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Economics > Topic 5: Economics of Financial Regulation > Flashcards

Topic 5: Economics of Financial Regulation Flashcards

1
Q

When mkt functions well, resources are allocated to their highest value uses and no alternative allocation of resources could make the community better off overall. List 5 occasions where markets don’t achieve efficient allocation

A
  1. Externalities: When the actions of an individual or business create benefit or cost for other parties that are not part of the transaction
  2. Public goods: non rivalrous in use, non excludable
  3. Imperfect information - unable to obtain all relevant information about the transaction and the parties to it
  4. Information asymmetry: one party knows more than another - could lead to adverse selection (biase the party towards lower quality or higher risk_, moral hazard (modify behaviour to exploit information advantage
  5. Lack of effective competition
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2
Q

Mishkin’s 3 reasons for regulation

A
  1. To increase information available to investor
  2. Ensure the soundness of the financial system,, to avoid risk of system wise contagion
  3. To improve the control of monetary policy
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3
Q

Role of banks / intermediaries

A
  1. liquidity management (loans illiquid vs at call deposits)
  2. maturity transformation (lend long / borrow short)
  3. credit risk screening / management (opaque loans / asymmetric info)
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4
Q

Two key regulatory constraints on banks

A
  1. capital: linked to loans and other risks

2. liquidity - linked to need to refinance funding in markets

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5
Q

Effective markets must have (2)

issuers & traders / participants must: (2)

A

Effective markets must have (2)
- competition in provision of trading services
- investors must feel safe to transact
issuers & traders / participants must: (2)
- act honestly
- provide information to investors & would be investors - accurate, timely, complete

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6
Q

Phases of the GFC

A
  1. Private Debt - sub prime crisis originates in US banks
  2. banking - systemic banking crisis spreads from united States to Europe
  3. Sovereign - problems in euro area periphery sovereign debt; medium term debt burdens in core advanced economies
  4. Political - difficulties in reaching political consensus on fiscal consolidation and adjustments
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7
Q

Wrong incentives lead to excessive risk taking & socially sub optimal outcomes

A
  1. loan origination: compensation linked to high loan volumes & high commission mortgages, not subsequent loan performance or suitability
  2. securitisation - high fee earning, complex, opaque, requiring advanced financial engineering & large quantities of underlying loans
  3. credit rating agencies - some securitised products awarded higher ratings than fundamentals suggested, correlations underestimated
  4. investors - As MP turned accommodative, search for yield intensified, banks retained contingent exposure to structured investment vehicles with high rollover risk
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8
Q

Government support for the financial system during the GFC

A
  1. monetary & fiscal policy stimulus
  2. deposit and wholesale funding guarantees
  3. support for SIFIs emerged - capital & liquidity - both financial & non financial corps in the US
  4. direct support for housing markets
  5. central banks use their balance sheets to unfreeze markets (buying liquid and toxic assets, FX swaps to fund banks / FIs short USD funds)
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9
Q

Economic & financial concerns evolved (shocks - 5)

A
  1. sub prime phase - output losses, rising unemployment, deflation risk
  2. banking shock - procyclicailty - impairs recovery & spreads globally. Illiquidity and rising NPL impair credit expansion
  3. Sovereign shock: unsustainable government debt - rescue costs, slower growth
  4. Capital shock - excessive global liquidity - capital inflow into emerging economies - potential for inflation and asset bubbles
  5. Politics / institutional shock - lack of cooperation, trust & difficulties in reaching consensus on policy adjustments
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10
Q

Macro & Banking Linkages (Euro area, Macro & Financial Mkts Condition

  1. Economic conditions weaken ->
  2. Bank funding conditions deteriorate ->
  3. Sovereign funding pressures rise ->
  4. Euro area breakup risk ->
A

Macro & Banking Linkages (Euro area, Macro & Financial Mkts Condition

  1. Economic conditions weaken -> ASSET PRESSURE: Bank asset quality & profitability weaken
  2. Bank funding conditions deteriorate -> FUNDING PRESSURE: Lower rollovers of wholesale funding; and deposit outflows
  3. Sovereign funding pressures rise -> FINANCIAL REPRESSION: Banks increase holdings of domestic govt bonds
  4. Euro area breakup risk -> FINANCIAL FRAGMENTATION: Asset-liability matching by country
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11
Q

How to fix EU / US banking & financial system

A
  1. Uncertainty about asset quality: Comprehensive, stringent & transparent stress tests (alleviat
  2. Leverage too high: greater quantity and quality of capital
  3. Weak tail of banks: resolve and restructure
  4. Investor concerns about bank debt: clarify policy on private sector bail-ins
  5. Bank funding pressures: reduce reliance on short term wholesale funding
  6. Sovereign risks: fiscal consolidation
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12
Q

ECB’s OMT - list features (5)

