Fundamentals of Financial Markets & Institutions Lecture: Bank Contagion PDF

**Fundamentals of Financial Markets and Institutions** **23.01.2025 -- Lecture 6** Bank contagion: the spread of financial distress from one bank to others, often triggering bank runs. 1. Public begins to suspect that banks may become insolvent. 2. Bank runs: large number of investors try to w...

**Fundamentals of Financial Markets and Institutions** **23.01.2025 -- Lecture 6** Bank contagion: the spread of financial distress from one bank to others, often triggering bank runs. 1. Public begins to suspect that banks may become insolvent. 2. Bank runs: large number of investors try to withdraw deposits within a short period of time. 3. Interbank market collapses as they refuse to renew loans. 4. Banks need to find new sources of funding -\> sell assets (loans). 5. Bank loans are not easily tradeable (illiquidity of loans), so they need to sell them at a discount (fire sale) to attract buyer. 6. Resulting in significant losses in capital reserves -\> become insolvent. 7. Impairment of confidence in the system may start the same process in other banks, even if they are sound. - *An example of this was the US 2023 bank runs, SVB.* Externality: unintended social or economic costs/benefits affecting individuals not directly involved in initial transaction. - Social costs: general banks run leads to a failure in payment system (cash and deposits), meaning people cannot buy or sell, employees may lose their job. - *In the GFC as industrial companies were not able to pay their bills, it affected the entire liquidity of the financial system, affecting unemployment, loans, etc.* - Social benefits: all people benefit form an efficient payment system without directly paying for it. - *Able to transfer money, access credit, make payments, stably and securely.* [Case: 2023 Silicon Valley Bank: Bank Run] A timeline of a bank collapse AI-generated content may be incorrect. - SVB relied heavily on short-term funding by venture capitalists (with around 90% of all US venture capitalists holding their deposits there). - However, these are flight deposits. - SVB purchased large amounts of long-term US treasury bonds. - However, the purchase of there with flight deposits meant they are not stable enough, exposing the bank to too much interest rate risk. - Trump had relaxed the regulatory rules allowing for smaller banks under \$250 bn, to not be as regulated, SVB with \$200 mn was therefore a part of this. - As the fed raised interest rates, SVB's long-term treasury bond values fell, leading to unrealized losses. - Stock prices plummeted, signalling SVB was struggling. - SVB announced \$2.25 bn capital raise to cover loses, sparking panic and leading many VCs to be advised to withdraw their money quickly. - Customers with drew around \$42 bn in a single day -\> bank run - Signature bank, exposed to tech startup and crypto firms consequently also saw a bank run, losing billions in deposits and collapsed. - The US government stepped in the guaranteed deposits, even over \$250,000 to prevent further contagion. - Investors had taken a risk to deposit over the deposit insurance limit, but due to government bailouts it did not realize. [Case Addition: Credit Suisse]  - Within the same week Credit Suisse went bankrupt, showing how to collapse of SVB was felt even in Europe. - Credit Suisse had previously been involved in a multitude of scandals but somehow had survived them, however this time they were not as lucky. - As Credit Suisse made a rights offering to a Saudi National Bank, it was not accepted, it signalled poor financial health. - This led to stock prices plummeting. - Eventually UBS agreed to buy it, a lifeline from the Swiss National Bank. - It was considered too important and large, so it had to be bought to avoid further contagion. A close-up of a document AI-generated content may be incorrect. [Consumer protection:] General rule: Caveat emptor: the buyer has the obligation to check that what she buys is suitable for the purpose. - This rule works for simple products and well-informed products, but with complex systems like banks, it becomes harder. - *It is the depositor's job to investigate the health of the bank.* - In modern financial systems, banks need to maximize the number of customers, to diversify risk, maximize economies of scale -\> not all customers are well informed. - They encourage the use of financial intermediaries. - However, governments don't want to leave customers to suffer, particularly the poor, elderly and financially unsophisticated. - *SVB was mostly used by CFOs, etc, customers that are financially sophisticated, but the government could not let these companies fail, as the negative externalities would be too large.* [Regulatory bodies:] - Europe: Harmonized within EU single market, with most national legislations based on EU directives. - Banking sector regulators: ECB and EBA. - Deposit insurance institution - DGF Finland 100,00 EUR - FDIC US \$250,000 - International: G-20, Basel Committee on Banking Supervision. - Security commission: Regulate primary and secondary markets. - European Securities and Markets Authority - Securities and Exchange Commission in US. [Bank regulation covers:] 1. Structure and activities of banks. 2. Bank liquidity. 3. Transparency 4. Bank capital adequacy: Basel I, II, 2,5, III, IV... 1. [Structure and activities of banks:] There was period of strict banking regulation: - Glass-Steagall Act: commercial banks cannot engage in underwriting securities, brokerage, insurance, real estate activities and investment banks cannot take deposits. - Ensured the separation of investment and commercial banking. - Bank failures of 1929, banks were speculating too much using the deposits of customers, this act ensured the separation to prevent this in the future. Followed by a period of deregulation: - EU: 2^nd^ banking directive allowed banks to offer full range of financial services, as the EU moved towards universal banking model. - US: Before the GFC, the Glass-Steagall act was removed by Regan administration, as the US adopted a new policy, similar to the universal banking model used in the EU. Period of reregulation: - Dodd-Frank Act: A wall street reform and consumer protection act signed by Obama. - The important rule here is the Volcker rule: reducing banks' ability to take excessive risks by restricting proprietary trading and investments in hedge funds and private equity -\> limited risk taking by barring them from using their own assets/funds. Now: - In 2017 Trump promised to trim banking regulations, signing the biggest rollback of bank regulations since the Dodd-Frank act, reducing the amount considered too big to fail. - The idea was that the collapse of these smaller banks, under the limit of \$250 bn, wouldn't bring down the economy, allowing them to lend more. - *For example, SVB was now classified as smaller bank, limit of \$250 bn.