Explain why the very assets that regulators have deemed safe for capital requirement calculations for banks have been the source of recent financial crises. Please provide two specific examples and explain them in some detail.
Curse of Zombies:Explain the different risk-return tradeoff (from same class of assets) faced by under-capitalized versus well-capitalized banking sectors, focusing on their incentives from the standpoint of bank shareholders. In turn, explain why leaving banking sectors under-capitalized after a crisis leads to delayed recoveries, providing one specific example of such an outcome in recent crises and the asset-choices made by the corresponding under-capitalized banking sector(s).
Market versus Book:Provide three rationales why equity market-based measures of leverage and volatility of a financial firm help predict its distress better than measures based on book (or accounting) and regulatory values.
Pie in the Sky:The European Central Bank completed its Asset Quality Review of over 100 large banks of the Eurozone this year. The stress test that was part of this exercise revealed capital shortfall for about 25 banks, totaling to about Euro 25 billion. Market data-based calculations reveal many more banks having capital shortfall totaling to an amount which is 5-10 times as large. Please explain this “discrepancy” in light of your answer to the previous question.
Stressful? Or Not Really! Regulatory stress tests predict a phase of 5-6 quarters of recovery following an initial 2-3 quarters of severe stress for the financial sectors being stress-tested. What bias does this lead to as far as regulatory assessments of financial sector health is concerned, focusing on the errors of omission in assuming the recovery phase? Explain one possible way of “fixing” these errors.
Living Will or Funeral Plan: Explain the tradeoff in subjecting distressed financial firms to “orderly liquidation” versus allowing them to be reorganized as “bridge banks”, the two options feasible under the Dodd Frank Act.
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