Question 1: Financial Systems and Risk Sharing [50 marks in total]

One of the main functions of financial systems is to allocate risks. Please answer the following questions regarding this function.

a.   Please explain the difference between idiosyncratic and systematic risks.     [10 marks]

b.   Please give an example of idiosyncratic risk and explain how financial systems can

help to mitigate and allocate the risk.                                                              [10 marks]

c.   Please give an example of systematic risk and explain how financial systems can help to share the risks.     [10 marks]

d.   Please explain the concept of market completeness and how it guarantees efficient risk-sharing.                 [10 marks]

e.   Credit Default Swap (CDS) is a credit derivative whose market experienced rapid

growth over the past decades. Please read the following description of the derivative and discuss how it helps to complete financial markets and improve risk-sharing.   [10 marks]

Question 2: Financing and credit crunches [50 marks in total]

As of 2010, the total of outstanding bank loans to UK private non-financial companies amounts to £722 billion and exceeds the amount of direct and public debt financing and equity financing combined. Indeed, direct external financing is used only by the largest firms in the economy, while smaller firms tend to rely on intermediated financing. Among the 1.2 million private non-financial firms in the UK, less than 1% of them raise direct external financing from the public. This shows why intermediated financing is important and the risk of credit crunch has to be carefully managed.

To appreciate this point, consider the following example of the Holmstrom-Tirole (1997) model. An entrepreneur wants to invest in a project that costs 10. But he has only personal wealth A = 1.5. If the project succeeds, it will generate an income of 12, but will yield 0 if it fails. The probability of success depends on whether the entrepreneur works hard or not. If the entrepreneur works hard, the project will succeed for sure, i.e., PH  = 1. If the entrepreneur does not work hard, he will be able to obtain a private benefit B = 2.5, but the project will only succeed with a lower probability PL   = 0.5.

a.   Can the project be financed by direct financing?                                            [10 marks]

Suppose now that a bank can monitor the entrepreneur and bring the private benefit down to b = 1.5 at a monitoring cost of C  = 0.5.

b.   If the bank is not capital constrained and the credit markets are perfectly competitive, can the project be financed by a mixture of direct financing and bank loans?              [10 marks]

c.   Now consider the bank being capital constrained and unable to provide any capital

input for the project. Can the project still be financed?                                   [10 marks]

d.   Please explain the concept of credit crunch.                                                    [10 marks]

e.   What policy responses can you think of to mitigate credit crunch?                [10 marks]

Question 3: Bank Runs [50 marks in total]

Please read the following excerpt from the Financial Times concerning the runs on the

Cypriot banks in 2013 to gain an idea of suspension of convertibility as a response to bank runs.

a.   Please explain why depositors may have incentives to run on a solvent bank by

relating to the Diamond-Dybvig (1983) model.                          [10 marks]

b.   Please explain how suspension of convertibility can stop bank runs in the Diamond-Dybvig (1983) model.       [10 marks]

c.   Please discuss why suspension of convertibility may not be an effective solution to

banking crises in practice.                              [10 marks]

d.   Please discuss an alternative solution to the problem of bank runs.               [10 marks]

e.   Please discuss the potential limitation of the alternative solution that you propose in

the last sub-question.                                          [10 marks]

Question 4: Bank Capital Regulations [50 marks in total]

Many believe that bank capital (equity) is the cornerstone of banking regulations. In an open letter, a group of financial economists argued that “if at least 15 percent of banks’ total, non- risk-weighted, assets were funded by equity, the social benefits would be substantial. And the social costs would be minimal, if any.” Admati et al., Financial Times (November 9, 2010)

a.   Please give two reasons why bank capital (equity) is important for financial stability.   [10 marks]

Regarding increasing bank capital requirements, there are also different voices, both from practitioners and some academics.

b.   Indeed, some consider bank capital as money that banks must set aside and cannot be used productively. For example,

“The British Bankers' Association ... calculated that demands by international banking regulators in Basle that they bolster their capital will require the UK's banking industry to hold an extra £600bn of capital that might otherwise have been deployed as loans to businesses or households.” The Observer (July 11, 2010)

Do you agree or disagree with the statement? Please explain why?                     [10 marks]

c.   Some also believe that increasing capital requirements can force banks to operate at a suboptimal scale and restrict socially valuable activities such as deposit-taking.

“Capital adequacy regulation can impose an important cost because it reduces  the ability of banks to create liquidity by accepting deposits.” Van den Heuvel (2008), Journal of Monetary Economics,

Do you agree or disagree with the statement? Please explain why?                     [10 marks]