Advanced Banking Exam Notes PDF

**Advanced Banking exam notes** **WEEK 1** **Lecture 1. Functions of the financial system** Functions of the financial system 1. Financial structure 2. Asymmetric information 3. Delegated monitoring 4. Bank-based & market-based systems What do we want the financial system to do? 1. pro...

**Advanced Banking exam notes** **WEEK 1** **Lecture 1. Functions of the financial system** Functions of the financial system 1. Financial structure 2. Asymmetric information 3. Delegated monitoring 4. Bank-based & market-based systems What do we want the financial system to do? 1. produce information ex ante about possible investments and allocate capital 2. monitor investments and exerting corporate governance after providing finance 3. facilitate the trading, diversification, and management of risk 4. mobilize and pooling savings 5. ease the exchange of goods and services. Financial systems differ.. A graph of the number of countries/regions Description automatically generated - Across jurisdictions - Over time [Bank-Based versus market-based systems] - Direct finance: sector in need of funds borrows from another sector via a financial market (market-based) - Indirect finance: a financial intermediary obtains funds from savers and uses these savings to make loans to a sector in need of finance (bank-based) Thus direct finance focuses on market based system where you can borrow funds from a different sector via a financial market. Whereas indirect finance is a bank based system which uses funds that they obtained from savers and uses these savings to give out loan to a sector in need of finance [Financial structure ] - The set of institutions that channel resources from its savers to its investors, allocate them across alternative uses and enable investors to share risks and diversify their portfolios. Langfield and Pagano (2016) discuss: 1. Differences 2. Determinants 3. effects on the real economy [Key points ] The real world is characterized by transactions costs owing to asymmetric information between users and providers of funds and to limited enforcement of contracts. In the presence of these frictions, comparative advantages can emerge.' 'a financial structure dominated by banks performing direct intermediation can mitigate frictions-but in some cases also exacerbate them.' [Assymetric information ] 1\. Would you be willing to lend EUR 100 to the person sitting next to you? Personal response= at a good interest rate yes Further: 2\. Would it be a good idea for the person sitting next to you to lend you EUR 100? Personal response= No. *What did we see here?* We had to assess probability of default (PD) 1\. It may be the case that you know the person sitting next to you fairly well\ 2. You have the best information about your level of 'credit risk' [Two key information asymmetries ] In general: One party of a transaction has a better information position than the other party. In a loan transaction: the borrower knows more than the lender. 1\. Ex ante (adverse selection): only high-risk borrowers may be willing to apply 2\. Ex post (moral hazard): once the loan is granted, borrowers may take on more risk Thus overall one party has more information than the other, generally being the borrower because they know most about themselves. In addition Ex ante focuses on before the even and Ex post after. Here is some more insight: **Chat explanation:** **\*Ex Ante:** **Adverse Selection** - **Definition**: Adverse selection occurs **before** a transaction (ex ante) when one party has private information that the other party lacks. In the context of lending, this leads to only **high-risk borrowers** being more likely to apply for loans. - **Why?** - Low-risk borrowers may find the loan terms unattractive or unnecessary. - High-risk borrowers have a greater incentive to seek funding because they are willing to accept higher risks. - **Example**: A bank offering loans without conducting credit checks may unintentionally attract primarily risky borrowers, as they are more likely to take advantage of the situation. **2. Ex Post: Moral Hazard** - **Definition**: Moral hazard occurs **after** a transaction (ex post) when one party changes their behavior because they no longer bear the full consequences of their actions. In lending, borrowers might take on **more risk** once they secure a loan because the lender shares the financial burden. - **Why?