Financial Markets and Institutions

J. de Haan, S. Oosterloo and D. Schoenmaker

Exercises for Chapter 1

Functions of the Financial System

1. A sound financial system is important for the working of the economy.

a. What is the main task of the financial system?

b. Explain the main functions of the financial system.
c. What is more stable over time: the functions of a financial system or the financial
institutions that make up the financial system?

2. Conventional finance and sustainable finance differ in several respects. Explain the difference in
time horizon and factors which are included by each type of finance.

3. How can you distinguish between bank-based and market-based systems?

4. Explain how the financial system may help to overcome the problem that investment projects
often only yield benefits after a long time, while investors often have a shorter investment
horizon. Why may this have a positive impact on economic development?

5. How can banks play a role in supervising the management of firms?

6. Explain why according to the 'law and finance' view, countries with a common law system are
more likely to have more developed financial markets.

7. Securitisation is often done through so-called special purpose vehicles (SPV).

a. How does the SPV work?

b. Mention one major advantage of securitisation.
c. Mention one major drawback.

Exercises for Chapter 2

Financial Crises

1. Financial crises come in different forms.

a. Please, describe the three main types of crises.

b. What is a twin crisis?
c. Government may need to need to provide money to rescue banks. At the same time, the
economy may go in recession. Which effect has usually a stronger impact on the
government’s fiscal position?

2. Bank run models.*

a. Explain how a bank run works? Which feature of a bank makes a run possible?
b. What is causing a bank run in the Diamond-Dybvig model?
c. What is causing a bank run in the Allen-Gale model?
3. Minsky links the business cycle to financial crises.

a. Explain the five stages of Minsky’s financial instability hypothesis.

b. Which factor is in particular driving the boom-bust cycle?
c. Please, explain how capital requirements can make the financial system pro-cyclical.

4. Loss spirals played a prominent role in the 2007-2009 financial crisis.

a. Please, explain the working of the loss spiral through the balance sheet.
b. Which assets were subject to a loss spiral in the financial crisis?
c. Which role did the accounting system play? What kind of changes would you recommend
to address these accounting problems?

5. Business and financial cycles can be distinguished.

a. Please, explain the difference between the two.

b. Which cycles are more converge within the euro area?

6. The euro crisis.

a. What are the main causes of the euro crisis?

b. What is the link between sovereign debt, the EU banking system and the euro crisis?
c. What role did the European Central Bank play during the euro crisis?
d. What role did the euro-area countries play during the euro crisis?

Exercises for Chapter 3

European Financial Integration: Origins and History

1. The institutional framework is relevant for integration in the European Union.

i. Explain the intergovernmental approach and the supra-national approach.

ii. Who (which institution) is the key player and what is the decision-making mechanism in
each approach?
iii. Which approach is more likely to yield European integration?

2. What is the difference between the Council of the European Union and the European Council?

3. Explain why monetary integration may be regarded as a necessary condition for financial
integration. Also explain why restrictions on national fiscal policy are necessary for monetary
integration, according to the ECB.

4. What is the difference between regulations and directives?

5. Explain what the principles of a single bank license and home country control are.

6. The Banking Union consists of five elements.

i. Which element(s) is (are) best developed (fully supranational)?

ii. Which element is least developed (still national)?
 Exercises for Chapter 4
European Monetary Policy

1. The European Central Bank is responsible for monetary policy in the euro area.
i. Explain what the main objective is of the ECB’s policy.
ii. Who (which institution) is responsible for taking monetary policy decisions?
iii. Explain the role of central banks of EU Member States outside the euro area
within the European System of Central Banks.

2 Explain why the monetary policy strategy cannot be considered as inflation targeting,
according to the ECB.

3 Explain how the ECB has reacted to the financial crisis in the euro area.

4 What is the difference between the economic analysis and the monetary analysis in the
monetary policy strategy of the ECB?