* - These regulations were then increased under the Biden administration. Proprietary trading: when a bank or financial institution trades on its own account rather than on behalf of a customer. - Using a bank's own capital and balance sheets. - Europe had proposed similar to rules on proprietary trading, like in the US under the Volcker rule, but it was scrapped due to political opposition. 2. [Liquidity]  - Banking operations are mainly finance using deposits. - Bank liquidity requirement: banks need to keep enough liquid assets to meet foreseeable demand for withdrawal. - To protect against unforeseen demands (bank runs) government safety nets are in place -\> protection against liquidity risk: 1. Lender of last resort (single resolution mechanism) by CB. 2. Deposit insurance scheme to stop rush for liquidity going underway. - In return for these facilities, banks are required to make frequent statistical figure, to enable the regulators to monitor the liquidity in the financial system. - These allow customers to be less fearful and trust banks -\> one of the core pillars for a bank function. Basel III: LCR and NSFR Liquidity coverage ratio: the quantity of high-quality liquid assets a bank must have at any given time, to meet its liquidity needs for 30 days under a specified acute liquidity stress. - (stock of high-quality liquid assets/total net cash outflows over the next 30 calendar days) \>= 100% - Used to manage short-term liquidity risk. Net stable funding ratio (NSFR): regulatory liquidity standard to ensure banks maintain a stable funding profile relative to their assets and off-balance sheet activities. - (available amount of stable funding/required amount of stable funding) \> 100% - Available stable funding: portion of capital and liabilities expected to be reliable over the time horizon considered by NSFR, 1 year. - Used to incentivize banks to seek more stable forms of funding. - Used to manage long-term liquidity risk. A screenshot of a report AI-generated content may be incorrect. 3. [Transparency ] Transparency: clarity and accuracy of information. - Regulators monitor how financial products are described and marketed for consumer protection. - Funds are required to have a prospectus, key information, fees -\> used to show commitment to regulations. - May be backed with system of compensation consumers can appeal with if they believe they have been misled into buying unsuitable products. Case: Wells Fargo - Wells Fargo has been one of the best banks in selling several products/services to each customer. - However, they had aggressive tactics; employees had to sell at least 8 products per customer. - As a result, employees ended up opening accounts in the name of clients without them even knowing. - Resulting in Wells Fargo being fined heavily and ruining their reputation. Consumer protection process: - The role of Financial supervisory authority (FSA) is the check whether the prospectus is good, does it include all the important components. 1. If a customer feels disappointed, they must first dispute with the bank. 2. If it is not resolved, they turn to FINE and make a case. 3. FINE makes a settlement proposal with the bank. 4. If the bank does not agree and pay, then the customer can take the bank to court. - After the GFC and the underestimation of systemic risk, it became of a priority for banks to have enough capital. - There was a domino effect, the collapse of one bank, led to the collapse of another, and so on. - Systemic risk facing the financial system is much larger than the sum of the individual risks. - For international consistency most nations adopted regulations developed by the Basel Committee Global Systematically Important Banks (G-SIBs):  - G-SIBs are subject to additional capital requirements, as the fall of any of them would lead to significant disruption to winder financial and economic activity. - The additional percentage of required common equity capital varies between 3.5 and 1%. Other systemically important institutions (O-SIIs) A table with text and numbers AI-generated content may be incorrect. - Nationally banks which would pose risk to domestic financial system as classified as O-SIIs and must hold additional capital buffer.  - There is a magnitude of additional capital buffer requirements, which are set by the FSA. - There has been a drastic increase in the amount of capital requirements. - However, some banks are complaining that they have gone too far, with bank chiefs globally taking a position that there is too much regulation. - There have been increased dividend payouts and purchases of share buybacks -\> are they really struggling to meet requirements or choosing to use funds for something else. - Regulators argue that if banks are so concerned, they should cut back on these instead of arguing against regulations. - There is conflict between what is good for banks privately and what is good for the broader economy. - Even some supervisory authorities are complaining about the complexity of regulations. [Costs of regulation] 1. Moral Hazard a. Government safety nets - Governments safety nets aim is good, allows consumers and institution to feel they are protected. - But does it lead to excessive risk taking. - Deposit insurance means depositors have less incentive to monitor the bank to make sure they are behaving properly -\> is anyone looking at what is going on? - Bank directors know they have a lender of last resort and may therefore take on more risk than otherwise. - SVB deposits were covered over the limit as it was considered to lead to more bank runs and too important to fail. - The same can be said for some banks during the GFC, considered too large to fail. - Banks now they can do the minimum set be the regulation, and not any extra. b. Forbearance - If a FSA notices a bank is riskier than their public records say, they cannot go and tell the public as it would lead to collapse in a few days -\> allowing banks to continue operating even if their capital is fully depleted. - Banks may end up observing this and therefore abiding less carefully to the regulations 2. Compliance Costs - Regulations increase costs. - Holding non-interest-bearing reserves. - Time and effort to keep in line with regulation. - GDPR compliance costs. 3. Barriers to Entry - With such high barrier of entry, it is very difficult for new competitors to enter the market. - This may lead to inefficiencies as banks now they hold market power. - This works as a feedback loop: more regulation -\> higher barriers to entry -\> more inefficiencies -\> more regulation -\> and so on.