Geld en Bankwezen Week 6

1. The Originate and Distribute model of banking and securitization a. Long-Term Loans go down to 45, !uit" goes down to 5, balance sheet total to #5. b. Long-Term Loans $, %eser&es '5. c. The bank needs to hold ($) of #$, 1* million in reser&es. That means that the ma+imum amount of new loans is 4,. d. The bank can re-eat this -rocess indefinitel" if it is able to kee- finding -eo-le that want to take out a loan and institutions that want to bu" the loans. e. ./lease re-lace the 1 for !uit" in the !uestion b" 1$ and re-lace the ## for 012/ in the !uestion b" #$3 4f the &alue of the CDOs dro-s b" 1$), CDOs dro- to #$, and as a result !uit" dro-s to $. 4f the hedge-fund doesn5t ha&e trouble rolling o&er its ABCPs, it does not need to make use of an" -otential 6credit line5 facilities offered b" the s-onsoring bank. 4f the hedge fund does ha&e -roblem in rolling o&er 7-art8 of its ABCPs, then it has two o-tions9 either sell -art of its CDOs or use the credit line. 4n the latter case, the funding or li!uidit" -roblem of the hedge fund becomes a li!uidit" -roblem for the s-onsoring bank. f. 4f the bank does not hold an" CDO directl" in its balance sheet, the dro- in &alue of CDOs does not ha&e an" direct im-act on the bank6s balance sheet. :owe&er, as we ha&e seen in -oint e., if the hedge fund makes use of credit lines, the li!uidit" or reser&es of the banks will decrease. (. /ros and cons of the securitization -rocess. The main advantages of securitizations are9 ; ; ; ; ; 4ncrease funding 7li!uidit"8 for banks arn ser&icing fees &ia the s-ecial -ur-ose &ehicles 7</=8 %educe ca-ital re!uirements for banks %educe 7transfer8 credit risk 4n&estors can di&ersif" their in&estment -ortfolios

The main disadvantages of securitizations are9 ; ; ; ; %educes incenti&e for bank to screen and monitor these loans 7onl" -i-eline risk9 the risk in making a commitment at a certain interest rate knowing that the interest rate ma" change before the loan contract is actuall" signed8 Lack of trans-arenc" and high com-le+it"9 nobod" knows an"more who e+actl" bears what risks and a large drain on risk management de-artments %ating agencies are not com-letel" inde-endent 7conflict of interest8 >aturit"-mismatch9 credit lines gi&en b" s-onsors of <4= e+-oses s-onsor to high li!uidit" risks

?. The si+ factors underl"ing financial crises are9 718 asset -rice effects on balance sheets, 7(8 @eterioration in financial institutions5 balance sheets, 7?8 1anking crisis, 748 increase

in uncertaint", 758 increases in interest rates, and 7'8 go&ernment fiscal imbalances. Aor a full e+-lanation of each of these factors see the book. Bo&ernment fiscal imbalances -la"ed an im-ortant role in the recent euro debt crisis. 0s a result of the sub--rime financial crisis in the C.<., man" C go&ernments had to bail-out their domestic banks in sol&enc" -roblems. This led the le&el of go&ernment debt to increase significantl". This -rocess was further worsened b" a slowdown of the econom" 7less ta+ re&enues8 and b" the fiscal stimuli that man" de&elo-ed countries im-lemented to tackle the resulting recessions. D&erall -rofligac" of the local go&ernment also -la"ed a central role in Breece. @ebt increased in most of the C countries, but in the so-called /44B<, it reached historicall" high le&els, which created fears of default and debt -rice declines. 4f these bonds are held b" domestic and foreign banks, it is eas" to see how these fiscal imbalances can lead to a deterioration of the balance sheets and a -rocess of dele&eraging. 4. a8 0fter cutting the 1ank %ate to Eust $.5) at its >arch ($$# meeting, the >2/ agreed that more stimulus was needed to mitigate the risk of de-ression and deflation. 0s a result the 1ank launched the 0sset /urchase Aacilit" 70/A8 -rogramme, in which the >/2 started bu"ing C.F. go&ernment securities 7gilts8 in the secondar" market as well as smaller !uantities of high-!ualit" -ri&ate sector assets 7including commercial -a-er and cor-orate bonds8, financed b" the issuance of central bank reser&es. The amount to the 0/A -rogramme was initiall" set to G,5 billions, but was -rogressi&el" e+tended till reaching G($$ billions in Ho&ember ($$#, an amount e!ui&alent to nearl" ?$) of the &alue of outstanding gilts held b" the -ri&ate sector and around 14) of annual nominal B@/. 1ut how can I!uantitati&e easing5 stimulate the econom"J 0lthough a full discussion of the monetar" transmission mechanisms is not de&elo-ed in this course, we can alread" identif" some im-ortant e+-ansionar" channels underl"ing a K -olic". Airst, as shown in Leek 1, an increase in the demand of bonds will -ush their -rice u- and lower the corres-onding "ield, effecti&el" reducing the cost of borrowing to firms and households leading to more consum-tion and in&estment. Aor instance, the 1ank of ngland bought nearl" all gilts with medium and long-term maturities, and estimated that these asset -urchases ma" ha&e lowered interest rates at 5-(5 "ear maturit" b" around 1$$ basis -oints. <econd, introducing !uantitati&e easing as an additional element of monetar" -olic" ma" send a strong signal to market -artici-ants to e+-ect -olic" rates to remain low in the future. 0s the e+-ectation theor" of the term structure of Leek ( demonstrates, e+-ectations of low future -olic" rates will lower toda"5s long-term interest rates, which stimulate economic acti&it". The following &ideo brings a sim-le o&er&iew of the abo&e channels9 [Link]!eM&[Link] 7b8 The K -rocess can be easil" e+-lained in the standard market for reser&e diagram. Dnce the o&ernight market rate reaches the lower bound set b" the de-osit rate 7or interest rate -aid on e+cess reser&es8, the central bank can add limitlessl" to the su--l" of reser&es without affecting the o&ernight market rate. 4n doing so, the focus of monetar" -olic" shifts from the -rice 7e.g. the o&ernight rate8 to the !uantit" of reser&es. 5. The global financial crisis that began with financial tensions in 0ugust ($$,, and the subse!uent economic downturn called for un-recedented -olic" res-onses b" all maEor

