Financial Institutions Management Midterm

Explain why the following statement is wrong: When an investor buys stock in a company, he helps financing this company.

This statement in only correct in case the company issues new equity; most trade on stock markets consists of existing stock being traded (so money changes hands between buyer and seller, but no new money is injected into the company).

a. Please, describe the three main types of crises. b. What is a twin crisis? c. Government may need to need to provide money to rescue banks. At the same time, the economy may go in recession. Which effect has usually a stronger impact on the government's fiscal position?

a. 1) banking crisis, in which large parts of banking system is (near) insolvent; 2) sovereign debt crisis, in which a sovereign country (may) default on its debt obligations (i.e. government bonds); 3) currency crisis, in which a country's currency drops significantly in value. b. A twin crisis may happen in a country with fixed exchange rates. Currency depreciation exacerbates banking sector problems through foreign currency exposures. c. Reinhart and Rogoff (2009) show that on average output falls by 9 per cent GDP and unemployment rises by 7 per cent after a banking crisis. This effect is stronger than the average cost of bailout, which is about 5 per cent GDP.

a. Explain the five stages of Minsky's financial instability hypothesis. b. Which factor is in particular driving the boom-bust cycle? c. Please, explain how capital requirements can make the financial system pro-cyclical.

a. 1) credit expansion with rising asset prices; 2) euphoria with overtrading; 3) distress with unexpected failures; 4) liquidations/failures; 5) panic with a flight to safety (cash and government bonds). b. Debt (credit) is the key factor driving the depth of a financial crisis. It may also be expressed as leverage (defined as debt to total assets; or debt to equity) c. Banks face minimum capital requirements. In good times, they add profits to capital (retained earnings). More capital expands loan business. In bad times, banks make losses, so capital is contracting. Less capital hampers the granting of new credit.

a. Explain how a bank run works? Which feature of a bank makes a run possible? b. What is causing a bank run in the Diamond-Dybvig model? c. What is causing a bank run in the Allen-Gale model?

a. Bank runs are possible because banks issue short-term deposits (sight deposits which can be withdrawn on demand) against long-term assets. If depositors start to doubt the solvency of the bank, they may withdraw their deposits causing a run on the bank. b. A bank run is a self-fulfilling prophecy. A "sunspot" (activity cycle) can cause a bank run in the Diamond-Dybvig model with multiple equilibria (good and bad). c. A bad realisation of the return R on the project. This relates to the state of the business cycle (recession).

What is the 'global financial system' and what does it do?

A financial system is the aggregate of financial institutions, financial markets and financial instruments that exist within a particular country. The global financial system, similarly, is the aggregate of financial institutions, financial markets and financial instruments that exist globally and are interconnected with each other across the borders of sovereign states. Although there are global institutions such as the International Monetary Fund or the World Bank, the interconnections that exist between each country's institutions and markets are really what constitutes the global financial system. For example, the capital markets are truly global, with financial institutions accessing the large pools of funding that exist outside of their own country's borders. The global financial system is facilitated by a vast communication network. The function of the global financial system is to shift funds from surplus units, wherever they may reside, to deficit units, wherever they may reside.

Explain the importance of maintaining a stable financial system, locally and globally.

A financial system performs its functions best when it is stable. In general, a stable financial system is a system in which market participants can reasonably anticipate the actions of their counter-parties. The legal and institutional frameworks are important for ensuring stability in financial systems. An investor who allocates capital will assess the risk involved, including the possibility of the financial institution going bankrupt. However, oftentimes, the investor does not consider the risk of the financial institution to renege on the contractual obligations. This is a separate consideration from stability, defined as the absence of excess vitality in the global financial markets. Excessively volatile markets do not necessarily lead to unstable global financial systems, but it can lead to similar outcomes in extreme cases. This is because higher volatility will make it harder to assess the risk involved in financial transactions. During such times, the financial system can no longer efficiently perform its role of channelling funds from surplus sectors to deficit sectors. The emphasis placed on stability by local and global regulators is borne out of these considerations.

