Finance Question

The assets that have been deemed to be safe for the purpose of calculations of capital requirements have been considered as one of the sources of the financial crisis. The assets those have relatively low risk and have high liquidity and that have a ready market for trading of such assets are considered safe assets. These assets include government bonds, collateralized debt obligations, land etc. These safe assets act as collateral against the loans taken by individuals or big corporate. Various reasons have been identified for the financial crisis. One of the reasons for the crisis is increased mortgage loan default which is referred to as sub-prime loans.

In USA, the loans were liberalized so that the poor could become homeowners. With this, the demand for property increased which in turn increased the value of the property. This property was considered as a safe asset and thus more loans could be issued. Further the bank policies were liberalized to grant more loans. Thus, higher loans could be given for this inflated value of the assets. However as this bubble burst all the loans that were granted could not be recovered as the property that was considered as collateral could not recover the loans. During this period of crisis in USA Lehman Brothers, one of the most reputed bank in USA, filed bankruptcy. The company was a major player in the mortgage market of USA. Consequently with the advent of crisis in 2007, the company witnessed huge default on the loans that were extended. Consequently the earnings of the bank reduced which finally resulted in erosion of wealth of the bank which led to filing of bankruptcy by the bank.

Second example of the failure of the safe assets is that of Eurozone. In 2011, most of the assets of the US prime money market funds were invested in the commercial papers issued by the banks in Europe which were dominated by the US dollar. With the increase in the Eurozone debt crisis, the value of most of these assets has been eroded. One of the examples of the company, which were affected by the Eurozone debt crisis, is Dexia. The firm had around 3.4 billion euros of exposure to Greek government bonds. The company also had 17.5 billion euros of exposure to sovereign debt other troubled economies such as Italy, Spain and Portugal. Dexia became the first bank to fail and it was evidently sunk by its holding of European sovereign debt, especially the Greek bonds. The bank was supported by the bailout by the government of Belgium, France and Luxembourg.

The above two instances clearly highlight the issues i.e. too much leverage in the safe assets and neglecting the effect of policies. Thus, it can be said that the policies world over to boost the economy has led to increased concentration on utilizing the safe assets. However, as discussed above, this has backfired in two cases.

Curse of Zombies

The return and risk for banks in under-capitalized and well-capitalized economies do vary a lot. The banks may be exposed to two types of risks. These are risk exposure taken up by banks and the regulatory risks. According to Proto (2007), the risk and return in undercapitalized economies is on the higher side. This is to say that the return is dependent on the investment made by the banks and that since the sector is under-capitalized or illiquid in order to increase the returns the investment is made in the risky propositions. The similar is the case of investments of banks in Italy and Spain wherein the financial crisis of 2007-08 in these countries led to problems through excessive risk taking. Second aspect is that restoring the capitalization of banks up to regulatory requirements if the regulatory risks become out of sync. Thus, overall the two kinds of risk that has a huge impact on the returns. The above discussion clearly highlights that the probability of risks increase and the levels of returns are higher in under-capitalized banking sectors.

In case of well-capitalized banking sectors, the risks are low and at the same time due to high level of market competition the return is also low. Also, the role of government in case of well-capitalized banking sectors is significant after the financial crisis as happened in the year 2007-08. Following the financial crisis in 2008 in USA, bankruptcy was filed by Lehman brothers. However with the government intervention and support the sector was provided necessary buffer and thus brought in the stabilization. Thus, the risks in case of well-capitalized banking sector are more related to the market and not the regulatory and illiquidity in the market.

Leaving banking sectors under-capitalized after a crisis leads to delayed recoveries. For example in the year 2008, after the financial crisis, that fundamental reforms will be there for the emerging economies as agreed by twenty governments of industrialized and emerging economies. However it has been viewed that apart from this many banks in Europe faced issues with refinancing. Thus, such delayed recoveries of the banks have led to negative growth of the companies. The growth of the countries in Europe, such as Greece, would have been better if the recovery was faster and refinancing would have been there.

Market versus Book

Market based measures of leverage and volatility helps in better prediction of the distress than book based measures. According to Choi and Richardson, equity volatility possess transitory component apart from permanent component. This transitory component can be provided by the market based measures rather than book based. Secondly according to the article by Correia et. al. (2013), it has been observed that market based measures highlight systematic sources of volatility. Thus, it has been used widely to identify the market factors that have a major impact on the leverage and volatility. Thirdly it the market based measures that provide necessary insight on the ability of the asset to generate future cash flows irrespective of the book value of the asset. Thus, the market based measures are helpful in identifying the transitory component of volatility and leverage, highlight the market factors as a result of systematic sources of volatility and finally the ability to generate future cash flows.

Volatility and Stress

A phase of 5-6 quarters of recovery is there following initial 2-3 quarters of severe stress for the financial sectors being stress-tested. This lead to bias as far as regulatory assessments of the financial sector health is concerned. This bias may be linked to the judgmental bias or errors of omission in assuming the recovery phase. This is to say that in order to avoid the variations in the probability of the event to occur certain omissions may be made. These omissions may lead to errors which may have a huge influence on the stress testing and thus would need to be observed.

Further according to the reports published by the Committee of European Banking Supervisors, there are limitations of stress testing which may lead to incorrect testing as a result of omission of certain factors that may have a major influence at a different point of time. This is to say that factor that has been omitted may have higher implications at different interval which might not have been there at the time it was omitted.

Volcker Rule

The Volcker rule implies trading restrictions that are placed on the financial institutions and thus prohibiting banks from entering into advisory and credit role with clients. Thus, it prevents banks from making speculative bets and thus resulting in risk to the customers. Further, it protects individual by not allowing banks to trade on their behalf and thus provide more transparent financial framework which can be regulated relatively easier.

On the other hand, various scholars have argued that Volcker rule comes in with some cost. According to Sorkin (2012), there are certain provisions in Volcker rule which could prevent banks from helping clients in the purchase and sale of foreign sovereign bonds and thus borrowing cost for foreign countries would increase. Further, it will be the responsibility of the banks to prove that there is no involvement of banks in such activities. Overall the profitability of the banks and the liquidity in the market would be impacted as a result of this. According to the report by PWC (2013), certain changes have been made and exclude foreign public funds and also certain loan securitization vehicles. This change is quite welcome as it creates parity between US and global funds and at the same time provides relief for collateralized loan obligations. In order to comply with the rule the discretionary power of regulators will have to be used wisely and on part of banks strong, well documented processes would be required to prove the case.

Financial Backstops

The fiscal backstops refer to last resort support provided to the banks. This fiscal backstop would be very important and will be the cornerstone in enhancing the effectiveness of the review. Firstly it will act as common financing mechanism for restructuring and resolution. Further this fiscal backstop will act as the first step for the restructuring that has been planned. Carletti (2012) highlights that fiscal backstop is required for bank union as it will reduce the overlap between the national and European competencies. It will also result in shielding taxpayers as the money from taxpayers will not be used to support distressed banks. Thus, financial backstop is one of the elements towards the European Banking and fiscal union. In the absence of financial backstop, the institutional setup would be unable to withstand the crisis that has been witnessed earlier and thus leading to the economic slowdown and huge impact on the tax payers.

The advantage of fiscal backstop will be greater than that of deposit guarantee scheme as such schemes consume considerable time and political capital that has very limited benefit associated with it as compared to fiscal backstops. This is to say that in the absence of fiscal backstop, the role of bank union as planned by European Central Bank will be limited, and the governments would still be looked upon to guarantee the deposits made in national banks.

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