Question

TURN YOUR ANSWERS IN WORD.

Define the purpose of the Commercial Bank Stress Tests

a.     Define the credit, default and liquidity risks that commercial banks face.

b.     Is regulation working the same for all banks? Explain.

c.     How financial institution size is correlated with overall uncertainty in the economic and financial landscape?

d.     Define the term “financial uncertainty” and explain how the Too Big to Fail (TBTF) issue may affect it.

Answer 1

The main goal of a stress test is to see whether a bank has the capital to manage itself during tough times. Banks that undergo stress tests are required to publish their results. These results are then released to the public to show how the bank would handle a major economic crisis or a financial disaster.Regulations require companies that do not pass stress tests to cut their dividend payouts and share buybacks to preserve or build up their capital reserves. Obviously, banks that fail stress tests look bad to the public. Even prestigious institutions can stumble: Santander and Deutsche Bank, for example, have failed stress tests multiple times.Sometimes banks are given a conditional pass of a stress test. This means a bank came close to failing and risks being able to make further distributions in the future. Banks that pass on a conditional basis have to resubmit a plan of action.

a

Credit Risk: also called default risk, is the risk associated with a borrower going into default (not making payments as promised)

Liquidity Risk: is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.

Default risk is the chance that a company or individual will be unable to make the required payments on their debt obligation. Lenders and investors are exposed to default risk in virtually all forms of credit extensions

b

In the United States, banks benefit from federal deposit insurance and (in the case of national banks and state-chartered member banks) membership in the Federal Reserve System. These benefits carry obligations, but even if the FDIC and Federal Reserve did not exist, you’d need some form of banking regulation to ensure stability, consistency, and public trust.

Banking regulation serves three primary purposes: 1) safety, 2) soundness, and 3) consumer protection.

“Safety” refers to whether a bank is an honest, responsible and competent custodian of its clients’ money. What does the bank do with your money once you deposit it? How does it make decisions about the loans it provides, the products it sells, and the vendors it affiliates with? You wouldn’t give your money to a stranger, but people open bank accounts every day at institutions they’ve done little research into. (The current bitcoin surge is baffling in this respect; bitcoin purchasers have *no* guarantee that their money is safe.)

“Soundness” refers to the strength and consistency of a bank’s internal operations. How much private capital does a bank have to protect it against losses? Does the bank have sufficient liquidity to support customers’ payments and withdrawals? Does the bank have the personnel it needs to keep its daily operations running smoothly?

“Consumer protection” is just that: is the bank treating its customers and the public fairly, and giving customers and the public all the information they need to make rational decisions about their interactions with the bank? Is the bank discriminating against individuals or groups for illegal reasons? Is the bank hiding fees, or enrolling customers in programs they didn’t ask for?

c

In the financial system funds flow from those who have surplus funds to those who have a shortage of funds, either by direct, market-based financing or by indirect, bank-based finance. The former British Prime Minister William Gladstone expressed the importance of finance for the economy in 1858 as follows: "Finance is, as it were, the stomach of the country, from which all the other organs take their tone."

The financial system comprises all financial markets, instruments and institutions. Today I would like to address the issue of whether the design of the financial system matters for economic growth. My view is that the answer to this question is yes. According to cross-country comparisons, individual country studies as well as industry and firm level analyses, a positive link exists between the sophistication of the financial system and economic growth. While some gaps remain, I would say that the financial system is vitally linked to economic performance. Nevertheless, economists still hold conflicting views regarding the underlying mechanisms that explain the positive relation between the degree of development of the financial system and economic development.

d

Since uncertainty, as distinct from risk, can exert a significant influence on individual behavior, it should also be a significant determinant of equilibrium outcomes. For example, Knight (1921) claims that risk is insurable through exchange while uncertainty is not. Uncertainty should arguably lead to two notable departures from standard risk-sharing behavior in expected utility models. When uncertainty is prevalent, some insurance markets might break down, resulting in equilibria with no trade. Moreover, indeterminacy may also arise in this setting. Without uncertainty, the probabilities of risky events are known and frictionless markets can precisely price contracts contingent on risky events, at least generically. Even well-functioning markets, however, may not be able to precisely price contracts conditional on uncertain events, since the probabilities of these events are unknown.

Perhaps the most vivid recent example of "too big to fail" is the bailout of Wall Street banks and other financial institutions during the global financial crisis. Following the collapse of Lehman Brothers, Congress passed the Emergency Economic Stabilization Act (EESA) in October 2008. It included the $700 billion Troubled Asset Relief Program (TARP), which authorized the government to purchase distressed assets to stabilize the financial system.

This ultimately meant the government was bailing out big banks and insurance companies because they were "too big to fail," meaning their failure could lead to a collapse of the financial system and the economy. They later faced additional regulations under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.