How can consumers benefit from increased competition in EU payments markets?

A general increase in competition should benefit all users including consumers by lowering price and improving service performance as well as promoting more innovation and wider choice. In markets where payments are relatively slow and expensive improvements will be greater than in markets where they are already very fast and efficient. In the latter markets, there will be much less scope for improvement. An integrated EU payments markets may increase competition in three main ways: existing providers will be able to compete more easily across borders; facilitating the market entry of new competitors; more transparent information.

What is a two-sided market?

A two-sided market is a market in which affects the volume of transactions by charging more to one side of the market and reducing the price paid by the other side of the market by an equal amount. Price structure matters and must be designed so as to bring both sides on board.

Explain why according to the 'law and finance' view, countries with a common law system are more likely to have more developed financial markets.

According to La Porta et al, common law countries protect both shareholders and creditors the most and that explains why financial markets will play a bigger role in these countries. For instance, if shareholders are not offered sufficient protection, investors will prefer to invest their funds in other ways than via the equity market.

Explain how central bank communication may enhance the effectiveness of monetary policy.

By using communication policies, the public may better understand what the central bank is after. As a correct understanding of the central bank's policy commitments does not occur automatically, it is clearly desirable for the central bank to explain its policies. By communicating to the public, the central bank may help anchoring inflation expectations. This will enhance the effectiveness of monetary policy, notably if the central bank is credible. An increase in inflation will not lead to higher inflation expectations if the public understands the central bank's inflation objective and believes that it will stick to this objective.

What is meant by 'clearing and settlement' and why is further integration needed?

Clearing and settlement takes place after trading, that is after two parties have agreed to transfer securities (e.g. in a stock exchange or over the counter). It comprises several key steps and its objective is to enable the final transfer of ownership of the securities from the seller to the buyer and the corresponding transfer of cash from the buyer to the seller. The term is constructed broadly, since it also covers custody. Without efficient cross-border clearing and settlement arrangements in the EU, the ability and willingness of participants to trade in EU securities will be sub-optimal, the liquidity of financial markets will be adversely affected and the cost of capital will be higher than it need be.

Conventional finance and sustainable finance differ in several respects. Explain the difference in time horizon and factors which are included by each type of finance.

Conventional finance is mostly short term oriented, while environmental effects in sustainable finance are more long term. Moreover, sustainable finance also includes social (labour conditions) and environmental factors.

Payment and securities market infrastructures are characterised by economics of scale and scope and network externalities. What does this mean and how do these characteristics affect the internal market?

Economies of scale arise when the cost per unit falls as output increases. This effect occurs when it is possible to spread fixed costs over a higher output. Economies of scope refer to the reduction of the per- unit costs resulting from the production of a wider variety of goods and services (i.e., when it is cheaper to produce good A and good B together rather than separately). A network externality is the effect that the value of a services and/or products offered depends on the number of other participants purchasing the same services and products. In principle these characteristics should amplify consolidation of European infrastructures.

Explain how the financial system may help to overcome the problem that investment projects often only yield benefits after a long time, while investors often have a shorter investment horizon. Why may this have a positive impact on economic development?

Financial instruments that can easily be traded create the opportunity for investors to invest while they do not necessarily have to wait until the end of the investment project to be rewarded. This may have a beneficial effect on economic development, because there will be more funds available for investment purposes than without these liquid instruments. A similar argument applies to financial institutions. For instance, various households can easily deposit their funds with a bank, which can use these funds for investment purposes.

Explain the three main functions of financial markets

Financial markets have the following functions: 1. Price discovery: the market facilitates the dissemination of information. This enables participants who want to buy or sell to find out the prices at which trades can be agreed upon (pre-trading phase). 2. Trading mechanism: the market provides a mechanism to facilitate the making of agreements. There must be a means by which those who want to sell can communicate with those who want to buy (trading phase). 3. Clearing and settlement arrangements: the agreements are executed. The market must ensure that the terms of each agreement are honoured (post-trading phase).

