Banking and Finance:

Basics 1 - Class 8

Lisa Davidson, Oct 2022

lisa.Davidson.aff@unilim.fr
Deregulation

• The regulator response to the deregulation cause and

effect on the 2008 financial crisis:

• the Volcker rule in the U.S. (part of the Dodd–Frank

Act that was a legislative response to the crisis),

• recommendations by the Vickers Commission in the

United Kingdom

• Liikanen proposals in the EU.

Securitisation
• Securitisation involves combining the loan with others of similar
characteristics, creating credit-enhanced claims against the cash flows
of this portfolio, and then selling these claims to investors.

• The securitising of various types of bank loans did not begin until
1985, but the evolution has been rapid in the U.S.

• Securitisation is of growing importance in the U.S. economy. As of

April 2011, the amount of securitised assets had risen to $11 trillion,
an amount that exceeded all marketable U.S. Treasury securities.

• The European volume is approximately 20–25% of that in the United

States, but showed a much higher growth rate before the 2007–
2009 financial crisis
Financial Crisis

• The financial crisis of 2007–2009 is widely regarded as the

worst financial crisis since the Great Depression of the 1930s

• The onset of the crisis in 2007 followed an extended period of:

• unusually low real interest rates,

• easy credit conditions,

• low volatility in financial markets and

• widespread increases in asset prices that had generated

large-scale but hidden vulnerabilities.
Financial Crisis

• There was the sharp decline in U.S. house prices that caused
increases in ‘haircuts’ on property repossessions in the short-
term funding markets in the shadow- banking system during
2007

• Credit rating agencies (CRAs) then downgraded their

assessments of the creditworthiness of asset-backed financial
instruments in mid-2007.

• Between the third quarter of 2007 and the second quarter

of 2008, $1.9 trillion of mortgage-backed securities (MBS)
received downgrades that reflected a higher assessment of
risk, causing shock to investors.
Financial Crisis - Key Events
• In the UK Northern Rock had expanded aggressively, turning to
international money markets to fund its rapid growth.

• Problems in the US sub-prime mortgage market started to spread to

Europe in the summer of 2007, this source of financing dried up.
Northern Rock was left facing a severe liquidity crisis.

• On 14 September, Northern Rock’s perilous position was made

public. Despite liquidity support from the Bank of England, a run on
Northern Rock was triggered - the first UK bank run for over 140
years.

• In response, the Chancellor, Alistair Darling, announced that the

Government would guarantee all existing deposits on 17 September.
Financial Crisis - Key Events

• In USA, two huge mortgage finance agencies, Fannie

Mae and Freddie Mac’s main business was packaging up
home loans into products called mortgage-backed
securities that were then sold on to investors.

• The two companies were considered key players in the

securitisation market in the United States

• As the US housing market steadily weakened and then

collapsed, so did Fannie and Freddie.
Financial Crisis - Key Events

• Lehman Brothers had been heavily involved in selling

collateralised debt obligations (CDOs) – complex financial
products based on mortgage-backed securities.

• The bank was dangerously exposed to the US sub-prime

mortgage crisis, and on 10 September Lehman Brothers
announced Q3 net losses of $3.9 billion, on top of a Q2 loss of
$2.8 billion.

• While one of Lehman Brothers' rivals, fellow investment bank

Bear Stearns, had been bailed out earlier in the year (14 March
2008), it became increasingly clear that Lehman Brothers
would be allowed to fail.
Financial Crisis - Key Events
• Lehman Brothers was part of the ‘shadow banking’ or ‘market-based
finance system’, defined by the Financial Stability Board as ‘entities and
activities structured outside the regular banking system that perform bank-
like activities'.

• The shadow banking system grew rapidly in the years leading up to the
crisis, and was not subject to the same level of oversight as the regular
banking system.

• Shadow banking plays an important role in the financial system by offering

alternative sources of credit.

• It also allowed banks to move certain risky activities off their balance
sheets, including sub-prime mortgage-backed securities and
collateralised debt obligations.
Financial Crisis - Key Events

• Following Lehman Brothers file for bankruptcy, the US

investment bank Merrill Lynch was exposed as also being
heavily involved in selling complex financial products like
CDOs.

• By mid-September it too was close to collapse, having lost

$19.2 billion between July 2007 and July 2008. Bank of
America stepped in and agreed to buy Merrill Lynch for
$50 billion, saving it from bankruptcy.

• Credit rating agencies downgraded insurance giant American

International Group (AIG), sparking a liquidity crisis.
Financial Crisis - Key Events
• AIG’s liquidity crisis intensified, and at 9pm EDT the Federal Reserve Board
announced that the US Government had stepped in to bail out the
insurance company. The immediate support was an $85 billion credit facility.

