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Banking and Finance EzyEconomics CPD June 2017

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EzyEducation Ltd
EzyEducation Ltd

A huge thank you to all of the teachers who attended our EzyEconomics CPD workshops in Bolton, London, Southampton and Worcester! Additional thanks must go to both Bolton School and RGS Worcester who kindly hosted us for two of these events. There was a dual focus to the workshops. They focused partly on exploring different perspectives of looking at two of the new content areas for the current specification: Behavioural Economics and Banking & Finance. The remainder of the workshops was spent discussing the power of digital platforms to support teaching and the various models used to achieve this. If you didn't manage to make it along then take a look at some of the slides used in the presentations here.

Education
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ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBanking and Finance Agenda Role of Financial Institutions Systemic Links Links with the Real Economy Functions Objectives Responsibilities Banking Regulation When Things Go Wrong Systemic Crises Real-World Application Iceland Case Study Greece Case Study
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBanks and FIs Borrowers (Deficit Units): • Large Amounts • Long-Term Payments • Fuel Purchases INCOME EXPENDITURE Financial Intermediary:Savers (Surplus Units): INCOME EXPENDITURE • Security • Liquid • Low Risk ASSET TRANSFORMATION FUNCTION CASH DEPOSITS LOANS ASSETS Profit = Interest Rate Spread Payment System Supplies Finance Insures against Risk Delegated Monitor:
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBanking is a Complex Business Banks and FIs Size No. of Clients Products Complexity Size Asset Values Products Complexity Leverage Leverage Commercial Activities Investment Activities
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsImportance of Bank Capital Credit Risk Market Risk Currency Risk Interest Rate Risk Liquidity Risk Operational Risk Sovereign Risk OBS Risk BANK CAPITAL BANK CAPITAL BANKCAPITAL BANKCAPITAL LOSSES LOSSES
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBank Performance: Credit Risk Bank Balance Sheet ASSETS Loans: - Households - Businesses - Banks Liquid Assets: - Cash - UK Gilts - CB Reserves LIABILITIES Deposits: - Sight Deposits - Time Deposits Debt: - Bond Sales Capital: - Equity - Profit Reserves Ezy Bank Capital Base acts as a Buffer Stock Loans = Risky Assets Uncreditworthy Borrowers Small Businesses Struggling Banks Loans Creditworthy Borrowers Large Businesses Safe Banks Ratio of Subprime Mortgages to Total Mortgages (%) Sub-Prime Mortgages Mortgage Default Rate
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsCredit Risk: Balance Sheet Solvency Bank Balance SheetSolvent Bank Insolvent Bank ASSETS Loans: - Households - Businesses - Banks Liquid Assets: - Cash - UK Gilts - CB Reserves LIABILITIES Deposits: - Sight Deposits - Time Deposits Debt: - Bond Sales Capital: - Equity - Profit Reserves ASSETS Risky Loans: - Households - Businesses - Banks Liquid Assets: - Cash - UK Gilts - CB Reserves LIABILITIES Deposits: - Sight Deposits - Time Deposits Debt: - Bond Sales Equity Capital Asset Losses Safe Loans: - Households - Businesses - Banks Capital: - Equity - Profit Reserves CAPITAL BASE ASSETS Risky Loans: - Households - Businesses - Banks Liquid Assets: - Cash - UK Gilts - CB Reserves LIABILITIES Deposits: - Sight Deposits - Time Deposits Debt: - Bond Sales Equity Capital Asset Losses Safe Loans: - Households - Businesses - Banks Capital: - Equity - Profit Reserves SHORTFALL Ezy BankEzy Bank Ezy Bank Capital Base acts as a Buffer Stock
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBank Performance: Liquidity Risk Balance Sheet ASSETS Loans: - Households - Businesses - Banks Liquid Assets: - Cash - UK Gilts - CB Reserves LIABILITIES Withdrawals: - Depositors - Investors Debt: - Bond Sales Capital: - Equity - Profit Reserves Ezy Bank Deposits: - Sight Deposits - Time Deposits Minimise Liquidity Mismatch Govt. Bonds Liquidity Trade-Off: CASH Liquidity support provided by secondary market Mortgage Return Liquidity Return Liquidity Pleases Depositors Pleases Shareholders