How can you distinguish between bank-based and market-based systems?

Generally, indicators of the size of financial markets and the importance of bank and non-bank financial intermediaries are used to distinguish between the two systems. For instance, bank credit as a ratio to GDP and stock market capitalisation as a ratio to GDP are frequently used. Bijlsma and Zwart apply several indicators such as household deposits, bank credit to non- financial firms, market capitalisation of listed firms, size of the banking sector, and volume of initial public offerings, venture capital investment activity to classify countries as more bank- based or more market-based.

How can banks play a role in supervising the management of firms?

In a market-based system, investors have various tools to monitor managers of a firm: the appointment of the board of directors, executive compensation, and the market for corporate control. In a bank-based system, financial institutions act as the outside monitor for firms. They often have a long-term relationship with the firm, may hold both equity and debt, and may actively intervene should the firm become financially distressed.

What is the difference between quote driven and order driven markets?

In quote-driven markets (also known as dealer markets), dealers quote bid and ask prices at which they are prepared to buy or sell, respectively, specified amounts of the security. In order driven markets (also known as auction markets), participants issue orders to buy or sell at stated prices. The price is then adjusted by an 'auctioneer' until the total orders to buy equal the total orders to sell. The auctioneer may collect the orders in an order book.

What are the key elements of retail payment systems?

Payment infrastructure (transacting and clearing payments), payment instruments (initiate payments), financial institutions (provide payment accounts), market arrangements (payment schemes) and laws, standards and regulations set by courts, legislators and regulators.

Interest rates on bonds are affected by the term premium, credit risk, and liquidity risk. Explain how.

Risk-averse investors demand a risk premium (term premium) for investments in long-term bonds to compensate them for the risk of losses due to interest rate hikes; those losses increase with bond duration. Credit risk is the risk of loss because of the failure of a counter-party to perform according to a contractual arrangement, for instance due to a default by a borrower. Liquidity is the ease with which an investor can sell or buy a bond immediately at a price close to the mid-quote (i.e., the average of the bid- ask spread). More credit risk and liquidity risk lead to a higher interest rate.

Describe the impact of the Single Euro Payments Area (SEPA) on the retail payment systems market.

SEPA has fully taken over credit transfer and direct debit transactions in the euro area by 2014. So euro retail payments are made on common business rules and technical standards. This is a major changeover; whereby domestic and cross-border payments carry the same cost within the euro area. The ultimate result is supportive of financial integration.

During a period of rising geo-political tensions around the world in 2013 and 2014, the SWIFT system came to be regarded as an important strategic consideration for all parties concerned. Explain why this was the case.

SWIFT is the major international electronic payments transfer system which allows financial institutions to send and receive payment orders. It links 200 countries together, and millions of payment orders are processed each day. From a strategic point of view (or national security), dependence on SWIFT can have significant implications, especially if some governments can enforce non-participation in SWIFT. From the point of view, the fact that SWIFT clears so many payment orders are a source of strategic advantage. From the point of view of governments who might be subject to such sanctions, reliance on SWIFT is a source of strategic disadvantage. In recent years, Iran has been the target of such sanctions.

Explain how the ECB has reacted to the financial crisis in the euro area.

The ECB reduced interest rates to historically low levels, and also introduced some unconventional measures, such as extended credit support. This was provided to smooth the conditions for banks and is built by five building blocks. They also introduced the securities market programme by buying government securities in response to tensions in sovereign debt markets. Increased recession risk meant that further unconventional measures had to be introduced, such as long-term refinancing operations (LTROs) and outright monetary transactions (OMTs). Quantitive easing was introduced in the fear of periods of too long inflation/deflation.

What is the difference between the economic analysis and the monetary analysis in the monetary policy strategy of the ECB?