** - Borrowers may feel less accountable for losses because they are using someone else\'s money. - Without proper monitoring, they may engage in riskier projects to maximize returns. - **Example**: After receiving a loan, a borrower invests in a risky project instead of the agreed safer option, knowing that losses are partially borne by the lender. \* [How do banks help here:] - They manage ex ante and ex post information asymmetries (screen, monitoring) - Reduce transaction costs, as banks are able to generate economies of scale [Delegated monitoring (Diamond, 1986) ] 'Why do investors first lend to banks who then lend to borrowers, instead of lending directly?' - Explains benefits of intermediaries - Some costs are lower when assets are held by intermediary rather than large number of individuals [One borrower, one lender ] Delegated monitoring pays when: K ≤ S - K: cost of monitoring - S: savings from monitoring *Two options* - Either all m lenders monitor, at a total cost m ∗ K - Monitoring is delegated, at a total cost D (per borrower) Delegated monitoring pays when: - K + D ≤ min\[S , m ∗ K \] - K + D: cost of using intermediary - S: cost without monitoring - m ∗ K : cost of direct monitoring [Insights from Diamond (1986) ] - Banks can avoid the duplication of effort of the monitoring of borrowers by small investors. - Banks monitor debt (loan) contracts, and issue unmonitored debt (deposit) contracts. - If the bank gets sufficiently diversified across independent loans \[\...\] then the chance that it will default on its deposits gets arbitrarily close to zero. [Banks have comparative advantage in monitoring if ] - Many projects are involved (diversification) - Capacity of individual lenders is small (m is large) - Cost of delegating monitoring is small [Financial structure: Determinants ] Observation: 'Europe's already bank-based financial structure became even more dependent on banks, while the USA became slightly more market-based.' Relevant factors:\ 1. Comparative advantage in mitigating financial frictions 2\. Public policy [Comparative advantage of banks is large when ] 1\. Relationship lending is important, e.g. small- and medium-sized enterprise 2\. There is a lot of tangible, pledgeable collateral 3\. When contract enforcement is difficult [Role of public policy ] Langfield and Pagano (2016) discuss the following factors: 1\. Promotion of 'national champions' 2\. Leniency of supervision 3\. Inadequate regulation 4\. Promotion of 'regional champions' They also point out steps 'in the right direction' 1\. Single Supervisory Mechanism (SSM)\ 2. Resolution\ 3. Capital Markets Union (CMU) [Financial structure: Real effects ] Do differences in financial structure have implications for growth or stability? Initially: no effect of financial structure on economic growth (Levine, 2002) *Recent evidence suggests* Capital-based systems can boost economic growth 1\. Improves total-factor productivity 2\. Boosts firms' investments Bank-based systems associated with more volatility 1\. Higher leverage 2\. More exposed to house prices **Lecture 2. Financial (in) stability and crises** Financial instability: 'A financial system is considered stable when its markets and institutions---including banks, savings and loans, and other financial product and service providers---are resilient and able to function even following a bad shock. This means that households, communities, and businesses can count on having the resources, services, and products they need to invest, grow, and participate in a well-functioning economy.' ' \[\...\] includes making the financial system more resilient and limiting the build-up of vulnerabilities, in order to mitigate systemic risk and ensure that financial services continue to be provided effectively to the real economy.' [Financial stability ] Key question: Can the financial system continue to support the real economy? Analytical focus on - Shocks - Financial vulnerabilities - Resilience [Systemic risk ] Systemic risk refers to the risk that an event will trigger a loss of economic value or confidence in a substantial part of the financial system that is serious enough to have significant adverse effects on the real economy Cyclical perspective: imbalances, bubbles Structural perspective: interconnections [Context:]  [Financial instability can take many forms ] Banking crisis: large part of banking sector in trouble\ Sovereign debt crisis: restructuring or default of government debt Currency crisis: external value of currency falls suddenly Stock market crisis: stock market valuation collapses \... or combinations of the above. A graph of a financial crisis Description automatically generated [Why worry about banking crises? ] 1\. Pressure on government finances \- Depositor insurance\ - Recapitalization 2\. Economic costs \- GDP shortfall [Origins of banking crises ] 1. Shortcoming in management, fraud 2. Government policies (directed credit) 3. Macroeconomic booms and busts [The global financial crisis (2007-09) ] *Vulnerabilities* - Boom in U.S. housing market - Banks repackaged mortgages ('originate to distribute') - Complex products (securitization): where is the risk? - Shortcoming in credit ratings agencies - Credit booms in E.U. countries - Interconnected financial system Shock - Cooling of U.S. housing market Resilience: not so much - Mortgage defaults - Loan losses for banks - Quick spread through internartional financial system - Too big to save (Iceland, cyprus, Ireland) - Liquidity crisis - Credit crunch [Two main views on banking crises ] 1\. Panic view: crises are random events\ 2. Banking crises are natural outgrowth of the business cycle [Panic view: Diamond/Dybvig (1983) ] This classic paper makes three points: 1. Banks are helpful: They can provide better risk sharing than competitive markets. 