MAF305 Topic 10 Bank safety and stability 2015 FV.ppt

1、1,BANK SAFETY AND STABILITY,MAF305Topic 10 Di Thomson,2,Learning Objectives,Review the sources of bank instability Examine bank instability in Australia Review Liquidity Risk and understand the causes of bank failures Learn how a FI can use either stored or purchased liquidity to manage its liquidit

2、y needs and Balance Sheet Understand the role capital plays in bank safety Examine factors leading to financial crises and bank runs Deposit Insurance and other methods to protect depositors Review recent liquidity and capital proposals BIS/APRA Reading: - Lange (2013) Ch 14 review pp. 497-502, 510-

3、513 - Ch 15, pp. 543-551 - Financial Stability Board Report 2011, Progress in the implementation of the G20 Recommendations for Strengthening Financial Stability. (On DeakinCloud),3,Sources of Bank Instability,Asset side of balance sheet -Defaulting or bad loans (CREDIT RISK) -Borrowers decide to us

4、e the loan commitment facilities (ie draw on loans) provided by the DI (LIQUIDITY RISK) Liability side of balance sheet -deposit outflow (LIQUIDITY RISK) Off-balance sheet activities (CAPITAL RISK) Disasters, fraud, operating systems failures etc (OPERATING RISK),4,Sources of Bank Instability,Two ma

5、jor causes of bank instability Credit risk where loans “go bad” and FI becomes insolvent Liquidity risk where FI cannot meet depositor demands A solvent bank (+ NW) can fail due to liquidity crisis - prevent failure by providing liquidity A = L = NW zero A L = NW positive A L = NW negative - insolve

6、nt Paradox - best for individual to withdraw funds but not in the interests of all depositors Insolvent bank should be allowed to fail - a form of market discipline!,5,Managing Liquidity,Two major ways to manage drains on deposits or exercise of loan commitments: Stored liquidity management Traditio

7、nal approach: Reserve Asset Management - running down reserves Purchased liquidity management Alternative approach: Liability Management - borrowing funds,6,Stored Liquidity Management,Liquidate assets. Decreases size of balance sheet Requires holding excess non-interest-bearing assets Better to com

8、bine purchased and stored liquidity management!,7,Asset Side Liquidity Risk,May be forced to liquidate assets too rapidly Problems of quick asset sales: High costs for turning illiquid assets into cash. Faster sale may require much lower prices; in worst case, fire-sale price. Risk from loan commitm

9、ents and other credit lines Where customer borrows funds from the FI over a commitment period Eg. Draws down loan as required (Line of Credit) FI must fund the loan on the balance sheet immediately causing immediate demand for liquidity,8,Liability Side Liquidity Risk -,Reliance on demand deposits C

10、ore deposits provide DI with long-term funding sources Depository Institutions need to be able to predict the distribution of net deposit drains. Seasonality effects in net withdrawal patterns Recent problem with low rates: finding suitable investment opportunities for the large inflows,9,Purchased

11、Liquidity or Liability Management,Liquidity can be purchased in financial markets, e.g. borrow funds Interbank market, repos market, rediscount facility (RBA). Borrowed funds are at market rates - higher rates than interest paid on deposits Purchased liquidity management allows DIs to preserves asse

12、t side of balance sheet or increase their overall balance sheet size.,10,Multiple Choice Question 1,Which of the following statements is true? A. An FI can manage a drain on deposits or an exercise of a loan commitment in two major ways, these being purchased liquidity management and stored liquidit

13、y management. B. Traditionally, FI managers have relied on stored liquidity management as the primary mechanism of liquidity management. C. Today, there is a higher reliance on purchased liquidity management. D. All of the given answers.,Ans D,11,Multiple Choice Question2,Fire-sale price refers to:

14、A. The price received for an asset that has to be at half price. B. The price received for a liability that has to be sold at half price. C. The price received for an asset that has to be sold immediately. D. The price received for a liability that has to be sold immediately.,Ans C,12,Asset-Liabilit

15、y Management (ALM) - The Role of Reserves,Assume balance sheet as follows: RRR of 10% holds excess reserves,13,Adjustment of B/S to a deposit drain, the Role of Reserves,Deposit Outflow of $10 occurs, impact on new B/S 2 - Bank loses $10 reserves and $10 deposits Excess reserves exist of $1 Reserves

