Mock Flashcards
How does the **Insurance Effect ** justify the use of countercyclical capital requirements as a way for
regulators to moderate systemic risk?
Banks pay a contribution to a dedicated fund during good times; the fund can be used to deal with a systemic crisis when it occurs.
How does the Credit crunch effect justify the use of countercyclical capital requirements as a way for
regulators to moderate systemic risk?
Under-capitalized banks are forced to sell assets and stop lending.
This leads to asset spirals and real economy negative feedback.
For this reasons, regulators allow banks to go below the normal level of capitalization during a crisis.
This reduces the pressure for banks to sell assets/stop lending.
How does the Loanable Funds Effect justify the use of countercyclical capital requirements as a way for
regulators to moderate systemic risk?
During booms, more credit available → more projects funded → average risk of funded project increases (since marginal returns on projects are decreasing).
Higher capital requirements
during a boom mitigate the potential formation of bubbles and the creation of hidden systemic risk.
Illustrate the three effects that justify the use of countercyclical capital requirements as a way for
regulators to moderate systemic risk:
Credit Crunch Effect
Insurance Effect
Loanable Funds Effect
Discuss briefly why equity is used as the main form of regulatory capital
Equity capital has the lowest seniority and can easily absorb losses.
As long as the bank has a positive
amount of equity, the latter can absorb losses without creditors being affected (which could trigger a
default of the bank) and without depositors being affected (which would trigger deposit insurance and
possible losses for uninsured amounts).
Discuss briefly one reason why the book value of equity is preferable to the market value of equity as a measure of regulatory capital.
Capital requirements based on book values are more stable. Since the market
value of equity can be highly volatile, requirements based on the market value of equity would result in a highly instable measure of regulatory capital.
Discuss briefly one reason why the market value of equity could have been potentially
considered to be a better measure of regulatory capital than the book value of equity.
With efficient markets, the market value of equity represents in principle the
amount of liquidity that the bank would be able to raise by selling its assets while still keeping the value of the remaining assets above the value of its debt & deposits.
Aside from common equity shares, list two other forms of capital that are considered to be tier 1 capital :
Disclosed Reserves;
Non-cumulative preferred stocks