5 Explain how central bank communication may enhance the effectiveness of monetary policy.

6 On January 15, 2009, the European Central Bank issues the following press release: "At
today’s meeting the Governing Council of the ECB took the following monetary policy decisions:
The interest rate on the main refinancing operations of the Eurosystem will be decreased by 50 basis
points to 2.00%, starting from the operation to be settled on 21 January 2009. The interest rate on the
marginal lending facility will be set at 3.00%, with effect from 21 January 2009. The interest rate on
the deposit facility will be set at 1.00%, with effect from 21 January 2009."

a. What are main refinancing operations?

b. What is the difference between the marginal lending facility and the deposit facility?
c. Why are the rates on these facilities different?

Exercises for Chapter 5

European Financial Markets

1. Explain the three main functions of financial markets.

2. What is the difference between quote driven and order driven markets?

3. The most important money market segments are the unsecured deposit markets (with various
maturity, ranging from overnight to 1 year), and the secured repo markets (often called repos)
with maturities also ranging from overnight to 1 year.

a. Explain the main differences between both segments in terms of risk and return.
b. Which segment declined during the financial crisis and the euro crisis? And why?

4. Interest rates on bonds are affected by the term premium, credit risk, and liquidity risk. Explain
how.

5. Explain why the following statement is wrong: When an investor buys stock in a company, he
helps financing this company.
 Exercises for Chapter 6
The Economics of Financial Integration

1. The literature on financial integration uses different price-based measures. One of these measures
refers to the dispersion of prices.

a. Give the formula for the dispersion of prices measure and explain the parameters.
b. What does a standard deviation (sd(i)) of 0 imply?

2. The literature on financial integration uses different price-based measures. One of these measures
is called the news-based measure.

a. Give the formula for the news-based measure and explain the parameters.
b. What does a beta (β) of 1 imply?

3. Explain why interest rates on bonds issued by different countries in the euro area can have
different yields even if they have the same remaining maturity.

4. Explain why financial market integration can help insuring against idiosyncratic risk.

5. What has been the impact of the financial crisis on integration in the money market and the bond
market?

6. Apart from price-based and quantity-based measures to examine financial integration, also so-
called news-based measures are used. Explain the underlying assumptions of this approach.

Exercises for Chapter 7

Financial Infrastructures

1. What is meant by ‘clearing and settlement’ and why is further integration needed?

2. European integration can differ between sectors and within sectors. This questions deals with
stock trading. The process of stock trading can be broken down in different steps: trading on stock
markets (primary trading of new equity (IPOs) and secondary trading of existing stock) and
clearing & settlement (C&S).
a. Discuss the degree of integration for each step (primary trading, secondary trading and
C&S).
b. Which part (stock markets or C&S) is more integrated?
c. What are the hurdles for further integration of stock markets (trading)?
d. What are the hurdles for further integration of C&S?

3. What are the key elements of retail payment systems?

4. How can consumers benefit from increased competition in EU payments markets?

5. Describe the impact of the Single Euro Payments Area (SEPA) on the retail payment systems
market.

6. What is a two-sided market?

7. Payment and securities market infrastructures are characterised by economics of scale and scope
and network externalities. What does this mean and how do these characteristics affect the
internal market?
Exercises for Chapter 8
Financial Innovation

1. What are key drivers of innovation?

2. What are the advantages and disadvantages of financial innovation?

3. Explain how financial innovation can make the financial system less transparent, using the
example of the securitisation of subprime mortgages.

4. New debt securities can be perceived to be safe, but can be at the same fragile.

a. Explain the fragile nature of debt securities

b. What can trigger the problems?

5. What services are provided by credit rating agencies?

6. Why were credit rating agencies criticised over the past years?

7. What is the main risk of comprehensive regulation and supervision of credit rating agencies?

Exercises for Chapter 9

The Role of Institutional Investors

1. Which types of institutional investors can one distinguish?

2. A special type of institutional investors is hedge funds. Please explain what hedge funds do.

3. Should hedge funds be regulated? Please explain the arguments.

4. What is the investment horizon of the various institutional investors? Rank the different types
according to length of investment horizon.

