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• Liquidity risk
o Deposits have a much higher liquidity than loans at the bank
• Credit risk
o Banks lend out money but what happens if it’s not paid back?
• Interest rate risk
o Can create profit/loss for the bank
o Interest rates on deposits ≠ interest rates on loans
CONTAGION PROBLEMS
• Liquidity contagion
o Interbanking = one bank borrowing money from another bank
o Dried up because they don’t trust other banks to pay them back
• Contagion through fair value accounting
o Assets sold means prices go down so causing more markt-to-market losses
o You end up in a vicious circle
• Contagion through rating agencies
o Downgrade of collateral
o Normally there would be collateral in place when one party is lending to another party
▪ To ensure that if the money isn’t paid back the collateral can cover the losses
o Government bonds are rated by rating agencies: if rating is downgraded, the value of the
collateral goes down
• What is the relation between financial stability and concentration in the banking sector?
• Not clear that a concentrated banking sector is related to how much a crisis would hurt your
economy (concentration = small number of big banks)
TO BIG TO FAIL / TO BIG TO SAVE
TBTF = to big to fail
• Banking groups cant go bankrupt because it would collapse your economy so you cant let them
go bankrupt
TBTS = to big to save
• So big that saving would require them to much money
,HIRSCHMAN-HERFINDAHL INDEX (HHI)
• Measures concentration in the banking sector
• Sum of quared market shares
• Example 4 players with each 25% -> 252 × 4 = 2500
• The US uses this measure to judge fusions
o HHI > 1800: Strong concentration
o 1000 < HHI < 1800: Medium concentration
o HHI < 1000: Low concentration
PROTECT CONSUMERS AND INVESTORS (2)
• Asymmetric information
o For financial products, many shortcomings only become clear when its to late
• Gathering information is hard
• We need regulation so that people keep trusting the financial products they buy
• Explicit and implicit deposit insurance
o To avoid bank runs
o Implicit deposit insurance
▪ The government will repay your deposit up to an amount of 100.000 euro.
INTERNALIZE EXTERNALITIES (3) MOST IMPORTANT!
Externality = situation where you have a transition between two parties that is impacting a third,
unrelated party
• Externalities are the main reason for regulating banks !
o If banks do not consider the effect of their negative/positive effects on society as a
whole, externalities exist and can be regulated
PROBLEMS WITH GOVERNMENT SUBSIDIES:
• Unfair competitive advantage
o Cheaper financing for banks with sate aid + reduction in funding costs
o Increase assets at the expense of smaller banks who don’t have the cheaper financing
advantage
• To much risk
o You might take more risk (moral hazard) because you know you will be saved
• Misallocation
o Banks attract funds that they should not have gotten without subsidies
THE IDEA OF “RATING UPLIFT ”
• Rating agencies even take into account government support when assigning ratings
o Standalone rating vs support rating
,EXTERNALITIES ARE LARGE BUT WHY?
• Informal contagion
o When a bank fails, one could question quality of banks with similar business models
o If one goes bankrupt what will happen with the others?
• Firms and households lose access to financing
o When banking systems break down, firms and households lose access to financing
▪ These clients will have to look for other financing where they will probably have
to pay higher rates
• Interconnectivity of banks
o Banks are highly interconnected
• Fire sales and liquidity spirals
o When everybody sells the price goes down what will trigger more sells
PROBLEMS WITH REGULATION
FACTS PRECEDE RULES (1)
• Regulation always comes after the facts.
FINANCIAL INNOVATION (2)
• New products can be designed to avoid regulation
REGULATION IS COSTLY (3)
• Regulation is not free
• Regulation could lead to the creation of new strictures
o Shadow banking = hedge funds..
o Not all shadow banking is bad
• Net regulatory burden
o The difference between the private cost and the private benefits to comply to regulation
• Border problem
o If regulation is effective: money is going to the n regulation sector
o Regulated sector will become smaller and smaller, unregulated sector will become
bigger and bigger.
