W1 Flashcards
Counterparty risk externality refers to …
…the negative impact on the ** broader financial system** that can arise when a financial institution, particularly one with significant interconnections, faces difficulties or fails.
This type of systemic risk stems from the counterparty relationships that a distressed institution has with other financial entities.
narrow banks are:
banks that invest only in riskless securities, such as short-term government securities
What is the trade-off of funding banks with equity rather than demand deposits?
This would make banks immune to runs but would be costly, as under certain conditions demand deposits dominate equity contracts in insuring consumers against random shocks to their intertemporal preferences for consumpion.
What do banks do?
What do banks do?
- monitoring and information processing
- asset transformation
- denomination (transformation from small deposits to large loans)
- risk management = evaluation of assets risk
banks are different from small investors as they can …
monitor the firms
What is attractive about a bad investment project?
Upward potential = it can produce a lot of value if it goes well, but there is a low probability of it going very well. But if it goes well, a lot of value is created.
The firm opts for the good project when…
Expected return with G > expected return with B
πG (G-R) > πB(B-R)
What is the asset substitution problem.
Creditors influence the firm’s choice by choosing R by demanding a lower or higher return.
By asking a higher return (interest rate), they incentivize the firm to do a bad project (high potential, but low probability -> gamble).
Narrow banking as solution for bank runs refers to….
Imposing restrictions on the use of capital by banks.
It determines how much of its capital should be kept liquid as reserves and how much can be invested in illiquid assets.
Securitization is…
Transforming an illiquid asset into a liquid asset, while no value is destroyed.
What are the advantage and disadvantage of minimum reserves with the Central Bank as a mesure againt bank runs?
Every commercial bank needs to keep some fraction of its deposits as a liquid reserve at the CB, and it can be used to pay deposits. It solves bank runs, but if it keeps excessive reserves.
Why do all EU countries need the same insurance deposit amount?
To avoid ‘flying-to-insurance’ = people moving their money to a country because the insurance is higher there
What are the unintended consequences Deposit insurance has for banks?
if they do not pay a fair premium to be insured, there exists an incentive to take more risk and be less capitalized.
What are the unintended consequences Deposit insurance has for depositors?
If there is no skin-in-the-game (as their whole deposit is insured), they will not screen nor monitor the banks. They will go for the highest rate on deposits instead of considering the risk.