• By March 2009 the US Treasury and Federal Reserve had committed

$182.3 billion to the rescue.

• The authorities had decided that AIG was too big and too interconnected
to fail. As of 30 June 2008 the company’s consolidated total assets totalled
more than $1 trillion and it was the largest provider of conventional
insurance in the world.

• AIG also sat at the centre of a dense web of financial contracts: had it been
allowed to go bankrupt, AIG could have taken down many of the banks
it had sold credit protection to.
Financial Crisis - Key Events

• In the UK, the Yorkshire bank Bradford & Bingley was

nationalised. The Government took control of the bank’s
mortgage and loan books, while its branches and deposits
were sold to the Spanish banking group Santander.

• Bradford & Bingleys rapid expansion into buy-to-let

mortgages left Bradford & Bingley vulnerable to a
downturn in the housing market.

• As short-term funding dried up after Lehman Brothers

went bankrupt, Bradford & Bingley’s ability to support
itself also evaporated.
Financial Crisis - Key Events
• On 7th Oct 2008, the British banks HBOS and RBS were in dire
financial straits, and The Bank of England stepped in to provide
emergency liquidity.

• £25.4 billion for HBOS and £36.6 billion for RBS.

• The UK authorities announced a comprehensive financial support

package aimed at recapitalising the banks and providing sufficient
liquidity to the financial system.

• In the case of the most vulnerable banks, this meant part-

nationalisation. Eight major UK banks then committed to
increasing their capital, allowing them to absorb losses more
effectively in the future.
Financial Crisis
Financial Crisis - Key Factors

• Political Influences

• Economic inequities had widened in the United States due

to structural deficiencies in the educational system that
created unequal access for various segments of society.

• Politicians from both parties viewed the broadening of

home ownership as a way to deal with this growing wealth
inequality, and therefore undertook legislative initiatives and
other inducements to make banks extend mortgage loans
to a broader borrower base by relaxing underwriting
standards, and this led to riskier mortgage lending
Financial Crisis - Key Factors
• Securitisation

• Several studies of Euro-area and U.S. Bank lending standards have found that
low short-term interest rates (relaxed monetary policy) lead to softer standards
for household and business loans.

• This softened policy is magnified by:

• securitisation,

• weak regulatory supervision over bank capital, and

• a lax monetary policy for an extended period.

• These developments led to a substantial increase in the credit that flowed into
the housing market to enable consumers to buy homes.
Financial Crisis - Key Factors

• Securitisation

• Financial innovation - prior to the 2007 crisis, banking had

evolved from the traditional business of accepting deposits
and granting and supervising loans, to providing services to
investors (asset/investment fund management, advice and
insurance) and companies (consultancy services, insurance,
mergers and acquisitions, underwriting share offerings and
debt securities, securitisation, risk management).

• The explosion of new asset-backed securities created by

securitisation prior to the crisis created an ideal environment
for asset price bubbles and high bank leverage.
Financial Crisis - Key Factors
• Securitisation in practise

• Banks and other lenders were willing to make increasingly large volumes of risky loans for a range of reasons:

• Competition increased between individual lenders to extend ever-larger amounts of housing loans that,
because of the good economic environment, seemed to be very profitable at the time.

• Many lenders providing housing loans did not closely assess borrowers’ abilities to make loan repayments.

• They sold large amounts of loans to investors, usually in the form of loan packages called ‘mortgage-
backed securities’ (MBS), which consisted of thousands of individual mortgage loans of varying
quality. Over time, MBS products became increasingly complex and opaque, but continued to be
rated by external agencies as if they were very safe.

• Investors who purchased MBS products mistakenly thought that they were buying a very low risk asset:
even if some mortgage loans in the package were not repaid, it was assumed that most loans would
continue to be repaid.

• These investors included large US banks, as well as foreign banks from Europe and other economies
that sought higher returns than could be achieved in their local markets.
Financial Crisis - Key Factors
• Monetary Policy

• The unusually low interest rates, a part of a monetary policy choice by the Federal
Reserve, have been viewed as responsible for accelerating the housing boom and
thereby ultimately leading to the housing bust.

• A study (Taylor (2009) estimates the empirical relationship between the interest rate
and housing market, it shows that there was a high positive correlation between the
decline in interest rates during 2001–2007 and the boom in the housing market.

• In the absence of the housing boom, there would be no bubble to burst and no
crisis.

• It appears that there was coordination among central banks to follow this easy-
money policy. Apparently, a significant fraction of the European Central Bank
(ECB) interest rate decisions can be explained by the influence of the Federal
Reserve’s interest rate decisions. Taylor (2009)
Financial Crisis - Key Factors
• In the previous two decades, emerging-market countries – most notably China
– accounted for an increasing percentage of global GDP.