LESS MAY BE MORE (4)
• Enforceability
o Can I enforce my regulation? The more rules the more difficult it will be to enforce all of
them
• Impact on financial stability
o How much regulation do you want In the economy
,THE FINANCIAL SAFETY NET & CRISIS MANAGEMENT
• Financial safety net
o You need rules to minimize negative consequences of a crisis
o 4 components of the financial safety net are:
RULES ABOUT FOUNDING AND DISSOLVING BANKS (1)
• A credit institution is a corporation that
o Accepts deposit
o Grant credit for their own account
• BRRD = Bank recovery and resolution directive
o Directive talks about how banks should be recovered or be resolved in case of a crisis
THE CENTRAL BANK AS A LENDER OF LAST RESORT (LOLR) (2)
• In a crises, the central bank should grant credit to banks thar are illiquid but solvent, without limit
and against collateral:
o Illiquid but solvent: good banks but problems with liquidity
• Constructive ambiguity
o = You ask banks to act as if theres nor LoLR
• Solvency constraints
o = If you have borrowed from other parties it puts a constraint on your firm because you
need to pay it back. If you cant you will go bankrupt
o ECB does not have that problem because they can print money
▪ Inflation constraint
• Printing more money will put inflation pressure on the economy
DEPOSIT INSURANCE (3)
• Deposit insurance in BE
o Before 2009: 20.000 EUR
o After 2009: 100.000 EUR
FINANCIAL OVERSIGHT (4)
• Micro prudential oversight:
o Looks at soundness of individual banks
o Rules about capital and liquidity
o Risk is exogenous
▪ = look at situations in which things are happening outside of your bank and look
what it does to your bank
• Macro prudential oversight:
o Look at soundness of the entire banking system
o Interaction between financial & real economy
o Risk is endogenous
▪ = taking into account all the risks being caused inside your system (because
you’re looking at the entire banking system; macro level)
,BESEL REGULATION (VERRY IMPORTANT)
BASEL 1
• Concept of risk weighted assets (RWA)
• Minimum capital = RWA x 8%
• Problem with basel 1
o Regulation arbitrage
▪ Because rules were so simple it was easy to avoid them
o Does not look (enough) at collateral and diversification
o Some firms are more creditworthy than others
BASEL 2
• Make capital requirements more risk-sensitive
o Looking at risks within categories of basel 1 (sovereign, banks…)
• Based on 3 pillars:
1. Risk quantification
a. Set up models to estimate credit risk
b. Only take into account risk types that basel tells you to take into account
2. Risk governance
a. Allowed to build your own models while you take into accoubt all the risk you
can come up with
3. Risk transparency
a. Transparency and communication to the market
BASEL 2 EN 3
• Basel 3 is much like basel 2 but with stricter capital, leverage and liquidity requirements
• Equity > 8% x RWA
, BASEL 4
• Input floor on PD, LGD, EaD
• Output floor of 72.5%
• Limits on portfolios
• Other changes
o See during later parts of this course
HOW TO IMPROVE CAPITAL REQUIREMENTS AS A BANK
• Offer new shares
o Easy way: issuing new shares
• Avoid capital leaving the bank
o Decrease dividends
• Convert debt into equity
• Decrease risk weighted assets!!!
o RWA on left side of balance
▪ Moving bad loans to good category by not lending money to bad clients but
lending it to good clients
o RWA goes down and ratio equity over RWA goes up
BASEL CAPITAL REQUIREMENTS
• Basel capital requirements = set of rules set by the BCBC (Basel Committee on Banking
Supervision
o Basel doesn’t set rules
▪ But gives a framework: they must be translated in national law by local
authorities
BASEL REGULATION IS STRUCTURED AROUND 3 PILLARS:
• Pillar 1: Minimum Capital Requirements
o Rules for calculating capital requirements
• Pillar 2: Supervisory Review
o Supervision of banks by national supervisory authorities (national bank)
• Pillar 3: Market Discipline
o Requires banks to meet specific disclosure obligations toward the market, such that
they might “punish” excessively risky banks by increasing their funding cost or even by
refusing to finance them
o You need to report your results to the market so the market can discipline you whenever
its needed
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