16、 protect against deposit outflows - no other change to Balance Sheet is necessary note B/S contraction (see Table 14.3, p 501),14,Adjustment of B/S to a deposit drain, the Role of Reserves,Insufficient bank reserves scenario using original B/S data in B/S 3 $10m deposit outflow Assuming no excess re

17、serves:,15,Adjustment of B/S to a deposit drain, the Role of Reserves,Balance sheet 4 - adjustment necessary to eliminate shortfall in reserves Requires $9m in legally required reserves Cant continue to operate as doesnt meet legal requirements! What will it do? A = L, but no liquid reserves,16,Adju

18、stment of B/S to a deposit drain, the Role of Liquid Assets,Methods to Eliminate Shortfall in Reserves - Asset Side (B/S 5 shrinks) 1.Sell securities - incurs brokerage and other transaction costs, insufficient securities for collateral and repurchase agreements.,17,Adjustment of B/S to a deposit dr

19、ain, Purchased Liquidity,Methods to Eliminate Shortfall in Reserves Liability side (B/S 6 does not shrink, see table 14.2, p 502) 2.Borrow from other banks interbank market via Exchange Settlement Accounts (ESA) or RBA - Repurchase Agreements. Cost - interest rate on loans,18,Adjustment of B/S to a

20、deposit drain, Purchased Liquidity,Methods to Eliminate Shortfall in Reserves Liability side (B/S 7 does not shrink) 3.Borrow from the central bank using rediscount facility Costs - (a) Interest - penalty rate (re-discount i/r) (b) Non-pecuniary RBA may refuse to allow further borrowing,19,Adjustmen

21、t of B/S to a deposit drain,Methods to Eliminate Shortfall in Reserves Asset side (B/S 8 does shrink) 4.Calling-In loans - not renewing ST loans when they fall due 5.Sell loans to another bank - at a discount to FV -Decrease loans by $9 to gain required reserves,20,Adjustment of B/S to a deposit dra

22、in,Methods to Eliminate Shortfall in Reserves Asset side (B/S 8 does shrink) Conclusion Excess reserves are insurance against deposit outflows The higher the cost associated with deposit outflow - the more excess reserves will be held,Adjusting B/S to a Loan Commitment,21,Note: the increase in asset

23、s post loan draw-down A L, NW is positive and increasingbut is unfunded .what will the bank do? How is the loan draw-down managed? Borrowed (purchased) funds to cover the required draw-down of funds (B/S increases) Reduction in cash and reserves (stored liquidity) to fund it (B/S decreases),22,ALM -

24、 Prevention of Bank Failure,Excess primary reserves and secondary reserves are held to prevent bank failure Using initial balance sheet data B/S 9:,23,ALM - Prevention of Bank Failure,Rumour - fraudulent behaviour, unsound bank deposit outflow of $20m Bank sells reserves and securities to meet short

25、fall (asset side, B/S 10 shrinks) A = L, but cant meet liquidity requirements,24,ALM - Prevention of Bank Failure,Problems Bank short of legally required reserves Other banks unwilling to lend no interbank loans Cant purchase liquidity on liability side of B/S No securities to use as collateral, una

26、ble to utilise repurchase agreements RBA wont lend to insolvent bank “Call-in” ST loans if possible! To continue functioning must attain $8 reserves: Sell loans at discount to other banks = Fire Sale of assets, loss may exceed bank K,25,ALM - Prevention of Bank Failure,Bank must hold 10% reserves; h

27、as sold securities to meet shortfall (asset side, B/S 11 shrinks) But still not enough. What will it do now? Must fire-sale assets - $20 loans sold at 50% discount to provide reserves $8 and securities $2 AL = NW negative,26,ALM - Prevention of Bank Failure,Value of assets liabilities = insolvency C

28、lassified as bank failure, merge or closed Excess reserves provide insurance against highest cost of deposit outflow - bank failure Higher cushion of K would have allowed bank to absorb losses from deposit outflow,27,ALM - Prevention of Bank Failure,Capital sell-off: ie use K to fund lack of reserve

29、s - B/S 12,28,ALM - Prevention of Bank Failure,B/S 13 - Capital sell-off: sell $8m of K to gain necessary reserves Assets Liabilities = + NW FI can continue operating but will have to raise further K,Effect of drop in value of investment portfolio - Adjusting B/S to a Loan Commitment,29,If i/r rise,

