Fundamentals of Financial Markets and Institutions Lecture 3 PDF

**Fundamentals of Financial Markets and Institutions** **15.01.2025 -- Lecture 3** A screenshot of a screen AI-generated content may be incorrect. Leverage: the ratio of a company's debt to its equity. - Equity works as a risk buffer, when a company suffers losses, it is first absorbed by...

**Fundamentals of Financial Markets and Institutions** **15.01.2025 -- Lecture 3** A screenshot of a screen AI-generated content may be incorrect. Leverage: the ratio of a company's debt to its equity. - Equity works as a risk buffer, when a company suffers losses, it is first absorbed by equity holders, and then by debtholders. - *During the GFC, banks held high leverage risks, so there was little equity that could absorb the losses -\> buffer.* - This led to a global decision to not allow banks to hold high leverage ratios. - Implementation of stress tests. **Stress Tests** - The goal of stress tests is to assess the resilience of financial institutions to adverse market developments and to assess systemic risk. - Adverse market developments: *rising interest rates (more expensive loans, slows consumer spending, reduced stock value, higher debt costs), increasing unemployment, market volatility*.  CORE tier 1 capital: A measure of a bank's financial strength, consisting primarily of common equity and retained earnings. 1. Bank started with 10% CORE tier 1 capital, 40% deposits and 50% SR and LR debt. 2. A scenario analysis is performed, such as mortgage loans losing 10% value (50-\>45). 3. Drop in equity ratio from 10% -\> 5.3%. The idea is to see how the bank's balance sheet would look like in case an adverse market development occurred; do they have enough equity to buffer these? a. [2011 EU-wide Stress Tests] - Initial test: In 2011 the first EU-wide stress test took place, issued by the European Banking Authority (EBA), with a threshold of CORE tier 1 capital ratio of 5%. - Outcome: 8 banks fell below this threshold, amounting to a capital shortfall of 2.5 bn. - Threshold increase: By the end of 2011 EBA raised this threshold to 8%. - 2012 Assessments: 2012 EBA published their assessments, announcing that banks shortfalls in are to be addressed through direct capital measures. - Banks strengthened their balance sheets by *reducing bonus payments, issuing new equity and increasing retained earnings* - Balance sheet management: The review showed banks had effectively managed their balance sheet risks through these measured. Case: Bankia and How it Changed EU Stress Tests - During the GFC the housing bubble burst, which led to a severe banking crisis in Spain. - However, Bankia had managed to increase its CORE tier 1 capital ratio significantly, or so they said. - Despite this, in May of 2012, Bankia asked for a bailout of 19 bn. - How did this happen? - Fraud: Bankia had falsified its accounts, these falsifications were accepted by managers, auditors and Spanish financial secretary - The whole Spanish banking sector was on the verge of collapse. - Spain had to seek up to 100 bn in European rescue money for its banks - This led to European Banking Union creating the Single Supervisory Mechanism (SSM) b. [2014 Stress Tests, Asset Quality Review, and SSM] - Single supervisory mechanism (SSM) was the first building block of the EBU. - National level supervision was no longer enough, there was a need for a centralized, uniform approach. - Large banks are supervised directly by the ECB, while smaller banks are still supervised on a national level. Asset quality review (AQR) conducted by the SSM in 2014. Objectives: 1. Enhanced supervision: more detailed and accurate evaluation of Europe's significant banks before ECB became the supervisor. 2. Transparency: increased transparency in banks' balance sheets and risk exposure. 3. Standardized stress tests: defining starting values for stress tests to allow easier comparison. 4. Supervisory credibility: Strengthen ECB's credibility. Implementation: 1. Capital focus: focus on equity not liquidity. 2. Stricter NPL classification: loans 90 days overdue as unlikely to be repaid. - Banks lacked incentive to recognize NPLs quickly, as it would worsen their reported financial condition. AQR helped fixed this issue with the NPL reclassification. Results: - The amount of troubled loans was significantly higher than what banks had reported in 2011 stress tests. - The stress test was spanned over a three-year period, with different thresholds, depending on whether there was an adverse scenario: Baseline 8%, Adverse: 5.5%. Assessment: - Banks had increased their equity due to stress tests, increasing financial stability. - However, there were also criticisms. 