The financial sector and crises - The bank leverage-centered feedback process - Investment bank behavior and leverage
6 important questions on The financial sector and crises - The bank leverage-centered feedback process - Investment bank behavior and leverage
Describe the assumptions of the simple model for the behavior of investment banks
2. Investment banks are not deposit-taking so they cannot fund their asset purchases through deposits.
3. The riskiness of assets is known to everyone.
What is the maximum the IB can borrow?
B = the amount the IB can borrow from savers
r = rate of return on the asset
z = the maximum possible loss per F asset
We assume that the money market rate is zero.
What is the maximum the IB can fund?
PF = the maximum an investment bank can spend on the F assets
e = equity
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Give the equation for the investment bank demand for F
P = price of an F asset
This equation highlights that the IB's demand for the F asset rises with its equity and rises as risk falls relative to its return.
Describe the pathways that can lead to a reduction in the perceived riskiness of the securitized assets.
2. Higher house prices reduce the credit risk to the bank since the market value of the asset rises relative to the associated debt.
3. Financial innovation.
Describe the paradox of credibility
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