MCB Part 2 Exam PDF

Part II: Money, Credit and Banking By Carola Theunisz November 26, 2024 Part II MCB: Overview Lectures 1. Financial Markets and 2. Financial Crises 3. Policies for the Infrastructure Financial Se...

Part II: Money, Credit and Banking By Carola Theunisz November 26, 2024 Part II MCB: Overview Lectures 1. Financial Markets and 2. Financial Crises 3. Policies for the Infrastructure Financial Sector (Parts of) DSW Chapters 1 DSW Chapter 2 + (Parts of) DSW Chapters Diamond & Dybvig (1983 12 + 13 +5+7 JPE) Financial regulation and Markets: money markets, supervision Different types of crises, bond markets, CDOs and the sovereign-bank Micro- and macro- nexus prudential policies Infrastructure: wholesale Bank resolution tools and retail payment The Global Financial Crisis of 2008 Video SVB 2023 systems, and post-trading market Theoretical models of bank runs Watch Video Big Short Watch Video DD 1983  Financial Markets and Financial Infrastructure FEB13021 Money, Credit and Banking Lecture 5 November 26, 2024 Carola Theunisz Learning Goals: DSW Chapter 5 explain the purpose and structure of financial markets describe the essentials of the euro money market, including its functions and main interest rates explain how the monetary policy of the ECB affects the money market discuss the most important developments in the bond markets since the start of the monetary union discuss the most important developments in the equity markets since the start of the monetary union describe the essentials of the derivatives market describe the foreign exchange market. Learning Goals: DSW Chapter 7 define what a payment system is explain the difference between wholesale and retail payment systems describe the various steps of the post-trading process understand the economic characteristics of the payment and securities market infrastructures, and explain how these characteristics influence the EU market structure assess the extent to which the different elements of the EU financial infrastructure are integrated understand the growing importance of central counterparties (CCPs) and the related concentration risk. European Financial Markets DSW Chapter 5 Primary functions of financial markets 1. Price discovery: Provide information to aid the price discovery process Enables buyers and sellers to find out prices at which trades can be agreed upon 2. Trading mechanism: Provide a marketplace or platform to facilitate the making of agreements Quote-driven versus order-driven markets 3. Clearing and settlement: Provide infrastructure to settle trades (infra DSW Chapter 7) Ensures that the terms of each agreement are honoured Price discovery The present value (PV) of a security represents its future payments: 𝐸(𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤) 𝑃𝑉 = , (1+𝑟)𝑡 where: 𝑟 = 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 𝑜𝑟 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑡 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 Expected cash flows are affected by size and risk of future payments Prices reflect all publicly available information: Efficient Market Theory Insider trading is forbidden by law (ESMA in Europe, or SEC in USA) Participants in the financial market Classified by their motive for trading (but non-mutually exclusive) Public investors Brokers Dealers - Ultimate owners - Act as intermediary - Own and trade on their - Motivated by return on for public investors own account holding securities - Motivated by commission fees - Motivated by profit from the - Private individuals and for their services differences between buy and institutional investors - Don’t own securities sell prices Trading mechanisms [1/3]: Quote-driven markets 1. Quote-driven markets Dealer markets (e.g., bond markets such as EuroMTS, illiquid commodities) Investors trade either directly with dealer or via broker Quotes the bid-ask prices and sets volume (at which he is prepared to deal) Buyer pays the ask price, and seller receives the bid price Bid-ask spread is profit for dealer (𝑝𝑎 − 𝑝𝑏 ) Dealer keeps inventory, ensuring there is always a market for the security 2. Order-driven markets 3. Hybrid markets Trading mechanisms [2/3]: Order-driven markets 1. Quote-driven markets 2. Order-driven markets Auction model (e.g., stock exchanges for liquid stocks) Prices are set by supply and demand of a security