Liquidity, financial crises and the lender of last resort – How much of a departure is the sub-prime crisis?

Liquidity risks are endemic to banks, given the maturity transformation they undertake. This gives rise to risk of bank runs, the first line of defence against which should be appropriate liquidity policy of banks. Nonetheless, solvent banks can face liquidity difficulties at times of stress, necessitating liquidity support. The traditional role of the lender of last resort (LOLR) is to avoid unnecessary failures that could threaten systemic stability, while ensuring that there are suitable safeguards for central bank balance sheets and that moral hazard is minimised. The sub-prime crisis has shown that traditional models of bank liquidity risk and of LOLR require revision, as was already apparent to a lesser extent in the Russia/LTCM episode. Funding risk now interacts with market liquidity risk, to create difficult challenges for central banks. The LOLR has had to adapt radically, for example, in terms of lending to investment banks, taking lower quality collateral and lending for longer maturities. Central banks have also been challenged by difficulties in maintaining confidentiality of support and by the interaction of these problems with low levels of deposit insurance

The lender of last resort and liquidity provision: How much of a departure is the sub-prime crisis?

The traditional role of the lender of last resort (LOLR) is to avoid unnecessary bank failures that could threaten systemic stability, while ensuring that there are suitable safeguards for central bank balance sheets and that moral hazard is minimised. The sub-prime crisis has shown that traditional models of bank liquidity risk and of LOLR require revision, as was already apparent to a lesser extent in the Russia/LTCM episode. Funding risk now interacts with market liquidity risk, to create difficult challenges for central banks. Even in the relatively non-systemic period up to September 2008, the LOLR had to adapt radically, for example, in terms of lending to investment banks, taking lower quality collateral and lending for longer maturities. Central banks have also been challenged by difficulties in maintaining confidentiality of support and by the interaction of these problems with low levels of deposit insurance. Since September 2008, although action has mostly been in line with traditional approaches for systemic crises, there have been some further adaptations in line with the systemic nature of the crisis, notably by the Federal Reserve acting as market maker or investor of last resort in illiquid securities markets

Too Big to Fail: A Misguided Policy in Times of Financial Turmoil

The bailouts carried out by governments for large banks and other financial entities in the recent financial turbulence are often characterized as a Too-Big-To-Fail (TBTF) policy. Proponents of such a policy argue that preventing the failure of large banks (and possibly other financial and non-financial entities) is necessary to limit the impact that such a failure might have on other institutions or on the real economy. Opponents argue that while such a policy might seem attractive in the short run, even given the enormous financial cost to government associated with its intervention, the long-run costs are even larger and are almost always ignored, making TBTF a poor policy choice.Financial Services, too-big-to-fail (TBTF)

Essays on Risk Creation in the Banking Sector

This thesis consists of four essays exploring risk creation in the banking sector. The essays examine how conflicting interests can compromise the objectivity, judgment, and decision making of economic agents. Consequently, they may prioritize their personal or institutional interests over the best interests of others or the entire financial system. Chapter 2 delves into the conflict of interest that arises when a bank serves as an investor in the stock market. Chapter 3 revisits the discussion of the potential misalignment between sovereign incentives and the collective interests of the currency union, particularly in the bond market. Chapter 4 draws attention to a situation where regulations in the banking sector may be advantageous for a government in the sovereign bond market. Finally, Chapter 5 looks at the flip side of the coin, examining how banks may be susceptible to moral hazard concerns in their FX lending decisions, given that they do not fully bear the consequences of their actions

Banking and Financial Regulation

This chapter provides a basic overview of banking and financial regulation for the forthcoming Oxford Handbook of Law and Economics (Francesco Paris, ed.). Among other things, the chapter compares traditional and shadow banking and their regulation, differentiating “micro prudential” regulation (which focuses on protecting individual components of the financial system, such as banks) and “macro prudential” regulation (which focuses on protecting against systemic risk). The chapter also examines how regulation can help to correct market failures that undermine financial efficiency. In that context, it discusses, among other things, capital requirements, ring-fencing, and stress testing. Finally, the chapter examines how regulation can help to protect against systemic risk, including by addressing potential triggers of systemic risk (such as maturity transformation—the asset-liability mismatch that results from the short-term funding of long-term projects—and limited liability)

The New Basel Capital Framework and its implementation in the European Union

Following the adoption by the Basel Committee of new capital rules for banks, a process is now taking place in the EU to transpose the rules into Community law and, ultimately, into national legislation. This paper gives an overview of the main issues that relate to the EU implementation, mainly from the perspectives of financial stability and financial integration. Although the EU rules are to a large extent based on the texts of the Basel Committee, modifications have been introduced to account for the specific legal and institutional setting, as well as for some features of the European financial system. The paper gives an overview of these modifications and deals in greater detail with a number of selected topics: the monitoring of procyclicality, the role of the consolidating supervisor and the treatment of real estate lending and covered bonds. The paper concludes with an outlook for the future.Banks, Basel II, capital requirements, financial regulation, financial stability, financial supervision, risk management.

Revealing the Black Box of Pension Fund Behavior : An Empirical Analysis of Norwegian Pension Funds in a Reach-for-Yield Environment

After the financial crisis in 2008, low-interest rates, increased life expectancy, and falling birth rates have put pension funds under pressure. In response, pension funds have increased their allocation towards risky assets to meet their return guarantees (the basic interest rate). This thesis analyses the determinants of the asset allocation of Norwegian pension funds. Further, we examine how the increased allocation to risky assets has impacted their relative performance and solvency position. We provide evidence that the basic interest rate is an important determinant for the allocation to risky assets. Our results suggest that public and private funds react differently to a change in the basic interest rate. Moreover, our analysis showcase that funds with higher buffer capital tend to utilize their risk capacity by investing more in risky assets. Additionally, our evidence indicates that public funds outperform the benchmark when they reach for yield, compared to private funds. Furthermore, we have examined the solvency position of the funds. Our analysis suggests that the reach for yield has negatively impacted their solvency position, ceteris paribus. However, we find that the building of buffer capital has offset the negative effect of the increased risky allocation. Lastly, our analysis highlights that funds with an inadequate solvency position react to this by reaching for yield.nhhma

Regulatory developments in bank solvency, recovery and resolvability

Most of the amendments to prudential and resolution legislation introduced in the European Union (EU) in 2019 have already been implemented for credit institutions over the course of 2021. These include a broad set of measures aimed at reducing risks in the banking sector, boosting its strength and progressing towards the completion of the Banking Union. These risk mitigation measures give continuity to the substantial change in prudential rules carried out in 2013 in response to the shortcomings identified in the financial sector in the wake of the financial crisis and which prompted the adoption of the Basel III framework in the EU. They also give continuity to the resolution framework introduced in 2014 to ensure the orderly resolution of non-viable banks, minimising the repercussions of banking crises on the real economy, taxpayers and depositors. The fresh revision of European rules here at hand aims to make progress in the pass-through to European regulations of the internationally agreed reforms. It also aims to change certain aspects in light of the experience accumulated and the inefficiencies detected in the years during which the previous regulations were applied. This article reviews the most salient prudential and resolution measures introduced, presents some reforms that have already been rolled out and describes certain aspects that have not yet been addressed

The Irish Banking Crisis: Regulatory and Financial Stability Policy

This report to the Irish Minister for Finance by the Governor of the Central Bank describes the the performance of the respective functions of the Central Bank and Financial Regulator in the period 2003-8 in order to arrive at a fuller understanding of the root causes of the systemic failures that led to the need for extraordinary support from the State to the Irish banking system.Ireland banking crisis; financial crises; financial stability policy