30、 value of securities falls , loss of market value of portfolio - NW or capital falls (NB duration effect of i/r on NW of a FI) FI must fund the $5m loss in value either by Borrowed (purchased) funds to cover the loss in value Reduction in cash and reserves (stored liquidity) to fund a purchase addit

31、ional security assets (B/S decreases),30,Financial Crises,How do we define it? Why do financial markets fail to function? What is the result?,31,Factors Causing Financial Crises.pre GFC!,1. in interest rates D for credit (impact of MP on economic activity) adverse selection as only “bad” risks will

32、wish to borrow at the i/r 2.Sharp declines in asset prices in share prices Net Worth of the Co lenders less willing to lend in I,32,Factors Causing Financial Crises,Unanticipated price deflation Net Worth due to burden of debt (contractually fixed debt payments liabilities) 4. in uncertainty recessi

33、on, stock market crash difficulty in screening good from bad credit risks 5.Failure of financial and non-financial firms intermediation role no. of F.I. and in supply of funds,Financial Crises 2007-2008 Sub-prime loans Securitisation of these “junk” loans in with “good” loans Defaults large write-of

34、fs Insufficient bank capital Bank failures,33,34,Do We Have Bank Runs?Do people line up for their money? Why?Have we had FIs fail in Aust?,35,Financial Institution Instability: Australia the 1990s,Northern Rock UK Bank Failure Nationalised, ie taken over by the UK Govt in August 2007,36,Indy Mac US

35、bank run July 2008,37,38,Bank Runs,Bank Run Abnormal Deposit Drains A sudden and unexpected increase in deposit withdrawal from an ADI Failure of a related ADI leading to heightened depositor concerns (contagion effect) Sudden changes in investors preferences eg. shares, T-notes relative to bank dep

36、osits Contagion effect Concerns about an ADIs solvency relative to other ADIs A bank triggers withdrawals at other “sound” FIs A bank run, justified or not, can force a DI into insolvency.,39,Bank Panics,Bank Panic A systemic or contagious run on the deposits of the banking industry as a whole Chang

37、e in other depositors behaviour is “sensed”, often irrational behaviour,40,Causes of Bank Failures/Runs,Instability in macro-economy -wars -rapid technological change -recession or depression Changes in expectations -bad earnings report -adverse change in relative prices - land, oil, property -rumou

38、rs about a F.I. -observed run at another F.I.,41,Causes of Bank Failures/Runs,Asymmetrical information Adverse selection - poor credit risks are chosen Moral Hazard - high risk activities undertaken by borrower increased probability of default Internal factors Operational risk poor management lack o

39、f diversification poor risk analysis dishonesty / fraud Attempt to avoid K loss currency withdrawal due to fear that F.I. will not honour its commitments,42,Why are we Concerned About Bank Runs?,Loss of confidence in other sound F.I.s Multiple deposit contraction less funds available to meet loan de

40、mand Calling-in loans directly affects production and investment Affects social welfare and allocative efficiency Wealth losses by depositors, S/H, owners Community banking arrangements disrupted depositors lose liquidity borrowers businesses are threatened banker-client relationship destroyed,43,De

41、mand Deposit Unique Characteristics,Underlying cause of bank runs: demand deposit contract. Demand deposit contract implies a first come, first served principle. Depositors are paid their full claims until the DI has no funds left. Depositors who come late will not receive the full amount of their f

42、inancial claims or, in the worst case, will receive nothing at all. Compare this to a managed fund!,44,Consequences of Bank Runs,As a bank run develops demand for net deposits grows it is met by Decreasing cash reserves Selling off liquid or readily marketable securities T-bills and notes Seeking to

43、 borrow in the money market As the liquidity crisis develops ADI finds it impossible to borrow at any price, is left with only illiquid loans, which can only be sold at large discounts = firesale prices, this threatening its solvency,45,Bank Run and Firesale Prices,What will depositors get if all wa

44、nt their funds on day 1? On day 3? Loans will be discounted 10% if sold in less than 2 days, and discounted 5% if sold within 4 days. Day 1 loans sold for $81, plus $10 cash reserves depositors get $91 on 1st come, 1st served basis Day 3 loans sold for $85.5, plus $10 cash reserves, depositors get $

