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Chapter 14 Regulating the Financial System Conceptual and Analytical Problems Explain how a bank run can turn into a bank panic. Answer: Bank runs occur when people fear that their bank has become insolvent. Depositors rush to their bank to withdraw their funds. Depositors at other banks become concerned about their own bank’s solvency, so they also hurry to withdraw their funds. Bank runs can turn into system-wide bank panics because customers have a difficult time distinguishing insolvent banks from solvent ones. Current technology allows large bank depositors to withdraw their funds electronically at a moment’s notice. They can do so all at the same time, without anyone’s knowledge, in what is called a silent run. When might a silent run happen, and why? Answer: Depositors may have their accounts set up so that funds are automatically withdrawn under certain conditions. If the value of the depositors’ other assets decreases (because of a fall in the stock market, for example), the depositors may have difficulty meeting their liabilities and will need to have funds withdrawn from their deposit accounts. Depositors are likely to need to withdraw funds at the same time, leading to a silent run. Explain why financial institutions such as pension funds and insurance companies are not as vulnerable to runs as money market mutual funds and securities dealers. Answer: Like deposit-taking institutions, money market mutual funds and securities dealers have liquid liabilities backing illiquid assets and can suffer from a loss of liquidity similar to a deposit withdrawal from a bank at any time. In contrast, liability holders of pension funds and insurance companies cannot withdraw funds whenever they want. Therefore, even though their assets tend to be illiquid, they are not as vulnerable to runs. Explain the link between falling house prices and bank failures during the financial crisis of 2007-2009. Answer: Falling house prices led to a higher rate of mortgage defaults (as some customers could not re-finance to a lower interest rate as they had planned, for example). These mortgage defaults, along with falling values of mortgage-backed securities held by banks, reduced the value of bank assets and so lowered bank capital. (Recall that bank capital is the difference between the value of its assets and liabilities.). In some cases, bank capital was wiped out and so the bank failed. Discuss the regulations that are designed to reduce the moral hazard created by deposit insurance. Answer: Regulators can restrict competition so that banks are not under as much pressure to engage in risky investments. They can also prohibit banks from making certain types of risky loans and from purchasing particular securities. U.S. banks are not allowed to hold common stock or bonds that are below investment grade. Their bond holdings from a single issuer cannot exceed 25 percent of their capital. Likewise, they cannot make loans to single borrowers that exceed 25 percent of their capital. Regulators have also developed minimum capital requirements. During the financial crisis of 2007-2009, the Federal Reserve used its emergency authority to lend to nonbank intermediaries. Explain how this extension of the lender of last resort function added to moral hazard. Answer: Nonbanks (including shadow banks) are subject to less oversight than the depository institutions that usually borrow under the lender-of-last resort mechanism and that are subject to heavy regulation and strict supervision. Therefore, there is a greater danger that access to loans from the central bank will lead to increased risk taking by the nonbanks. Why is the banking system much more heavily regulated than other areas of the economy? Answer: The banking system, by its nature, is fragile, and banks play a crucial role in the economy. Therefore, the government provides a safety net to banking customers to ensure the smooth functioning of this part of the economy. The provision of the safety net, however, compounds moral hazard problems and so heavy regulation and supervision is required to prevent bank managers from assuming excessive risk. Explain why, in seeking to avoid financial crises, the government’s role as regulator of the financial system does not imply it should protect individual institutions from failure. Answer: Failure of less competitive, less efficient institutions or firms is part of the competitive process that promotes the health of the industry as a whole. The role of the regulator is to provide a framework to prevent contagion effects adversely affecting efficiently run institutions. Explain how macro-prudential regulations work to limit systemic risk in the financial system. Answer: Macro-prudential regulations aim to safeguard the financial system by promoting better risk management by firms and reducing the financial system’s vulnerability to the failure of any single firm. To this end, macro-prudential regulations seek to make intermediaries internalize the costs associated with their behavior by imposing a systemic capital surcharge on institutions that contribute most to systemic risk based upon the riskiness of their balance sheets and on how interconnected they are to other firms. Capital requirements could also vary with the business cycle, making the system more stable by building up capital buffers in good times that could be drawn upon to lend to good quality borrowers in lean times. Regulators could also require banks to purchase catastrophe insurance that would replenish its capital in times of crisis. Why were runs during the financial crisis of 2007-2009 not limited to institutions with large exposures to sub-prime mortgage lending? Answer: Banks and shadow banks are highly interconnected with one another and so problems in one institution can quickly spread to others, making otherwise healthy institutions vulnerable. Suppose you have two deposits totaling $280,000 with a bank that has just been declared insolvent. Would you prefer that the FDIC resolve the insolvency under the payoff method or the purchase-and-assumption method? Explain your choice. Answer: You would prefer the purchase and assumption method, because under the payoff method, you would lose any funds above the insurance limit. Currently, the limit is $250,000, so you would lose $30,000. The insurance is per depositor not per account, so the balances on your deposits will be added together and insured up to a maximum of $250,000. Under the purchase-and-assumption method, the bank would simply reopen under new ownership and depositors would not suffer a loss. How might the existence of the government safety net lead to increased concentration in the banking industry? Answer: In an effort to avoid financial crisis, large institutions realize that the government would not allow them to fail. This too-big-to-fail policy adds to moral hazard problems and allows large banks to engage in extremely risky behavior. This, in turn, puts small banks at a competitive disadvantage and may drive these smaller institutions out of the market, leading to an increase in concentration. One goal of the Dodd-Frank Wall Street reform is to end the too-big-to-fail problem. How does it propose to do so? Why might it fail? Answer: The government’s implicit willingness to bail out the creditors of a large intermediary causes the too-big-to-fail (TBTF) problem, contributing to moral hazard. For example, if investors believe that an institution has TBTF status, they perceive relatively less risk when lending to it. Thus, the TBTF intermediary can borrow more cheaply and take on more risk. Dodd-Frank attempts to limit the mechanisms for government bailouts. It constrains Fed lending to individual nonbanks, limits the FDIC’s guarantee powers, subjects large institutions to regular “stress tests,” requires systemically important financial institutions (SIFIs) to have living wills, and calls for higher capital requirements. However, given the size and interconnectedness of designated SIFIs, investors may doubt the willingness of the government to let them fail in a crisis. If so, these firms would have continued access to relatively low funding costs. A government can overcome the challenge of time consistency only if it is both able and willing to make credible commitments. With this in mind, how might the U.S. laws and procedures for bankruptcy affect the too-big-to-fail problem?
