Conceptual Framework: What Does the Financial System Do? 1. Financial contracting: Get funds from savers to investors

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1 Conceptual Framework: What Does the Financial System Do? 1. Financial contracting: Get funds from savers to investors Transactions costs Contracting costs (from asymmetric information) Adverse Selection Moral Hazard 2. Generate Funding & Market Liquidity Funding liquidity: Attribute of firms or households Ability to raise cash Market liquidity: Attribute of financial asset Buyers and sellers Symmetric information 3. Risk Management: Allow agents to share risks efficiently 1 of 15

2 1. Financial Contracting Bank s Role in Financial System Overcome adverse selection & moral hazard (lending) 2. Liquidity Information / relationships Financial contracting Restructuring (overcoming financial distress costs) Funding liquidity: Deposits (asset transformation) Lines of Credit Market liquidity: Securitization Trading & market making 3. Risk Management Pooling funds (traditional intermediation) Managing credit, market & liquidity risks Derivatives (market makers) Understand how other institutions provide these services! 2 of 15

3 Bank Lending (Financial contracting) Bond market v. Syndicated lending (HK Disney) Banks get back in the game in large corporate finance Competitive response to growth in global bond market Big market ~= $1.6 Trillion Unique features of syndication Lead v. participant role Lead arranger bears both credit & underwriter risk Advantage over bonds Concentrated ownership More collateral & covenants ==> better pricing Easier to restructure than bonds Advantage over traditional loans Diversification 3 of 15

4 Risks at Financial Institutions 1. Credit Risk Old-Approach Probability of loss & salvage value Credit Scoring, Altman s Z Risk depends on loan terms Loan amount, interest rate, covenants, collateral Modern Approaches Spread Risk: Ratings-based approach Basis for Revisions to Risk-based Capital Securitization (Bistro Trust) Risk transfer from bank to markets Incentive problems ( Seven Deadly Sins ) 4 of 15

5 2. Interest rate risk Risks at Financial Institutions Measurement Duration: Weighted average of time to receive payments Modified duration: Sensitivity of asset value to unit change in interest rates. Net Worth ΔP ~=-D * PΔr Duration of NW = weighted average of duration of assets and liabilities: ΔNW~=-(D * A - kd * L) A Δr Hedging a Balance Sheet Swaps & Futures 5 of 15

6 3. Market Risk (OC Case) Risks at Financial Institutions Measurement Value-at-Risk (holding period & confidence level) Scenarios & Stress Testing Statistical approaches Historical Simulation Monte Carlo Delta Normal Estimation period Long v. Short Does tomorrow look like yesterday? Holding Period Role of liquidity Tail risk not measured by VAR (Nocera / NT) VAR is a peacetime statistic Danger of Black Swans 6 of 15

7 4. Liquidity Risk Funding v. market Risks at Financial Institutions Banks dominate in supplying funding liquidity Many financial institution play role in provision of market liquidity How do banks manage their liquidity-risk exposure? Cash on Balance Sheet Access to Interbank Market (reputation) Access to Federal Reserve (regulation) Institutional Design Deposits flow in during crisis (as in 2008) Hedge funds & I-banks more unstable than banks! Key Lesson of 1998 & 2008 Crises 7 of 15

8 Regulation and Safety Net Funding liquidity role makes banks (potentially) unstable Safety Net: FDIC, Federal Reserve Safety Net Weakens market discipline No incentive for depositors to price risk or monitor bank s actions (example of a moral hazard) Too much risk Too much debt Worse for large institutions (Too-big-to-Fail Problem) LTCM (Fed acts as honest broker ) BSC (bailout of portion of portfolio) Fannie/Freddie (government takeover) AIG (bailout) Citigroup & Bank of America (government capital injection) 8 of 15

9 Regulation & Supervision Regulation and Safety Net Exams Limits to activities Limits to competition Capital adequacy (Limits to leverage) Basel I (1992) Regulatory Arbitrage (e.g. Bistro Trust / securitization: sell off the good stuff) Basel II (2004) Pro-cyclical capital Too reliant on credit rating Basel III (2018?) Counter cyclical capital Liquidity ratios (new) Wall Street Firms are now subject to these restrictions! Goldman & Morgan Stanley (Bank holding comps) Merrill Lynch, Bear Stearns owned by banks 9 of 15

10 Financial Evolution: Rise of Markets Both sides of bank balance sheets have evolved: Liabilities: Reduced availability of funds Fewer deposits (less need to have checking acct) More alternative investments (money market funds) Assets: Replace traditional lending with Securitized lending (mortgages, credit card, CLOs) Less need to fund assets on the balance sheet Syndicated lending Compete with bond markets 10 of 15

11 Within banking Financial Evolution: Greater competition Price competition More contestable markets (National / international markets) Banks vs. other institutions Mutual funds Finance companies & mortgage companies Venture capital Investment banking Hedge Funds Will financial specialists survive? Intermediaries v. markets Bond & CP markets Syndicated loan market 11 of 15

12 Financial Evolution: Securitization What makes it work (Coval et al)? Pitfalls Pooling to reduce idiosyncratic risk Correlation assumption is key!! Tranching of cash flows to change distribution of risks CMOs (structure on order of pre-payment) CLOs & CDOs (structure on default priority) To reduce asymmetric information: Rated pools of mortgages & credit card receivables Or GSE backing To reduce moral hazard Issuer keeping skin in the game by holding first loss Regulatory arbitrage (Bistro) Seven frictions 12 of 15

13 Financial Evolution: Derivatives Explosive growth in OTC derivatives Interest rate swaps (1990s) CDS (2000s) Allows risks to be traded efficiently Pitfalls OTC market: possibility of opaque concentration of risk AIG Exposure to risk is hard to understand (LTCM) Counterparty risk Advantages of Centralized Clearinghouse (Cecchetti) CCP has no market risk Multi-lateral netting less counterparty risk Market is more transparent (no AIG problem) 13 of 15

14 Financial Evolution: Shadow Banking Traditional Banking Long-term, illiquid assets Short-term, liquid deposits Asset Transformation Shadow banking Securitize pool of illiquid assets Finance with Short-term Commercial Paper (Acharya et al) With liquidity guarantee from originating bank Financed with repurchase agreements (Gorton & Metrick) Key point: Long-term, illiquid assets (MBS) financed in overnight repo market (Lehman, Bear) Liquidity risk remains in the system but leaves bank balance sheets Required capital is reduced for banks (regulatory arbitrage) 14 of 15

15 Three Key Lessons from the Crisis 1. Large financial institutions are Too-Big-to-Fail This lesson also should have been learned in 1998! Worsened by increased concentration post-2008 Will Dodd Frank help?? 2. Recipe for Financial Crisis (Brunnermeier Liquidity Spiral) High leverage + Short-term Debt + Losses + Opacity Liquidity crisis Derivatives foster off-balance sheet leverage OTC Derivatives make allocation of risks hard to understand 3. Liquidity risk resides in Shadow Banking System Long-term assets financed with wholesale, short-term debt Opposed to loans financed with deposits 15 of 15

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