Postings and assignments for students in Econ 3334 at UH
Tuesday, February 19, 2008
Bailing out Banks
This article has relevance to our next class, on the current state of the U.S. economy and the sub-prime mortgage mess. It's pretty dense, but think about it in terms of the model of money creation we went over.
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Anonymous
said...
Even the proponents of free economy accept some form of regulatory intervention on organizations that become too powerful. The regulatory authorities have a right to intervene, if the market forces are giving unfair advantages such as monopoly or pollution. Commercial banks can become mighty powerful and at the same be very fragile. Even flourishing capital markets have not undermined the importance of commercial banking. Commercial banks are a widely used tool to stimulate the economy through loans that stimulate consumption and investment. Therefore, in essence the health of the banking sector is directly related to the health of an economy.
Liquidity risk is inherent to commercial banking because the depositors can come and claim their deposits at anytime. A mismatch of time to maturity of advances and deposits can create severe problems. For instance, a wave of panic-stricken withdrawals can essentially bankrupt a bank in no time. This can trigger systematic risk and leave the entire economy shaken. The banks need to monitor their asset liability management statistics because any mismanagement can lead to bank runs or cash shortages.
For these problems, central banks require of commercial banks to insure their deposits and provide them with liquidity support. By providing liquidity support central banks regulate the money market and injecting cash in the economy when demanded. These solutions in effect can lead to other problems. For example, in insured deposits, depositors stop monitoring a bank’s performance and the banks increase their risk appetite by increasing lending. To address this issue the central bank requires banks to maintain a minimum capital adequacy ratio, and regulate insurance premiums to be proportional to the risk of a bank’s lending. However, recent stats suggest that capital adequacy is not a safe determinant to monitor banking sector. Commercial banks start to over rely on central bank’s liquidity support and tend to lend high premium loans to institutions with lower credit ratings. Even if such lending results in volatility in the money market such variations are small compared to the bank’s capital.
Central banks need to be proactive rather than be reactive because the public cost of economic instability and high interest rates is too high. Even the Basel 2 agreement addresses risk capital framework but does not address provisioning for funding shortages. The emphasis should be on liquidity rather than on solvency alone. Therefore, commercial banks need to be scrutinized through stricter prudential regulations.
We find that banks have a comparative advantage in hedging liquidity risk in the economy because banks experience deposit inflows following a market crisis or liquidity shock that allow them to have more funds to provide the additional loans drawn down under commitments at such times. Banks should manage market access. Each bank should periodically review its efforts to establish and maintain relationships with liability holders, to maintain the diversification of liabilities, and aim to ensure its capacity to sell assets. In addition, banks should have contingency plans in place that address the strategy for handling liquidity crises and which include procedures for making up cash flow shortfalls in emergency situations. Moreover, banks should manage their foreign currency liquidity. Banks must be able to track and evaluate their current and anticipated liquidity position and capacity. The most successful banks create objective targets for each liquidity measure, which often have multi-level trigger points, to maximize their liquidity position. As such, because banks vary widely in their funding needs, no one set of universally applicable liquidity measures or targets can be applied to all institutions.
If a business has a monopoly or pollutes, the general consensus is that government should step in. However, that is not the only reason government intervention should be sought as examined in the article “When to bail out” from the Economist. Commercial banks could be just as dangerous and vulnerable as they are the pillars to the economy. Their vulnerability lies in the difference between liquid debt and illiquid assets. Whereas deposits withdrawn can be converted to cash on point, loans to homes and businesses are not afforded this ease. Also, holding any liquid assets would take away from what could have been used as investment leading to cash shortages.
Deposit insurance was created to lessen the problems that come with bank runs. This keeps people from running to the bank and withdrawing their money in panic. However, deposit insurance produces trust that in turn, leaves little reason to check on the banks. Banks will be able to make more risky loans considering that the insurers are accountable. Depending on how risky a loan is, an insurance premium is charged, but often, limits on the bank’s assets are put in place to stimulate capital growth. Banks can also fall back on the Federal Reserve to provide enough capital to cover their expected losses. However, the bank’s over reliance on the Federal Reserve was made all too clear with interest rates rising. For the central banks to stop these effects, they would risk hurting the economy. If any bigger shocks occur, the government would have to intervene proportionately.
The banks are happy to offer up loans to people with bad credit at an adjustable rate. The payments due started out low, but rose with time and borrowers defaulted. People who are evil or stupid can be blamed for this sub-prime mortgage mess or maybe it’s the Fed’s fault. With the money supply increasing, interest rates also grew, causing output to fall and unemployment increased. Home prices fell, because mortgages shut down. In the loanable funds market, investment and interest rates went down. The Fed’s could raise the money supply to lower the interest rate, but there is the danger that the reserve ratio may keep going up. Taxes could be lowered, but if the marginal propensity to consume were already low, then there would be little effect, because people are scared. The solution lies in determining and monitoring if banks have enough liquidity.
