Paradox of “Safe” Assets: Explain why the very assets that regulators have deemed safe for capital requirement calculations for banks have been the source of recent financial crises. Please provide two specific examples and explain them in some detail.
Curse of Zombies: Explain the different risk-return tradeoff (from same class of assets) faced by under-capitalized versus well-capitalized banking sectors, focusing on their incentives from the standpoint of bank shareholders. In turn, explain why leaving banking sectors under-capitalized after a crisis leads to delayed recoveries, providing one specific example of such an outcome in recent crises and the asset-choices made by the corresponding under-capitalized banking sector(s).
Market versus Book: Provide three rationales why equity market-based measures of leverage and volatility of a financial firm help predict its distress better than measures based on book (or accounting) and regulatory values.
Volatility and Stress: Regulatory stress tests predict a phase of 5-6 quarters of recovery following an initial 2-3 quarters of severe stress for the financial sectors being stress-tested. What bias does this lead to as far as regulatory assessments of financial sector health is concerned, focusing on the errors of omission in assuming the recovery phase?
To Volcker or not to Volcker: Explain one potential benefit of subjecting the financial sector to the “Volcker rule” of the Dodd-Frank Act and one potential downside, explaining each in some detail.
Pie in the Sky: The European Central Bank is planning an Asset Quality Review of over 100 large banks of the Eurozone next year. The regulators have been calling for national or Eurozone-wide fiscal backstops to recapitalized troubled banks before the Review is undertaken. Explain how the availability of such a backstop will likely impact the effectiveness of the review, and how lack of the availability of such a backstop will impact its effectiveness, focusing on regulatory choices made during the review.