Essays on Financial markets

The instability of the banking system and banking panics can be attributed to the institutional source of systemic risk, which is based on at least two reasons. The first follows from the model of banks as financial intermediaries that convert short-term liabilities into long-term loans, based on the assumption that not all account holders will use their right of withdrawal of funds. However, this assumption is no longer valid when the depositors, fearing for the safety of their money, tend to urgently recover their deposits. The second reason stems from the banking panic of the first and is for informational purposes. (Rosemberg, 2008)

Failure of one bank to meet its obligations could lead to “escape” of depositors from a number of banks and a series of bank failures due to lack of awareness of investors about the financial condition of the bank. It is believed that the system of guaranteeing the repayment of deposits “prevents” systemic risk, prevents the spread of panic through the system, if there are enough funds to meet the demands of depositors. (Williams, 2010)

In the financial market spread of systemic risk goes is associated with unexpected sale of assets, which greatly reduces their value. If these financial assets serve as collateral for interbank lending, which automatically leads to reduction in their quality and reduction in liquidity in the interbank market. Reduced market liquidity leads to an increase in interest rates in the credit market and cuts of active operations. In addition to external causes, the source of systemic risk may be internal problems of the financial sector. One such problem is a bubble of financial assets during the credit boom, which leads to an increase in imbalances in the financial sector and determines the “procyclicality” of the financial system. (Rosemberg, 2008)

The basis of the imbalances consists of the following reasons:

1) Tendency to similar behavior of market participants in financial markets leads to investments in instruments with similar risk profiles, based only on an analysis of the actions of other market participants. Check out smâlâ

2) Low interest rates in periods of credit “boom” encourage banks to take substantial risks and at the same time, increase the value of the collateral (due, for example, to the growth in property prices).

3) An increased level of borrowings and investments in the economy, resulting in increased rate of leverage (the ratio of capital to assets) in banks and other business entities.

4) The reason may be associated with mitigation of lending standards during the cycle due to the changing perceptions of investors (moral hazard).

The recent financial crisis has also demonstrated a lack of proper evaluation of the influence of a number of financial intermediaries in the systemic risk and financial stability. An example may be bankruptcy of investment bank Lehman Brothers. Despite that the bank was considered strong and “too big to fail”, in September 2008 it was decided not to save Lehman Brothers, that caused panic in the international financial markets. (Zhou 2010)

Financial crisis of 2008 has demonstrated the fact that the problem of “procyclicality” is present not only in the financial system, but also banks. In particular, the bankruptcy of British bank Northern Rock have revealed the presence of pro-cyclicality. This Bank before the crisis made assessment of the risk level of its assets and informed about the level of capital met the requirements of Basel, but also exceeded these requirements. Northern Rock announced an increase in the amount of dividends by 30%, the payment of which was planned in October 2007. However, the losses incurred by the bank in June 2007 led to a decrease in the cost of equity capital, the bank’s capital levels fall to a record 10,2%, and dividend payments were cancelled. Bankruptcy of Northern Rock was a shock to the entire financial system of Great Britain. (Williams, 2010)

These market failures of Northern Rock and numerous American banks, as well as other financial institutions allowed to systematize the reasons of crisis and take lessons both for market participants and regulators. For financial institutions a lesson was in proper organization of the risk management system, based not only on mathematical models, but also on the analytical ability of risk managers to anticipate and respond to market conditions. For the regulators the main lessons was the need to assess the internal risk management procedures, identify potential weaknesses and deficiencies. In addition, the need to regulate not only banks but also other financial institutions, financial markets, payment and market infrastructure, taking into account the potential level of system threats. (Praet 2010)

In contrast to the non-system risks that are present in the activities of individual actors or institutions, systemic risks affect the financial markets or the financial system as a whole and can not be mitigated by traditional methods. The structure of the assessment of systemic risk is an independent, but at the same time complementing macroprudential analysis and stress-testing of banks with assessment of strength of network relationships between banks and the probability of distribution of shocks between them. (Praet 2010)

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