Notes - All lectures Financial Markets and Institutions - WEEK 1 Lecture 1 Key questions: Why do - Studeersnel (2024)

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WEEK 1

Lecture 1Key questions:

• Why do banks exist and what should they do?
• Why are banks’ contracts the way they are?
• How do banks manage risks?
• Why is the banking sector so fragile?
• Are we making the system safer?

Topic 1: Review on the role of financial intermediaries

Financial intermediaries (FI): Economic agent who specializes in the intermediating betweenproviders and users of financial capital. A commercial bank (CB) is a type of FI.

• The general public (dispersed depositors, households, people without specificknowledge in finance) lacks information to evaluate what the bank is doing and howtheir money are managed. Thus, rational for bank regulation: safeguard ofdepositors’ interests

FI’s are divided in two groups: 1) Depository institutions (CBs) 2) Non-depository institutions  Venture Capitalists, Insurance Companies, Pension and Mutual Funds, Hedge Funds, and Investment Banks

In contrast with non-financial firms FI hold relatively large quantities of financial claims asassets and they tend to be more leveraged.

As opposed to a non-depository institution a CB transmits monetary policy through changesin interest rates and they have a different balance sheet.

There holds a mismatch between Assets and Liabilities under 3 dimensions: 1) Credit risk: Bank’s claim against borrowers (Assets) is riskier than the deposit ors’ claim against the bank (Liabilities). 2) Maturity: Assets have longer maturities than liabilities. Deposits are rede emable on demand, while loans can range from 1 up to 30 year maturities. 3) Liquidity: Assets have lower liquidity; deposits are redeemable without notice. Banks cannot call performing loans at-will and some loans are not traded in a secondary market.

A key player today in all financial markets is the Dealer Bank (DB):  DB acts as an intermediary in the market for securities, repurchase agreements, securities lending, and over-the-counter derivatives.  Conducts speculative trading in conjunction with these services  Is a prime broker to hedge funds (HF) and provides asset management services to institutional and individual investors. Sometimes they own their internal HF.

 May have conventional commercial banking operations, including deposits taking as well as lending to corporations and consumers Can act as investment bank, which involves managing and underwriting securities issuances and advising corporate clients on M&A. Operates under the umbrella of holding companies, also called Large Complex Financial Institutions (LCFI) The failure of a dealer bank could place significant stress on its counter-parties and clients, and also on the prices assets and securities that it holds The failure of a DB, which is a systemic risk, reduces the ability of the financial system to absorb further losses and to provide credit to major market participants.

Topic 2: Major risks faced by banks

Risk 1: Default / Credit RiskThe risk that a borrower does not make a contractual payment on time (or not at all).

Three sources of default risk: 1) “Physical” hazard: Cash flow variations beyond borrower’s control 2) “Moral” hazard: Borrower’s incentive to take actions that increase the bank’s risk exposure 3) The role of asymmetric information in lending (moral hazard, adverse selection)How can the bank control default risk:  Screening borrowers, assessing the risk of physical hazard, reducing informational asymmetry with respect to project quality  Monitoring of borrower’s compliance with covenants that are included in loan contracts to restrict the activities of borrowers  Collateral  Diversification in the pool of loans (put together loans with imperfectly correlated cash-flows)

Risk 2: Interest Rate RiskRisk due to mismatch of maturities of assets and liabilities. The risk induces variations ofbank value (ultimately: shareholders’ value) due to changes in either the level or structureof interest rates.  Shareholder value = value of assets – value of liabilities (debt)  Shareholders care if interest rate changes affect the value of assets differently than the value of liabilities  Interest rate changes affect the value of assets/liabilities differently because of maturity / duration mismatches  Another aspect is prepayment risk, this is the risk that arises from a borrower’s option to prepay. If interest rates rise, no prepayment will occur. And it is likely that prepayment through refinancing happens if interest rates fall sufficiently