central banks. 0s we ha&e seen abo&e, the 1ank of ngland im-lemented a !uantitati&e easing -olic" b" -urchasing long-term Treasur" bonds -redominatel" from non-banks. Dn the other hand, reflecting the financial structure of the euro area, the non-standard measures undertaken b" the 21 were -rimaril" bank-based. These measures e+-loited the fle+ibilit" of the e+isting con&entional tools of the 21 and are contained in the socalled -rogramme of I nhanced 2redit <u--ort5. The latter is a set of non-standard measures to su--ort financing conditions and the flow of credit be"ond what could be achie&ed through reductions in ke" 21 interest rates alone. These measures were ado-ted in Dctober ($$* and com-lemented in >a" ($$#. The 1o+ e+-lains one b" one the following measures9 718 +tension of the maturit" of li!uidit" -ro&ision 7(8 Ai+ed rate full allotment 7?8 2urrenc" swa- agreements 748 2ollateral re!uirements 758 2o&ered bond -urchase -rogramme. The I<ecurities markets -rogramme5 ser&es a com-letel" different -ur-ose, namel" ensuring that bond markets do not become d"sfunctional 7think of the markets for <-anish and 4talian go&ernment bonds. The goals thus is not the -ro&ision of li!uidit" such that the li!uidit"-enhancing effect of -urchase of for instance 4talian go&ernment bonds are immediatel" sterilised &ia the sale of for instance @utch and Berman go&ernment bonds. '. %es-onse and lessons of the crisis The res-onse of go&ernments and central banks in the recent crisis has been to bail outM guarantee most financial institutions in trouble and to -ro&ide essentiall" unlimited li!uidit" when the interbank market sto--ed functioning correctl". These actions -re&ented a com-lete colla-se of the financial s"stem so in the short run we can be reasonabl" sure that these actions ha&e hel-ed calm financial markets. 4n the longer run, it is not at all clear what the conse!uences of the course of action taken b" go&ernments and central banks will be. The lessons that can be learned from this crisis are9 ; ; ; ; ; ; ; 4m-ro&e risk management faster, kee- u- with financial inno&ation Tr" to get rid of -er&erse incenti&es with high bonuses based on short-term -erformance for managers of financial institutions 4m-ro&e li!uidit" risk management 7e.g. additional ca-ital re!uirement with regard to li!uidit" or Icredit line5 facilities to <4=s or other conduits8 4m-ro&e the stress testing models which didn5t -redict losses accuratel" :a&e rating agencies be inde-endent of the issuers of -roducts that the agencies ha&e to rate 4ncreasing minimum ca-ital reser&es %educing moral hazard being for instance cutting down the size of for instance 4HB

Nou are strongl" recommended to read the lecture slides 0H@ the article b" 1runnermeier 7($$#8 to ha&e a dee-er understanding of the recent crisis. @o "ou think there will be other crises in the futureJ Le belie&e that there are going to be crises in other market segments that we do not foresee right now. /olic" and regulation b"

definition are alwa"s behind de&elo-ments within the econom", where imbalances in sectors will lead to crises again. 4n case "ou did not come to the last tutorial, ha&e a laugh watching this &ideo. 4t is !uite funn". htt-9MMwww."[Link]&Ou<DeQlia2gCPfeatureOrelated htt-9MMwww."[Link]&OLz/iERT"(aC 0 more serious but instructi&e &ideo on the securitization -rocess and the sub--rime crisis can be found in htt-9MMwww."[Link]&O'D&F@m,w(14