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBank Performance: Liquidity Risk Balance SheetSolvent Bank Insolvent Bank ASSETS Loans: - Households - Businesses - Banks Liquid Assets: - Cash - UK Gilts - CB Reserves LIABILITIES Withdrawals: - Depositors - Investors Debt: - Bond Sales Capital: - Equity - Profit Reserves Liquid Assets Withdrawals Liquid Assets Withdrawals Ezy BankEzy Bank Ezy Bank Deposits: - Sight Deposits - Time Deposits Minimise Liquidity Mismatch ASSETS Loans: - Households - Businesses - Banks Liquid Assets: - Cash - UK Gilts - CB Reserves LIABILITIES Withdrawals: - Depositors - Investors Debt: - Bond Sales Capital: - Equity - Profit Reserves Deposits: - Sight Deposits - Time Deposits Opportunity Cost ASSETS Loans: - Households - Businesses - Banks Liquid Assets: - Cash - UK Gilts - CB Reserves LIABILITIES Withdrawals: - Depositors - Investors Debt Capital: - Equity - Profit Reserves Deposits Liquidity Crisis
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsMaking Sense of the Balance Sheet Barclays Balance Sheet (2016): Liquid Assets Loans/Advances Tangible Assets Other Assets Total Investments Total Deposits Debt Securities Provisions Derivatives Other Liabilities
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsStylised Balance Sheets Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Total Loans Tangible Assets Other Assets 104 569 449 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Equity Capital Assets - Liabilities Provisions Other Liabilities 4 76 Barclays Balance Sheet (2016):
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsStylised Balance Sheets How leveraged is the bank? Total Liabilities + Equity 1,214 Barclays Balance Sheet (2016): Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Total Loans Tangible Assets Other Assets 104 569 449 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Equity Capital 72 Provisions Other Liabilities 4 76
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsStylised Balance Sheets Leverage Ratio £72bn £1,214bn x 100 Total Liabilities + Equity 1,214 Barclays Balance Sheet (2016): Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Total Loans Tangible Assets Other Assets 104 569 449 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Equity Capital 72 Provisions Other Liabilities 4 76
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsStylised Balance Sheets 5.93% Would not take much to go wrong! Total Liabilities + Equity 1,214 Barclays Balance Sheet (2016): Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Tangible Assets Other Assets 104 569 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Equity Capital 72 Provisions Other Liabilities 4 76 1,101.75 0 1,142 Leverage Ratio 25%Total Loans 44925% 336.75
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsStylised Balance Sheets Would have to start selling assets off at fire sale prices! Technically Insolvent! 25% Total Liabilities + Equity 1,214 Barclays Balance Sheet (2016): Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Total Loans Tangible Assets Other Assets 104 569 449 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Equity Capital 72 Provisions Other Liabilities 4 76 1,101.75 0 1,142 25% 336.75
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsStylised Balance Sheets Future of bank depends on timing of default events 25% Total Liabilities + Equity 1,214 Barclays Balance Sheet (2016): Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Total Loans Tangible Assets Other Assets 104 569 449 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Equity Capital 72 Provisions Other Liabilities 4 76 1,101.75 0 1,142 25% 336.75 Independent Events Short-Term Cover Simultaneous Events Insufficient Cover LR Performance Damaged
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsLeveraged Banks Expected Losses Past Data Diversify Loans Portfolio to Mitigate Credit Risk! Sophisticated Models Interest Rate Charged on Loans £1 lent out each to 100 people Model 5% default rate Expected Loss = £5 Interest Charged = £5/95 = 0.053 INTERPRETATION: A financial firm may determine an asset has a 5% one-month VaR of 3%.
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsUnexpected Losses - RBS 0 10000000 20000000 30000000 40000000 50000000 60000000 70000000 80000000 0.00 1000.00 2000.00 3000.00 4000.00 5000.00 6000.00 7000.00 8000.00 2007-01-02 2007-03-02 2007-05-02 2007-07-02 2007-09-02 2007-11-02 2008-01-02 2008-03-02 2008-05-02 2008-07-02 2008-09-02 2008-11-02 2009-01-02 2009-03-02 2009-05-02 2009-07-02 2009-09-02 2009-11-02 NumberofTrades RBSSharePrice(GBX) Volume Close Received a £45bn Rescue Package from government. £58bn accumulated RBS losses over nine years. ZOMBIE BANK!£7.8bn Credit Loss 2007 - €72bn Takeover Deal £2.4tn 2008 Assets Size £24bn Loss due to ABN Amro Unexpected Loss
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsCapital Resilience Major UK Banks’ Capital Ratios Source: Bank of England UK banks have built up their capital resilience over time. Means the banks are better prepared for a financial crash.
