Regulation of the FMs

Question 1

3 main purposes of the Diamon-Dybvig Model (1983)?

Answer 1

1) Provides a rigorous model of bank runs
2) Provides a justification for regulation of banks
3) Explains why banks subject to runs may attract deposits

Question 2

Explain what causes a bank run. Give an example of a bank run.

Answer 2

If someone is worried about the bank they are with -> incentive to withdraw money from the bank. If others see them doing this may copy; if enough people do this in quick succession this is a run on the bank, and the bank will fold because by nature it will not be 100% liquid

eg. Northern Rock 2007

Question 3

Explain the set up of the DD model?

Answer 3

3 periods (T=0,1,2)
Productive technology R, R>1
Period 0: Agents identical, so all invest in the productive technology
Period 1: Agents find out if they are type 1 or type 2
Type 1 (liquidators) find out in P1 that they need money (ie. value consumption in P1), therefore receive ‘salvage value’ in P1, Type 2 do not need money tf keep money invested and earn R.(units invested) in period 2!

Question 4

What is the ‘salvage value’? (DD)

Answer 4

Initial investment amount

Question 5

What is R? (DD)

Answer 5

Productive technology that yields R>1 in P2 for each unit invested in P0 (ie. investment return)

Question 6

What is it called when investors find out they are type 1? (DD)

Answer 6

Liquidity shock (ie. unexpected demand for money)

Question 7

What problem is demonstrated by the DD model?

Answer 7

There is uncertainty for investors that is only resolved in P1

Question 8

3 assumptions on DD model? (not too important)

Answer 8

1) information on type is private (asymmetric info.)
2) agents endowed with 1 unit of ‘good’ and store it costlessly
3) known fraction of agents, t, will be type 1

Question 9

What is the competitive equilibrium in the DD model, and the payoffs for each type?

Answer 9

Comp. eq. is where all agents invest their endowment in the productive technology:

• Type 1 liquidate in P1: payoff = 1unit
• Type 2 realise investments in P2: payoff = R units

Question 10

Explain one way the competitive equilibrium in the DD model may be improved upon, but the problem with this?

Answer 10

It is possible for agents to insure themselves against the risk of being a T1 agent BUT this would require publicly observable types in P1 - tf this equilibrium would not be possible!

(private information means the insurance company could not tell if they are withdrawing bc they actually need the money or not!)

Question 11

Explain another solution to the problem in the DD model?

Answer 11

Bank deposit contract:
Demand deposit contract that gives each agent withdrawing (ie. liquidators) in P1 a fixed claim of r1/unit deposited in P0
The bank then offers a Pro Rate Share(???) of its P2 assets not withdrawing in P1

Question 12

What does a demand deposit contract satisfy and what does this mean?

Answer 12

Satisfies a sequential service constraint tf when withdrawing money people join a queue of withdrawers - if they get to the front and there’s no money left in the bank that’s tough!

Question 13

Why will a bank never have enough money to pay everyone if they all withdraw at the same time?

Answer 13

Because they pay interest rate+deposit sum back - this is more than total amount of money put into the bank

Question 14

With the demand deposit contract described, what are the equilibria? Explain them.

Answer 14

1) ‘Full information optimal risk sharing’ outcome, where T1 withdraw in P1 and T2 withdraw in P2 (ie. people only withdraw money when they actually need it!)
2) Bank run equilibrium (for R>1): all individuals seek to withdraw at time 1, but only a fraction succeed (SSC)! Tf some depositors lose everything!

Question 15

Given the existence of the bank run equilibrium, why does anyone deposit money in banks?

Answer 15

The bank run equilibrium is inferior to the equilibrium where all agents hold assets and there is not bank. This is because the probability of a bank run is very low, tf agents prefer this to holding all assets as cash (prob. of being burgled is probably higher!)

Question 16

How do governments reduce the probability of a bank run equilibrium? What may affect the effectiveness of this action?

Answer 16

Providing government deposit insurance schemes, whereby all agents who deposit in a bank have their money insured up to a certain level by the government. This means that the chances of people panicking and creating a bank run is much lower since their money is insured! (US 1934 first used)
This action is only effective if the government is credible!

Question 17

Who is the lender of last resort and what is their job?

Answer 17

CB acts as a LoLR to the financial system, and lends if liquidity problems arise

Question 18

Explain one issue that the DD model does not capture? What is the implication of this issue?

Answer 18

Moral hazard of deposit insurance: depositors know that DI exists tf no incentive to monitor bank, tf bank has an incentive to make risky loans and invest in risky projects! (eg. 2007-08 FC)

Implication: banks should be regulated (ie. gov. intervention)

Question 19

What aspect of banks is it that makes them useful but also susceptible to bank runs?

Answer 19

The transformation of illiquid assets into liquid ones!

Question 20

Explain one other problem with the DD model?

Answer 20

It misses the idea that expectations play a large role in bank runs - ie. if some people see people withdrawing, leads to others and so on…

Question 21

4 main reasons for bank regulation with examples?

Answer 21

1) Externalities (eg. in a financial crisis)
2) Asymmetric information (eg. depositors/banks may have information the other doesn’t)
3) Moral hazard (eg. both banks and depositors in gov. DI)
4) Principal agent considerations (eg. banks taking excessive risks with depositors money)

Question 22

What was the old financial regulation system in the UK? What 3 parts was it replaced by?

