Money and Financial Institutions

Bank panics

What role does asymmetric information play in causing a bank panic?
How do liquidity and solvency problems interact during a banking crisis? (Address both how liquidity problems create solvency problems, and why insolvency fears cause widespread liquidity problems).

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The Troubled Asset Relief Program (TARP)

Consider a bank with assets of 100, capital of 20, and short-term credit of 80. Its assets include securitized assets whose value depends on housing prices. These assets have a value of 50.




Set up the bank’s balance sheet. (Include 2 asset categories: securitized assets & other assets).

Suppose housing prices decline. As a result, the value of the bank’s securitized assets falls by an uncertain amount, and are now worth between 25 and 45. These securitized assets are “troubled assets”. The value of other assets remains at 50. Due to the uncertainty about the value of the bank’s assets, lenders are reluctant to provide short-term credit to the bank.

Given this change in the value of the bank’s assets, what is the range in the value of the bank’s capital?

The government considers purchasing troubled assets, with the intention of re-selling them again when markets stabilize. (This was the original version of TARP).

If the government pays 25 for the troubled assets, what is the value of the bank’s capital? How much would the government have to pay for the troubled assets to ensure that the bank is not insolvent?

In the end, the U.S. government did not buy troubled assets. Instead, it provided capital to banks by buying ownership shares (to re-capitalize banks), with the intention of reselling the shares when the markets stabilize. The government exchanged Treasury bonds for ownership shares.

Say the government exchanges 25 of Treasury bonds for ownership shares. Assuming the worst-case scenario (troubled assets are worth only 25), set up the bank’s new balance sheet.

(Note: the bank now has 3 types of assets: untroubled assets, troubled assets, and Treasury bonds). What is the total value of capital? Is the bank insolvent?

Given your work in this question, explain why recapitalization might be a better policy than buying troubled assets.

The financial crisis:

Describe the process of ‘securitization’ in your own words. How was securitization designed to spread final default risk (from the perspective of investors)? What assumption about the underlying mortgage risks must hold for mortgage backed securities to spread risk?
What is the difference between the “originate and hold” model, and the “originate and distribute (or sell)” model?


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