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsLiquidity Risk Barclays Balance Sheet (2016): Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Total Loans Tangible Assets Other Assets 104 569 449 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Provisions Other Liabilities 4 76 Does the bank hold sufficient liquidity? Total Liabilities + Equity 1,214 Equity Capital 72
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsLiquidity Risk Liquidity Coverage Ratio £104bn £472bn x 100 Barclays Balance Sheet (2016): Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Total Loans Tangible Assets Other Assets 104 569 449 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Provisions Other Liabilities 4 76 Total Liabilities + Equity 1,214 Equity Capital 72
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsLiquidity Risk 22% Liquidity Crisis if more than 22% of deposits withdrawn! Barclays Balance Sheet (2016): Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Total Loans Tangible Assets Other Assets 104 569 449 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Provisions Other Liabilities 4 76 Total Liabilities + Equity 1,214 Equity Capital 72Liquidity Coverage Ratio
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsStylised Liquidity + Capital Positions Improve LiquidityIncrease Capital BaseTypical Bank ASSETS Loans Liquid Assets LIABILITIES Short-Term Debt Long-Term Debt Capital Short-Term Debt Retired ASSETS Loans Liquid Assets LIABILITIES Short-Term Debt Long-Term Debt Capital Replace with Newly Issued Equity Liquidity Coverage Ratio Improves How can a bank directly improve their solvency chances? ASSETS Loans Liquid Assets LIABILITIES Wait for Illiquid Loans to Mature Purchase Liquid Assets e.g. Gilts Short-Term Debt Long-Term Debt Capital INDIRECT EFFECT Risk-Weighted Capital Ratio Improves INDIRECT EFFECT
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsSystemic Impacts US Bank Failures, 1934-2014 Source: FDIC The collapse of a single Bank may prompt a ‘run’ on other banks due to informational asymmetries. Opaque Balance Sheet
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsFinancial Contagion Impact of the Financial Sector on the Real Economy: Banks Stock Markets Currency Markets Bond Markets
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBanking and Finance Financial Stability Matters for an Economy: Confidence Levels Level of Savings Business Investment Debt Levels Asset Prices Consumer Spending Availability of Credit Trust in Institutions Interest Rates Inequality Competitiveness Living StandardsSYSTEMIC RISK!
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsReal-World Application Can feel like a dry and abstract topic for students: ICELAND GREECE Full Recovery Still Recovering Real-World Examples
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsReal-World Application ICELAND GREECE Full Recovery Still Recovering Financial Institutions Role of Central Banks Financial Regulation Austerity Measures Currency Crises Talking Points: Can feel like a dry and abstract topic for students: Real-World Examples
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsReal-World Application Principles can be applied to UK examples in an exam situation. ICELAND GREECE Full Recovery Still Recovering Can feel like a dry and abstract topic for students: Real-World Examples
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsIcelandic Financial Crisis Why is this such an interesting case to look at? Global Financial Crisis (’07 - ’08) Icelandic Banking Crisis (‘08) Icelandic Financial Crisis (’08 – ‘11) Political Change (‘12)
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsIcelandic Financial Crisis Where did it all begin? Pre-2002 Banks Publically-Owned High Corporation Tax Low Interest Rates Highly Regulated Difficult to Obtain Credit Post-2002 Banks Privatised Low Corporation Tax High Interest Rates Deregulation Capitalist Culture
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsIcelandic Financial Crisis 0 2 4 6 8 10 12 14 1995 1996 1997 1998 1999 2000 2001 Iceland US EZ UK Where did it all begin? Short-term Interest Rate SpreadPost-2002 Banks Privatised Low Corporation Tax High Interest Rates Deregulation Capitalist Culture
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsIcelandic Financial Crisis 0 2 4 6 8 10 12 1995 1996 1997 1998 1999 2000 2001 Iceland US EZ UK Where did it all begin? Long-term Interest Rate SpreadPost-2002 Banks Privatised Low Corporation Tax High Interest Rates Deregulation Capitalist Culture
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsCarry-Trade Opportunities Borrowed in Dollars The equity index in the Icelandic Stock Exchange increased more than 50% per year on average between 2003 and 2007. Converted to Krona Kr Bond AcquisitionsProfitable Opportunities Attractive Investment Proposition
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBalance Sheet Impact Kaupthing Landsbanki Glitnir Total Assets Three Largest Icelandic Banks (2007) IKR 3.7tn IKR 4.5tn IKR 4.1tn Harpa Concert Hall, Reykjavik Banks become more confident and reckless with their money. West Ham United Takeover
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBalance Sheet Impact Kaupthing Landsbanki Glitnir Total Assets Three Largest Icelandic Banks (2007) IKR 3.7tn IKR 4.5tn IKR 4.1tn Might not seem a problem… 2007 Icelandic GDP Banks Assets IKR 1.3tn 10 times GDP of Iceland
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsTrigger Point Annual Global GDP Growth Rate (%) -3 -2 -1 0 1 2 3 4 5 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 -8 -6 -4 -2 0 2 4 6 8 10 12 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Annual Iceland GDP Growth Rate (%)
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsRegulatory Concern Kaupthing Landsbanki Glitnir Total Assets Three Largest Icelandic Banks (2007) IKR 3.7tn IKR 4.5tn IKR 4.1tn 20 times the size of Icelandic State Budget! Regulatory Concern: Too Big To Fail Too Big To Save Banks debt value at 6 times Icelandic GDP
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsNegative Feedback Loop ECONOMIC RISK SKEPTICISM Interest Payments on loans soared to 300%. Iceland external debt rose to 7 times of Iceland GDP. Stock Market Collapsed by 85%. 80% of businesses technically bankrupt. 97% of the banking sector collapsed in three days. Icelandic Stock Market (ONX15) 50,000 savings deposits lost, 25% of mortgages defaulted on.