Key points to remember about Duration:  Higher duration means greater bond price sensitivity to interest rate changes

New Instrument (MMF):  An open-end mutual fund which invests only in money markets. Money market funds are very liquid investments, and therefore are often used by financial institutions to store money that is not currently invested.  These funds invest in short term debt obligations such as treasury bills, certificates of deposit, and commercial paper.  Unlike bank accounts and money market accounts, most deposits are not insured.  Higher competitive pressure leads corporations to seek out more cost-effective funding channels  Financial and non-financial firms grow in size and complexity  need to better manage large cash holdings

Shadow Banking:  Declining in traditional banking masks an increase in off-balance sheet activity by banks  Banks still important but no longer mainly through their loan portfolios  Banks embrace innovations that increase the risks on the asset side of their balance sheet o In the presence of either explicit guarantees of bank liabilities (Deposit Guarantee Schemes DGS) or implicit guarantees (too big to fail TBTF)  Shift from an oligopolistic and comfortable low return on equity business to high return-on-equity (RoE) strategy that attempts to preserve profitability on ever thinner capital cushions

Lecture 2Key questions:

• How costly are crises? Who is actually paying and how?
• Who is to blame for a crisis? In particular, who caused the sovereign crisis in Europe?
• Are safe assets the issue?
• Who could have seen it coming? Was it not all to opague?
• What is securitization? Does it make the global financial system more fragile?

Topic 1: Crises are costly

 International activities of dutch banks declined sharply after the start of the crisis. This is partly due to the selling of the international subsidiaries of ABN Amro due to a general reversed movement op the Dutch home market. We are now five years on from the deepest point of the recession that followed the global financial crisis. The world’s largest banks threatened the stability of the global system. The damage – to jobs, to wealth, and to the productive capacity of the economy – has been great. Looking back, nobody had expected that public finances would so quickly become a problem. The financial crisis caused an unusually large fiscal deterioration. Note that stimulus and financial sector bailouts only played a modest role (refer to graph). The deterioration is primarily caused by the deep and prolonged downturn itself, as a result of which revenues decreased and expenditures increased.

Topic 2: Different phases of the crisis

 Financial crises have become more frequent and severe in both developed markets and emerging markets.

The 6 stages of the Global Financial Crisis: 1. 2007 – 2008: From subprime to Bear Stearns 2. 2008: Liquidity or solvency crisis? 3. 2008: Lehamn and the collapse of confidence 4. 2008 – 2009: Markets adjust to uncertainty 5. 2009: Cautious optimism 6. 2010 - ?: The sovereign debt crisis

Stage 6 (sovereign debt crisis):  The recovery is led by financial markets. But this is threatened by concerns about the sustainability of public finances and bank health  This leads to bouts of financial market volatility  Buildup of government debt and slowing growth fuel concerns about sovereign risk  European sovereign debt markets under stress  Spillovers to the banking sector, which remains fragile  Financial markets in the euro area have become fragmented  Monetary policy provides stimulus while fiscal policy tightens

What avoided a great depression 2 after the GFC?  Large conventional/unconventional monetary easing  Massive fiscal stimulus for a while  Backstop and bailout of the private sector (financial system, households, corporations)But, the massive monetary/fiscal/bailout response had side effects:  How to exit from zero interest rate policy?  How and how fast to reduce fiscal deficits and debts that may be unsustainable?  How to deal with the moral hazard that bailouts have induced?

