Question: Outline the process of securitization and explain why the securitization of financial products is often considered a risky practice?

Question 1 (Total of 50 points)
One of the observations regarding the interest rates in advanced countries is the increase in the spread between yields of 10 year bonds issued by BAA-rated corporates and the 10 year bonds issued by the Treasuries during times of economic recessions.
a. Explain why such an increase can occur. (10 points)
b. To what extent do you think the spread between 10 year BAA-rated bonds and 10 year Treasury bonds is correlated with the external finance premium? Why? (10 points)
c. How does the decrease in the value of collateral and the net worth of a potential borrower affect credit intermediation? Explain in detail. (15 point)
d. Propose two policy interventions that central banks can use to mitigate challenges associated with an increase in the external finance premium (15 points).

Question 2 (Total of 50 points)
Answer the following questions regarding the information problems in financial intermediation (Total of 50 points):
a. Describe the principle-agent problem within the context of the possible use of equity finance by the non-financial corporate sector. Propose a method which investors can utilize to reduce the extent of the principal-agent problem. (15 points)
b. Give two examples of how principle-agent problems can occur in the banking sector.

Discuss differences and similarities with the principle agent problems faced in the case of equity financing of the non-corporate sector. (15 points)
c. Suppose there are two economies characterised with differences in coverage of deposit insurance schemes. In country A, the government provides insurance for all deposits in the economy. In country B, the government provides insurance only for deposits up to USD 50000. Compare country A and B in terms of the degree of possible adverse selection and moral hazard problems that would be observed in these two economies. (20 points)

Section B
Question 3 (Total of 50 points)
Banks are often asked to increase their capital requirements, such as their tier-one ratio, following stress tests, or in times of distress.
a. Explain what is meant by a bank’s tier-one capital ratio. (10 points)
b. The CAMELS ratings used in the US to monitor banks’ health include capital adequacy as a feature. Do you think the CAMELS ratings are a suitable and effective means of gauging a bank’s health? (20 points)
c. Explain the mechanisms through which increasing banks’ capital requirements may be detrimental to the real economy? (20 points)

Question 4 (Total of 50 points)
Banks have long been involved in the process of securitization of financial products.
a. Outline the process of securitization and explain why the securitization of financial products is often considered a risky practice? (12.5 Points)
b. Explain the main differences between a CDO (collateralized debt obligation) and a CLO (collateralized loan obligation) (17.5 Points)
c. How did securitization contribute to the global financial crisis? (20 Points)