Advanced Finance Banking and Insurance

Questions and model answers

Exam 13 December 2018

1. A well-developed financial system can contribute to economic growth by improving

resource allocation. But when a systemic financial crisis occurs, the financial system can also
be a source of instability.
a. What is a systemic banking crisis?
b. Explain why the financial system may be pro-cyclical during the upswing of the
financial cycle.
c. Explain why a sovereign crisis and a banking crisis and a may be linked, i.e. why there
may be a so-called ‘doom loop’ between sovereign risk related to government bonds
and risk in the banking sector.

2. Investments in FinTech have grown rapidly since 2014. According to some, FinTech
innovations in retail payment systems have a profound influence on the way retail payment
systems function, e.g. with respect to customer contact and payment processes.
a. What is FinTech?
b. Analyse how FinTech innovations related to retail payments could affect customer
contact and payment processes. In doing so, give concrete examples of FinTech
innovations that affect retail payment systems.
c. FinTech is not just driven by advances in technology, but also by changes in
regulation. Explain how the introduction of the Payment Services Directive 2 (i.e.
PSD2) may affect the operation of retail payment systems.

3. Financial markets for debt and equity function differently. For example, debt that is backed
up by collateral is seen as less ‘information sensitive’ than equity.
a. Explain why collateralized debt could be less ‘information sensitive’ than equity.
b. Under which circumstances can debt suddenly become ‘information sensitive’?
c. Please mention three other differences in the characteristics of stock markets and
debt markets.

4. Asymmetric information lies at the core of banking. Banks therefore monitor potential and
existing clients. The model by Freixas and Rochet (2008) analyses when it is optimal to
delegate monitoring to banks.
a. Explain how the process of delegating monitoring to a bank works (that is: who
delegates the monitoring to whom; and who is being monitored).
b. Under what conditions is it optimal to delegate monitoring to banks, according to
the model by Freixas and Rochet (2008)?
c. In actual practice in the EU, do depositors monitor the bank? Why or why not?

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5. The main aim of micro-prudential regulation is to ensure the soundness of individual
financial institutions. After the financial crisis, a revised capital accord has been agreed for
the banking sector, under the name Basel-3.
a. How high should the minimum leverage ratio be for banks under Basel-3?
b. Explain why next to the risk-weighted capital ratio, a leverage ratio was introduced
under Basel-3.
c. What is the aim of the Liquidity Coverage Ratio (LCR) and how is it defined?
d. In the final Basel-3 accord as agreed at the end of 2017, what is the main change
with respect to the so-called Internal Ratings-Based (i.e. IRB) approach, with respect
to the calculation of risk weights?

6. Suppose a hedge fund has assets that are worth 100, debt with a value of 95 and equity
with a value of 5.
a. How high is the leverage of this hedge fund?
b. Suppose the value of the assets drops to 99. How high will the leverage of this fund
be now? Did leverage increase or decrease?
c. Suppose the hedge fund now wants to adjust its leverage back to the starting level
(i.e the leverage as measured under question a), by selling assets and repaying debt.
Assuming no price impact on the assets, what will be the new value of the assets,
equity and debt?
d. What are fire sales?