The ECB takes policy decisions based on the economic analysis and the monetary analysis. The so- called "monetary analysis" focuses on a medium to long-term horizon. Initially, it focused on the growth rate of a broad monetary aggregate (M3), as it was shown to be an indicator for future inflation. Nowadays, the monetary analysis also includes a comprehensive analysis of the liquidity situation. The "economic analysis" focuses more on how the current economic and financial developments affects price stability in the short to medium-term. It identifies the nature of shocks hitting the economy, and their effects on cost and pricing behaviour. Variables included are in this analysis include fiscal policy, exchange rate developments (movements have a direct effect on price developments through their impact on import prices), the balance of payments, the global economy, financial markets, and balance sheet positions. Macroeconomic staff projections also play an important role. ECB also carries out surveys to provide input in economic analysis. Also asset prices and financial yields are analysed to derive information about the expectations of the financial markets, including expected future price developments.

Explain the importance of credit ratings agencies in the context of the international debt markets.

The credit ratings agencies provide an assessment of a borrower's ability to meet its obligations. From a corporation's point of view, the credit rating that it is accorded is of significant importance. A higher credit rating will usually ensure lower borrowing costs. Companies with lower credit risk are not accorded as a high risk premium by investors. However, there are other important implications as well, including access to markets. For a US based company seeking to raise capital by issuing bonds, its credit rating may allow or restrict access to some capital markets. In particular, the Euromarkets are dominated by corporations and governments with AA credit ratings or above, representing high investment grade. The Euromarkets, for a number of reasons, may allow borrowers to issue bonds at lower yields than would be available in the domestic markets. As such, access to the Euromarkets may be an important means of lowering the cost of debt capital. Without a AA credit rating, however, a corporation will probably be restricted to its domestic capital markets and will face higher borrowing costs, both because of its credit rating and because borrowing costs may be higher domestically for other reasons.

Explain how imprudent sales of credit default swap (CDS) protection by one large financial institution may lead to systemic failure in the financial system.

The financial system is characterized by a closely woven network of financial contracts and obligations. Each party depends on the solvency and, often, the goodwill of each party in order to carry on business day to day. The CDS markets are a primary example of how one dominant party can weave a pattern of transactions that creates systemic risk. A dominant seller of CDS can become the linchpin of an entire segment of the financial markets. AIG performed this role leading up to the global financial crisis, as they sold CDS to many buyers. The financial institutions became exposed to AIG and their financial positions became dependent upon AIG's ability to meet its obligations if any credit events were recorded.

Explain why the monetary policy strategy cannot be considered as inflation targeting, according to the ECB.

The monetary policy strategy of the ECB is not an inflation targeting (IT) strategy as under IT monetary policy decisions are based on the difference between the central bank's inflation target and its inflation forecast, while the ECB Governing Council takes decisions based on the outcomes of the economic and monetary analysis. Although inflation forecasts (they are called projections by the ECB to make it clear that they are not necessarily endorsed by the ECB Governing Council) are part of the economic analysis, they are just one of the many information variables that are used to come to a decision.

The biggest four banks in Australia are too big to fail. With reference to financial system stability, critique this statement.

