Large default-management losses to clearing members, resulting in contagion Disorderly unwind of CCPs, fire sales Loss of continuity of system-critical clearing services

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Alle weken

32 important questions on Alle weken

Benefits and drawbacks of securitisation

Benefits: Diversification, reduce capital requirements, expansion of funding, yield enhancement.

Drawbacks: complexity makes it hard to monitor risk and price the products, eases the credit risk of borrowers.

Types of regulation in the banking industry (3 types)

Branching restrictions: where can banks locate
Activity restrictions: what types of activities are permissible banking activities
Lender-of-last-resort (LOLR): depository insurance and other type of guarantees

Shortcomings of Basel I

Too simple risk classes, easy to exploit. They do not accurately present credit risk exposure. Assumes equal banking risk across countries and time.

Three pillars of Basel II:

1.Minimum capital requirement: More accurate but also more complicated, relate requirements to broader risks (credit, market, operational risk)

2.Supervisory review of capital adequacy: Ensure that banks have adequate capital to support all risk, also encourage better risk management.

3.Market discipline: Monitoring banks by professional investors and financial analysts as a complement of bank supervision.

5 sources of systemic risk

Asset price bubbles, mispricing of assets due to liquidity or asymmetric information problems, crises, contagion, sovereign risk.

Measures of market liquidity

Number of market makers / participants,
availability of quotes
trading volumes
frequency and size of transactions.

Why is market liquidity reduced? (4 reasons)

Bank deleveraging: banks make more efficient use of capital and liquidity recourses.
Reduction in market-making activity.
Shift in trading patters: more central clearing and electronic trading platforms.
Rules and collateral requirements increase the need for banks to hold high quality liquid assets. This reduces their function as supporter of transactions.

Two international liquidity regulations:

Liquidity Coverage Ratio (LCR): Short-term ratio requiring financial institutions to hold enough liquid assets to withstand a 30-day stress scenario.
Net Stable Funding Ratio (NSFR): Long-term ratio for stable funding to fund their assets.

4 different kinds of institutional investors

·Pension funds: pooled funds to provide retirement benefits. Can’t go bankrupt.

·Sovereign wealth funds (SWF): State-owned investment funds. Created when governments are in a stable financial situation.

·Insurance Companies: Bearing the capital market risk by providing a defined benefit (life insurance)

·Asset Managers: intermediaries that pool assets from clients which can be PF, SWF, insurance comp. or individuals.

Total Loss Absorbing Capital (TLAC)

Consists of instruments that can be written down or converted into equity in case of resolution

CoCos (Kiewiet et al 2017)

Contingent Convertibles: A conversion happens when certain capital conditions are met. Issuing CoCos is more advantageous to companies than issuing regular convertibles.

Conclusion: the market can't handel cocos.

they have advantages but also come with sever warnings
Price drop is not influenced by distance to maximum distributable amount

Two components of the banking union

Single supervisory mechanism (SSM): Level playing field, banks need to pass Asset Quality Review (AQR).

Single resolution mechanism (SRB): Includes a sing resolution fund (SRF). SRB ensures an orderly resolution of failing banks with minimum impact on the real economy and the public finances of the participating member states of the banking union.

Internal capital markets

Financial markets characterised by frictions. Banks cannot raise unlimited capital.

Global banks actively move fixed amount of capital across borders

3 macro impacts of internal capital markets

Absorb host-country financial shocks
Exacerbate local business cycle
Transmit financial shocks across borders

Ranking nodes by a random walker

A random walker following edges in a network for a very long time will spend a proportion of time at each node which can be used as a measure of importance

Three states of interbanks:

1.Solvent: can meet demand using short assets and deposits
2.Insolvent: can meet demand only by liquidating long assets
3.Bankrupt: can’t meet demand even if liquidating everything

Contagion in an interbank system depends on 2 things

·Structure of the network: complete vs incomplete
·Size of the shock, how much a bank owes and how much buffer it has

Integrated balance sheet management

Ideal situation in which the physical location of assets/liabilities does not matter

What if subsidiaries have asset shortages?

They have to buy costly market assets or deposit funds at the ECB

What if parent has a liability shortage?