ezyeducation.co.uk1 1 3 Lender of the Last Resort Function not viable: $2.1bn Provide certainty to depositors Domestic Distress Foreign Distress Module 8 – International EconomicsIcelandic Meltdown
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsCrushed Ice Icelandic Krona per Euro: Increased Value of Dollar Denominated Debt Weaker Currency Higher Import Prices Higher Inflation Rate Annual CPI Inflation Rate 2007 5.07% 2008 12.59% 2009 12.19% Higher Interest Rates Consumer Spending Collapse Recession
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsGovernment Reaction CAPITAL CONTROLS Movements of capital to and from Iceland were banned without a license from central bank. Prevented any further destabilising currency swings. Kaupthing Landsbanki Glitnir New Old New Old New Old Debt carried over Debt carried over Debt carried over 16% capital ratio 16% capital ratio 16% capital ratio
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsTurn of the Icelandic Tide Current Account Balance (% of GDP) Source: Arion Research External Devaluation Effectively reduced wages by 50% making exports more competitive and imports more expensive. Weaker currency boosted exports volumes and tourism visitors! Current Account Improvement
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsEconomic Recovery -8 -6 -4 -2 0 2 4 6 2008 2009 2010 2011 2012 2013 2014 2015 Iceland Annual GDP Growth Rate (%) 2017 – Capital Controls Removed To help prevent export boom coming to an end. REPEAT CRISIS!
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsPolitical Movements Icelandic Pirate Party Set up in 2012 to satisfy wave of anti- establishment vote since financial crisis. Election Year Votes % of Vote Seats Won Cabinet Position 2013 9,647 5% 3/63 6th 2016 27,449 15% 10/63 3rd Founded by a former Wikileaks activist Appeal to young voters by turning polling stations into ‘Pokestops’
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsGreek Debt Cover-Up Greek Debt Crisis Sleight of Hand How Did it Work? Stability and Growth Pact (Deficit < 3% of GDP) Greek Government understated Greek debt and deficit levels. Greek State Railway Losses of +€1bn Employees > Users
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsGreek Debt Cover-Up Issued Shares Govt. Bought Shares Transaction rather than Expenditure Greek Debt Crisis Sleight of Hand How Did it Work? Stability and Growth Pact (Deficit < 3% of GDP) Greek Government understated Greek debt and deficit levels. Greek State Railway
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsDebt Impact Maastricht Treaty Reported Deficit Actual Deficit ≤ 3% of GDP 1.5% 8.3% What could they do? Borrowed, Borrowed, Borrowed… €9bn Cost
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBorrowing Costs 10-Year Greek Government Bond Yields, 2001-2009: Why could they borrow at this rate? Greece uses the single currency Locked into German Stability: LOW BORROWING COSTS
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsGreek Debt Revelation Investors became nervous: Economic Collapse: Budget Deficit and Public Debt to GDP (2009) Unemployment Rate
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsGreek Panic Bank Runs PANIC Rational Propensity to Run! Capital Controls - ATM withdrawals limited to €60 a day. 2,000 out of the 5,500 ATMs ran out of Euro banknotes on one day. During the crisis, €1bn withdrawn daily from banks.
ezyeducation.co.uk1 1 3 Stay Nash Equilibria Module 8 – International EconomicsGreek Panic Bank Runs PANIC Rational Propensity to Run! Run Stay Run (25, 25) (50, 0) Stay (0, 50) (110, 110) Bank Run Game 2x2 Payoff Matrix Table Depositor2 Depositor 1 Run Nash Equilibria
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsGreek Panic Extended Bank Holidays June 29th July 16th Bank Runs PANIC Rational Propensity to Run!
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsEmergency Measures Source: Press Reader Overnight Assistance
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsGreek Bailouts TROIKA - €110bn Bailout European Commission European Central Bank International Monetary Fund TAXATION INCREASES PUBLIC SECTOR CUTS SPENDING CUTS PRIVATISATIONBENEFIT PAYMENTS CUTS LABOUR MARKET REFORMS Greeks limited withdrawing €420 a week from their accounts. Aiming to achieve a budget surplus of 3.5% in 2018.
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsAusterity Measures Internal Devaluation Implementation of austerity measures to increase competitiveness. Could not devalue their own currency. These measures are said to have prolonged the crisis… Greek Household Consumption Spending, January 2007 = 100 Greek Household Holdings of Currency and Deposits (€bn) Source: FT Source: FT
ezyeducation.co.uk1 1 3 Module 8 – International EconomicsThe Big Picture Internal DevaluationExternal Devaluation PreventionCure Full Recovery Still Recovering What happens when it all goes wrong?