Topic 3: Contributing factors

1. Macro finance: the market for safe assets

Safe asset: a debt instrument that is expected to preserve its value during adversesystematic events.  Informationally insensitive  Simple assets  Strategic complementarities / expectations

Currently safe interest rates are at the effective lower bound. Solutions:  FX appreciation of safe asset producer countries  Issue public debt  Produce more private safe assets

o Lender-of-last-resort (LOLR): depository insurance and other type of guarantees

Challenges with banking regulation:  Regulation is the rational response to these market failures  Failing to respond would result in excessive risk taking and/or monopoly power  The existence of banking regulation changes the nature of the information problems because the regulator itself is an interested party  regulatory capture  Any intervention will create its own inefficiency/externality  lucas critique / Goodhart’s law

The costs of regulation:  Administrative costs o The cost of implementing regulation is significant  Influence and lobbying costs o Banks may spend significantly to influence regulators o This may be a social waste  Regulatory opportunism and uncertainty o How to make sure that regulators do not abuse their power?  Impair net present value creation: no risk, no return! o Banks’ risk taking incentive may be stifled excessively

Shortcomings of Basel I:  The risk classes are crude, inviting for exploitation  Risk classes do not properly reflect actual credit risk exposure. The risk classes can be manipulated  Does reward diversification within portfolios  No recognition of the covariance of returns that affect diversification and portfolio risk  It assumes that banking risk is the same across countries and time  Capital ratios are expressed in book-value and they fail to adjust for changing in return volatilityBasel II:  Basel II reform: address shortcomings of capital adequacy regulation  Three pillars 1. Minimum capital requirement a. Same as Basel I but with adjustments to link capital requirements to a broader range of risk: credit risk, market risk, operational risk b. More accurate but also more complicated – more risk sensitive requirements c. Use of risk management models 2. Supervisory review of capital adequacy a. Insure that bank have adequate capital to support all risk but also encourage better risk management b. Supervisors evaluate how well banks are assessing their capital needs relative to their risks and intervene when appropriate c. Supervisors can use discretion to impose markup on individual bank’s capital requirement to reflect risk taking

3. Market discipline a. Monitoring banks by professional investors and financial analysts as acomplement of bank supervision b. Higher disclosure standards to enhance role of market participants inencouraging banks to hold adequate capital and to refrain from excessive risktaking c. Depositors discipline banks by withdrawing deposits and by requiring higherinterest ratesShortcomings of Basel III: It may have gone overboard in attempting to deal with all of the risks modern banksface  becoming quite complex and lost much on the intuitive, common-senseappeal of Basel I Still silent about key issues: threshold and form of supervisory interventiono May not focus adequately on what regulators should do when banks do notcomply with capital requirementso Concerns that capital requirements under Basel II are likely to be pro cyclical

Key drivers for a Basel III:  Too high leverage  No liquidity framework  Poor risk management  Interconnectedness  Too big to fail  Too low quality and quantity of capital

Basel III:  Tougher conditions for capital and asset classification  Leverage ratio  Liquidity buffers  Mitigate procyclicality of Basel II / reduce systemic risk  Systemically important banks need special regulation  Bail-in capital

But aren’t simpler rules the answer? The Basel III regulations are based on black boxmathematical algorithms which are too complex.

Systemic risk:  Bank failure can be very costly for the proper functioning of the overall economy and can have very high economic and social costs: o Efficient allocation of credit is threatened o Proper functioning of payment system is impaired o Failure of one institution may spread to other institutions (contagion)  The social costs of bank failure are not necessarily internalized by bank shareholders and managers (limited liability)  5 sources of systemic risk: o Asset price bubbles created by loose monetary policy and excess credit availability

Some measures of market liquidity:  Number of market makers  Number of market participants  Availability of quotes  Average frequency of transactions and transactions sizes  Number of ‘zero-trading days’  Trading volumes  Dealer inventory holding

Why is market liquidity reduced?  Bank deleveraging, refocusing and exits o New regulatory environments have led banks to make more efficient use of capital and liquidity resources.  Reduction in market-making activity o Market making in fixed income, credit, derivatives and commodities have been particularly impacted  Shifts in trading patterns o More central clearing and electronic trading platforms. New regulatory rules may improve liquidity for standardized, centrally cleared trades o Industry claims it will reduce liquidity for those OTC instruments that are not suited to central clearing or trade reporting  Increased demand for and hoarding of liquid assets o Liquidity rules and collateral requirements increase the need for banks to hold high quality liquidity assets, which, reduces their availability to support other transactions, including repos. Thus, liquidity contraction in repo markets.