The notion that some financial institutions are too big to fail stems from the fact that the affairs of the largest financial institutions are so interconnected with the rest of the financial system that a failure of a single large institution may lead to systemic failure or the collapse of the entire financial system. Because of this, a perception exists that regulators might be relied upon to ensure that a large financial institution would be supported rather than allowed to become insolvent. This implicit guarantee of support might be a source of stability during times of extreme market volatility. However, there is a contrary argument. This argument is that the implicit guarantee embedded within the notion of 'too big to fail' creates a moral hazard that may ignite rather than quell volatility. With a safety net in place, counter-parties might be less cautious, more prone to taking risks and less diligent in assessing potential transactions. Fortunately, these considerations are rarely tested in practice. Australia has escaped the need to confront the possibility that one of its financial institutions may be too big to fail. During the Global Financial Crisis, the notion of too big to fail was played out against the backdrop of the rapidly evolving crisis in the United States. Although some US financial institutions did receive government support, notably AIG, others were allowed to fail, most notably Lehmann Brothers. The interconnectedness of the latter with many different parts of the financial system ensured its failure had catastrophic consequences. It is likely that, with the benefit of hindsight, Lehmann Brothers would not have been allowed to fail. Although each case will have unique circumstances, it might be argued that Lehmann's failure reinforced the idea that large financial institutions are too big to fail. Although history is sometimes neglected, the Lehmann episode will likely have some bearing on the outcomes if Australian regulators ever face the decision to either support one of its large institutions or allow it to collapse.

a. Please, explain the working of the loss spiral through the balance sheet. b. Which assets were subject to a loss spiral in the financial crisis? c. Which role did the accounting system play? What kind of changes would you recommend to address these accounting problems?

a. In an asset price boom, the bank balance sheet becomes stronger, which has a positive impact on leverage. Banks then increase their balance sheet, which fuels the asset boom further. An asset price decline works in the opposite way, causing a loss spiral. In such a loss spiral, fire sale of assets plays a prominent role. The price of assets drop below their fundamental value. b. Sub-prime mortgages were experiencing fire sales. c. New international accounting standards require market value accounting, under which assets are marked to market. When fire sales lead to very low market prices of a particular asset, all holders of that asset have to mark down that asset in their balance sheet. Different responses are possible: 1) book value accounting for assets which are not for sale, but the values on the balance sheet become less meaningful; 2) make a reserve for profits on paper, so that windfall gains cannot be distributed to shareholders. As fire sales are often preceded by an asset price boom, the profits on these assets should not be handed out to shareholders as dividend, but added to capital in a special revaluation reserve. When a crisis happens, banks can first draw on this reserve.

a. What are the main causes of the euro crisis? b. What is the link between sovereign debt, the EU banking system and the euro crisis? c. What role did the European Central Bank play during the euro crisis? d. What role did the euro-area countries play during the euro crisis?

a. Lack of fiscal discipline, diverging financial cycles, diverging competitiveness (e.g. unit labour costs) b. Sovereign debt assets were held in large amounts by banks, with a significant bias for the bonds of the country in which the bank is headquartered, but also significant cross-border exposures to other euro area countries' sovereign debt. As many banks were in a relatively bad shape as a result of the 2007-2009 financial crisis, timely sovereign debt restructuring became impossible, thereby prolonging the euro crisis. c. The ECB did buy sovereign bonds of the weak countries through its Securities Markets Programme and provided almost unlimited liquidity to banks through three-year loans (so- called Long Term Refinancing Operations). d. The euro-area countries created the European Financial Stability Facility and later the European Stability Mechanism. These facilities in conjunction with the IMF provided funds to the crisis-struck countries (Greece, Ireland, and Portugal).

a. What are main refinancing operations? b. What is the difference between the marginal lending facility and the deposit facility? c. Why are the rates on these facilities different?

a. Main refinancing operations (MROs) are open-market operations conducted in the form of weekly tenders for repurchase agreements (repos) with a maturity of one week. Via this instrument, the ECB provides liquidity to the banking system. b. The marginal lending facility can be used to obtain (against eligible collateral) overnight liquidity in case of an individual shortage, whereas the deposit facility may be used to make deposits in case of individual excess liquidity. c. It is a similar difference as between interest rates on a deposit with a bank and a loan provided by the bank.

