W2 Flashcards
Give 2 examples of narrow banking as a measure to bank runs.
Minimum reserves with the Central Bank
Liquidity Coverage Ratio (Basel III, HQLA / Total Net cash outflows over the next 30 days > 100%)
What is the regulatory instrument used when a bank crisis suddenly occurs. It’s an “emergency tool”?
Suspension of convertibility
Claim: empirically, banks tend to rise equity.
FALSE
An alternative solution to moral hazard created by deposit insurance is to have a …
…deposit rate ceiling.
A governmental institution (i.e. the Central Bank) can lend money to banks with liquidity problems but too hight will lead to …
…moral hazard
A governmental institution (i.e. the Central Bank) can lend money to banks with liquidity problems but if int. rate is too low (cheap money) it will lead to …
…banks reducing their own capital as CB loans are cheaper!
If one bank has liquidity problems, the others could lend to it (Interbank Market) but there are 2 problems:
- Coordination/trust: if some banks refuse to lend, liquidity problems become solvency problems.
- Systemic risk: Banks tend to all have problems at the same time.
Interbank Market can solve bank runs only if…
▪ There is no systemic shortage of liquidity
▪ There is no crisis of confidence
▪ There is no solvency crisis (𝑅 as expected)
▪ Assets’ illiquidity does not increase (L as expected)
Which crisis created the FED?
the Panic of 1907
Which crisis lead to the creation of the Federal Deposit Insurance Corporation (FDIC)?
the Great depression of ‘29
In a series of steps from late 70s to early 2000s, the Glass- Steagall act was repealed. Why?
- Business found easier and easier to self-finance without intermediaries→lower returns from traditional banking
- Investment banking in the meantime soared in returns
- Some post-2008 new rules partially “repealed the repealing” (e.g., Volcker rule)
- Current development is once again toward de-regulation
Which crisis lead to the creation of the Basel Committee (1976)?
Bankhuis Herstatt (1974)
What are some Amplification Mechanisms in a banking crisis?
Liquidity-driven crises: When market prices drop, banks need to sell assets to get cash. This selling pressure leads to further price drops, creating a cycle of more selling.
Market freezes: interbank markets freeze because banks become reluctant to lend to each other due to uncertainty about the health of other banks.
Coordination failures and runs: Banks and financial institutions can become fragile if there’s a lack of coordination among their creditors
Countercyclical means…
counteracting the flactuations of the economics cycle.
Countercyclical capital buffers are introduced to …
…smoothen the leverage cycle.
Measures to address amplification mechanisms include…
- extending deposit insurance,
- changes in lending of last resort frameworks, and
- the use of stress tests.
Challenges in regulating systemic risk include …
…discouraging herding behavior and addressing the too-big-to-fail problem.
What happens if the CB lends too high or too low interest rate?
Too high: moral hazard, they will increase risk
Too low: banks reduce own capital as CB loans are way cheaper to finance their capital
Interbank markets can solve bank runs only if:
- there is not a systemic reduction in liquidity
- there is not a crisis of confidence
- there is not a solvency crisis
‘Solutions’ for bank runs and its problems: Interbank market
Does not really solve the problem due to bank liquidity shortages
‘Solutions’ for bank runs and its problems: Narrow banking
kills the positive effect of banking
‘Solutions’ for bank runs and its problems: Deposit insurance
Distorted incentives for banks
‘Solutions’ for bank runs and its problems: Lender of Last Resort
Distorted incentives for banks
What are the pros and cons of separating commercial and investment banking:
Pro’s separation:
- investment banks use their own capital for proprietary trading (which is a risky type of trading)
- volatile securities are on the investment bank’s balance sheets, not commercial bank
- before, banks could sell their own securities to their own customers
- incentive for banks could push lemons to their retail customers if they wanted to get rid of them
- Before separation, you could create huge banks which were too big to fail. Due to TBTF and deposit insurance, moral hazard could exist
- Before, the a bank which is both a commercial and investment bank has excessive control of the credit market
- if a bank both originates loans and sells bonds to investors, you are either way (debt or equity) dependent on the bank for getting capital
Cons separation:
- a combined bank has more asset classes, and is thus more diversified
- combined banks can provide a full range of financial services
- a combined bank can give a loan to a firm and be one of the main shareholders of a
firm. So: banks are both lenders and shareholders, this mitigates conflict of interest
- combined banks have economies of scope, which results in cheaper banking