Expensive wholesale funding would need to be issued -> more liabilities issued means that there is also need of a bigger liquidity buffer

Holmstrom and Tirole (1997) Double-decker model

1.Entrepeneur needs external funding to finance new firm
2.Entrepreneur can influence project success -> not exerting earns private benefit -> moral hazard -> uninformed investors are not willing to finance the company
3.MH can be overcome by bank monitoring -> uninformed investors are reassured that entrepreneur works hard
4.Monitoring is costly -> bank itself will be tempted to shirk -> second layer of moral hazard -> Bank needs to inject some of its own capital into the firm
5.Uninformed investors are now reassured that neither the bank nor the firm shirks

Perfect external capital markets

No need for internal capital markets
Each subsidiary finances all projects with NPV >0
Lending by various subsidiaries is uncorrelated

Conclusions post-crisis period (de haas & lelyveld 2014)

Foreign banks were not a source of strength during the crisis
Parent influence: subsidiaries of wholesale-funded an undercapitalised parents had to cut bank lending more during the crisis
banking integration is a double edged sword: higher economic growth and less severe local financial crises but exposure to foreign financial shocks
Funding structure matters for both foreign and domestic banks: wholesale funded subs reduced lending but some domestic banks relied heavily on international wholesale funding

Diamond and Dybvig findings:

Liquidity demand shocks justify banks and cause bank runs. This leads to financial fragility
The good equilibrium happens if late types don’t panic.

•Early types: Never a reason to withdraw late.
•Late types: Could have reason to withdraw early,
if they think other late types also do it. --> Bank run

Modelling fire sales (Cifuentes et al 2005)

·Balance sheet is broken down into three components
oCash reservers (r)
oIlliquid asset (q) with price (a)
oDeposits in other banks
·If a bank is hit by a shock, it raises cash by selling the illiquid asset. However, its price depends on how much is sold:
oSelling of q goes up -> a(q) goes down
oThe more you sell, the less it’s worth
or should increase whenever a drops (according to authors of article)

Interaction between CDS and the behaviour of the underlying firm (Bartram et al 2017)

Debt capacity will be enhanced more
Investment will increase more
The risk of equity returns increases more
CDS is more likely to be introduced in uncertain environments
The effect of introducing is larger when local legal certainty is low
Companies behave different because they know there are CDSs used -> changes the way they invest

Does interest rate hedging affect the behaviour of banks? (Purnanandam 2007)

Two ways to hedge the risk: On-balance sheet vs Off-balance sheet (using interest rate derivatives)

Findings:

Banks with higher probability of distress manage their interest rate risk more aggressively, both with on and off-balance sheet instruments
Financial distress cost positively affects a bank's hedging decisions
High-growth banks and banks with less liquid assets engage in higher hedging activities
Inconclusive on whether derivatives are substitutes or complements for on-balance sheet hedging.

Does dealers' credit risk affect the prices of CDSs? (Aurora et al 2011)

YES!

Magnitude of the effect vanishingly small

Correlation of seller with underlying should affect pricing
Overcollateralization could lead to unwanted exposure

Bank can give each other loans of different sizes: who owes whom how much? explain (Elsenberg & Noe 2001) proof an its limitations

The proof that there is a unique list of all payments any bank owes to the rest of the world, this depends on:

Who shocked in the beginning and by how much
The assets and liabilities of all banks

They essentially simulate a shock and calculate what would happen step-by-step

Limitations:

Assumed that the balance sheet is frozen
Do not distinguish between types of debt
Defaulting banks can sell assets without bankruptcy costs
No information contagion

Covering losses at a CCP, explain the waterfall

Defaulting member's initial margin and default fund contribution
Part of CCP's equity
Surviving members' default contributions
Rights of assessment
CCP's remaining equity
If this all not helps -> CCP insolvent in the absence of a mechanism to allocate the residual loss

CCP failure risks:

Large default-management losses to clearing members, resulting in contagion
Disorderly unwind of CCPs, fire sales
Loss of continuity of system-critical clearing services

How is duration calculated?

Duration is a measure of the weighted average life of an asset (the average time taken by the bond, on a discounted basis, to pay back the original investment. The weighted average of the durations of al the assets in the portfolio

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Financial Markets

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