Existing bankruptcy procedures are not designed for the speedy resolution of large, complex financial intermediaries like SIFIs. If these procedures impede creditors from using their assets to make payments, the failure of one SIFI can trigger a cascade of failures of its otherwise healthy creditors. Consequently, investors may doubt a government promise not to bail out a failing SIFI. Streamlining bankruptcy procedures to minimize systemic risks when a SIFI fails could enhance the credibility of the no-bailout commitment. Diminished expectations of a bailout would encourage creditors to require appropriate compensation – in line with Core Principle 3 – for loans to risk-taking SIFIs. The resulting market discipline would diminish SIFIs’ incentives to pursue risky strategies, making the financial system as a whole less vulnerable. For these reasons, legal scholars and experts are exploring the creation of a special U.S. bankruptcy code (sometimes called “Chapter 14”) for large intermediaries. If banks’ fragility arises from the fact that they provide liquidity to depositors, as a bank manager, how might you reduce the fragility of your institution? Answer: You could reduce the risk of large-scale unexpected withdrawals by increasing the portion of your liabilities accounted for by deposits that have restrictions on withdrawals, such as increasing time deposits, and reducing demand deposits as a percentage of liabilities. You could increase the excess reserves you hold on the asset side of the balance sheet so that you are prepared in the event of unexpected withdrawals. You could also hold a higher portion of assets in the form of liquid securities that could be sold easily to meet withdrawals. Why do you think bank managers are not always willing to pursue strategies to reduce the fragility of their institutions? Answer: In Problem 16, we identified ways to reduce a bank’s vulnerability to sudden withdrawals. These methods, however, are likely to adversely affect the bank’s profits. Demand deposits often pay zero or very low rates of interest and so represent and relatively inexpensive source of funds for banks. On the asset side of the balance sheet, holding excess reserves or liquid assets that pay relatively low rates of interest are also likely to reduce profit margins. Regulators have traditionally required banks to maintain capital-asset ratios of a certain level to ensure adequate net worth based on the size and composition of the bank’s asset on its balance sheet. Why might such capital adequacy requirements not be effective? Answer: The importance of off-balance sheet activities of banks has been increasing and the nature of these activities, such as engagement in derivative markets, facilitate a high level of risk taking by banks that is not apparent from the institution’s balance sheet. In addition, banks learn over time to evade existing rules. For example, in the years preceding the financial crisis of 2007-2009, banks carried US mortgage-backed securities because they had high ratings and thus lowered the banks’ risk-weighted capital requirements. You are the lender of last resort and an institution approaches you for a loan. You assess that the institution has $800 million in assets, mostly in long-term loans, and $600 million in liabilities. The institution is experiencing unusually high withdrawal rates on its demand deposits and is requesting a loan to tide it over. Would you grant the loan? Answer: Based on the information given, you should grant the loan. The institution has positive net worth (assets are greater than liabilities) and so is solvent. It appears to be experiencing a short-term liquidity problem and a loan could prevent this otherwise healthy institution from failing. You are a bank examiner and have concerns that the bank you are examining may have a solvency problem. On examining the bank’s assets, you notice that the loan sizes of a significant portion of a bank’s loans are increasing in relatively small increments each month. What do you think might be going on and what should you do about it? Answer: This may be a case where the bank has a large portion of non-performing loans. When the loan payments are not made, the bank may be rolling the payment and associated interest costs into the principal of the loan, thus causing the loan size to increase incrementally. As an examiner, you need to establish which loans may eventually be repaid and which should be written off and to assess the impact on the solvency of the institution. In the period since the financial crisis of 2007-2009, several countries experienced very low rates of inflation and in some cases, outright deflation. Why might deflation be of particular concern to someone managing a bank? Answer: Deflation is associated with falling net worth of borrowers, as the nominal value of their assets fall but the dollar amount of their liabilities don’t. This can lead to reduced lending as asymmetric information problems worsen and the associated downturn in economic activity can increase defaults. This, in turn, leads to a deterioration in the quality of the bank’s balance sheet and may eventually lead to insolvency. Data Exploration When banks failed in the 1929-1933 period, the lack of deposit insurance meant