2. But, there is an inherent vulnerability: The demand deposit contract has one undesirable equilibrium in which all depositors prefer to withdraw liquidity immediately (bank run). 3. And, such bank runs matter: Even inherently 'healthy' banks can fail, with adverse implications for investments. [Business cycle view: Gorton (1988) ] 1\. Empirical analysis of banking panics in the U.S.\ 2. Panics are not random\ 3. Rather, consumption smoothing by cash-constrained people 4\. As a reaction to perceived higher economic risks [Business cycle view: Allen/Gale (1998) ] 1. Model with three periods 2. Consumption can be early (period 1) or late (2). 3. Bank invests in risky asset with return R at t = 0 4. At t = 1, depositors receive signal about R (e.g. leading economic indicator on state of business cycle) 5. Runs occur depending on R by a fraction of early-withdrawing late consumers. [A third view of crises: Minsky ] - Credit boom-bust starts with a 'displacement', invention, or policy change that excites investors. Five stages: 1. credit expansion, characterised by rising assets prices 2. euphoria, characterised by overtrading 3. distress, characterised by unexpected failures ('Minsky moment') 4. discredit, characterised by liquidation 5. panic, characterised by the desire for cash Tutorial week 1 *Asymmetric information* 1\. How is asymmetric information relevant in the context of banking? 2\. What are two key examples of information asymmetry in banking? 3\. What can banks do to manage information asymmetries? Answers: 1. Asymmetric information is relevant in the context of banking due to the Ex ante and Ex post effects of moral hazards and that the borrower always has more information and then the loanee. 2. Ex ante and ex post, consisting of moral hazard and adverse selection 3. Banks can do background checks and screening to impact the asymmetries of information *Total cost per dollar= 0.03 +0.0004= 0.0304* *Loan rate = 0.0304/ 0.6F +0.4* *Diversification, Efficient monitoring, Economies of scale* **WEEK 2** **Lecture 3. Bank lending, monetary policy, and the real economy** [Macroeconomic fluctuations] Do banks actions matter much? Money view: No. It's all about money supply Credit view: Yes. Bank loans also matter From the perspective of a bank's balance sheet:  Examples of money view - Monetary policy a key factor in US business cycles - Monetary contraction by the federal reserve caused the Great Depression Example of credit view: ' \[\...\] when the Federal Reserve reduces the volume of reserves, and therefore of loans, spending by customers who depend on bank credit must fall, and therefore so must aggregate demand. This provides an additional channel of transmission for Federal Reserve policy to the real economy, over and above the usual liquidity effects emanating from the market for deposits.' Recent contribution to credit view: 'Our key finding is that all forms of the model show that a credit boom over the previous five years is indicative of a heightened risk of a financial crisis.' 'Our ancestors lived in an Age of Money, where credit was closely tied to money, and formal analysis could use the latter as a proxy for the former. Today, we live in a different world, an Age of Credit, where financial innovation and regulatory ease broke that link, setting in motion an unprecedented expansion of the role of credit in the macroeconomy.' Within the credit view: Monetary policy has an effect via - Loan supply: bank lending channel - Loan demand: balance sheet channel Example: monetary policy tightens Then:\ Consumers hold fewer deposits (D ↓) Banks cannot reshuffle assets (S is constant) Other funding is not readily available (OF is constant) Then banks will give out fewer loans (L ↓) This will reduce consumption & investment [The empirics of the bank lending channel ] Methodological approaches included: Analyzing macroeconomic aggregates Exploits the heterogeneity among different types of banks (e.g. size, liquidity, capital) Disentangle supply and demand using loan level data [Recent development: Risk-taking channel ] Monetary policy can also affect quality of loans Softer lending standard Taking extra risks [Monetary policy since early 2000's ] - Stable and straightforward untill 2007 - Crisis fighting mode - A new normal *Stable and straight forward* - Regular meetings - Some communication, mainly with experts - Focus on low and stable inflation (2%) - One policy instrument - Great moderation: it seemed to work! *Crisis-fighting mode* 'The global financial crisis had a profound impact on the practice of monetary policy in a range of countries. \[\...