EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term

EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETSDr Helen Weeds2013-14, Spring Term Lecture 2: Financial intermediation; bank runs and bank regulation

LEARNING OUTCOMES At the end of the topic the student should understand: • Financial intermediation and liquidity • Bank management • Liability and asset management • Capital adequacy and liquidity management • Bank runs • Government intervention • Government support for the banking system • Bank regulation • Proposals for reform of UK banking

FINANCIAL INTERMEDIATION • Bank as a financial intermediary: • Consolidates bank deposits and transforms the funds into bank loans Three functions: • Maturity (or liquidity) transformation • Deposits: mostly short-term (high liquidity) • Lending: typically longer terms (low liquidity) • Risk transformation • Individual investments (loans) are risky • Bank deposits are relatively risk-free • Consolidation • Matching small deposits with large loans and vice versa

Demand for liquidity • Depositors can demand their funds at short notice • Only a small percentage of deposits are kept as cash reserves • Rest is lent out to borrowers, mostly on long-term loans • Liquidity demand • With many depositors, only a small proportion are likely to require funds at the same time • If many depositors try to withdraw their funds at the same time, cash reserves may be insufficient to meet all withdrawals • Meeting demand for liquidity • Available cash reserves (small) • Sell longer-term assets (e.g. loans) to raise cash • But this is likely to incur losses, compared with waiting for repayment • If many banks need to do this, prices fall further

HOW A BANK OPERATES • Loans made = bank’s assets • Deposits (and other loans to bank) = bank’s liabilities • Capital: shareholders’ funds (from selling shares in bank + retained profits) • Pay for buildings, equipment, etc. • Provide a buffer against losses • Permanent capital: shareholders cannot withdraw their money from the company (can only sell shares to other investors)

Liability management • Composition of liabilities • Amount of deposits • Current vs. term deposits • Wholesale market funding (selling bonds and commercial paper; borrowing from other banks) • Balance between retail and wholesale funding • Building up deposits takes time; advertising; branch network • But may be more reliable than wholesale market lenders, who respond quickly in moving their money • Adjusting of interest rates offered to lenders to the bank (depositors, bondholders)

Asset management • Risk management • Assessing credit risk of borrower • Diversification to limit exposure to one (class of) borrower • Liquidity management • Long-term loans may give higher return, but difficult to release the money quickly Exhibit 2.8 The three objectives to be traded off in asset management

Capital adequacy and liquidity management • Capital adequacy • Bank must have enough capital (margin between assets and liabilities) to cover potential losses on bad loans • Bank prefers to hold less in reserve, as it makes little return on this amount • Regulation typically sets a minimum capital reserve • Liquidity management • Cash reserves (liquid) • Cash held in the bank’s account with the central bank • Cash held on its own premises (‘vault cash’) • Bank needs to retain sufficient liquid assets to repay obligations falling due if there is a sudden outflow of cash

BANK RUNS • Occurs when a large number of bank customers withdraw their deposits simultaneously • Perhaps due to concerns about the bank’s solvency (ability to repay obligations over the longer term) • As more people withdraw their deposits the probability of default increases, prompting more people to do the same • A bank run is typically the result of panic, rather than actual insolvency • But as more and more individuals withdraw funds this can turn into default • Importance of expectations; ‘confidence’

Diamond & Dybvig model • Model of liquidity transformation and bank runs • Illiquid asset • Early liquidation (or sale) incurs loss of value compared with present value of future payoff(s) • Demand for liquidity • Depositors have unpredictable liquidity need: may need to consume at date T=1 or T=2 (type 1 and type 2) • Depositor is initially uncertain of his/her type, so wants a liquid account giving immediate access • Bank can act as an intermediary between liquid savings accounts and long-maturity loans • Depositors’ needs for cash are largely uncorrelated • Bank holds a small fraction of deposits in reserve for withdrawals (‘fractional banking’)