that depositors experienced sizable losses. How big were these losses? For September 1929 through February 1933, plot the deposits in suspended banks (FRED code: M09039USM144NNBR). Download the data and sum the deposits lost to bank failures in 1931. Using this total, compute its ratio to 1931 gross national product of $77.4 billion. Using that ratio, how large would the losses be compared to first-quarter 2016 nominal GDP of $18.3 trillion. Answer: The data plot is below. In 1931, the cumulative loss was $1,690 million, about 2.2 percent of nominal GDP. Based on early-2016 GDP of $18.3 trillion, the comparable loss would be about $403 billion. Bank runs are costly. How frequently are the payoff and the purchase-and-assumption methods used by the FDIC? Using FRED, plot the total number of institutions receiving such assistance (FRED codes: BKTTPIA641N for purchase and assumption; and BKTTPOA641N for the payoff method). On the same graph, plot as a second line the purchase-and-assumption data separately (so that your graph will show one line with the total and a second line with the purchase-and-assumption data only). Describe the evolution over the long run. From what you know about the total number of depository institutions, does the total number of resolutions seem high or low? Answer: Until the late 1980s, the payoff method was used to restore the balances to depositors at failing banks. The FDIC only began to use the purchase-and-assumption method thereafter. At the recent peak in 2009, 14 institutions out of a total of 6,978—or 0.20%–were resolved. At the peak in 1989, the number of institutions resolved was 71. This represented 0.56% of 12,869 then-existing institutions. The number of resolutions is relatively low. Using FRED, examine the capital ratios of large banks (FRED code: EQTA5) and small banks (FRED code: EQTA1). What can you say about the risk-taking propensity of these banks over the long run? How did the financial crisis of 2007-2009 influence the risk-taking behavior of large banks?
Answer: Historically, small banks have had higher capital ratios than large banks. That is, large banks have been more inclined to take on leverage (and risk). As the final crisis deepened in the fall of 2008, the large-bank capital ratio fell, in part due to falling values of assets such as mortgage backed securities. Thereafter, a combination of government capital injections, private equity-raising, reduced dividend payouts, and persistent deleveraging boosted the capital ratios of larger banks. This building of capital by larger banks was reinforced by the imposition after 2010 of annual stress tests on SIFIs. How important was the lender-of-last-resort function of the Federal Reserve in the financial crisis of 2007-2009? Beginning in 2000, plot the ratio of (in percent) of borrowing from the Fed (FRED code: DISCBORR) to its asset holdings (FRED code: WRESCRT). What happened to the borrowing ratio during the 2007-2009 financial crisis? Answer: The data plot is below. Usually, discount window borrowing is a negligible portion of the Fed’s holding of assets, as it was even during the recession of 2001. During the crisis, discount window borrowing reached a record level in absolute terms and approached 25 percent of the value of its assets. Note that the 2008 surge in discount borrowing includes lending to nonbanks (such as credit extended to American International Group, the largest U.S. insurer at the time). In addition to these loans through the discount window, the Fed also auctioned term credit to depository institutions for periods of up to 84 days during the financial crisis. Shadow banks typically fund their assets by issuing liabilities of shorter maturity that are close substitutes for bank deposits. The maturity mismatch between their assets and liabilities creates rollover risk that can trigger fire sales and systemic disruption. Plot the outstanding level of one such liability – asset-backed commercial paper (FRED code: ABCOMP) – from the start of 2002 to the end of 2007. Based on the plot, discuss how the use of asset-backed commercial paper influenced the financial crisis of 2007-2009?
Answer: The plot appears below. From 2005 to the summer of 2007, shadow banks increasingly relied on the issuance of asset-backed commercial paper (ABCP) to fund their asset purchases. In August 2007, investors became highly uncertain about the value of subprime mortgage securities and other instruments that were used as collateral for ABCP. Investors’ inability to distinguish good collateral from bad collateral (a “lemons problem” as discussed in Chapter 11) suddenly diminished the demand for any ABCP, forcing shadow banks that could no longer roll over their ABCP issues to sell their assets or to bid aggressively for other sources of funding. These fire sales and the scramble for liquidity both catalyzed and then aggravated the crisis. Having disappeared suddenly in 2007, the market for ABCP remains depressed as of August 2016, with ABCP outstanding stagnating below $300 billion, down by more than 75 percent from the 2007 peak. indicates more difficult problems. Solution Manual for Money, Banking and Financial Markets Stephen G. Cecchetti, Kermit L. Schoenholtz 9781259746741, 9780078021749, 9780077473075
