Topics 8-10 Flashcards
Asset-backed commercial paper (ABCP)
Commercial paper is created when nonfinancial firms with high credit ratings raise capital by issuing short-term debt. ABCP is the bundling of longer-term debt from mortgages, credit card receivables, and other loans. When ABCP reaches its maturity date, it is rolled over and bundled into new ABCP.
Bank run or “run”
A bank run occurs when depositors withdraw cash from a bank thinking the bank is about to fail. A run can also be used as a generic term describing the withdrawal of cash by investors from any type of financial intermediary [e.g., a pension plan (depositor) withdrawing cash from a money market mutual fund (MMF)]. This example would be a run on the MMF.
Shadow bank
A shadow bank is a financial institution other than a regulated depository institution. Examples of regulated depository institutions are commercial banks, thrifts, and credit unions. Examples of shadow banks are private equity funds, investment banks, hedge funds, mortgage lenders, and insurance companies.
Haircut
A haircut is the amount of collateral in a repo agreement in relation to a deposit. For example, if an institutional investor deposits $90 million with a shadow bank and the investor receives collateral worth $100 million, the haircut is 10%.
A banking crisis can be characterized by
A banking crisis can be characterized by either o f the following occurring:
- a run on banks that leads to a merger, takeover by the government, or closure of a financial institution, or
- merger, takeover, government assistance, or closure of a financial institution that spreads to other financial institutions.
Distinguish between triggers and vulnerabilities that led to the financial
crisis and their contributions to the crisis
The main trigger of the financial crisis was the prospect of losses on subprime mortgages.
In the first half of 2007, housing prices in the United States started to decline, causing several subprime mortgage lenders to file for bankruptcy and subsequently fail.
These losses became amplified as they had a ripple effect that spread to the main vulnerabilities of the crisis, asset-backed commercial paper (ABCP) and repurchase agreements.
Describe the main vulnerabilities of short-term debt especially repo
agreements and commercial paper
When housing prices declined and homeowners defaulted on their mortgage loans, it reduced the value and prices of ABCP. These declining prices resulted in bank runs on shadow banks and money market mutual funds (MMFs) and signaled the start of a liquidity crisis.
The liquidity crisis continued to spread into repo agreements with the average haircut going from near zero at the beginning of 2007 to 25% by September of 2008 (Lehman Brothers bankruptcy).
Assess the consequences of the Lehman failure on the global financial
markets
The Lehman Brothers bankruptcy filing in September 2008 is considered the tipping
point in the financial crisis. It eroded confidence and caused a run on MMFs. This lack of confidence spread across markets and countries, amplifying losses in the subprime mortgage market.
Describe the historical background leading to the recent financial crisis
The recent financial crisis was not unique compared to previous banking crises. It followed a similar pattern of increased public and private debt, increased credit supply, and increased housing prices preceding and leading to the crises
Distinguish between the two main panic periods of the financial crisis and
describe the state of the markets during each
The two main panic periods o f the financial crisis were August 2007 and September 2008 through October 2008. The first panic period in August 2007 occurred when there were runs on ABCP. The start o f the second panic period was September 2008 when Lehman Brothers filed for bankruptcy.
Lehman’s failure caused a run on a particular MMF called Reserve Primary, which
contained commercial paper issued by Lehman. The run on Reserve Primary spread to other MMFs, which started a contagion effect that spread to other assets that were falling in price in tandem with rising haircuts.
Assess the governmental policy responses to the financial crisis and review
their short-term impact
The International Monetary Fund (IMF) studied 13 developed countries and their
responses to the financial crisis. This resulted in 153 separate policy actions that
were divided into 5 subgroups consisting of interest rate change, liquidity support,
recapitalization, liability guarantees, and asset purchases.
To measure the impact of interest rate cuts, the IMF used the economic stress index (ESI) and the financial stress index (FSI). Liquidity support was measured using interbank spreads and the FSI. Recapitalization, liability guarantees, and asset purchases were measured using the FSI and an index of credit default swaps (CDSs) on banks.
The evidence suggests that the most effective measures taken were the liquidity support stabilizing the interbank markets before the Lehman failure and recapitalization (capital injections), which was considered the most effective tool after the Lehman failure.
Describe the global effects of the financial crisis on firms and the real
economy.
Studies done on the effects of the global financial crisis on corporations and consumers pointed out that as the global recession strengthened, the demand for credit decreased.
The role of risk management (tasks)
The role of risk management involves performing the following tasks:
- Assess all risks faced by the firm.
- Communicate these risks to risk-taking decision makers.
- Monitor and manage these risks (make sure that the firm only takes the necessary amount of risk).
The main objective of risk management
The main objective of risk management should not be to prevent losses.
However, risk management should recognize that large losses are possible and develop contingency plans that deal with such losses if they should occur.
The process of risk management can fail if one or more of the following events occur
The process of risk management can fail if one or more of the following events occur:
- Not measuring known risks correctly.
- Not recognizing some risks.
- Not communicating risks to top management.
- Not monitoring risk adequately.
- Not managing risk adequately.
- Not using the appropriate risk metrics.