Econ 291 – Lecture #10
Presented by Joshua F. Boitnott, PhD
Expectations
• Before talking Financial Regulation, a bit about Bonds
Expectations
• We will focus on a 1-year bond versus a 2-year bond.
‐ We use the Net Present Value to calculate: 𝑃𝑉 1 + 𝑖𝑛 𝑛 = 𝐹𝑉
‐ In other words, given an interest rate and number of years, the price of a
𝐹𝑉
bond should be: 𝑃𝑛 =
𝑛
1+𝑖𝑛
• Why does this matter for expectations?
‐ The previous slide with the yield curve should that a 1-year bond with face
value of $100 had a price of P1 ≈ $95.48 (i.e. a yield of 4.77%).
‐ The slide also showed that a 2-year bond with a face value of $100 had a
price of P2 ≈ $88.59 (i.e. a yield of 4.12%)
Expectations
• There should not exist any continuing/meaningful opportunities for
arbitrage in a well function financial system
‐ That means that if I buy a 2-year bond and sell it next year, the price I get
𝑒
should be: 𝑃2 1 + 𝑖1 = 𝐸𝑡 𝑃1,𝑡+1 = 𝑃1,𝑡+1
‐ Given the face value of the two year bond was $100, that means the
100
𝑒
expected price should be: 𝑃1,𝑡+1 =
𝑒
(1+𝑖1,𝑡+1 )
‐ That means I could write the price of the 2-year bond with a face value of
100
$100 as: 𝑃2 =
𝑒
(1+𝑖1 )(1+𝑖1,𝑡+1 )
‐ No arbitrage means: P2 = P2 ⇒
100
1+𝑖2 2
=
100
𝑒
(1+𝑖1 )(1+𝑖1,𝑡+1
)
Expectations
• From the previous no arbitrage we get the following:
1 + 𝑖2
2
‐ We can simplify to get: 𝑖2 ≈
𝑒
= (1 + 𝑖1 )(1 + 𝑖1,𝑡+1
)
1
(𝑖
2 1
𝑒
+ 𝑖1,𝑡+1
)
𝑒
‐ Or: 𝑖1,𝑡+1
≈ 2𝑖2 − 𝑖1
‐ Households, firms, and governments can use this to show what the market
predicts will happen to future interest rates
𝑒
• For example, with 𝑖1 = 4.77% and 𝑖2 = 4.12%, then 𝑖1,𝑡+1
≈ 3.47% or lower nominal
interest rates in the future
• Alternatively: in January 1997 (Canadian data): 𝑖1 = 3.64% and 𝑖2 = 4.44%, then
𝑒
𝑖1,𝑡+1
≈ 5.24% or higher nominal interest rates in the future.
Financial Regulation
• In 2008/2009 there was a financial crisis that impacted the world
markets for finance.
‐ Often attributed to issues associated with the housing market, derivatives in
particular.
‐ How did derivatives work/what are they?
• Can generally thinks of them as a financial instrument that pays a certain rate of return
based on the bundle of mortgages included.
• In other words, since households will be paying interest on mortgages, the rate of return
is based on expected value of future interest payments.
• Not everyone pays back their mortgage, meaning there’s some risk of default; however,
bundle of mortgages was from different parts of US housing market (thought to be
diversified since different parts of US housing market do different things)
• Instead, issue of systematic risk due to all being in same country
Financial Regulation
• How can we think about pricing these derivatives?
Financial Regulation
• The derivatives were initially thought to be equally risky to
government issued bonds (i.e. AAA rating)
‐ However, there was a crash in the US housing market that cause the
percentage of people defaulting to increase substantially above expectation
‐ This resulted in firms that were holding these derivatives having an asset that
was less valuable than initially expected as the rate of return fell.
‐ Big challenge was issue of asymmetric information: what percentage of assets
were the derivatives for any particular bank (or other financial intermediary).
• Result of this uncertainty is increase in the Interest Rate Spread
• Interest Rate Spread is the gap between interest rates on risky loans and safer loans, or
the difference in interest rates at which some class of individuals/firms can lend and
borrow.
Financial Regulation
• This is data for the Interest
Rate Spreads for Canada
comparing corporate bonds
to government of Canada
bonds.
‐ Can see financial crisis effects
here.
‐ Means that access to credit is
less certain during a financial
crisis.
Financial Regulation
• Insolvencies at some banks reduce confidence in others, and
individuals with uninsured deposits withdraw their funds.
‐ To replace their shrinking reserves, banks must sell assets. Selling by many
banks causes steep price declines—called a fire sale.
• See similar things happen with bankruptcy where firms often pays bond holders pennies
on the dollar as selling all assets immediately means accepting any price.
‐ In 2008–2009, the collapse of investment banks Bear Stearns and Lehman
Brothers reduced confidence in other large institutions, many of which were
interdependent.
• Note: both Bear Stearns and Lehman Brothers are financial intermediaries and not
traditional banks (i.e. they were Shadow Banks).