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Banking and Finance EzyEconomics CPD June 2017

  • 1. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBanking and Finance Agenda Role of Financial Institutions Systemic Links Links with the Real Economy Functions Objectives Responsibilities Banking Regulation When Things Go Wrong Systemic Crises Real-World Application Iceland Case Study Greece Case Study
  • 2. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBanks and FIs Borrowers (Deficit Units): • Large Amounts • Long-Term Payments • Fuel Purchases INCOME EXPENDITURE Financial Intermediary:Savers (Surplus Units): INCOME EXPENDITURE • Security • Liquid • Low Risk ASSET TRANSFORMATION FUNCTION CASH DEPOSITS LOANS ASSETS Profit = Interest Rate Spread Payment System Supplies Finance Insures against Risk Delegated Monitor:
  • 3. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBanking is a Complex Business Banks and FIs Size No. of Clients Products Complexity Size Asset Values Products Complexity Leverage Leverage Commercial Activities Investment Activities
  • 4. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsImportance of Bank Capital Credit Risk Market Risk Currency Risk Interest Rate Risk Liquidity Risk Operational Risk Sovereign Risk OBS Risk BANK CAPITAL BANK CAPITAL BANKCAPITAL BANKCAPITAL LOSSES LOSSES
  • 5. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBank Performance: Credit Risk Bank Balance Sheet ASSETS Loans: - Households - Businesses - Banks Liquid Assets: - Cash - UK Gilts - CB Reserves LIABILITIES Deposits: - Sight Deposits - Time Deposits Debt: - Bond Sales Capital: - Equity - Profit Reserves Ezy Bank Capital Base acts as a Buffer Stock Loans = Risky Assets Uncreditworthy Borrowers Small Businesses Struggling Banks Loans Creditworthy Borrowers Large Businesses Safe Banks Ratio of Subprime Mortgages to Total Mortgages (%) Sub-Prime Mortgages Mortgage Default Rate
  • 6. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsCredit Risk: Balance Sheet Solvency Bank Balance SheetSolvent Bank Insolvent Bank ASSETS Loans: - Households - Businesses - Banks Liquid Assets: - Cash - UK Gilts - CB Reserves LIABILITIES Deposits: - Sight Deposits - Time Deposits Debt: - Bond Sales Capital: - Equity - Profit Reserves ASSETS Risky Loans: - Households - Businesses - Banks Liquid Assets: - Cash - UK Gilts - CB Reserves LIABILITIES Deposits: - Sight Deposits - Time Deposits Debt: - Bond Sales Equity Capital Asset Losses Safe Loans: - Households - Businesses - Banks Capital: - Equity - Profit Reserves CAPITAL BASE ASSETS Risky Loans: - Households - Businesses - Banks Liquid Assets: - Cash - UK Gilts - CB Reserves LIABILITIES Deposits: - Sight Deposits - Time Deposits Debt: - Bond Sales Equity Capital Asset Losses Safe Loans: - Households - Businesses - Banks Capital: - Equity - Profit Reserves SHORTFALL Ezy BankEzy Bank Ezy Bank Capital Base acts as a Buffer Stock
  • 7. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBank Performance: Liquidity Risk Balance Sheet ASSETS Loans: - Households - Businesses - Banks Liquid Assets: - Cash - UK Gilts - CB Reserves LIABILITIES Withdrawals: - Depositors - Investors Debt: - Bond Sales Capital: - Equity - Profit Reserves Ezy Bank Deposits: - Sight Deposits - Time Deposits Minimise Liquidity Mismatch Govt. Bonds Liquidity Trade-Off: CASH Liquidity support provided by secondary market Mortgage Return Liquidity Return Liquidity Pleases Depositors Pleases Shareholders
  • 8. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBank Performance: Liquidity Risk Balance SheetSolvent Bank Insolvent Bank ASSETS Loans: - Households - Businesses - Banks Liquid Assets: - Cash - UK Gilts - CB Reserves LIABILITIES Withdrawals: - Depositors - Investors Debt: - Bond Sales Capital: - Equity - Profit Reserves Liquid Assets Withdrawals Liquid Assets Withdrawals Ezy BankEzy Bank Ezy Bank Deposits: - Sight Deposits - Time Deposits Minimise Liquidity Mismatch ASSETS Loans: - Households - Businesses - Banks Liquid Assets: - Cash - UK Gilts - CB Reserves LIABILITIES Withdrawals: - Depositors - Investors Debt: - Bond Sales Capital: - Equity - Profit Reserves Deposits: - Sight Deposits - Time Deposits Opportunity Cost ASSETS Loans: - Households - Businesses - Banks Liquid Assets: - Cash - UK Gilts - CB Reserves LIABILITIES Withdrawals: - Depositors - Investors Debt Capital: - Equity - Profit Reserves Deposits Liquidity Crisis
  • 9. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsMaking Sense of the Balance Sheet Barclays Balance Sheet (2016): Liquid Assets Loans/Advances Tangible Assets Other Assets Total Investments Total Deposits Debt Securities Provisions Derivatives Other Liabilities
  • 10. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsStylised Balance Sheets Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Total Loans Tangible Assets Other Assets 104 569 449 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Equity Capital Assets - Liabilities Provisions Other Liabilities 4 76 Barclays Balance Sheet (2016):
  • 11. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsStylised Balance Sheets How leveraged is the bank? Total Liabilities + Equity 1,214 Barclays Balance Sheet (2016): Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Total Loans Tangible Assets Other Assets 104 569 449 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Equity Capital 72 Provisions Other Liabilities 4 76
  • 12. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsStylised Balance Sheets Leverage Ratio £72bn £1,214bn x 100 Total Liabilities + Equity 1,214 Barclays Balance Sheet (2016): Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Total Loans Tangible Assets Other Assets 104 569 449 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Equity Capital 72 Provisions Other Liabilities 4 76