45、95.5, the remainder will have to wait for liquidity After Day 5, loans sold at FV = $90 + $10.all depositors paid in full,46,Consequences of Bank Runs,Alternative scenarios for depositors Redeposit at other “safe” banks no change to Money Supply (MS) no transmitted instability Purchase other securit

46、ies - “flight to quality” basically no change to MS i/r change safe securities D (P and i/r) risky securities reverse scenario Hoard currency MS (Great Depression 1930-1933),47,RBA Role in Maintaining FS Stability,Repos or Repurchase Agreements provide ST liquidity An agreement between RBA and ADI t

47、o buy or sell ST Commonwealth Government securities, with price and timing of reversal of the transaction agreed to. Intra-day repurchase facility - ADI can enter into a RBA repos to obtain liquidity during the day, reversed later in the same day. Overnight Repurchase facility repos to obtain liquid

48、ity overnight Committed Liquidity Facility (CLF) - new in 2015 for countries like Aust which do not have sufficient liquid assets. A line of credit from the RBA where ADIs can access liquidity to meet its Liquidity Coverage Ratio (LCR),48,Multiple Choice Question 3,Which of the following are the two

49、 main sources of exchange settlement liquidity for Australian FIs provided by RBA repos? A. ESAs and intra-day repurchase agreement facilities. B. Inter-day repurchase agreement facilities and overnight repurchase agreement facilities. C. ESAs and inter-day repurchase agreement facilities. D. Intra-

50、day repurchase agreement facilities and overnight repurchase agreement facilities. E. ESAs and overnight repurchase agreement facilities.,Ans D,49,Multiple Choice Question 4,Which of the following statements is true? A. In case of a liquidity crisis, depositors do not need to worry as the RBA will p

51、ay out any deficit balances. B. In case of a liquidity crisis, any available balances will be divided equally among depositors. C. In case of a liquidity crisis, any available balances will be divided proportionally to each depositors investment. D. In case of a liquidity crisis, the first comes, fi

52、rst serves principle holds.,Ans D,50,Multiple Choice Question 5,Bank panic refers to: A. A contagious run on the deposits of banking institutions in particular suburbs. B. A contagious run on the deposits of the big four banks. C. A contagious run on the deposits of all branches of a particular inst

53、itution. D. A contagious run on the deposits of the banking industry as a whole.,Ans D,51,Multiple Choice Question 6,What are typical reasons for abnormal deposit drains? A. Concerns about an FIs solvency relative to other FIs. B. Failure of a related FI leading to heightened depositor concerns abou

54、t the solvency of other FIs. C.Sudden changes in investor preferences regarding holding non-bank financial assets relative to deposits. D. Concerns about an FIs solvency relative to other FIs, failure of a related FI leading to heightened depositor concerns about the solvency of other FIs and sudden

55、 changes in investor preferences regarding holding non-bank financial assets relative to deposits.,Ans D,52,Why Should Depositors be Protected?,Depositors unable to determine: quality of bank assets risks taken by bank managers Moral hazard and adverse selection explain why government regulate FIs t

56、he forms of bank regulation chosen methods to these problems have counterpart in private financial markets,53,Methods of Providing Depositor Protection,Self - Insurance - diversification of loan portfolio risk, adequate K, liquid assets Co-insurance Optional “Redeemability on demand” Industry suppor

57、t and private insurance interbank formal contributory scheme or mutual support for members in difficulty lines of reciprocal credit Reform banking - hold 100% cash reserves!,54,Forms of Safety Regulation,Bank licensing (screening) Prudential supervision / regulation APRA Liquidity reserves, Liquidit

58、y Coverage Ratio (LCR) Restrictions and covenants on risky holdings and activities Capital requirements Basel I, II and III (restrictive covenants re net worth),55,Forms of Safety Regulation,Deposit Insurance Depositor protection schemes ? whether this bank safety and stability Should stop bank runs

59、? Requires full coverage of deposits Argue it moral hazard banks take risk, borrowers monitoring as dont suffer losses Adverse selection,56,Forms of Safety Regulation,Source: Text P552,Financial Claims Scheme - Aust,Financial Claims Scheme (FCS) - October 2008 for three-years, 100 per cent guarantee of deposits in ADIs - Unlimited guarantee, up to $1,000,000 is free Review FCS and cap on the guarantee in late 2011 Feb 2012 FCS made permanent scheme $250,000 per person, per tects 99% of deposit A/C, 80% of the value of household deposits) Applies t