Call-market: price is determined at specified time (e.g., IPO) Continuous auction market: orders can be executed at any time via order books - Limit order: buy or sell at specific max/min prices - Market order: buy or sell at the best available price Buy and sell orders are matched directly based on price and time priority 3. Hybrid markets Trading mechanisms [3/3]: Hybrid markets 1. Quote-driven markets 2. Order-driven markets 3. Hybrid markets Order-driven market with flavors of quote-driven markets to provide greater liquidity and efficiency As transparent as order-driven market, but with dealer as in quote-driven markets for instantaneous matching of orders Firms can hire a dealer (or market maker) to act as ‘liquidity provider’ for their stock Improves market efficiency Most stock exchanges function this way (Euronext, NASDAQ, NYSE, LSE) Five principal financial markets: Money markets Bond markets Equity markets Derivatives markets Foreign exchange markets Relative importance European bond markets are larger than European equity markets Equity Markets Bond Markets (in year-end market value) (in year-end amount outstanding)  What’s so special about bond markets? Or (collateralized) debt markets more generally  Money markets A place for warehousing surplus funds for short time periods Low-cost, short-term funds Overnight or maturity ≤ 12 months Dominated by banks, for liquidity management Strongly influenced by monetary policy tools: Standing facilities Open market operations (OMOs) Reserve requirements Two money market segments With varying degree of counterparty credit risk Unsecured funds Money borrowed/lent without collateral, i.e., no (financial) assets are pledged Liquidity providing party bears the counterparty credit risk E.g., interbank deposits, certificates of deposits, commercial paper Secured funds Money borrowed with collateral in return, i.e., some (financial) asset is pledged Repurchase agreement (repo): borrower will repurchase asset at specific price at specified date in the future → lowers counterparty credit risk Repo agreement: an example Bank A Bank B (dealer) (buyer) Bank A sells asset Bank B lends cash Bank A needs (e.g., $1M) cash and owns some assets (e.g., bonds worth $1,01M). Bank B has excess cash and wants to earn some return (e.g., 5%). Bank A engages in a repo agreement and gives the asset it owns to Bank B → collateral Bank A agrees to repurchase the asset at a specified date for a higher price. Bank B gives Bank A the cash it needs (e.g, $1M). Reverse repo: example continued Bank A Bank B (dealer) (buyer) Bank B sells asset Bank A pays more At the specified date, Bank A repurchases the asset from Bank B at a higher price. For example, with 5% repo rate and a 3-month term: $1M x (1 + 0,05 x 90/360) = $1,0125M In other words, Bank B engages in a reverse repo agreement and made some return.  Euro money market interest rates Who sets Interest rate Type Segment Period Function it? Rate at which banks deposit Remunerating banks for reserves Deposit facility Unsecured Overnight excess funds with the ECB they hold in Eurosystem Marginal lending Rate at which banks borrow Providing banks with liquidity Secured Overnight facility overnight from the ECB ECB Main refinancing Providing weekly funding Key ECB rate for short-term operations Secured One week for banks and liquidity provision to banks (OMOs) steer interest rates via OMOs Eurozone repo market EUREPO Secured interbank rate Secured ≤ 12 months reference rate Euro overnight offered rate Base rate for Eurozone EONIA Unsecured Overnight (discontinued in 2022) interbank loans Eurozone short-term Base rate for Eurozone Interbank ESTER wholesale rate Unsecured Overnight interbank loans (replaced EONIA) 1 week to Base rate for Eurozone EURIBOR Euro interbank offered rate Unsecured 12 months interbank loans  Bond markets Fixed income debt securities Supranational Can be unsecured, secured, or covered (i.e., dual-recourse) Government Sovereign bonds Different maturities/duration Liquidity risk → ease of selling Municipal Interest rate risk → term premium Bond market Different credit qualities/ratings Financial Default or credit risk companies Corporate Bonds’ secondary market prices bonds Nonfinancial vary inversely with interest rates companies  Bond issuers Governments and financials are the largest groups of issuers Bonds by issuer, 