5. Institutional investment has grown both in Europe and the US over the last two decades.

a. What are the drivers of growth of institutional investment? Please explain.

b. What is the strongest driver. Please explain.
6. Investors in country x have 20% foreign equity. The share of the domestic market of country x in
the world market portfolio is 40%. Give the formula for the equity home bias and calculate the
equity home bias of country x.

7. What is the impact of EMU on the regional bias (both equity and bond) of European investors?
Please, distinguish between investors based in the euro area and the non-euro area.

8. What is the impact of a large proportion of institutional investors in a country on the equity home
bias?

Exercises for Chapter 10

European Banks

1. Banks incur liquidity risk.

a. Explain the concept of liquidity risk.

b. What are the two main categories of liquidity risk?
c. Why are banks better able to provide liquidity than non-banks?

2. Banks have a comparative advantage in monitoring borrowers.

a. Why have banks this advantage?

b. What determines the choice between direct (ie market) and intermediated (ie bank)
lending?

3. In banking, risk management has become a main activity. In modern risk management models,
different notions are used. Explain the meaning and the usefulness of the following concepts:

a. Economic capital
b. Value-at-Risk

4. Integration is uneven across the banking markets. Discuss the degree of integration of the
wholesale and retail banking market. Do you expect the degree of integration of these two
markets to converge?

5. The market structure is an important determinant of the degree of competition. Is it possible for a
concentrated banking market to be competitive?

6. The too-big-to-fail doctrine has been reinforced during the 2007-2009 financial crisis. Please,
explain this doctrine. Which structural measures are proposed to curtail the too-big-to-fail
doctrine?

7. The Banking Union creates a new banking landscape.

c. What is the impact of the Banking Union on concentration in European banking (higher,
lower or equal concentration)?
Do you expect changes over the next five years?
 Exercises for Chapter 11
European Insurers and Financial Conglomerates

1. The mathematics of small claims insurance follows a particular pattern.

a. Which mathematical tool is used to calculate the total amount of small claims?
b. What are the main risk drivers for an insurer?

2. How important is invest income for life and non-life insurance companies?

3. Catastrophe insurance can cause large losses.

a. Give a few examples of catastrophes for which insurance can be bought.

b. What is the distribution pattern of catastrophe insurance?
c. How do insurance companies manage these large risks?

4. In insurance, the term ‘underwriting cycle’ is used. Several theories underpin the
underwriting cycle.

a. What is the underwriting cycle?

b. Mention two theories and explain how they work.

5. Asymmetric information plays an important role in insurance.

a. Explain the role of moral hazard. Give an example.

b. What are the mechanisms to contain moral hazard?
c. Explain the role of adverse selection.
d. What are the mechanisms to reduce adverse selection?

6. Financial conglomerates combine banking and insurance activities.

a. What are the arguments in favour of financial conglomerates?

b. What are the arguments against financial conglomerates?
c. Which arguments dominate? How can you measure that?

Exercises for Chapter 12

Financial Regulation and Supervision

1. Explain the main market failures in the financial system and the role of government intervention
to remedy these failures.

2. There are different forms of financial supervision.

a. What are the two main forms of financial supervision?

b. What is the focus of each type of supervision?
c. What kind of skills is needed for each type of supervision?
3. Prudential supervision has an impact on the business cycle. More broadly, the financial system
has an impact on the business cycle (see also chapters 1 and 2).

a. Explain the impact of prudential supervision on the business cycle.

b. Which financial system has a stronger impact on the business cycle: a market-based
financial system (more arm’s length) or a bank-based financial system (less arm’s
length)?
c. What is the impact of interest deductibility (deductible of corporate tax) on the cyclicality
of the financial system?