Diamond & Dybvig (cont.) • D&D model has multiple Nash equilibria • Fractional banking works well as long as depositors only withdraw cash to meet liquidity needs (i.e. only type-1s withdraw at T=1) • But a type-2 depositor may fear too many withdrawals at T=1, and the bank will be unable to meets its demand at T=2 • Rational then to withdraw at T=1, though no immediate need • Bank run • Depositors forecast that all others will withdraw at T=1 • All try to withdraw at T=1: a bank run occurs • Self-fulfilling prophecy: depositors expect the bank to fail, so they rush to withdraw their money, so it does fail • This can happen even if the bank is solvent (i.e. would be able to meet its obligations over the long term)

Recent bank runs • Countrywide Financial, US mortgage lender, August 2007 • Bank run due to subprime mortgage crisis • Northern Rock, UK bank, September 2007 • Liquidity problem when funding from money market dried up • First UK bank run since 1866 (Overend, Gurney & Co.) • Bear Stearns, US investment bank, March 2008 • Panic by bondholders • IndyMac Bank, US mortgage lender, July 2008 • Washington Mutual, largest US ‘savings and loan’, September 2008 • Wachovia, 4th largest US bank, September 2008 • Kaupthing and Landsbanki, Iceland's 1st and 2nd largest banks, October 2008 • DSB Bank, Netherlands, October 2009

Overcoming a bank run What can a bank do to limit a bank run? • Manage beliefs to restore confidence • Concealing the run may help, e.g. avoiding queues building up in branches • Suspension of convertibility • Bank allows only fraction t of deposits to be withdrawn • Turn to the government…

GOVERNMENT INTERVENTION Government (often via central bank) supports banks in several ways • Why? • Protect individual savers • Protect financial system – ‘domino effect’ of bank failure • Importance of financial system to the economy • Provision of credit to households, SMEs, corporations, govt. • Finance is an ‘input’ into every sector of the economy • Economy-wide effects of financial crisis • Transmission and amplification mechanisms are the subject of current research, in light of 2007-09 financial crisis • Recessions linked to financial crises experience particularly slow recoveries

Forms of intervention • Government support for the banking system • Lender of last resort • Depositor insurance • Recapitalisation of banks • Bank regulation • Prudential supervision • Capital adequacy

Lender of last resort • Liquidity insurance to the banking system • Central bank provides cash reserves (liquid funds) when no one else will lend to the bank • Secured against illiquid securities • Idea goes back a long way: Walter Bagehot (Lombard Street, 1873) recommended (in aftermath of 1866 Overend Gurney bank failure) • Unlimited lending • At a high interest rate • banks will apply only if necessary • On good collateral • idea is to provide liquidity, not to support insolvency

LOLR in practice • September 11, 2001 • Bank reserves dropped (inflow of money disrupted, customer demand for cash) • Federal Reserve added $38 billion to US banking system (through repurchase agreements) to support the financial system • 2008 financial crisis • Fear among banks over incidence of sub-prime mortgage losses caused inter-bank lending and money market liquidity to dry up [lecture 3…] • Fed, ECB, BoE provided large amounts of short-term funds to banks • E.g. BoE Special Liquidity Scheme (2008) • Allowed banks to exchange bonds backed by mortgage payments (securitised bonds) for UK Treasury bills, for up to 3 years • T-bills could then be sold when the bank needed extra reserves

Depositor insurance • Government (or some regulatory body) guarantees that depositors will be repaid • Aims to overcome incentive to withdraw funds when there is a loss of confidence in a particular bank, overcoming a run • Insurance is capped at some level • European scheme: €100,000 per depositor • UK: £85,000 (Financial Services Compensation Scheme) • US: $250,000 (Federal Deposit and Insurance Corporation, FDIC) • These amounts were increased during the financial crisis • May be financed from an industry levy, but govt-backed • Cyprus: ‘bail-in’ of deposits above the cap • May become more common under recent EU agreement (2013) for handling failed banks: see FT

Criticism of depositor insurance Moral hazard issue, encouraging risk-taking behaviour • Depositors are insulated from risk of investing in less safe banks • Do not factor solvency of bank into savings decisions • Banks compete only on rates paid to savers, not on security of deposits • Encourages riskier lending • E.g. Following 100% deposit guarantee issued by Irish government, Irish banks operating in the UK were able to offer highly competitive interest rates and attract deposits