\] monetary policymakers rarely had the luxury of performing extensive ex ante analyses of prospective changes in their responsibilities, instruments, or communications. Necessity was often the mother of invention.' A table with numbers and text Description automatically generated with medium confidence *A new normal for monetary policy?* 'The key question today is to what extent these changes will prove to be temporary, primarily motivated by the financial crisis, or lasting?' (Blinder 2017). *Central bankers on mandates after the financial crisis:*  [Role of financial stability ] 'the change most frequently discussed, both internally and externally, is adding a financial stability objective to the mandate.' (Blinder, 2017) Our take in 2017 ' \[\...\] a future consensus on financial stability \[\...\] might be this: Central banks should pay more attention to the build-up of financial imbalances, notably credit bubbles. But macro-prudential policies, not monetary policy, should be the first line of defense. In normal situations, conventional monetary policy should focus on price stability, while macro-prudential instruments are used to lean against excessive credit expansion.' (blinder, 2017) Some examples since 2017: - Norges bank - RBNZ: dual mandate - Federal reserve: average inflation targeting - ECB: strategy review **Lecture 4. Structure and competition** A diagram of a financial system Description automatically generated [Structure-conduct-performance ] Concentrated banking sector → Less competition → Higher profits How to measure? - Structure: concentration ratios, HHI, etc. - Performance: return on assets, return on equity, etc - Conduct: ??? [Why care about competition?] More efficient provision of financial services Better quality of financial products More innovation in the long run In banking research, two approaches Traditional industrial organization (IO) -- 1950s till 1990s New empirical IO (NEIO) -- sinces 1990s *Traditional IO (industrial organization)* What explains link between concentration and profits---if any? SCP paradigm: concentration will lead to higher profits Efficiency hypothesis: more efficient banks will gain larger market shares. *NEIO (New empirical industrial organization)* Objective: measure competition more directly Panzar-Rosse's H-statistic Lerner index Boone indicator [Panzar-Rosse approach] H-statistic: sum of elasticities of gross revenue wrt factor input prices H = 1: perfect competition\ 0 \< H \< 1: monopolistic competition I H ≤ 0 monopoly [Further evidence on banks in EU-28 countries ] - Moderate average levels of bank concentration (across different indicators) - Competition measures: less homogeneous, though in general point to monopolistic competition - High concentration does not imply low competition (and vice versa) [Does competition affect stability? ] Two views\ competition - fragility competition - stability [Competition - fragility ] Competition will lead to more bank fragility:\ Incentives for banks to take on more risks Less incentives to screen borrowers properly [Competition - stability ] Competition will lead to less bank fragility Lower lending rates increase success rate of enterpreneurs This means banks have lower credit risks. [Since crisis, more focus on systemically important banks ] Five indicators to identify G-SIBs - Size - Interconnectedness - Substitutability - Complexity - Cross-jurisdictional [Implications for being a G-SIB ] Allocation to five buckets based on: - G-SIB methodology - Supervisory judgment Additional capital requirements ranging between 1.0% and 3.5%.  **WEEK 3** **Lecture 5. Regulation and supervision** A diagram of a financial system Description automatically generated Why regulation? Bank failures have severe negative consequences for - Borrowers (credit crunch) - The rest of the financial sector (contagion) - The real economy (growth) Market failures Government intervention to address various market failures i.e. a situation where market outcome would be sub-optimal. Market failures -- and related government policy - Vulnerability to runs (deposit insurance) - Moral hazard and excess risk (improve transparency, capital, liquidity) - Systematic risk (macroprudential) Types of regulation for the banking sector: 1. Microprudential: ensure soundness and safety of individual financial institutions 2. Macroprudential: preserve financial stability 3. Competition policy: to protect consumers against abuse of market power 4. Conduct-of business: focuses on how banks conduct business with customers and how they behave in markets Basel I, II,.. III are the basel committee on banking supervision and the global standard setter for prudential regulation of