European integration can differ between sectors and within sectors. This question deals with stock trading. The process of stock trading can be broken down in different steps: trading on stock markets (primary trading of new equity (IPOs) and secondary trading of existing stock) and clearing & settlement (C&S). a. Discuss the degree of integration for each step (primary trading, secondary trading and C&S). b. Which part (stock markets or C&S) is more integrated? c. What are the hurdles for further integration of stock markets (trading)? d. What are the hurdles for further integration of C&S?

a. Primary markets are integrated through European prospectus. Secondary markets are integrated because of mergers of stock exchanges. C&S still fragmented because of different national infrastructures. b. Stock markets. c. Not many. d. There are technical, legal and fiscal obstacles and there is no EU regulatory framework.

a. How does the SPV work? b. Mention one major advantage of securitisation. c. Mention one major drawback.

a. The SPV buys the assets from the originator (often a bank) and issues securities against these assets. The SPV is a separate legal entity. Individual securities are usually split into tranches with a different risk exposure. b. An advantage is that banks can liquefy (trade) their assets through securitisation. In that way, the functions of granting loans and funding loans are separated. Securitisation provides funding for banks. c. A major drawback is that information about the borrower is lost in the originate- and-distribute model. The assets are passed on from the originator (the bank) to the SPV and then sold to investors. Not all the information about the borrower is past on in each stage. Moreover, the incentive for the originator to collect information is diluted.

Business and financial cycles can be distinguished. a. Please, explain the difference between the two. b. Which cycles are more converge within the euro area?

a. The business cycle measures changes in GDP. The financial cycle measures conditions in the financial system and is driven by credit growth and house prices growth. b. In the euro-area, the business cycle is converging, but the financial cycle remains asymmetric (i.e. diverging).

The European Central Bank is responsible for monetary policy in the euro area. a. Explain what the main objective is of the ECB's policy. b. Who (which institution) is responsible for taking monetary policy decisions? c. Explain the role of central banks of EU Member States outside the euro area within the European System of Central Banks.

a. The main objective of the ECB's policy is price stability. National legislators have decided this when they approved the Maastricht Treaty. As the treaty does not define price stability, the ECB has given it a more precise meaning, namely: an increase of prices (measured using HICP) in the euro area as a whole in the medium run that is close to but below 2%. b. The Governing Council of the ECB is responsible for taking monetary policy decisions. It consists of the 6 members of the Executive Board of the ECB and the governors of the national central banks of the EU Member States in the euro area. c. The ECB and all central banks of EU Member States make up the European System of Central Banks (ESCB). The governors of the central banks of EU Member States outside the euro area do not decide on monetary policy issues within the euro area as they are not part of the Governing Council, but they are part of the General Council.

a. What is the main task of the financial system? b. Explain the main functions of the financial system. c. What is more stable over time: the functions of a financial system or the financial institutions that make up the financial system?

a. The main task of the financial system is to channel funds from sectors that have a surplus of funds to sectors with a shortage. b. The main functions of the financial are: 1) reducing information asymmetry and transaction costs; 2) facilitating the trading, diversification, and management of risk. c. Functions are more stable, as these functions have to be fulfilled over time. But the form through which these functions are executed (i.e. the type of financial institutions) changes over time. Financial innovation spurs the development of new type of financial products and financial institutions to perform the functions more efficiently.

The most important money market segments are the unsecured deposit markets (with various maturity, ranging from overnight to 1 year), and the secured repo markets (often called repos) with maturities also ranging from overnight to 1 year. a. Explain the main differences between both segments in terms of risk and return. b. Which segment declined during the financial crisis and the euro crisis? And why?

a. When providing unsecured interbank deposits, a bank transfers funds to another bank for a specified period of time during which it assumes full counterparty credit risk. In the secured repo markets, this counterparty credit risk is mitigated as the bank that provides liquidity receives collateral (e.g., bonds) in return. In the event of a credit default, the liquidity-providing bank can utilise the collateral received to satisfy its claim against the defaulting bank. Because of this lower credit risk, secured repo rates are usually somewhat lower than unsecured deposit rates. b. The unsecured market segment declined during the crisis, because of doubts about banks' solvency (i.e. heightened credit risk).