2017 (EUR trillion)  Yield curves: term structure of interest rates AAA-rated government bonds with different remaining maturities Euro area yield curve (2008-2018, %) Term premium: the upward slope of the yield curve reflects the positive term spread for bonds with longer maturities. Expected ST interest rates: negative yields for 4y maturities after GFC reflect the negative interest rate environment. Credit risk: during the sovereign debt crisis of 2011, the yield curve shifted upward reflecting increased default risk. Liquidity risk: the yield curve has shifted down after GFC due to unconventional ECB policies providing liquidity. Relative bond yields and credit risk premia Corporate versus Government (AAA-rated or investment grade bonds) What happened in 2015- 2016?? Spreads Years (2000-2019) Corporate bond yields > government bond yields Financial bond yields > nonfinancial bond yields, since Global Financial Crisis of 2008  Quiz time! Scan QR to Mentimeter! Rank these key categories of bonds through a potential risk/return lens Corporate A Bonds Investment Grade B C Risk Corporate Corporate Bonds Covered Speculative Bonds Grade D Government Bonds Return Let’s take a 10-minute break Rise of Alternative Finance DSW Chapter 1 Section 1.3. Securitisation Goal: Credit risk transfer and funding How? Bundling of bank loans and other financial assets into a ‘diversified’ tradable asset, which is tranched and sold to investors Off-balance sheet: special purpose vehicles (SPVs) with recourse to bank Issues asset-backed commercial paper: CDOs Low/high risk: Super senior tranche – mezzanine tranches – equity tranches Examples: mortgage-backed securities Global Financial Crisis of 2008-9 U.S. sub-prime mortgage market → mispricing of housing → real estate bubble Defaulting mortgages that were pooled into CDOs— via mortgage-backed securities sold in the secondary market Widely sold to European banks and investment banks (e.g., Lehman Brothers, Bear Stearns) Large interconnectedness and contagion: Quiz time! Scan QR to Mentimeter! 1. Mention one major advantage of securitisation. 2. Mention one major drawback of securitisation. 3. Which of the following characterize the early stages of a financial crisis? a. Stable house prices. b. Stagnating share prices. c. Excessive euphoria about the future price of certain assets. Corporat d. Excessive pessimism about future asset prices. Covered Bonds 4. The financial crisis of 2008-9 started in the USA and spread to other countries because: a. Banks in developing economies had invested heavily in US sub-prime mortgages. b. Bank of China had lent massively to sub-prime borrowers in the USA. c. European banks were taken into public ownership. d. Foreign banks had bought securities based on US sub-prime mortgages. Financial Infrastructure DSW Chapter 7 Post-trading systems Securities clearing and settlement systems Arrangement of ownership-transfer and payment between buyers and sellers in security markets Various steps: 1. Confirmation 2. Clearance (in CSD) 3. Settlement (payment and delivery) Payment systems What is a payment system? Transfer of money between two economic actors to pay for delivered goods or services, using (cash or) non-cash money (consumer/merchant) Requires cooperation between banks Retail versus wholesale payment systems Retail: card-based payment systems Wholesale: TARGET2: real-time gross settlement systems (RTGS) EURO1: net settlement system between EU banks Retail payment systems Low-value and non-time-critical payments Mass payments in consumer and business sectors Consists of: Payment instrument: e.g., credit card Payment infrastructure: e.g., card reader or other payment terminals Financial institutions: provide payment accounts and instruments Payment scheme: set of interbank rules, standards, and practices, e.g., fee structure Laws, standards and rules: set by legislators, e.g., PSD2 Retail payment systems Push transaction: initiated by the payer (e.g., direct bank transfer) Pull transaction: initiated by the payee (e.g., Tikkie) Four-party payment scheme versus three-party payment scheme Wholesale payment systems High-value and time-critical payments Between financial institutions: 1. Correspondent banking: Payment through intermediary 2. Real-time gross settlement (RTGS) systems: TARGET2 Each payment immediately settled on a gross basis by central