banks Basel III (2011) = Reaction to the global financial crisis - More capital - Higher quality capital - Leverage ratio ≥ 3% - Liquidity (LCR/NSFR) page14image19950640 Basel III (final, 2017) Reaction to the global financial crisis - Risk weight floor - Rebalancing away from internal models & complexity [In Europe: Banking Union ] - Break vicious cycle between banks and sovereigns - Reduce costs to taxpayers of banking distress - Harmonize rules and standards to improve quality and efficiency of supervisory and regulatory frameworks  Two stable outcomes (assuming we want financial stability): 1\. Supra-national solutions to keep international banks\ 2. National solutions with limited financial integration [Responsibilities of the SSM (single supervisory mechanism)] Microprudential: safety and soundness of credit institutions - direct supervision of significant institutions (SI) - indirect supervision of less significant institutions (LSI) Macroprudential: financial stability - shared responsibility with national authorities (NCA) - can decide to apply more stringent measures than NCA (if covered in CRD-IV) - ensure consistent implementation of macroprudential policy Solvency of european banks: two types of required in CRD-IV being risk weight and unweighted (leverage ratio) A white background with black text Description automatically generated Liquidity Requirements for liquidity are: the global finacne crisis started as a liquidity crisis, Hence Basel III introduced: - liquidity coverage ratio (LCR) - Net stable funding ratio (NSFR) LCR - Bank needs to hold sufficient liwuidity to withstand 30-day stress - LCR \>= 100% - Limit occurrence of fire sales (macroprudential) NSFR - Available stable funding relative to required stable funding - NSFR \>= 100% - Reduce vulnerability to runs (microprudential) **Lecture 6. Macroprudential policies and stress testing** Macroprudential policies and stress testing 1. Lender-based and borrower-based measures 2. Stress testing, illustrated using flood risk The ultimate objective of macroprudential policy is **to preserve financial stability**. This includes making the financial system more resilient and limiting the build-up of vulnerabilities, in order to mitigate systemic risk and ensure that financial services continue to be provided effectively to the real economy. [Macroprudential tools ] Aimed to ensure stability of the financial system as a whole 1.Structural tools: build resilience irrespective of business cycle e.g. G-SII buffers, loan-to-value limits 2\. Cyclical tools: build resilience in anticipation of downturn e.g. CCyB [Key concepts for financial stability: ] Can the financial system continue to support the real economy? - Shocks (hard to predict) - Financial vulnerabilities (we can monitor those) - Resilience (macroprudential tools) 1. Shocks: events that may lead to disruption or failure in part of the financial system 2. Financial vulnerabilities: a property of the financial system that: (i) reflects the accumulation of imbalances, (ii) may increase the likelihood of a shock, and (iii) when acted upon by a shock, may lead to systemic disruption. 3. Resilience: the capacity of a financial system to absorb shocks and prevent them from leading to an unravelling of the accumulated imbalances. How to analyze? - Monitoring indicators: where are we now? - Stress testing: where could we end up? Example of a stress test: flood risk in the netherlands done by Caloia (2023) - Shocks: flood events - Vulnerabilities: real estate exposures - Resilience: CET1 depletions - Tranmission channel: increased loan to value ratios (LTV) Can floods affect financial stability through a credit risk channel? 1. Focus on the Netherlands---flood risk top of mind, insurance gap 2. Studying real estate---key exposure for banks 3. Forward-looking perspective---literature looks at historical data 4. Combination of granular data sets---unique data setting \*more info in slides Recap: Would floods impair financial stability? 1. Property damages would cause a drop in system-wide capital of between 30 and 50 basis points 2. Depletion due to flood specificities and starting-point loan-to-value ratios 3. Compared to current levels of bank capital, such levels of depletion seem small However, Some intuition Resilience due to 1. High level of flood protection---very low probabilities of floods 2. Floods mostly local---only part of real estate would be affected 3. Flood protection is highest where most of real estate is concentrated 4. Floods sometimes affect areas where starting-point LTVs are relatively low Tutorial week 3 *Basel regulations* 1. Which are the two key metrics for bank liquidity? - LTV - SGI - Correct is LCR and NSCR - These are the LCR leverage coverage ratio consisting of that they need to with-stand 30 days of stress - NSCR is the net stable funding ratio. It ensures that banks have a stable