Week 1 - Financial Systems Flashcards
Describe the role of financial systems?
they enable lenders and borrowers to find each other and exchange funds, through direct/indirect finance
Direct finance
a direct connection between lenders and borrowers i.e. stock markets
Indirect finance
when a financial intermediary is the middle man facilitating the transfer of funds between borrowers and lenders i.e. banks
Why do we need financial markets?
they enable the most efficient allocation of capital for economic growth
What is the banking system?
a network of institutions that provide financial services to consumers i.e. central banks
What are central banks?
public institutions that act as bankers to governments
What is the main role of central banks?
to implement monetary policy
to manage the currency of a country ensure safe banks - bank regulation
resilient financial system
What is The Bank for International Settlements (BIS)
the central bank of the world.
an international organisation that promotes financial cooperation across countries
What does the Bank of international settlements do?
Acts as a forum for discussion and policy analysis within the international financial community.
Also acts as a research center for monetary policy.
What is fractional reserve banking?
a system where only a fraction of bank deposits are required to be available for withdrawal. enabling them to reallocate the rest of it to “create more money”
generally only have to have 10% on hand
Bank regulation objective
to maintain banks solvency by avoiding excessive risk using tools such as:
- reserve requirements
- capital requirements
- investment restrictions
to reduce the risk bank creditors are exposed to
to reduce the systemic risk
to prevent financial crime
to protect banking confidentiality
The Basel Committee on Banking Supervision (BCSC)
created in 1974 to promote discussion and policy analysis among central banks.
governments realized that internationally operating banks needed some kind of global regulations to follow.
Describe Basel I
the main idea is to ensure that banks have enough capital to absorb losses
one pillar = minimum capital requirements
Basel II
3 pillars = minimum cap requirement, supervisory review process, market discipline disclosure
Basel III
this one considers another additional risk - liquidity risk
Why do we have financial intermediaries?
they increase efficiency
provide liquidity
facilitate economic growth
diversify risk
What are risk weighted assets (RWA)
they are a banks assets weighted by their perceived risk, used to determine the minimum capital a bank must hold to maintain solvency
assigns different risk levels to different assets based on how risky they are
cash/bonds = 0%
mortgages = 50%
corporate loans = 100%
in general banks have to hold at least 8% of their RWA
Describe capital adequacy ratio (CAR)
this represents the minimum amount of capital a bank must hold based on the risk profile of its assets
CAR = Total Capital / RWA
this enables banks to absorb losses better
tier 1 vs tier 2 capital
tier 1 - banks core capital includes retained earnings disclosed reserves and equity capital
tier 2 - a banks supplementary capital, typically more risky assets
market risk
the risk that arises from movements in stock prices, interest rates, exchange rates and commodity prices
credit risk
the risk that a borrower defaults on their loan
operational risk (basel 2)
the risk associated with losses due to inadequate internal processes, people or systems