Financial Regulation
• Shadow banks engage in financial intermediation and include
investment banks, hedge funds, private equity firms, and insurance
companies.
‐ Their deposits are not federally insured, so they are not heavily regulated like
traditional banks and can take on much more risk.
‐ Their failures can hurt the broader economy, so many policymakers suggest
limiting the risk they can take, increasing capital requirements for them, and
allowing more government oversight.
Financial Regulation
• Bubbles and Informational Cascades?
Financial Regulation
• During this time, the credit crunch and uncertainty hits everyone and
results in a fall of the aggregate demand.
‐ In other words, the result is a recession!
‐ This recession hits more than just financial institutions as the credit market is
important for all lenders and borrowers.
‐ Consider what this does for households and firms:
• Households become more reluctant to lend/invest as not clear who will be able to pay
you back
• Firms that want to borrow become more reluctant to borrow as cost of borrowing
increased substantially.
Financial Regulation
• One big issue is always how credit constrained are firms/households.
‐ To examine this idea, we will look at a household and make some simplifying
assumptions to think about a budget constraint between now and the future.
‐ Imagine you have income and taxes that are
known for this year and next.
‐ Suppose the interest rate you face for borrowing
differs from the interest rate for saving
‐ The result is a budget constraint that has a
point like E.
Financial Regulation
• Consider more extreme credit limitations for household such as no
borrowing today without collateral (i.e. pre-existing wealth)…
Financial Regulation
• How does/should a government deal with these issues?
‐ Suggestions from the OECD report in recommended readings:
1.
2.
3.
4.
5.
6.
Ensure public confidence in the financial system
Create systemic stability for the financial system (i.e. make it so less likely to have a
cascade of failed financial firms due to interdependence)
Ensure risk is managed prudently to create safety and soundness of financial
institutions
Implement greater amounts of transparency in the system and ensure fraud/abuse of
market power are quickly dealt with
Create safeguards for consumers and market participants
Try to make financial markets work efficiently and ensure risk s is properly reflected
Financial Regulation
• Note: the list from the OECD report is a set of policy goals.
‐ Different countries are likely to have different policy goals; however, the idea
was to highlight the most important aspects
‐ Additionally, the OECD report recognizes that different countries will have
different methods or responding to these types of concerns.
‐ This weeks reading focus on what was done in the US in response and how
some issues have not been fully sorted out.
Financial Regulation
• One success discussed in the paper was tiering:
‐ Placing requirements of “‘more stringent’ capital, liquidity, risk management,
and other standards for banking organizations with more than $50 billion in
assets, explicitly ‘to prevent or mitigate risks to the financial stability of the
United States’.”
• In other words, this tries to address those firms that would be a systemic risk to the
system if they collapsed and has more robust requirements.
• Notice the law changed in 2018 to $250 billion in assets, which moved Silicon Valley Bank
out of this group…
‐ Firms that are not in the top tier are still subject to stress testing to determine
if unusual financial events would cause the firms to fail.
‐ As well as “the so-called ‘Volcker Rule’ prohibition against a bank engaging in
proprietary trading.” Limits speculative investing by banks.
Financial Regulation
• The paper also discusses the success as related to risk management:
‐ The author claims there has been “a dramatic increase in the resiliency of the
prudentially regulated part of the financial system.”
‐ This is related to two different types of credit constraints that have been
imposed on financial institutions:
• Leverage ratio comparing equity to assets (Note: different from how the OFSI calculated
for Canada using assets to equity ratio)
• Risk-weighted capital ratio “is calculated by dividing bank capital by a dollar value of
assets, other exposures, and off-balance-sheet items that has been adjusted for the
perceived riskiness of each asset, determined on the basis of past experience.”
‐ Concern over if this causes efficient investment to not be undertaken is
legitimate as this does limit financial institutions.
Financial Regulation
• Finally, there has been a move to more orderly resolution of a
financial institution being bankrupt (or likely to be bankrupt).
‐ The author claims the three large benefits would be:
1.
2.
3.
“the moral hazard issue of financial firms taking on excessive risk in the expectation of
a government bailout would be substantially contained;”
“crisis amplification effects arising from the prospect of serial failures would be
limited;”
“and taxpayer bailouts would be averted.”
‐ In other words, this would reduce issue of moral hazard, reduce concerns
over cascade of failures, and not have the negative consequences be paid via
taxes.
Financial Regulation
• The author also points to some concerns, despite being 10 years later.
These concerns include:
‐ Fact that financial regulations had not be finalized despite law being passed in
2010.
‐ Created a large number of regulatory agencies with a large amount of
discretion in applications of the law.
‐ Concerns over the Shadow Banking system with regulatory agency having
very little it can do
‐ Issues of Liquidity Regulation are limited to large banks via liquidity-deposit
ratio from stress testing (30-day self reliance)
Final
• Match midterm, but longer
• I’ll get exact numbers soon, but 6-7 True/False and 4-5 Short Answer
Questions.