Week 8 Flashcards
What does the assets are ’marked-to-market’?
This means that asset values in the balance sheet reflect market prices.
Given that banks are crucial to the system, the policymaker faces the following trade-off:
- maintain the health of the banking system and avoid moral hazard
- maintain the health of the banking system and avoid adverse selection
- privatize the financial sector and keep enough money to pay wages
- output and inflation
- none of the above
maintain the health of the banking system and avoid moral hazard
Liquidity and solvency issues are related through:
- a perverse feedback loop of falling asset market value as firms sell assets to repay debt
adjusting expectations - collateral losing value to back assets
- all of the above
- none of the above
all of the above
Interconnectedness:
- decreases overall systemic risk
- is at the heart of many complexity studies
- can be easily regulated
- was a keyword before 2007
- is made of universal and investment banks
- all of the above
is made of universal and investment banks
The paradox of credibility says:
that when people think risk went down they change their actions and the system becomes more risky
Claim: Financial crises usually are tied to the size of the financial sector
True
Claim: Credit crunch is a sudden sharp reduction in the availability of money or credit from banks and other lenders
True
(6.2) What are the three key characteristics of banking crises according to Reinhart and Rogoff (2009)? How would you expect these characteristics to influence the IS curve?
According to the Reinhart and Rogoff (2009) analysis of historical examples, they typically have three key characteristics:
- Deep and prolonged asset price collapses.
- Large and lasting adverse impacts on output and employment.
- Government debt explosion.
These, along with the financial accelerator (the idea that changes in asset prices can influence borrowing conditions for households and businesses), the collapse in asset prices will then ace the fall in collateral value. This likely to increase credit-constrained households.
This will likely reduce consumer spending and shift the IS curve to the left.
On the other hand, countercyclical fiscal policy attempts to shift the IS curve to the right to mitigate the output contraction.
(6.4) To what extent is the financial cycle taken into account when inflation-targeting central banks are setting monetary policy?
In inflation-targeting, central banks prioritize stable prices, focusing on forecasted consumer price changes.
However, this approach might miss financial risks.
Consider housing loans: if easily available, people borrow more for houses and spending, boosting the economy. This increases construction and spending, shifting the IS curve rightwards.
To curb potential inflation, the central bank tightens borrowing rules, indirectly influenced by the impact on spending and inflation, not directly on house prices.
(6.6) Using the housing market as an example, explain the following concepts:
(a) Loan-to-value ratio
(a) The loan-to-value (LTV ) ratio is calculated as the value of the loan received divided by the value of the property purchased.
For example, if a borrower took out a loan of $160000 to buy a house worth $200000, then the LTV ratio would be 80%.
(6.6) Using the housing market as an example, explain the following concepts:
(b) Asset price bubble
Let’s consider the case of a rise in demand for mortgages, which pushes up house prices.
This may in turn trigger the expectation that house prices will rise further (hot hand fallacy).
If this happens, then holding more houses is a good strategy: there will be a capital gain from holding them because they can be **sold later at a higher price **than the price paid to acquire them.
This process can continue indefinitely – at least until something happens to change the expectation of continuously rising prices (and of a growing deviation of the price from its initial value).
(6.6) Using the housing market as an example, explain the following concepts:
(c) Financial accelerator
The financial accelerator is a (positive) feedback loop in the housing market. When house prices rise, people’s homes become more valuable, relaxing their borrowing limits.
This prompts them to borrow more for spending and buying houses.
This increased demand for housing directly shifts the economic equilibrium (IS curve).
As housing prices continue to go up, the loop restarts – higher prices mean more borrowing and spending, creating a cycle.
Explain the role of the implicit state guarantee for ‘too-big-to-fail’ institutions in the upswing in the financial cycle that preceded the global financial crisis.
The global financial crisis was partly fueled by the promise that certain large institutions wouldn’t be allowed to fail (known as ‘too-big-to-fail’).c
This safety net, combined with a regulatory environment letting banks assess their own risks, allowed for risky strategies.
In the lead-up to the crisis, banks aggressively gave mortgages to riskier borrowers, andunloading the risk with securitization.
While these strategies were profitable, banks didn’t keep enough money aside for tough times (low capital cushion), choosing higher risk (high leverage).
This happened because they didn’t consider the external impact of their choices and relied too much on the belief that the government would step in if things went south.
Explain the role of the following factors in the upswing in the financial cycle that preceded the global financial crisis:
(b) The assumption the MBSs bundled together in CDOs were not highly correlated.
In the years leading up to the global financial crisis, banks created complex financial products known as CDOs, combining mortgage-backed securities (MBSs).
One critical assumption was that these MBSs, bundled together, weren’t strongly connected or correlated.
However, assessing this correlation was challenging due to limited historical data on housing loan defaults.
Credit rating agencies set these correlations at very low levels in their models, giving the top tranches AAA ratings.
Because of these high ratings and attractive returns, institutional investors worldwide, like pension funds and banks, eagerly bought these CDOs.
Unfortunately, the crucial mistake was overlooking the similarity among the MBSs within the CDOs, leading to unforeseen risks and contributing to the financial crisis.
Explain the role of the following factors in the upswing in the financial cycle that preceded the global financial crisis:
(c) Capital regulation based on risk-weighted assets.
Before the global financial crisis, European banks used rules that made them set aside less money for safer assets.
However, they invested heavily in assets labeled safe, like triple A-rated ones, even though there were few genuinely safe ones.
This practice made banks riskier as they increased their total value without setting aside enough money.
(7.2) Why did rising house prices make US retail banks more willing to provide mortgages for low-income earners with poor credit histories?
Consistent with the financial accelerator, when house prices rise, banks feel safer lending more money because the homes act as collateral.
They believe that even if borrowers can’t repay, the value of the houses will cover the loan. So, when everyone thought house prices would keep going up, banks were more willing to give mortgages to people with not-so-great credit histories.
(7.4) SOS! (Exam 2024) Assume that an investment bank is at its maximum desired leverage of 20: it has $10 million of its own equity (net worth) and has borrowed $190 million to buy assets of $200 million. The price of the bank’s assets falls and reduces their mark-to-market value to $195 million. What has happened to the bank’s equity and leverage? How much must the bank reduce their assets to restore leverage to its desired level? How will it affect the bank’s efforts to return to their desired leverage if other financial institutions are attempting to de-lever at the same time?
The fall in the mark-to-market value of assets implies a reduction of equity to $5 million.
In turn, leverage increases to 39. (leverage = Assets / equity)
To restore the maximum desired leverage of 20, banks need to reduce their assets to $100 million.
If all the financial institutions are attempting to de-lever at the same time, it is likely that the price of assets will fall, because of excess supply, making it harder to achieve the desired level of leverage.
