Banks looked for loopholes because increased capital reduced ROE The assignment

Banks looked for loopholes because increased capital

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Banks looked for loopholes because increased capital reduced ROE: - The assignment of risk weights to broad categories of asset means banks can shift toward the riskier assets in each category - Considering only credit risk means banks can increase ROE by taking on interest rate and exchange rate risk, or risk through being a forward intermediary - Risk weightings of lines of credit are different for 364 days versus 1 year, etc - Capital requirements increased the regulatory costs of bank intermediation and so accelerated the trend toward off-balance-sheet banking and stimulated the development of new techniques of off-balance-sheet banking like securitization and credit derivatives Increased offsheet balance bank and increased interest rate risk and exchange rate risk iii. Why were Japanese banks taking a position in interest-rate swaps? What were the risks? What was the role of the capital standards? Japanese banks could offset losses from write-offs of bad loans by taking on huge exposure in derivatives - they purchase interest-rate swaps, locking in
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income from a fixed-rate of interest in return for paying a lower floating rate. These derivatives were roughly equal to the banks’ holdings of government securities, so they double exposure to interest rate fluctuations. A 1% rise in interest rates is estimated to cost the banks 3 billion yen - a year of operating profits. The accounting loophole allowed the banks to not disclose the investments to investors, so provided a way to earn more income with less equity. Demand for such investments has caused the rates on swaps with maturities between five and 15 years to fall below the yields on government bonds. iv. Do you think the capital standards have made banks safer? No - data on government regulation of banks across countries has shown that stringency of capital requirements and intensity of supervision has led to decreased stability. Banks don’t stop taking risks, they just find new ways to do so (that may be riskier). v. How did they affect the business of banking? Regulation makes the cost of providing banking services more expensive, either because other institutions that don’t face regulation perform them or because banks perform them at higher costs. This means financing costs more and is less available than it would have been. iv. What would you suggest as an alternative to capital standards? Market discipline is likely to be the only effective solution, along with measures that facilitate market control like disclosure requirements and improvements in corporate governance of banks. Increased payouts and subordinate debt are two ways the government has aimed to increase market discipline in the past. D. Read “More questions than answers: The Volcker rule” (19.7) and answer the following: i. What is the Volcker Rule? What is its purpose? How is it reminiscent of Glass-Steagall? How does it differ?
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