4. The financial trilemma argues that policy makers have to choose 2 out of 3 objectives.

a. What are the three policy objectives in the financial trilemma?

b. Which policy objectives to policy makers currently pursue?
c. Is this choice stable? Please, explain why or why not.

5. Financial supervision has been moved to the euro-area level in Europe.

a. What is the determining factor for moving to European arrangements for financial
supervision?
b. Describe also the economic arguments for this factor (that is why would this factor be a
reason to move from national to European arrangements?).
c. Explain how you could measure this factor.

6. In November 2014, the Banking Union started in which the ECB and the national banking
supervisors of the euro-area countries cooperate.

a. What are the four building blocks of Banking Union?

b. Which body has the final say in the Single Supervisory Mechanism?
c. Can non-euro area countries join Banking Union? If yes, should they join?

Exercises for Chapter 13

Financial Stability

1. Macroprudential supervision

a. Explain the concept of macroprudential supervision and the difference between micro-
and macroprudential supervision.
b. Provide an example of a situation where micro- and macroprudential supervision may
conflict and explain which of the two should prevail in this specific situation.

2. Define and explain financial stability and systemic risk.

3. Describe the cyclical and structural dimension of systemic risk and explain how a boom in credit
growth can impact both dimensions of systemic risk.

4. What are the key indicators for financial stability analysis?

5. What are the main reactive instruments that can be used in crisis situations?
6. Resolution authorities have new powers to bail in creditors. A bank with total assets of €100 has
the following liability structure: equity of €4, deposits of €80, subordinated debt of €8, and senior
debt of €8.

a. Please explain the process of bail in.

b. The bank faces a loss of €15. Please explain what the resolution authority will do.
c. Which group will become the equity holders of the bank?

7. Explain the relevance of ex ante burden sharing arrangements.

8. An international bank operates with 40% of assets located in the home country, 30% of assets in
other European countries within the Banking Union, and 30% of assets in the rest of the world.

a. Suppose that decisions on recapitalisation versus liquidation of this bank would be taken
at the national level. Above which level of social benefits B divided by social costs C (i.e.
B/C) would the bank be recapitalised?
b. With the arrival of Banking Union, the decision will be taken at the European level.
Above which level of social benefits B divided by social costs C (i.e. B/C) would the
bank be recapitalised?
c. What would be the efficiency benefit of the European solution relative to the national
solution, expressed as a percentage of distance from the home solution to the global
optimum of B/C≥=1?

Exercises for Chapter 14

European Competition Policy

1. What are the objectives of EU competition policy?

2. Two large German banks, Bayern and Westgermania, are proposing a merger. Bank Bayern has a
turnover of € 4 bn; all the business is in Germany. Bayern is a universal bank offering retail
services (retail payments and loans to SME) and wholesale services (investment banking and
corporate loans). Bank Westgermania has a turnover of € 3 bn, of which 50% is in Germany, 20%
in the Benelux, 20% in the UK and 10% in the USA. Westgermania is only doing wholesale
banking (investment banking, derivatives trading and corporate loans).

a. Which competition authority is competent (DG Competition or Bundeskartellamt)?

Please, motivate your choice.
b. Describe the different dimensions (product and geographical) of the relevant market in
this case.
c. What will the verdict of the compenent competition authority be? Please, motivate the
verdict.

3. Policy areas can be organised differently (national or supra-national) in the European Union.

a. How are the areas of competition policy and financial supervision organised?
b. Give historical and economic arguments for the differences in organisation of these two
areas.
c. Do you expect changes in any of these two areas in the medium term?
4. What is a monopoly and why are monopolies considered to be bad?

5. When banks are receiving state aid, they need to restructure.

a. Which body is responsible for applying the state aid rules in Europe?
b. What are the three main principles for restructuring?

6. What is the ‘Small, but Significant Non-transitory Increase in Prices’ methodology? Apply this
methodology to retail banking.

7. If a banking group has a large market share, does this automatically entail that it has a dominant
position? Explain your answer