Tutorial 3 - answers

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Apr 3, 2024

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THE AUSTRALIAN NATIONAL UNIVERSITY School of Finance, Actuarial Studies and Applied Statistics College of Business and Economics Financial Intermediation and Debt Markets Tutorial 3 - answers Question 1 What is moral hazard? How did the fixed-rate deposit insurance program of the FDIC contribute to the moral hazard problem of the savings association industry? What other changes in the savings association environment during the 1980s encouraged the developing instability of the industry? How does a risk-based insurance program solve the moral hazard problem of excessive risk taking by FIs? Is an actuarially fair premium for deposit insurance always consistent with the social goal of equal access to financial services? How does the US deposit insurance system differ from Australia’s? What are your opinions regarding the current Australian system? What changes might you make if you were asked to? Solution Moral hazard occurs in the depository institution industry when the provision of deposit insurance or other liability guarantees encourages the institution to accept asset risks that are greater than the risks that would have been accepted without such liability insurance. The fixed-rate deposit insurance administered by the FDIC created a moral hazard problem because it did not differentiate between the activities of risky and conservative lending institutions. Consequently, during periods of rising interest rates, savings associations holding fixed-rate assets were finding it increasingly difficult to obtain funds at lower rates. Since the deposits were insured, managers found it easier to engage in risky ventures in order to offset the losses on their fixed-rate loans. In addition, as the number of failures increased in the 1980s, regulators became reluctant to close down savings associations because the fund was being slowly depleted. The combination of excessive risk-taking together with a forbearance policy followed by the regulators led to the savings association industry crisis. A risk-based insurance program should deter banks from engaging in excessive risk- taking as long as it is priced in an actuarially fair manner. Such pricing currently is being practiced by insurance firms in the property-casualty sector. However, since the failure of commercial banks can have significant social costs, regulators have a special responsibility towards maintaining their solvency, even providing them with some form of subsidies. In a completely free market system, it is possible that DIs located in sparsely populated areas may have to pay extremely high premiums to compensate for a lack of diversification or investment opportunities. These DIs may have to close down unless

subsidized by the regulators. Thus, a strictly risk-based insurance system may not be compatible with the social goal of equal access to financial services. The key difference between the Australian and US schemes today is that Australian banks do not pay for the insurance they receive. The Australian scheme was hastily implemented in the middle of the GFC and so the policy parameters were not well thought out. We have seen the problems that underpriced or miss-prices insurance can cause and so free insurance (from a moral hazard point of view) is not a very good idea. The most obvious change is that one should introduce risk-based pricing of deposit insurance for our banks, collect the fees and set up a fund to manage the premiums. The other concern is that because there are no fees collected, the scheme is totally unfunded which means if a failure were to occur that then Treasure (i.e. tax-payer) will have to pay for the losses. Not an ideal situation. Question 2 Read the articles “Too big to fail, so why have deposit insurance?” and “Deposit insurance can’t handle large bank failures” and answer the following questions. a. Explain why the failure of a large institution is problematic for a deposit insurance fund. Large institutions have lots of deposits! So the failure of one large institution is the same a many small institutions at the same time. The CBA for example has about 20% of all Australian deposits so if it fails this might pose a big problem. Deposit insurance funds only have a limited amount of money available so large losses can drain the fund of all its reserves and then it will have to start selling assets. The sale of assets could lead to losses and send the fund itself broke. We saw this with the FSLIC in the US. b. How does the solution the Indian regulators came up with to handle Yes Bank’s failure get around this problem? Indian regulators orchestrated a bailout of Yes bank. A government owned bank SBI recapitalized Yes bank meaning that it is no longer in default. c. What other problems can the solution identified in (b) create for regulators? Well. Yes bank is a big bank. And bailing out a big bank creates the “too big to fail” problem and its associated costs. One of these costs in the moral hazard problem that is created. Question 3 Read the article “What negative interest rates mean for savers and investors” below and answer the following questions:

a. We learnt in class that banks are typically short-funded implying that they are exposed to rising interest rates. Why then, do most commentators believe progressively negative interest rates is a problem for banks? This sentence from the article highlights the problem: “One fear that experts have regarding negative deposit rates is that customers could try to pull their cash out of “costly” banks and store it under the “free” mattress.” If banks fear this, then they will not (and have not as yet) passed on negative interest rates to their depositors. Negative rates then will have a negative effect on profitability since banks do not charge depositors to deposit money with them however, the central bank changes the banks for any exces reserves they may have (which is likely to be a lot given no one wants to borrow). b. Given you answer in (a), is the risk to banks from progressively negative interest rates a cash-flow risk or market value (discount rate) risk? Explain your answer. From the discussion above, the problem appears to be a cash-flow effect rather than a discount rate/market value effect. The inability of banks to change depositors to deposit while at the same time having to pay to deposit reserves at the central banks implies a negative cash-flow effect. The effect on market equity value seems to be an unlikely channel since negative rates reduces the discount rate and this reduction is larger for long-dated assets so one might expect asset values to rise by more than liabilities resulting in a rise in equity value. So here, we have a situation where the cash-flow effect works in the opposite direction as the market value effect. The fact that commentators have stated negative rates are a big problem for banks implies they must view the cash- flow effect to dominate. c. What is the one other major risk you think that banks face due to progressively negative rates? Be sure to provide justification for your answer. “One fear that experts have regarding negative deposit rates is that customers could try to pull their cash out of “costly” banks and store it under the “free” mattress….So far we haven’t observed a significant withdrawal from bank accounts within the nine negative rate countries, as banks have not passed their negative rates onto individual customers. However, some large corporate clients are getting charged for big balances; as such negative rates will continue to induce these companies to make new investments, or merely use cash to buy back outstanding stock or debt, or even buy other companies” The paragraph above from the article highlight a potential problem related to liquidity risk. If banks pass on the costs to retail depositors or if corporate depositors get sick of paying to park money at their bank, we might see a drain on deposits leading to a funding problem for banks. Funding and liquidity risks might also arise in the wholesale market due to the impact negative rates are predicted to have on bank cash flow. One example we’ve discussed in class is the cost of funding using hybrids like CoCos. Since lower profitability increases the risk that coupon payments may be missed for these

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instruments, investors have sold off CoCos leading to a spike in yields. Funding problems further compound the problems for banks.

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Related Questions

What are the possible arguments for setting up a firewall between investment banks and commercial banks? Do you think a firewall between investment banks and commercial banks can prevent a financial crisis like the subprime loan crisis? Elaborate your answers

QUESTION 4 The following is true of deposit insurance, except Depositor no longer has incentives to monitor the activities of the bank Moral hazard dissuades the bank manager from taking risky projects In theory, regulators have replaced depositors in the monitoring of banks Moral hazard encourages the bank manager to take on risky projects

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Which one is not an incentive for a bank to securitize its mortgage loans? Reduce insurance premium paid to FDIC Meet the regulations on equity capital adequacy Increase the duration of the bank's asset portfolio Reduce the bank's illiquidity exposure hich one is not an incentive for a bank to Securitize its mortgage loans? A Reduce insurance premium paid to FDIC B Meet the regulations on equity capital adequacy Increase the duration of the bank's asset portfolio Reduce the bank's illiquidity exposure

The following is true of deposit insurance, except a Depositor no longer has incentives to monitor the activities of the bank b Moral hazard dissuades the bank manager from taking risky projects c In theory, regulators have replaced depositors in the monitoring of banks d Moral hazard encourages the bank manager to take on risky projects

Which innovation has caused the most trouble for financial institutions that issue residential mortgage loans? A. Securitization B. Junk bonds C. Commercial paper D. None of the above

Deposit Insurance a. depositor indifference generates a moral hazard problem that encourages banks to engage in risky activities b. exists only in the USA, not in the oer countries. c. It is a privately owned insurance company. d. successfully helped US to overcome the problems in 1980's S&L crisis and 2008 Financial Crisis.

What risks might commercial bank operations face by funding long-term loans such as mortgages to borrowers (often at fixed interest rates) with short-term deposits from savers? What steps could the financial institution take to reduce these risks?

hich one is not an incentive for a bank to Securitize its mortgage loans? A) Reduce insurance premium paid to FDIC B Meet the regulations on equity capital adequacy Increase the duration of the bank's asset portfolio D Reduce the bank's illiquidity exposure

Why were credit unions less affected by the sharp increase in interest rates in the late 1970s and early 1980s than the saving institution industry? What are the three types of finance companies and how do they differ from commercial banks?

What are the advantages and disadvantages of direct lending for the bank? How are banks reducing the effect of the disadvantages?

Which of the following has caused banks difficulty in estimating liquidity needs?A. competition for loans from other financial institutionsB. deregulation of interest rate ceilings on depositsC. competition for loans from nonfinancial institutionsD. a, b, and c

What is evergreening in banking and why it may arise as an equilibrium choice of banks. Carefully explain all relevant concepts and mechanisms. Additionally discuss how much of a problem this may present in the aftermath of a banking crisis.

The policy that requires regulator intervention when ____, and it was bank capital falls too low is introduced by the prompt corrective action; Financial Services Modernization Act of 1999 FDIC insurance; FDIC Improvement Act of 1991 prompt corrective action; FDIC Improvement Act of 1991 FDIC insurance; Financial Services Modernization Act of 1999

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Problem 1 Does the lender of last resort function of central banks introduce moral hazard into the financial system? Explain. Briefly explain why central bank independence can be a solution to the time- inconsistency problem. What is shadow banking and what was its role in the financial crisis of 2007-2009?

What bank regulations are designed to reduce moral hazard problems created by deposit insurance? Willthey eliminate the moral hazard problem?

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