W4

Question 1

How does Systemic Risk arise?

Answer 1

Systemic Risk arise by:
▪ Direct Contagion
▪ Informational Spillovers
▪ Liquidity Spirals
▪ Finance-Economy feedbacks

Question 2

Systemic risk that can arise because institutions are directly linked is called…

Answer 2

Direct Contagion

Question 3

In Direct Contagion what can regulators do?

Answer 3

De-centralized Approach: Governmental institutions step-in to guarantee inter-bank transactions.

or

Centralized Approach: Utilise Central Clearing Counter Parties for inter-bank transactions.

Question 4

Systemic risk arises under Informational spillovers when…

Answer 4

…trouble at one institution is a signal that
can create fear of similar problems at other institutions.

Question 5

What can regulators do to avoid Informational Spillovers?

Answer 5

Increase available information

Question 6

Funding Liquidity is…

Answer 6

How easily financial institutions can
get short-term financing to buy or lend long-term assets.

Question 7

Market Liquidity is…

Answer 7

How easily financial institutions can
sell an asset at short notice without a sizable impact on its price.

Question 8

The fallacy of composition is….

Answer 8

systems do not behave as the sum of their components.

Question 9

Roll-over risk is …

Answer 9

Risk that it will be too costly or impossible to refinance maturing debt.

Question 10

Redemption risk. AKA withdrawal risk is…

Answer 10

Risk that capital holders (e.g., depositors) require the capital back sooner than
expected (e.g., bank runs).

Question 11

What are three effects that justify the use of countercyclical capital requirements as a way for regulators to moderate systemic risk.

Answer 11

1. Credit crunch effect: Under-capitalized banks forced to sell
   assets and stop lending leads to asset spiral, real economy negative feedback
2. Insurance effect. Regulators can “tax” systemic risk during booms, and use the capital when actually needed.
3. Loanable funds effect: During booms, more credit available hence more projects funded hence average risk increases.

Question 12

L-retention regulatory requirements for structured finance products mandate that the issuer keeps…

Answer 12

At least 5% of each tranche and the first-loss tranche

Question 13

How does systemic risk arise?

Answer 13

• Direct contagion
• Informational spillovers
• Liquidity spirals
• Finance-Economy feedbacks

Question 14

Basel II was procyclical. Once a crisis started, it made things worse. It exacerbated systemic risk for four main reasons:

Answer 14

1. ** steady capital requirements.** Taxi metaphor
2. historical volatility as input VAR models. Volatility goes up, VaR goes higher, Cap. Req. go up
3. hedging positions in IRB method. Allow to take into account risk hedged by derivatieves (Internal Rating Based )
4. use of CRA ratings in the standarised approach.

Question 15

SRISK

Answer 15

the capital shortage in case of a crisis

Question 16

Which of the following is most likely to be a caveat of imposing a maximum leverage ratio for banks?
(A) It might increase the impact of model errors
(B) It might increase the impact of measurement errors
(C) It might increase the potential for regulatory arbitrage
(D) It might increase the incentives toward extra risk taking

Answer 16

It might increase the incentives toward extra risk taking

Question 17

Under the foundation Internal Rating Based method for credit risk of Basel II, which of the following
assumptions is made on the relationship between probability and correlation of defaults?
(A) Correlation is higher when the probability of default is lower
(B) Correlation is higher when the probability of default is higher
(C) Correlation first increases and then decreases with the probability of default
(D) Correlation does not depend on the probability of default

Answer 17

Correlation is higher when the probability of default is lower

Question 18

What is the meaning of the Composition fallacy for regulators?

Answer 18

The fallacy of composition = systems do not behave as the sum of their components.

Implication for financial regulation:
-It does not mean that if your rules make each individual bank resilient, it will also make the system resilient.

• Each individual institution trying to reduce its level of risk could increase the level of risk for the system as a whole.

Question 19

How does systemic risk rise throught contagion?

Answer 19

When each institution tries to protect itself by limiting its risk exposure, it is increasing the overall risk of the financial system.

Question 20

There are two forms of (il)liquidity for financial intermediaries:

Answer 20

1. Funding Liquidity
2. Market Liquidity

Question 21

Funding liquidity =

Answer 21

the ease at which financial institutions can get (short-term) financing to buy (lend) long term assets.

Question 22

Market liquidity =

Answer 22

= the ease at which financial institutions can sell an asset at short notice without a sizeable impact on its price.

Question 23

haircut risk =

Answer 23

risk that leverage should be suddenly reduced.

Question 24

roll-over risk =

Answer 24

risk that it will be too costly or impossible to refinance a maturing debt.

Question 25

Redemption risk (aka withdrawal risk) =

Answer 25

risk that more capital holders (e.g. depositors) require the capital back sooner than expected (bank run kind of problem)

Question 26

Funding liquidity is affected by 3 risks:

Answer 26

• haircut risk
• roll-over risk
• redemption risk (aka withdrawal risk)

Question 27

SOS: Illustrate the three effects that justify the use of countercyclical capital requirements as a way for
regulators to moderate systemic risk.

Answer 27

1. Credit crunch effect: Undercapitalized banks are forced to sell assets and stop lending which can cause an asset spiral and negatively impact the economy. However, countercyclical regulations allow banks to operate with reduced levels of capitalization.

2.** Insurance effect:** regulators can ‘tax’ (make them keep higher capital) systemic risk during booms, and use the capital when actually needed.

3. **Loanable funds effect: ** During economic booms, there tends to be a greater amount of credit available. As a result, more projects receive funding, even if there are only a limited number of good projects available. This increase in funding can raise the average level of risk (known as systemic risk). However, implementing countercyclical capital requirements can help to mitigate this risk and reduce the potential for bubbles and systemic risk to occur.

Question 28

SOS: What are Countercyclical capital requirements?

Answer 28

Countercyclical capital requirements means Higher capital requirements through good times (to build capital position for crisis times), lower capital requirements through bad times.

That way, capital can actually be used to absorb losses in bad times. If they go below the normal capital requirement, the bank will not be allowed to pay dividends and bonuses.

Question 29

What are the 2 key differences between deposit insurance and insurance against systemic risk?

Answer 29

Deposit insurance are triggered when the bank cannot pay its depositors anymore and the funds are given directly to the depositors or to the bank so they are able to pay their deposits.

However, for insurance against systemic risk, the trigger which allows the use of these resources is not obvious. Moreover, funds are not necessarily directed to the troubled institution.

Question 30

Expected shortfall of the market =

Answer 30

the expected return of the market conditional on being in a crisis (this is decided on a certain threshold C).