  • 13. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsStylised Balance Sheets 5.93% Would not take much to go wrong! Total Liabilities + Equity 1,214 Barclays Balance Sheet (2016): Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Tangible Assets Other Assets 104 569 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Equity Capital 72 Provisions Other Liabilities 4 76 1,101.75 0 1,142 Leverage Ratio 25%Total Loans 44925% 336.75
  • 14. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsStylised Balance Sheets Would have to start selling assets off at fire sale prices! Technically Insolvent! 25% Total Liabilities + Equity 1,214 Barclays Balance Sheet (2016): Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Total Loans Tangible Assets Other Assets 104 569 449 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Equity Capital 72 Provisions Other Liabilities 4 76 1,101.75 0 1,142 25% 336.75
  • 15. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsStylised Balance Sheets Future of bank depends on timing of default events 25% Total Liabilities + Equity 1,214 Barclays Balance Sheet (2016): Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Total Loans Tangible Assets Other Assets 104 569 449 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Equity Capital 72 Provisions Other Liabilities 4 76 1,101.75 0 1,142 25% 336.75 Independent Events Short-Term Cover Simultaneous Events Insufficient Cover LR Performance Damaged
  • 16. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsLeveraged Banks Expected Losses Past Data Diversify Loans Portfolio to Mitigate Credit Risk! Sophisticated Models Interest Rate Charged on Loans £1 lent out each to 100 people Model 5% default rate Expected Loss = £5 Interest Charged = £5/95 = 0.053 INTERPRETATION: A financial firm may determine an asset has a 5% one-month VaR of 3%.
  • 17. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsUnexpected Losses - RBS 0 10000000 20000000 30000000 40000000 50000000 60000000 70000000 80000000 0.00 1000.00 2000.00 3000.00 4000.00 5000.00 6000.00 7000.00 8000.00 2007-01-02 2007-03-02 2007-05-02 2007-07-02 2007-09-02 2007-11-02 2008-01-02 2008-03-02 2008-05-02 2008-07-02 2008-09-02 2008-11-02 2009-01-02 2009-03-02 2009-05-02 2009-07-02 2009-09-02 2009-11-02 NumberofTrades RBSSharePrice(GBX) Volume Close Received a £45bn Rescue Package from government. £58bn accumulated RBS losses over nine years. ZOMBIE BANK!£7.8bn Credit Loss 2007 - €72bn Takeover Deal £2.4tn 2008 Assets Size £24bn Loss due to ABN Amro Unexpected Loss
  • 18. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsCapital Resilience Major UK Banks’ Capital Ratios Source: Bank of England UK banks have built up their capital resilience over time. Means the banks are better prepared for a financial crash.
  • 19. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsLiquidity Risk Barclays Balance Sheet (2016): Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Total Loans Tangible Assets Other Assets 104 569 449 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Provisions Other Liabilities 4 76 Does the bank hold sufficient liquidity? Total Liabilities + Equity 1,214 Equity Capital 72
  • 20. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsLiquidity Risk Liquidity Coverage Ratio £104bn £472bn x 100 Barclays Balance Sheet (2016): Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Total Loans Tangible Assets Other Assets 104 569 449 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Provisions Other Liabilities 4 76 Total Liabilities + Equity 1,214 Equity Capital 72
  • 21. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsLiquidity Risk 22% Liquidity Crisis if more than 22% of deposits withdrawn! Barclays Balance Sheet (2016): Assets (£bn) Liabilities (£bn) Liquid Assets Total Investments Total Loans Tangible Assets Other Assets 104 569 449 3 89 TOTAL ASSETS 1,214 Total Deposits Debt Securities Derivatives 472 119 471 TOTAL LIABILITIES 1,142 Provisions Other Liabilities 4 76 Total Liabilities + Equity 1,214 Equity Capital 72Liquidity Coverage Ratio
  • 22. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsStylised Liquidity + Capital Positions Improve LiquidityIncrease Capital BaseTypical Bank ASSETS Loans Liquid Assets LIABILITIES Short-Term Debt Long-Term Debt Capital Short-Term Debt Retired ASSETS Loans Liquid Assets LIABILITIES Short-Term Debt Long-Term Debt Capital Replace with Newly Issued Equity Liquidity Coverage Ratio Improves How can a bank directly improve their solvency chances? ASSETS Loans Liquid Assets LIABILITIES Wait for Illiquid Loans to Mature Purchase Liquid Assets e.g. Gilts Short-Term Debt Long-Term Debt Capital INDIRECT EFFECT Risk-Weighted Capital Ratio Improves INDIRECT EFFECT
  • 23. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsSystemic Impacts US Bank Failures, 1934-2014 Source: FDIC The collapse of a single Bank may prompt a ‘run’ on other banks due to informational asymmetries. Opaque Balance Sheet
  • 24. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsFinancial Contagion Impact of the Financial Sector on the Real Economy: Banks Stock Markets Currency Markets Bond Markets
  • 25. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBanking and Finance Financial Stability Matters for an Economy: Confidence Levels Level of Savings Business Investment Debt Levels Asset Prices Consumer Spending Availability of Credit Trust in Institutions Interest Rates Inequality Competitiveness Living StandardsSYSTEMIC RISK!