Outright Monetary Transactions

A
  1. conditionality: assisted sovereign signs of for an ESM / EFSF program or precautionary credit line
  2. mode of intervention: unlimited, fully sterilised, short dated (1 - 3 years), ECB bond purchases in the secondary market with no formal yield target
  3. ranking of claim: pari passu with other bondholders for OMT purchases
  4. transparency: OMT holdings and their market values to be published weekly and average duration & country breakdown published monthly
  5. collateral policy: minimum credit rating requirements for sovereign issued collateral used for ECB liquidity operations to be suspended for sovereigns eligible for OMT
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13
Q

Sovereign debt rerating and procyclicality

A

sell assets ->
tighten credit availability ->
negative feedback into economy

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14
Q

Reasons for GFC (9)

A
  1. poor underwriting standards
  2. poor risk mgmt practices (couldn’t est fat tails for CDOs etc
  3. Poor investor due diligence (rely on ratings agencies)
  4. Poor credit rating agency perf (inadequate models, lack of due diligence on collateral pools, insufficient transparency, insufficient education on meaning of rating, conflict of interest (consulting & rating)
  5. incentive distortions
  6. weakness in disclosure esp off b/s
  7. thin mkt feeback loop with sharp price falls (losses -> more selling)
  8. weakness in reg frameworks (unreg exposures & liq risk)
  9. originate to distribute model
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15
Q

Principles, GFC

A
  1. strengthen bank liquidity & capital standards
  2. improve OTC mkts
  3. enhance incentive structures
  4. improve transparency
  5. reduce moral hazard imposed by SIFs (Systemically important financial institutions)
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16
Q

Basel III capital rules

A
  1. higher & better quality capital for banks & ODI
  2. better risk coverage
  3. new (non risk based) leverage ratio (common eq tier 1 + other tier 1 + tier 2 + capital buffer = 4 + 2 + 2 + 2.5 = 10.5% of RWA. Plus countercyclical buffer = 0 - 2%
    G-SIBs have higher capital requirement of 11.5 - 13%
17
Q

Basel III liquidity risk management

A
  1. Liquidity coverage ratio: to withstand 30 day shock
  2. net stable funding ratio (need more retail funds)
  3. In Australia this is modified due to shortfall in liquid assets - banks have access to RBA liquidity facility for a fee
18
Q

Moral Hazard (banking)

Systemically important

A

Moral hazard: if shareholders / bondholders expect govt bailout, may not exercise due caution / oversight

Systemically important: size, interconnectedness, substitutability, concentration, common exposures

19
Q

SIB policy measures

A
  1. structural measures; size or activity restrictions
  2. increase loss absorption capacity
  3. enhance supervision of systemically important banks
  4. enhance transparency and disclosure requirements
  5. increase bail in powers
  6. bank contribution to resolution funds
20
Q

Ring fencing proprietary trading (reforms)

A

US:

  • Volcker rule; prohibit banks from prop trading & impose limits on invetsments in & relationships with hedge funds or private equity funds
  • strengthen supervision & regulation of large foreign banking organisations. Foreign banking org with sig US presence must establish intermediate holding company. HC is subject to same prudential standards as a US bank HC
21
Q

Addressing Moral Hazard

A
  1. supplementary / differentiated regulation - systemic risk capital surcharges based on risk posed to system
  2. framework to allow authorities to resolve failures without systemic disruption (orderly wind down, living will, limited safety net
  3. ongoing peer review & more intensive supervisory oversight with international cooperation & cross border crisis mgmt. Consistent reg to avoid reg arbitrage, stress testing
  4. Strengthen infrastructures - eg clearing houses
22
Q

Australia - regulatory framework

A
  1. RBA: (incl payments system board): key role = MP, systemic stability, payments systems regulation
  2. APRA = prudential regulation of deposit taking institutions, life & general insurance, superannuation
  3. ASIC: market integrity, consumer protection, corporations
    These 3 combine = Council of Financial Regulators
23
Q

principles for effective supervision / oversight:

A
  1. ensuring supervisors have anambiguous mandates, sufficient independence, appropriate resources
  2. provide supervisors with full suite of powers nec for effective early intervention
  3. improve supervisory standards to reflect complexity of financial institutions and system as a whole
  4. increase the frequency of assessments of supervisory regimes
24
Q

In each of the following policy areas, list the primary objective and the financial stability objective

  1. PRUDENTIAL
  2. MONETARY
  3. EXCHANGE RATE
  4. FISCAL
A
  1. PRUDENTIAL: limit distress of individual financial institutions
    FS: address systemic risk
  2. MONETARY : stabilise prices
    FS: lean against boom-bust cycles in credit & asset prices
  3. EXCHANGE RATE : stabilise exchange rate
    FS: reduce capital flow volatility
  4. FISCAL : Manage demand countercyclically
    FS: maintain fiscal buffers that allow a response to financial system stress

Economics (6 decks)

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