Answer 22

FSA
replaced by:
1) FPC - financial policy committee
2) PRA - Prudential regulation authority
3) FCA - financial conduct authority

Question 23

Who is in the FPC? What are its 2 main objectives, and a third side-objective? What is its main instrument

Answer 23

1) 13 BofE members (bank staff+experts)
2) Main objectives: identify, monitor and take action to remove/reduce systemic risk to the UK FS OR to increase the UK FSs resilience to these risks
3) Main instrument: Countercyclical capital buffer (roughly 0-1%, currently at 1%)

Question 24

What is the countercyclical capital buffer requirement?

Answer 24

The countercyclical capital buffer requirement requires banks to add capital at times when credit is growing rapidly so that the buffer can be reduced when the financial cycle turns.

Question 25

What additional method is used by the FPC to manage the FS?

Answer 25

Can conduct STRESS TESTS on borrowers and banks to see their resilience to various economic changes, for example increases in the interest rate

Question 26

What did the FPC do in 2014 to manage credit risk?

Answer 26

They limited (to 15%) the proportion of new mortgages that major lenders could issue to income multiples>4.5

NOTE: FPC also monitors developments, produces bi-annual financial reports etc.

Question 27

What if the PRA a part of, and what do they do?

Answer 27

Part of BofE, the PRA regulates many different services providers (roughly 1700 of largest ones), carry out prudential regulation

(NOTE: also protects insurance policy holders and promotes ‘effective competition’)

Question 28

What is prudential regulation?

Answer 28

Different to conduct regulation, prudential regulation ensures that banks etc. have adequate reserves and liquid assets

Question 29

What is the role of the FCA?

Answer 29

The FCA (not part of BofE) is responsible for the conduct regulation on roughly 56,000 FS firms, and the prudential regulation for roughly 24,000 FS firms

Question 30

What is conduct regulation?

Answer 30

Regulation surrounding the correct treatment of customers (eg. making sure they aren’t overcharged/taken advantage of etc.)

Question 31

What did the 2013 FS Banking Reform Act do? What was the main recommendation?

Answer 31

It implemented results of the ‘Vickers Commission’
Main recommendation: Banks should ‘ring-fence’ retail (conservative attitudes) and investment banking (riskier attitudes) sectors

(HSBC moved retail head office from London to Birmingham to comply with the regulation)

Question 32

What did the 2013 FS Banking Reform Act also make recommendations on?

Answer 32

Bank capital requirements and competition

Question 33

What are the Basel I, II and III agreements?

Answer 33

International agreements on bank capital adequacy, stress testing and liquidity risk

Question 34

3 different areas that are discussed ITO the aims of financial regulation?

Answer 34

Should regulation aim to a) stabilise prices, b) prevent bubbles from occurring, or c) burst bubbles once they are evident?

Question 35

Should authorities seek to stablise asset prices?

Answer 35

No: asset prices should naturally fluctuate as their FVs change
Therefore, although the CB has the power to affect asset prices directly by changing interest rates, it makes more sense to try to keep the inflation rate at the target (2%) and allow asset prices to fluctuate naturally to reflect their FVs

Question 36

Should authorities seek to prevent bubbles from occurring? (6 in favour of this)

Answer 36

Yes:

1) May imply Overinvestment in some sectors (eg. .com)
2) Significant Distribution effects if they burst (eg. house price booms and busts)
3) A true bubble will never last tf crash is inevitable
4) People often do not insure themselves against bubbles crashing
5) Asset price increases may cause issues in macroeconomic management
6) WHEN A BUBBLE HAS BEEN ACCOMPANIED BY A SIGNIFICANT CREDIT EXPANSION, ITS COLLAPSE CAN CAUSE A FINANCIAL CRISIS (most important one!)

Question 37

2 possible benefits of bubbles?

Answer 37

1) To those who exploit them, can profit lots!
2) If there is too little investment in a sector due to tax distortions, then a bubble may raise investment to a more appropriate level (speculative point)

TF overall seems like a good idea to try prevent bubbles/eliminate them

Question 38

Why is it difficult to tell if there is a bubble or not?

Answer 38

Because cannot easily tell if price rises are due to increases in FVs of assets or not

Question 39

2 ways to burst/combat a bubble if we detect it?

Answer 39

1) changing (ie. increasing) interest rates might prevent additional lending tf decrease demand for the bubbling asset (EV: could be quite a weak action overall)
2) Restrictions on lending (eg. restricting lending in property market if there’s a housing boom)

Question 40

Discuss briefly, using an example, whether bursting a bubble is a good idea?

Answer 40

From 2004-2006 the Federal Reserve raised interest rates 17 times from 1% to 5.25%, which arguably burst the ‘subprime bubble’ and may have caused the 2007-08 financial crash!
This suggests bursting a bubble may be bad!
BUT if they had left it longer, it may have made things even worse!

Question 41

2 other ways one might burst a bubble?

Answer 41

1) Tobin tax (ie. increase cost of trading in the FMs)
2) Reduced restrictions on short-selling (allowing the overvalued asset’s price to be forced down to its fundamental value) (BUT if prices are rising continually is unlikely that investors will want to do this since chances are they will lose money still!)