  • 26. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsReal-World Application Can feel like a dry and abstract topic for students: ICELAND GREECE Full Recovery Still Recovering Real-World Examples
  • 27. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsReal-World Application ICELAND GREECE Full Recovery Still Recovering Financial Institutions Role of Central Banks Financial Regulation Austerity Measures Currency Crises Talking Points: Can feel like a dry and abstract topic for students: Real-World Examples
  • 28. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsReal-World Application Principles can be applied to UK examples in an exam situation. ICELAND GREECE Full Recovery Still Recovering Can feel like a dry and abstract topic for students: Real-World Examples
  • 29. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsIcelandic Financial Crisis Why is this such an interesting case to look at? Global Financial Crisis (’07 - ’08) Icelandic Banking Crisis (‘08) Icelandic Financial Crisis (’08 – ‘11) Political Change (‘12)
  • 30. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsIcelandic Financial Crisis Where did it all begin? Pre-2002 Banks Publically-Owned High Corporation Tax Low Interest Rates Highly Regulated Difficult to Obtain Credit Post-2002 Banks Privatised Low Corporation Tax High Interest Rates Deregulation Capitalist Culture
  • 31. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsIcelandic Financial Crisis 0 2 4 6 8 10 12 14 1995 1996 1997 1998 1999 2000 2001 Iceland US EZ UK Where did it all begin? Short-term Interest Rate SpreadPost-2002 Banks Privatised Low Corporation Tax High Interest Rates Deregulation Capitalist Culture
  • 32. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsIcelandic Financial Crisis 0 2 4 6 8 10 12 1995 1996 1997 1998 1999 2000 2001 Iceland US EZ UK Where did it all begin? Long-term Interest Rate SpreadPost-2002 Banks Privatised Low Corporation Tax High Interest Rates Deregulation Capitalist Culture
  • 33. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsCarry-Trade Opportunities Borrowed in Dollars The equity index in the Icelandic Stock Exchange increased more than 50% per year on average between 2003 and 2007. Converted to Krona Kr Bond AcquisitionsProfitable Opportunities Attractive Investment Proposition
  • 34. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBalance Sheet Impact Kaupthing Landsbanki Glitnir Total Assets Three Largest Icelandic Banks (2007) IKR 3.7tn IKR 4.5tn IKR 4.1tn Harpa Concert Hall, Reykjavik Banks become more confident and reckless with their money. West Ham United Takeover
  • 35. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBalance Sheet Impact Kaupthing Landsbanki Glitnir Total Assets Three Largest Icelandic Banks (2007) IKR 3.7tn IKR 4.5tn IKR 4.1tn Might not seem a problem… 2007 Icelandic GDP Banks Assets IKR 1.3tn 10 times GDP of Iceland
  • 36. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsTrigger Point Annual Global GDP Growth Rate (%) -3 -2 -1 0 1 2 3 4 5 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 -8 -6 -4 -2 0 2 4 6 8 10 12 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Annual Iceland GDP Growth Rate (%)
  • 37. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsRegulatory Concern Kaupthing Landsbanki Glitnir Total Assets Three Largest Icelandic Banks (2007) IKR 3.7tn IKR 4.5tn IKR 4.1tn 20 times the size of Icelandic State Budget! Regulatory Concern: Too Big To Fail Too Big To Save Banks debt value at 6 times Icelandic GDP
  • 38. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsNegative Feedback Loop ECONOMIC RISK SKEPTICISM Interest Payments on loans soared to 300%. Iceland external debt rose to 7 times of Iceland GDP. Stock Market Collapsed by 85%. 80% of businesses technically bankrupt. 97% of the banking sector collapsed in three days. Icelandic Stock Market (ONX15) 50,000 savings deposits lost, 25% of mortgages defaulted on.
