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Summary Financial Innovations and Institutions
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Summary of Financial Innovations and Institutions 2020 Lecture 1-7 (FEM11023) - With additional notes of professor incorporated.
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Risk Management - Comprehensive Summary - Corona Edition
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Samenvatting / Summary boek: Risk Management and Financial Institutions 4th edition (John C. Hull) 2015
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LECTURE 1 → Introduction and Covid crisisBank balance sheet
- Deposits are the main liabilities
- Loans are the main assets
- Increasing role of short-term debt
- Increasing focus on trading assets
- Low equity ratio (5%-8%)
Bank balance sheet → Credit Risk
- Credit risk is the risk that counterparties in loan and derivatives transactions will
default
- Credit risk can wipe out parts of loans and trading assets
- Provision for Loan Losses (Non-performing loans with 90 days delays in payments)
can wipe out Equity
Bank Balance Sheet → Market Risk
- Market risk is the risk relating to the possibility that instruments in the bank’s trading
book will decline in value
- Market risk depends on the future movements in market variables
- Which market variable is the most relevant for banks? Interest rates because they
are related to a lot of fixed securities
- Can wipe out trading and other assets and equity
Bank Balance Sheet → Liquidity risk
- Liquidity risk is the risk that a bank may be unable to meet short-term financial
demands
- Can withdrawals of deposit or a roll-over freeze of short-term debt be absorbed by
assets? Related to the ability to convert assets into cash → Loans and trading
assets are often long-term and with limited marketability
- Can wipe out deposits and other short-term debts
Operational risk
- Operational risk is the risk of loss resulting from inadequate or failed internal
processes, people, and systems or from external events
- Pandemic risk falls in this category
,Credit, market, and operational risk can wipe out assets and equity leading to
insolvency
When is a corporation insolvent?
- When it’s not able to pay its debt
Test → Do liabilities exceed its assets?
→ Can it raise new equity from private investors? (Bank can have it from
government)
Financial innovations generate new approaches to financial circumstances
- Usually, new products, services or securities that improve efficiency or transfer
risks
Innovations can carve out some risks and transfer them
- Risks have different cost and benefits for different investors, depending on:
Risk attitude (aversion etc), Portfolio diversifications (hedging), financial constraint
(unload risk), regulation
Financial Innovations → Credit Default Swaps (CDSs)
- Insurance contract that protects against borrower default
- Buyer (long protection, short credit risk) pays premiums, receives a lump sum at a
default event
- Seller (short protection, long credit risk) receives premiums, pays a lump sum at a
default event
- Could be used for hedging (if the buyer is exposed to the credit risk) or speculation
on changes in creditworthiness
Connection between financial risk and financial regulation
- Banks can not liquidate quickly is a problem if depositors want to withdraw →
Deposit insurance (be sure that they get their money) → Cheap debt for banks
(they can take a lot) → Excessive risk → Systemic risk higher (of the system) if
banks take excessive risk
- Because of this we created capital regulation on deposit insurance
Capital regulations
- Regulators set minimum levels for the capital a bank is required to keep
- Equity is an example of Tier 1 capital
- Subordinated long term debt is an example of Tier 2 capital
Regulatory Arbitrage
- Regulatory arbitrage involves entering into a transaction or series of transactions,
without affecting the risks being taken, in order to reduce regulatory (capital)
requirements
Types of regulatory arbitrage
- Cross-national (countries compete
- Cross-sector (arbitrage in which fin. inst try to lower the requirements by moving
business to shadow banks (unregulated)→ fintech)
- Single-rule → Securitization (portfolio good for rules but actually more risky)
, Covid-19 Crisis
Covid-19 is a massive shock in both aggregate supply and demand → large loss of output,
staggering unemployment
Overarching goals of economic policy
- Smooth consumption
- Allocate losses fairly and efficiently
- Contain forces that can amplify the initial economic shock
Broad consensus that there should be a large expansion of social insurance programs for
households
- Unemployment insurance etc
Rationale for providing direct support to firms(capital) is somewhat less obvious and
policy design more controversial
Classic Lender-of-Last Resort Logic
- Bagehot’s Rule → Lend freely to solvent firms, against good collateral, at a penalty
rate
- Oftewel, lend to firms that are illiquid but fundamentally solvent.
In hindsight this LOLR approach is a decent superficial characterization of 2008-09
- TARP funds were almost entirely prepaid, Fed didn't lose a nickel
- Looks ex post to have been in significant parts liquidity crisis
- Not to downplay importance insolvency-driven interventions, e.g. stress tests.
Which instrument to use?
- Reversed policies → Evergreening proposal
- Objective policy should promote evergreening of loans to carry business, especially
small businesses, through their liquidity shortfall
Evergreening (zombie lending) in normal cases?
- In order to avoid insolvency the bank offers its clients new loans at very
advantageous interest rates, which allows companies to use new loans to repay
existing ones and the bank can avoid writing off these loans and does not have to
classify them as non-performing
- Healthy banks (with more equity capital) can afford taking these losses, so incentive
to engage in zombie lending is closely linked to level of bank capitalization
- Loss in loans is loss in equity
, Why is this bad for the economy?
- Zombie firms use new loans to repay interest or old loans, suggesting that zombie
lending might lead to distortions for healthy firms
Two potential channels through which non-zombie firms could be negatively affected by
zombie firms
1. Lower loan supply
- Undercapitalized banks might shift loan supply to existing borrowers that struggle to
service debt
- Leads to lower loan supply for creditworthy firms
2. Distorted market competition
- Normal competitive would be that impaired firms shed workers and lose market
share
- But zombies are artificially kept alive and congest markets
- Distorting effects include → depressed product market price, higher market wages
- Since non-zombie primarily reduce investments in project with low productivity, their
average productivity increases
Evergreening: the COVID world → inverse regulation
The existing productive structure just needs to be kept alive until the point where the
COVID19-pause lifts. Government programs should use carrots and sticks to provide banks
with
1. Positive incentives for banks to evergreen loans → Central bank provided cheap
refinancing for rolling over existing loans
2. Punish banks which do not rollover existing loans, e.g. by strictly enforcing
non-performing loan rules.
Regulators should announce that they will act more strictly in classifying loans as
non-performing.
- This stick will induce banks to evergreen
- This policy only requires a minor adjustment of Basel bank regulation rules and
central bank policy.
- Inverse of policy prescriptions in the typical recession
Owner-manager has pledged firm and personal assets towards a loan
Earnings decrease triggers Debt Servicing Problems
- Owner’s equity tapped out: liquidity constraint
- Prioritize scarce liquidity towards debt service, rather than actions that maintain
enterprise value (maintaining workforce, capital)\
This produces scars
- In the recession, firm value erode as real expenditure falls
- Post-bankruptcy, firm will scale up slowly even if pandemic ends because net worth
of owner remains low
- Policy: provide cheap liquidity to firm Closeanalogy to high MPC household since
2008 recession
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