The article states there are good reason when government should regulate or tax markets or industries which may exist as a monopoly, and when there is no market price (ie pollution) or when there is some ”other” reason when the state must act. Although banks do not have these circumstances, they do have power and yet have fragility. Bernanke wrote a paper stating the bank failure where a cause for the severity and length of the Great Depression. Their mixture of liquid debt and illiquid assets creates this weakness and the more reason for them to be supervised. Another issue for banks is the difficulty of predicting the demand for money which comes into play when there are profitable investments versus having sufficient funds to supply the money demand. This has caused regulators to impose the deposit insurance (to mitigate bank runs). Although this remedy brings a level of security to the access of fund for customer, this creates little incentive on the customer to monitor the dealing of the bank. The deposit insurance also creates an incentive for banks to take excessive risk as the risks have shifted to the insurers. The article proposes to change insurance premiums reflective of the bank’s lending practices (level of riskiness). Another solution is to force them to increase their capital holdings if they make risky loans. The objective is to keep banks solvent by ensuring that banks have enough capital to cover expected losses. The credit crisis of late exposed the banks philosophy of holding not enough capital and extend credits when the situations arose, which added more risks. They did this on the belief that the central banks would provide liquidity when in a pinch. The issue here is that this market dynamic puts to little penalties on the risks taken by banks and adds a disproportionate cost to the consumer through instability and high interest rates. The recent problems in the sub-prime market created a huge shock to the financial market although the potential losses where small relative to the banks’ capital. The Basel 2 agreement looks at the risk-capital framework and regulation is suggested to focus more heavily on the liquidity than solvency. Raghuram Rajan remarks that the recent crisis has put focus on the liquidity issue and likely has set the benchmark for future monitoring.
Important economic topics discussed in this article are the relationship of the Fed to banks to ensure market stability for consumers and the unanticipated consequences of federal intervention. We learned that the Fed regulates the reserve ratio so that banks maintain a certain percentage of capital in reserve and the balance goes to loans. This RR provides stability in the market if there were a run on the banks for currency. Although this function helps the Fed regulate currency and market activity, it also serves as the limiting factor for banks and their investment capacity. Since the Great Depression, the Fed have tried to be more proactive in the market, but this philosophy have made the banks more dependent on this security blanket (ie Fed’s bail-out propensity), which has resulted in the detriment of the consumer. Although their market interventions were to provide security of the market and thus benefit the consumer, it has lead to more risk taking activities, which in the end, the consumer pays for.
3 comments:
Even the proponents of free economy accept some form of regulatory intervention on organizations that become too powerful. The regulatory authorities have a right to intervene, if the market forces are giving unfair advantages such as monopoly or pollution. Commercial banks can become mighty powerful and at the same be very fragile. Even flourishing capital markets have not undermined the importance of commercial banking. Commercial banks are a widely used tool to stimulate the economy through loans that stimulate consumption and investment. Therefore, in essence the health of the banking sector is directly related to the health of an economy.
Liquidity risk is inherent to commercial banking because the depositors can come and claim their deposits at anytime. A mismatch of time to maturity of advances and deposits can create severe problems. For instance, a wave of panic-stricken withdrawals can essentially bankrupt a bank in no time. This can trigger systematic risk and leave the entire economy shaken. The banks need to monitor their asset liability management statistics because any mismanagement can lead to bank runs or cash shortages.
For these problems, central banks require of commercial banks to insure their deposits and provide them with liquidity support. By providing liquidity support central banks regulate the money market and injecting cash in the economy when demanded. These solutions in effect can lead to other problems. For example, in insured deposits, depositors stop monitoring a bank’s performance and the banks increase their risk appetite by increasing lending. To address this issue the central bank requires banks to maintain a minimum capital adequacy ratio, and regulate insurance premiums to be proportional to the risk of a bank’s lending. However, recent stats suggest that capital adequacy is not a safe determinant to monitor banking sector. Commercial banks start to over rely on central bank’s liquidity support and tend to lend high premium loans to institutions with lower credit ratings. Even if such lending results in volatility in the money market such variations are small compared to the bank’s capital.
Central banks need to be proactive rather than be reactive because the public cost of economic instability and high interest rates is too high. Even the Basel 2 agreement addresses risk capital framework but does not address provisioning for funding shortages. The emphasis should be on liquidity rather than on solvency alone. Therefore, commercial banks need to be scrutinized through stricter prudential regulations.