With asymmetric information, idiosyncratic risk (risk of a specific asset and not a wholeportfolio) should be priced as well as:  Liquidity risk  Informational risk (in price discovery)

Topic 2: Liquidity Regulation

Why was liquidity regulation incorporated?  First, the sentiment was that as long as an institution has sufficient capital, liquidity wasn’t an issue  However, after the crisis it was made clear that neglecting liquidity risk comes at substantial costs  Key lesson is that wholesale funding can dry up very quickly and now there is widespread consensus that banks’ extensive reliance on short-term wholesale funding should be avoided

So, the Basel committee introduced two international liquidity regulations:

1. The Liquidity Coverage Ratio (LCR): A short-term ratio requiring financial institutions to hold enough liquid assets to withstand a 30-day stress scenario. It combines idiosyncratic and market-wide shocks.a. LCR = (Stock of High Quality Liquid Assets HQLA) / (Net cash outflows over the next 30 calendar days NCO).b. HQLA = Level 1 + Level 2A + Level 2Bc. Level 1: Low risk weight (0% haircut)d. Level 2A: Medium risk weight (15% haircut)e. Level 2B: High risk weight (25% - 50% haircut)

2. The Net Stable Funding Ratio (NSFR): Requires institutions to hold a sufficient amount of longer-term stable funding to fund their assetsa. NSFR = (Available Stable Funding over the next year ASF) / (Required Stable Funding RSF)

Topic 3: BCBS RTF Liquidity Stress Testing

Look at lecture slides 27 – 31

Topic 4: Asset managers and Liquidity

Institutional Investors:  Pension funds o Pooled funds from unions, corporates, or governments to provide retirement benefits  Sovereign Wealth Funds (SWF) o State-owned investment funds, often funded by commodity income (oil) or exchange reserves o Typically created when governments have budgetary surpluses and have little or no international debt  Insurance Companies o General accounts insurance company is bearing the capital market risk by providing a defined benefit (life insurance)  Asset Managers o Intermediaries that pool assets from clients which can be Pension Funds, SWF, Insurance companies or individuals

The growth of the Assets Under Management (AUM) industry is directed by:  Increase of middle class and high-net-worth-individuals in emerging economies  Expansion and emergence of (new) SWFs  Shift from government related pension funds to individual pension solutions  Ageing of individuals

WEEK 3

Lecture 5 (Resolution)Key questions:

o Force banks to invest only with short term maturity, maturity assets matches maturity liabilitieso  little value creation, since valuable investment projects are typically long- term Suspension of convertibilityo No further withdrawals after a threshold is reached, no self-fulfilling bankrunso  impractical: how to set tresholds? Lender of last resorto Central banks provide banks with liquidity, no self-fulfilling bank runso  moral hazard: investors have little incentive to monitor banks Deposit insuranceo If the bank can’t pay, somebody else will, no self-fulfilling bank runso  moral hazard: investors have little incentive to monitor banks

Deposit Insurance: Pros and Cons  Reduces the risks of individual bank-runs and financial contagion between banks. o But, recent evidence emphasizes that retail depositors have limited knowledge about deposit insurance, and that even informed and insured depositors are likely to withdraw.  Deposit insurance reduces the incentives for market discipline o Depositors may also over-discipline  Deposit insurance increases incentives of banks to take excessive risks  Evidence on impact of deposit insurance is ambiguous

Summarizing:  Under normal circ*mstances diversification allows banks to match cash inflows with cash outflows  If a bank faces unexpected withdrawals it may be forced to liquidate part or all of its assets at a loss  This will undermine the bank’s ability to satisfy future payment obligations  In turn, this may trigger a run on the bank  In practice, there are several remedies against bank runs, the most important being deposit insurance  Due to these remedies, bank runs were very rare in modern days