banks 3. Net settlement system between EU banks: EURO1 Net balances are settled at close of business using ECB accounts  Economic features Economies of Economies of Network Switching scale scope externalities costs Fixed costs shared Fixed costs shared Value of product Consumers face over a higher output over a wider range of depends on the substantial costs → cost per unit falls products and number of when they want to as output increases services participants that buy switch from one → cost per unit falls the same product network provider to with production of → Infrastructure- another different types of intensive industries: → ‘lock-in’ products e.g., railroads, telecommunication Thank you for your attention!  Part II: Money, Credit and Banking By Carola Theunisz December 3, 2024 Part II MCB: Overview Lectures 1. Financial Markets and 2. Financial Crises 3. Policies for the Infrastructure Financial Sector (Parts of) DSW Chapters 1 DSW Chapter 2 + (Parts of) DSW Chapters Diamond & Dybvig (1983 12 + 13 +5+7 JPE) Financial regulation and Markets: money markets, supervision Different types of crises, bond markets, CDOs and the sovereign-bank Micro- and macro- nexus prudential policies Infrastructure: wholesale Bank resolution tools and retail payment The Global Financial Crisis of 2008 Video SVB 2023 systems, and post-trading market Theoretical models of bank runs Watch Video Big Short Watch Video DD 1983  Financial Crises FEB13021 Money, Credit and Banking Lecture 6 December 3, 2024 Carola Theunisz Learning Goals: DSW Chapter 2 explain the characteristics of different types of financial crises understand the link between sovereign and banking crises explain the main theoretical models of banking crises understand the pro-cyclicality of the financial system explain the main drivers and contagion mechanisms of the 2007– 2009 financial crisis explain the euro crisis. Financial Crises DSW Chapter 2 Types of financial crises Can happen concurrently Bank insolvency (due to investment losses, banking panics, or both) Banking crisis Systemic versus non-systemic Government default: fails to meet payments on its debt obligations Sovereign debt crisis Post-war restructuring and recovery leading to debt burdens Abrupt drop in the value of a county’s currency Currency crisis Fixed exchange rate regimes are prone for confidence crises Twin and triple crises From 1970-2017 Banking crises Banks transform short-term funding into long-term loans Maturity mismatch makes them vulnerable to panics and runs Wholesale run versus retail run Liability-side run versus asset-side run What causes panics and runs? - Sunspots: self-fulfilling prophecies - Business cycle: shocks to economic fundamentals Bank Runs, Deposit Insurance, and Liquidity Diamond & Dybvig (1983) Journal of Political Economy Simple, classic model with major insights Explains the role and usefulness of “textbook” banks in the financial system: banks as liquidity creators Shows that a bank run is a possible equilibrium and that even healthy banks can fail, causing economic distress Underpins the usefulness of deposit insurance (“deposit guarantee schemes”) and central bank lender-of-last-resort facilities Building blocks of the model Investment opportunities: banks invest in long-term risk-free assets which are more productive (i.e., yield higher returns) than short-term assets, but they are also more illiquid Consumption preferences (utility): Individuals are uncertain about when they want to consume (patient depending on liquidity shocks, which is private information) and thus how long to hold the assets. They care about the value of liquidating their assets on different dates Investment opportunities (assets of banks) T=0 T=1 T=2 Short-term asset -1 1 0 (e.g., storage in vaults) Long-term asset -1 R>1 (illiquid asset) early liquidation L≤1 (e.g., fire sale) Consumption by savers/consumers/investors Two types of consumers have an initial endowment E of 1 each Ex-ante identical: type gets revealed at T=1 (patient or impatient) and is private information (i.e., information asymmetry) Utility function is increasing and concave (i.e., risk-aversion) Banks are competitive, make zero profits, and assumpted to maximize the expected utility of their depositors Consumption preferences: 2 types of agents T=0 T=1 T=2 Type I consumer 1 c1 = d (d ≥ 1) Type II consumer 1 c2 = r (1