We find that banks have a comparative advantage in hedging liquidity risk in the economy because banks experience deposit inflows following a market crisis or liquidity shock that allow them to have more funds to provide the additional loans drawn down under commitments at such times. Banks should manage market access. Each bank should periodically review its efforts to establish and maintain relationships with liability holders, to maintain the diversification of liabilities, and aim to ensure its capacity to sell assets. In addition, banks should have contingency plans in place that address the strategy for handling liquidity crises and which include procedures for making up cash flow shortfalls in emergency situations. Moreover, banks should manage their foreign currency liquidity. Banks must be able to track and evaluate their current and anticipated liquidity position and capacity. The most successful banks create objective targets for each liquidity measure, which often have multi-level trigger points, to maximize their liquidity position. As such, because banks vary widely in their funding needs, no one set of universally applicable liquidity measures or targets can be applied to all institutions.
If a business has a monopoly or pollutes, the general consensus is that government should step in. However, that is not the only reason government intervention should be sought as examined in the article “When to bail out” from the Economist. Commercial banks could be just as dangerous and vulnerable as they are the pillars to the economy. Their vulnerability lies in the difference between liquid debt and illiquid assets. Whereas deposits withdrawn can be converted to cash on point, loans to homes and businesses are not afforded this ease. Also, holding any liquid assets would take away from what could have been used as investment leading to cash shortages.
Deposit insurance was created to lessen the problems that come with bank runs. This keeps people from running to the bank and withdrawing their money in panic. However, deposit insurance produces trust that in turn, leaves little reason to check on the banks. Banks will be able to make more risky loans considering that the insurers are accountable. Depending on how risky a loan is, an insurance premium is charged, but often, limits on the bank’s assets are put in place to stimulate capital growth. Banks can also fall back on the Federal Reserve to provide enough capital to cover their expected losses. However, the bank’s over reliance on the Federal Reserve was made all too clear with interest rates rising. For the central banks to stop these effects, they would risk hurting the economy. If any bigger shocks occur, the government would have to intervene proportionately.
The banks are happy to offer up loans to people with bad credit at an adjustable rate. The payments due started out low, but rose with time and borrowers defaulted. People who are evil or stupid can be blamed for this sub-prime mortgage mess or maybe it’s the Fed’s fault. With the money supply increasing, interest rates also grew, causing output to fall and unemployment increased. Home prices fell, because mortgages shut down. In the loanable funds market, investment and interest rates went down. The Fed’s could raise the money supply to lower the interest rate, but there is the danger that the reserve ratio may keep going up. Taxes could be lowered, but if the marginal propensity to consume were already low, then there would be little effect, because people are scared. The solution lies in determining and monitoring if banks have enough liquidity.
The article states there are good reason when government should regulate or tax markets or industries which may exist as a monopoly, and when there is no market price (ie pollution) or when there is some ”other” reason when the state must act. Although banks do not have these circumstances, they do have power and yet have fragility. Bernanke wrote a paper stating the bank failure where a cause for the severity and length of the Great Depression. Their mixture of liquid debt and illiquid assets creates this weakness and the more reason for them to be supervised. Another issue for banks is the difficulty of predicting the demand for money which comes into play when there are profitable investments versus having sufficient funds to supply the money demand. This has caused regulators to impose the deposit insurance (to mitigate bank runs). Although this remedy brings a level of security to the access of fund for customer, this creates little incentive on the customer to monitor the dealing of the bank. The deposit insurance also creates an incentive for banks to take excessive risk as the risks have shifted to the insurers. The article proposes to change insurance premiums reflective of the bank’s lending practices (level of riskiness). Another solution is to force them to increase their capital holdings if they make risky loans. The objective is to keep banks solvent by ensuring that banks have enough capital to cover expected losses. The credit crisis of late exposed the banks philosophy of holding not enough capital and extend credits when the situations arose, which added more risks. They did this on the belief that the central banks would provide liquidity when in a pinch. The issue here is that this market dynamic puts to little penalties on the risks taken by banks and adds a disproportionate cost to the consumer through instability and high interest rates. The recent problems in the sub-prime market created a huge shock to the financial market although the potential losses where small relative to the banks’ capital. The Basel 2 agreement looks at the risk-capital framework and regulation is suggested to focus more heavily on the liquidity than solvency. Raghuram Rajan remarks that the recent crisis has put focus on the liquidity issue and likely has set the benchmark for future monitoring.
Important economic topics discussed in this article are the relationship of the Fed to banks to ensure market stability for consumers and the unanticipated consequences of federal intervention. We learned that the Fed regulates the reserve ratio so that banks maintain a certain percentage of capital in reserve and the balance goes to loans. This RR provides stability in the market if there were a run on the banks for currency. Although this function helps the Fed regulate currency and market activity, it also serves as the limiting factor for banks and their investment capacity. Since the Great Depression, the Fed have tried to be more proactive in the market, but this philosophy have made the banks more dependent on this security blanket (ie Fed’s bail-out propensity), which has resulted in the detriment of the consumer. Although their market interventions were to provide security of the market and thus benefit the consumer, it has lead to more risk taking activities, which in the end, the consumer pays for.
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