1. Under tougher CET1 many banks would have failed. 2. The adverse scenario definition was too harsh, not considering all possible scenarios. - The main issue is how do we know what the right parameters should be? c. 2016 Stress Tests - Unlike previous stress tests, this year did not have a specific threshold. - The average CET1 ratios weren't alarming but there were large discrepancies. - A notably one was Monte dei Paschi, the world's oldest bank, which had a negative CET1-ratio, meaning it would be insolvent in an adverse scenario. - Nordic countries performed well. A graph of a number of banks AI-generated content may be incorrect. - As a result of the stress tests CET1 capital ratio had almost doubled, showing the success of stress tests.  - However, these values still differ country-wise. [EU vs US Banking] - EU has higher NPL rates. - Particularly in southern European countries, due to local challenges with high unemployment rates. - EU has slower economic growth. - EU has a more fragmented banking system. - There are many small to medium sized banks across different countries, meaning banks are not able to have the same level of economies of scale as the US. A graph with blue and white bars AI-generated content may be incorrect. - Overall, there has been a decrease in amount of NPL. - Spain used to have around 20%, now it has come down to 4%.  Net Interest Income (NII): the difference between interest revenue and interest expenses. - Europe faces stagnant margins, indicating consistent challenges in banks profitability. - Reference rates do not directly influence NII, however they impact banking profitability, by reducing margin between what banks can charge for loans what they must pay on deposit rates. - This is exacerbated by the floor on deposits: 0%. - In recent years there has been improvements with NII increasing by roughly one third. - However, there is still a valuation gap, with EU usually trading at price to operations below one 1%, while us above 1%. - In the it is US easier to raise capital. - *Ex: Before 2007 Danske bought Sampo for 4\* book value, now banks typically trade for below book value -\> major change in banking markets.* d. New Stress Tests - Climate Stress Tests: banks resilience to potential impacts of climate-related risks. - Cyberattack Stress Tests: tests banks' ability to withstand cyberattacks. - The core value of banks is credibility therefore it essential customers are able to trust in them -\> as well will see later banks invest a lot of their funds into cyber security. [European Banking Union] A diagram of a banking union AI-generated content may be incorrect. The three main building blocks of the banking union: 1. SSM - ECB and national supervisory authorities. - Large banks, above a certain threshold, supervised directly by ECB. 2. Single resolution mechanism (SRM) - Before if banks needed to be bailed out it was through taxpayers' money. - Now it is managed by the European resolution fund, so it is done on a European level to minimize costs to taxpayers. 3. European deposit insurance scheme (EDIS) - All bank deposits are covered up until 100,000 EUR - However, it is not finalized due to worries. - Some countries, like Germany and Finland, are opposed to the pooling of financial risks due to fears that it would lead to excessive risk taking (moral hazard). [Capital Markets Union] [ ]  - Europeans trust their banks, and predominantly rely on them for borrowing, while American companies tend to issue bonds -\> a more developed financial market in the US. - One of Europe's main issues is the lack of financing options. - Europe has money, but it is most in bank account instead of in financial markets. - Bank lending is however not optimal for high-risk ventures, capping funds for innovative projects and slowing economic growth. - The increase the amount of risky financial assets the Capital Markets Union was formed A screenshot of a graph AI-generated content may be incorrect. - Getting financing for risky projects is a lot harder in the EU. - Europe needs stronger capital markets to provide more options for financing. - Reducing reliance on bank funding would make the financial system more resilient. - There was some progress being made by risk-loving countries like England, compared to the risk-averse countries like Germany, but has now been slowed down due to Brexit.  - If we fail to increase the availability of risky lending, we slow down economic growth. - The final stages of financing are in the capital markets.