  • 39. ezyeducation.co.uk1 1 3 Lender of the Last Resort Function not viable: $2.1bn Provide certainty to depositors Domestic Distress Foreign Distress Module 8 – International EconomicsIcelandic Meltdown
  • 40. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsCrushed Ice Icelandic Krona per Euro: Increased Value of Dollar Denominated Debt Weaker Currency Higher Import Prices Higher Inflation Rate Annual CPI Inflation Rate 2007 5.07% 2008 12.59% 2009 12.19% Higher Interest Rates Consumer Spending Collapse Recession
  • 41. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsGovernment Reaction CAPITAL CONTROLS Movements of capital to and from Iceland were banned without a license from central bank. Prevented any further destabilising currency swings. Kaupthing Landsbanki Glitnir New Old New Old New Old Debt carried over Debt carried over Debt carried over 16% capital ratio 16% capital ratio 16% capital ratio
  • 42. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsTurn of the Icelandic Tide Current Account Balance (% of GDP) Source: Arion Research External Devaluation Effectively reduced wages by 50% making exports more competitive and imports more expensive. Weaker currency boosted exports volumes and tourism visitors! Current Account Improvement
  • 43. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsEconomic Recovery -8 -6 -4 -2 0 2 4 6 2008 2009 2010 2011 2012 2013 2014 2015 Iceland Annual GDP Growth Rate (%) 2017 – Capital Controls Removed To help prevent export boom coming to an end. REPEAT CRISIS!
  • 44. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsPolitical Movements Icelandic Pirate Party Set up in 2012 to satisfy wave of anti- establishment vote since financial crisis. Election Year Votes % of Vote Seats Won Cabinet Position 2013 9,647 5% 3/63 6th 2016 27,449 15% 10/63 3rd Founded by a former Wikileaks activist Appeal to young voters by turning polling stations into ‘Pokestops’
  • 45. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsGreek Debt Cover-Up Greek Debt Crisis Sleight of Hand How Did it Work? Stability and Growth Pact (Deficit < 3% of GDP) Greek Government understated Greek debt and deficit levels. Greek State Railway Losses of +€1bn Employees > Users
  • 46. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsGreek Debt Cover-Up Issued Shares Govt. Bought Shares Transaction rather than Expenditure Greek Debt Crisis Sleight of Hand How Did it Work? Stability and Growth Pact (Deficit < 3% of GDP) Greek Government understated Greek debt and deficit levels. Greek State Railway
  • 47. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsDebt Impact Maastricht Treaty Reported Deficit Actual Deficit ≤ 3% of GDP 1.5% 8.3% What could they do? Borrowed, Borrowed, Borrowed… €9bn Cost
  • 48. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsBorrowing Costs 10-Year Greek Government Bond Yields, 2001-2009: Why could they borrow at this rate? Greece uses the single currency Locked into German Stability: LOW BORROWING COSTS
  • 49. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsGreek Debt Revelation Investors became nervous: Economic Collapse: Budget Deficit and Public Debt to GDP (2009) Unemployment Rate
  • 50. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsGreek Panic Bank Runs PANIC Rational Propensity to Run! Capital Controls - ATM withdrawals limited to €60 a day. 2,000 out of the 5,500 ATMs ran out of Euro banknotes on one day. During the crisis, €1bn withdrawn daily from banks.
  • 51. ezyeducation.co.uk1 1 3 Stay Nash Equilibria Module 8 – International EconomicsGreek Panic Bank Runs PANIC Rational Propensity to Run! Run Stay Run (25, 25) (50, 0) Stay (0, 50) (110, 110) Bank Run Game 2x2 Payoff Matrix Table Depositor2 Depositor 1 Run Nash Equilibria
  • 52. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsGreek Panic Extended Bank Holidays June 29th July 16th Bank Runs PANIC Rational Propensity to Run!
  • 53. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsEmergency Measures Source: Press Reader Overnight Assistance
  • 54. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsGreek Bailouts TROIKA - €110bn Bailout European Commission European Central Bank International Monetary Fund TAXATION INCREASES PUBLIC SECTOR CUTS SPENDING CUTS PRIVATISATIONBENEFIT PAYMENTS CUTS LABOUR MARKET REFORMS Greeks limited withdrawing €420 a week from their accounts. Aiming to achieve a budget surplus of 3.5% in 2018.
  • 55. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsAusterity Measures Internal Devaluation Implementation of austerity measures to increase competitiveness. Could not devalue their own currency. These measures are said to have prolonged the crisis… Greek Household Consumption Spending, January 2007 = 100 Greek Household Holdings of Currency and Deposits (€bn) Source: FT Source: FT
  • 56. ezyeducation.co.uk1 1 3 Module 8 – International EconomicsThe Big Picture Internal DevaluationExternal Devaluation PreventionCure Full Recovery Still Recovering What happens when it all goes wrong?