Question

Describe the following

a.Structured investment vehicles

b.Credit default swaps

c.Systemic risk (not systematic risk)

d.Proprietary trading

e.The Volcker rule

f.Basel Capital requirements and their relation to the severity of the financial crisis of 2008 and 2009

i.Shadow banking system

Answer 1

a) A structured investment vehicle (SIV) is a non-bank financial institution established to earn a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities it issues. They are generally established as offshore companies and so avoid paying tax and escape the regulation that banks and finance companies are normally subject to.

The Strategy used by the SIV are they raise capital and then lever that capital by issuing short-term securities, such as commercial paper and medium term notes and public bonds, at lower rates and then use that money to buy longer term securities at higher margins, earning the net credit spread for their investors. Long term assets could include bank and corporate bonds,, auto loans, student loans.

b) Credit Default Swaps - Swap is to trade/ to exchange or something that is going to be exchanged. A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, may expect to receive a payoff if the asset defaults. In the event of default, the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan or its market value in cash.

c) Systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the entire system. It can be defined as "financial system instability, caused or exacerbated by unique events or conditions in financial intermediaries". It refers to the risks imposed by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market.

d. Proprietary trading (also to be known as "prop trading") is trading through use of self funds. It occurs when a trader trades stocks, bonds, currencies, commodities, their derivatives, or other financial instruments with the firm's own money, aka the nostro account, contrary to depositors' money, in order to make a profit for itself. Proprietary traders may use a variety of strategies such as index arbitrage, statistical arbitrage, merger arbitrage, fundamental analysis, volatility arbitrage or global macro trading, much like a hedge fund.

e) The Volcker rule :- The rule was originally proposed by American economist and former United States Federal Reserve Chairman Paul Volcker to restrict United States banks from making certain kinds of speculative investments that do not benefit their customers. Volcker was appointed by President Barack Obama as the chair of the President's Economic Recovery Advisory Board on February 6, 2009. President Obama created the board to advise the Obama Administration on economic recovery matters. The proposal was to specifically prohibit a bank or institution that owns a bank from engaging in proprietary trading, and from owning or investing in a hedge fund or private equity fund, and also to limit the liabilities that the largest banks could hold. The rule came into effect on July 21, 2015.

f)First we understand the menaing of capital requirement (also known as regulatory capital or capital adequacy) is the amount of capital a bank or other financial institution has to hold as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity that must be held as a percentage of risk-weighted assets. These requirements are put into place to ensure that these institutions do not take on excess leverage and become insolvent. The Basel II capital framework contains recommendations for international capital requirements made by the Basel Committee on Banking Supervision to which most advanced financial economies adhere to. The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1974.It provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. Banks needed to manage their risk and to meet their Basel capital requirements. Consequently, they sought protection against the riskiest securities. This came in the form of a financial derivative called a credit default swap (CDS) which, in return for a fraction of the potentially large return, insured the holder of the mortgage-backed security or collateralized debt obligation against the risk of default. The existence of naked CDSs – CDS contracts where neither party actually held the underlying asset – created fertile ground for speculation as well as risk management.

i) The shadow banking system is a term for the collection of non-bank financial intermediaries that provide services similar to traditional commercial banks but outside normal banking regulations.Like regular banks, shadow banks provide credit and generally increase the liquidity of the financial sector. Yet unlike their more regulated competitors, they lack access to central bank funding or safety nets such as deposit insurance and debt guarantees.they rely on short-term funding provided either by asset-backed commercial paper or by the repo market, in which borrowers in substance offer collateral as security against a cash loan, through the mechanism of selling the security to a lender and agreeing to repurchase it at an agreed time in the future for an agreed price. These Shadow Banks do not take deposits like traditional banks. Leverage is considered to be a key risk feature of shadow banks.