funding profile, Reduce vulnerability to runs (microprudential) LCR - Bank needs to hold sufficient liwuidity to withstand 30-day stress - LCR \>= 100% - Limit occurrence of fire sales (macroprudential) NSFR - Available stable funding relative to required stable funding - NSFR \>= 100% - Reduce vulnerability to runs (microprudential) 2. What is generally the biggest component of banks\' risk weighted exposure? - Credit risk - Credit risk consists of the risk of that the borrower fails to meet their debt obligations 3. What is the unweighted capital measure in Basel III? Tier 1 capital / assets (total unweighted exposure) \>= 3% *Macroprudential and stress testing\ *1. Give a description of the concept of *financial vulnerability* Finanacial vulnerability consists of the inbalances for example in the financial system such as the increase in likelihood of a shock, impact of climate change etc. *\ *2. What is the difference between microprudential and macroprudential policy? Microprudential focuses on small measures of policy that can be undertaken to impact financial stability such as leverage ratio's LSR etc where macro focuses on nation wide impacts. **Microprudential Policy:** Focuses on the **safety and soundness of individual financial institutions**. The goal is to ensure that banks and firms remain solvent and manage risks effectively.\ Example: Capital adequacy requirements for a single bank. **Macroprudential Policy:** Focuses on the **stability of the entire financial system**. It aims to mitigate systemic risk and address financial vulnerabilities that could harm the broader economy.\ Example: Countercyclical capital buffers or stress tests to prevent asset bubbles. **Key Difference:** Microprudential policy looks at individual institutions, while macroprudential policy addresses system-wide risks and financial stability. Look at loan ratios for empirical perspective **Week 4** **Lecture 7. Intro to part II** A bank can be defined in terms of 1. Economic function it performs\ - Transferring funds from savers to borrowers and in paying for goods & services 2.Services it offers to its customers, however changing profile. \-  Historically: Checking & debit accounts, credit cards, saving plans, loans for businesses, consumers & governments \-  Recently: Investment banking, insurance protection, financial planning, advice for merging companies, the sale of risk management services and numerous other innovative products 3.Legal basis for its existence \-  A bank is any business offering deposits subject to withdrawal on demand and making loans of a commercial or business nature \-  Any institution that could qualify for deposit insurance administered by the Federal Deposit Insurance Company (FDIC) Three building blocks: 3 regulations. 2 the credit function: it is about the three questions (next lecture on Friday) three questions on when to give loan. 1 asset and liability management: ALM what is on the balance sheet of a bank. Start a... company: slide 16 Start a... bank slide 17: nothing special here Grow your bank go to people that provide money, pension funds, then we get some saving accounts. Getting saving accounts changes everything; it will change your business model Because we then got **the watchdog** Regulators have to guarantee saving accounts that is why they are so strict Slide 20: important Basic balance sheet of the bank. On the liability side we got the deposits that need to be protected. Regulator looks at banks trough five different lenses: solid banks, solid financial systems, properly managed, customer protection, protection for society (don't want financing Russia or money laundering). This might be exam question above, tell something about one of the lenses. Important \> The business model concerns maturity and risk transformation, distribution and management What is the revenue model: slide 23. Loan loss expense: provision for customers that don't pay. Fee income: example Arrangement fee, commitment fee (company wants to invests but because bank guarantees money in some time for example three months then they charge commitment fee), waiver fee(a company has no collateral, but in good held it can make arrangements about risk profile (ratios etc.) the re-negotiations are then covered in a waiver fee. Non interest expense: housing, people etc. it infrastructure is very constly for banks these days. **The Function of Capital** 1.Cushion against the risk of failure, i.e., absorbing financial / operating losses\ 2.Promote public confidence\ 3.Funds for new development of new services and facilities\ 4.Regulator for growth, i.e., it should be relative to the asset side of the balance sheet 5.Limit how much risk exposures a financial firm can accept, i.e., not only safeguard public confidence but also protect government's deposit insurance system A diagram of a helicopter Description automatically generated