Topic 3: New types of capital

Total Loss Absorbing Capital (TLAC)  Consists of instruments that can be written down or converted into equity in case of resolution

 The minimum TLAC requirements is in addition to minimum regulatory capital requirements, but qualifying capital may count towards both requirementsMinimum Requirements for Eligible Liabilities (MREL) Same concept as TLAC

CoCosContingent convertibles (CoCos) are similar to traditional convertible bonds in that there is astrike price, which is the cost of the stock when the bond converts into stock. What differs isthat there is another threshold in addition to the strike price, which triggers the conversionwhen certain capital conditions are met. Issuing contingent bonds is more advantageous tocompanies than issuing regular convertibles.  It is a new instrument that has not been tested o Unclear what the stacking order was for capital components in relation to the maximum distributable amount (MDA)  The market can’t handle CoCos o They have advantages but also come with sever health warnings o Price drop is not influenced by distance to MDA o Market does price

Topic 4: New Institutions

We need the Banking Union to end the Sovereign-Bank doom-loop.

Main components of the Banking Union:  Single Supervisory Mechanism (SSM) o Level playing filed o Banks need to pass Asset Quality Review (AQR)  Single Resolution Mechanism (SRB) o Includes a Single Resolution Fund (SRF)Mission of the SRB: Ensure an orderly resolution of failing banks with minimum impact onthe real economy and the public finances of the participating Member States of the BankingUnion.  SRB is directly responsible for: o Significant banks

WEEK 4

Lecture 7 (Global banks and crisis transmission)Key questions:

• Are foreign banks good or bad? Do they bring new technology and help fund growth or is itjust money that flies at the first sign of trouble?
• Has the view changed after the crisis?
• Do the effects we see on a micro firm level carry over to macro effects?

The ideal situation is integrated balance sheet management. Physical location ofassets/liabilities does not matter. The subsidiaries are in trouble when looking at theliquidity and capital buffers. The subs in reality could have asset shortages, in this case theywould have to buy costly market asset or deposit funds at the ECB. There could also be aliability shortage (asset surplus). Then, expensive wholesale funding would need to beissued  more liabilities issued means that there is also need of a bigger liquidity buffer.

Subsidiary is a legal entity on itself and can default. A branch, however, is part of the bankholding. If it fails the losses fall at where the headquarters are located, not where thebranch is operating.

Why do banks matter? One answer: help firms grow by overcoming agency problems

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 shirt  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

The support effect: Helps the country with a banking crisis.

Substitution effect: Makes the crisis even worse. If the economy goes bad in brazil  pullmoney out and move it to US.

Internal capital markets:  An internal capital market is both a capital allocation method and a department within a company that disperses money to other sections of the company. Unlike an external capital market, an internal capital market owns the sections of the company to which it is giving money, which increases control of the funds.  An external market makes money by charging interest on the borrowed money, while an internal market makes money through the projects and work done with the money  Perfect external capital markets: o No need for internal capital markets o Each subsidiary finances all projects with NPV > 0 o Lending by various subsidiaries is uncorrelated  Internal capital markets o Financial markets characterized by frictions. Banks cannot raise unlimited capital o Global banks actively move this fixed amount of capital across borders  Is this efficient? o Bright side: Better operating bank o Dark side: Operating projects with negative NPVs

The macro impacts of internal capital markets:

Cross border Multinational Internal Capital Market

WEEK 5

Lecture 9 (Financial Networks)

Topic 1: What are networks?

Topic 2: Network aspects

Small worlds: A friend of a friend is also frequently a friend. Only six hops separate any twopeople in the world.

Small world network: A few random links in an otherwise structured graph make thenetwork a small world  the average shortest path is short.

Power-law networks:  Many real-world networks contain hubs: highly connected nodes  Usually the distribution of edges is extremely skewed