Recapitalisation • Government recapitalisation of weak / failing banks • Government provides capital to the bank • Deals with insolvency, not just lack of liquidity Two main approaches • Nationalisation (full or partial) • Government takes equity stake (shares) in the bank • UK: Northern Rock (nationalised in Feb 2008); RBS, Lloyds (partially nationalised by Bank Recapitalisation Fund, Oct 2008) • Ireland: Allied Irish Bank, Bank of Ireland, Anglo Irish Bank (2009) • Purchase (distressed) assets from the bank • US: Troubled Asset Relief Program (TARP), Oct 2008 • Treasury purchased illiquid, difficult-to-value assets, especially mortgage-backed securities [lecture 5…]

‘Too big to fail’ Large or systemically important financial institutions (SIFI) • Banks that are too large and too interconnected with the financial system to allow them to fail • Interbank borrowing • Derivatives transactions • Systemic risk • If such a bank fails, counterparties suffer losses: could bring down the financial system • March 2008: Bear Stearns (US investment bank) was bailed out • September 2008: Lehman Brothers was not… • Moral hazard problem • Bailing out SIFIs means that their losses are borne by the public, not their shareholders, managers and investors • Martin Wolf (FT): financial sector ‘privatises gains’ and ‘socialises losses’

Possible approaches • Break banks up into smaller units? • Fewer banks would be systemically important • Tax banks more because of the costs they impose on society? • An ‘insurance premium’ for govt guarantees given to banks • Impose very high capital reserve ratios and liquidity reserve ratios, to reduce the likelihood of liquidation? • Inhibits banks’ ability to lend, at a time when governments want to stimulate bank lending esp. to businesses • Introduce ‘living wills’ • Set out orderly winding-up procedures or recovery plans for banks, in advance of failure

BANK REGULATION • Rationale for regulation • In the presence of explicit and implicit government guarantees, banks are likely to hold less capital than would be prudent • If a bank fails, governments (taxpayers) bear much of the cost Two main ways in which banks are regulated • Prudential supervision • Regulatory authority monitors activities of banks • Capital adequacy regulation • Regulation sets a floor for bank capital and liquidity, which must be maintained

Prudential supervision • Operates through a license or charter system for banks • Regulator oversees • Appointment of senior bank executives (‘fit and proper persons’) • Paul Flowers, ex-chairman of Co-operative Bank – ?! • Activities undertaken by the bank • Compliance with safety rules • Consumer protection: e.g. mis-selling of financial products • Makes regular visits to the bank • UK bank regulation • Prudential Regulation Authority of the Bank of England • prudential regulation and supervision of banks, building societies, etc. • Financial Conduct Authority • conduct regulation of financial services firms, consumer protection, etc.

Bank inspection Exhibit 7.16 The CAMELS method of bank inspection

Exhibit 7.16 The CAMELS method of bank inspection (Continued)

Capital and liquidity adequacy Two distinct risks • Solvency risk • Bad debts, losses on securities, failure of a subsidiary • Losses on loans may shrink the bank’s capital base to such an extent that the bank’s assets (loans to customers, etc.) are barely greater than its liabilities (deposits, bonds issued, etc.) • Capital adequacy: margin by which assets exceed liabilities • Liquidityrisk • Cash and short-term lending are usually less profitable than long-term lending: incentive to increase long-term lending, leaving just a small cash buffer • Liquidity support from govt / central bank increases this incentive • Liquidity adequacy: amount of cash relative to other assets

Capital reserves • A capital buffer held against the risk of default on bank assets • Amount of capital (relative to asset value) depends on risk, e.g. • Cash: no risk of default, no reserve needed • Lending to (stable) governments: very small risk of default, say 1.6% of asset value needed in capital reserves • Unsecured corporate loans: higher risk, say 8% of balance sheet value needed in capital reserves • Risk-weighting of assets • Asset values are adjusted according to the riskiness of the asset • Unsecured corporate debt: weighting of 100%, i.e. no reduction • e.gsuppose capital reserve level is 8% of risk-weighted asset value • £10 million corporate loan requires bank to have £800,000 in capital (£10m x 100% x 8%) • Weight for mortgages might be 50% • if bank holds £5 billion of mortgages, it must back this with capital of £200 million (£5bn x 50% x 8%)

