and increase consumer confidence in the financial system.

Essentially they act to reduce systemic risk.

Question 3

Stress tests:

Answer 3

Stress tests are used to measure the extent to which financial institutions such as commercial banks are vulnerable to the effects of extreme economic events such as the Global Financial Crisis and the coronavirus crisis. They are also designed to lower systemic risk.

Question 4

Minsky’s Financial Instability Hypothesis

Answer 4

Economists argue that capital financial systems are inherently unstable. Over periods of prolonged economic prosperity and high optimism about future prospects, financial institutions invest more in ever-riskier assets in search of higher returns, which can make the economic system more vulnerable in the case that default materializes.

Question 5

Systemic risk (Market failure in the Financial Market)

Answer 5

Systemic Risk - Occurs due to the profit incentive for banks to make higher risk/higher return loans when economic prospects are good. This can lead to bad debt and banks collapsing (or requiring a bail out) when the economy starts to falter. This is known as “Minsky’s financial instability hypothesis”.

Due to banks interconnectedness, one bank failure can have a domino effect, leading to a widespread failure or collapse of the financial system which can have devastating effects on the economy.

Question 6

Moral Hazard (Market failure in the Financial Market)

Answer 6

Moral Hazard - One example of a moral hazard leading up to the 2008 financial crisis was financial institutions’ expectations that regulating authorities would not allow them to fail due to the systemic risk that could spread to the rest of the economy. Financial institutions holding the loans that eventually contributed to the financial crisis were often some of the largest and most important banks to businesses and consumers.

There was the presumption that some banks were so vital to the economy, they were considered “too big to fail.” Given this assumption, stakeholders in the financial institutions were faced with a set of outcomes where they would not likely bear the full costs of the risks they were taking at the time.