Risk weighting • Risk-adjusted assets: £13,100m in total • Total capital required: £13,100m × 8% = £1,048 million • I.e. bank assets must exceed bank liabilities by £1,048 million, to withstand the possibility of a substantial proportion becoming bad loans

The Basel Accords Basel, Switzerland • Home to the Bank for International Settlements (BIS) • “Banker to the central banks” • Since the 1980s, member countries of the Basel Committee on Banking Supervision (BCBS) have met to agree minimum capital standards for their banks • ‘Basel rules’ now adopted in over 100 countries • Current discussion over reforms to capital adequacy rules following the 2007-09 financial crisis

Basel I: The 1988 Basel Accord • Aim: a level playing field for internationally-active banks • Focused on credit risk • Established a set of minimum capital requirements for banks • 5 broad categories of assets, with different risk-weights • Risk weights of 0% (cash, bullion, home-country Treasuries), 20% (AAA-rated securitisations), 50%, 100% (most corporate debt), and No Rating • Distinguished between ‘tier 1’ and ‘tier 2’ capital • Tier 1: bank equity, retained profits, certain preference shares, minority interests in subsidiaries • Tier 2: other preference shares, subordinated debt, etc. • Banks must hold capital equal to 8% of risk-weighted assets (RWA), at least half of this tier 1 capital

Criticism of Basel I • 8% capital ratio became target, not minimum • Crude risk classes with same risk weight • Did not properly differentiate between loans to companies with different credit ratings • Manipulable • E.g. rename loan as mortgage: cuts capital requirement to 50% • Incentive to maximise risk within a category (regulatory arbitrage) • Lend to riskiest clients within a category, as this pays highest interest without requiring more capital • Considers credit risk only (not market risk) • No consideration of asset portfolios (correlations between asset values)

Basel II (published June 2004) • Made much greater use of credit ratings [lecture 5…] for govt and corporate debt to decide risk weightings • Where bank assets had no externally-produced credit ratings, banks were permitted to use ‘internal ratings’ from own models • Other risks taken into account • Market risk: falls in market prices for traded financial assets (e.g. securitised bonds) • Operational risk: risks in how bank is run, e.g. rogue traders • Concentration risk: too many eggs in one basket • Liquidity risk • Off-balance-sheet assets (and liabilities) were included with on-balance-sheet assets to calculate capital requirement

Basel II’s ‘three pillars’ • Minimum capital requirements • Regulatory capital calculated for three major components of risk: • credit risk, operational risk, market risk • Supervisory review • Aimed to give regulators better ‘tools’ to oversee banks • Market discipline • A set of disclosure requirements, allowing market participants to gauge the capital adequacy of an institution

Basel III • Basel II was not a success • Complicated rules did not work well • Internal ratings could be manipulated • Too much faith in market value of assets: these could drop rapidly • Little recognition of systemic risk: knock-on effects on others • Implementation was slow: ‘light-touch’ approach to regulation (prior to 2008) • Basel III: new rules currently being formulated and agreed • Being phased in by end-2018 • ‘Capital’ narrowed to ‘core tier 1’: bank equity + retained earnings • Capital requirement raised from 4% (for tier 1) to 7% (core tier 1) • also possibility of an additional counter-cyclical buffer (0-2.5%) • some countries setting higher capital requirements for their banks • Liquidity management rules: ‘liquidity coverage ratio’ and ‘net stable funding ratio’

Basel III core tier 1 capital to be held by banks as a percentage of risk-weighted assets

REFORM OF UK BANKING • Post-2007 investigations into banking failures • Report of the Independent Commission on Banking, September 2011 (‘Vickers Report’) • Proposals for reform of UK banking • ‘Ring-fencing’ of retail banking • Restriction on services • Higher capital reserves • Debt bail-ins • Competition issues • Financial Services (Banking Reform) Bill currently going through parliament: see website • Financial Services Act 2012: new regulatory framework • Financial Services Authority replaced by Financial Conduct Authority and Prudential Regulation Authority (part of the Bank of England)

EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term