• Rather than invest or spend domestically, the foreign savers sought to invest in
safe assets, resulting in huge inflows of investments in the United States in
assets like bank debt, and AAA-rated mortgages.
Financial Crisis - Key Factors

• There are many who have suggested that misaligned

incentives also played a role.

• Financial institutions, especially those that viewed

themselves as too big to fail (TBTF), took excessive
risks because of known safety-net protection via deposit
insurance and the understanding that there is a certain
regulatory reluctance to allow such institutions to fail.

• Risk-taking was permitted due to lax oversight by

regulators whose incentives were not aligned with those
of taxpayers.
Financial Crisis - Key Effects

• House Prices - house prices in the United States

experienced significant appreciation prior to the crisis,
especially during the period 1998–2005.
Financial Crisis - Key Effects
• The housing price bubble facilitated a substantial increase in
individual consumption. U.S. households, feeling rich in an
environment of low taxes, low interest rates, easy credit,
expanded government services, cheap consumption goods, and
rising home prices, went on a consumption binge.

• Personal savings rate drop below 2% for the first time since the
Great Depression.

• Some of this higher consumption was financed with higher

borrowing, which was supported by rising home prices. Indeed,
the simplest way to convert housing wealth into consumption is
to borrow against the equity built up in one’s house.
Financial Crisis - Key Effects
• Evidence suggests that securitisation may have weakened the
incentives of banks to screen their borrowers.

• Demyanyk and Van Hemert (2011) suggest that during the

dramatic growth of the subprime (securitised) mortgage market,
the quality of the market declined dramatically and that lenders
seemed to be aware of this.

• In particular, the quality of loans, measured as the performance of

loans, deteriorated for six consecutive years prior to the crisis, and
this deterioration is statistically significant even after loan
performance is adjusted for differences in borrower characteristics
like the credit score, level of indebtedness, loan amount, and ability
to provide documentation
Financial Crisis - Key Effects

• The crash in house prices or Bubble burst - The drop in

home prices meant that they had negative equity in their
homes (given that many of these loans were granted at
100% Loan To Value or higher).

• When rates adjusted upward, borrowers found it difficult

to make the higher monthly mortgage payments.

• As these borrowers defaulted on their mortgages, Credit

Ratings Agencies began to downgrade Mortgage
Backed Securities, and many of the downstream
adverse events began.
Financial Crisis - Key Effects

• Liquidity - The bankruptcy filings of subprime mortgage

underwriters and the massive downgrades of MBS by the
rating agencies in mid-2007 created significant concerns
about the credit qualities of many types of collateral being
used in repo transactions, as well as possibly the quality
of the credit screening conducted by the originators of the
underlying mortgages.

• This resulted in repo haircuts to spike up significantly,

causing the short-term borrowing capacity in the
shadow banking sector to decline substantially, creating
what appeared to be a liquidity crunch.
Financial Crisis - Key Effects
• Was this a market-wide liquidity crunch or a bank-specific increase in concerns about
solvency risk that caused the availability of funding to shrink for some banks but not for
others?

• One viewpoint is that when people realised that MBS were a lot riskier than they thought,
liquidity dried up across the board because the high level of asymmetric information
and opaqueness in the product meant it was difficult to assess the quality.

• Another viewpoint is that this was, at its core, a bank-specific solvency issue, and not a
liquidity crisis.

• Boyson et al. (2014) examines funding sources and asset sales at commercial banks,
investment banks, and hedge funds. It hypothesizes that if liquidity dries up in the
financial market, institutions that rely on short-term debt will be forced to sell assets
at fire-sale prices. The empirical findings are, however, that the majority of
commercial and investment banks did not experience funding declines during the
crisis, and did not engage in the fire sales predicted to accompany liquidity
shortages.
Financial Crisis - A Timeline
Financial Crisis - A Timeline
Financial Crisis
• The Bank for International Settlements states that the crisis developed in
five more or less distinct stages of varying intensity, starting with the
subprime mortgage-related turmoil between June 2007 and mid-March
2008.
Financial Crisis - Recap
• Stage one: prelude (up to mid-March 2008)

• During the first stage of the crisis, concerns over losses on US subprime
mortgage loans escalated into widespread financial stress.

• Starting in June 2007, losses from subprime mortgages exposed large-

scale vulnerabilities. These included the widespread use of leverage and
off-balance sheet financing, so that supposedly low-risk assets – many of
which related to US mortgage market exposures – were effectively
financed on a rolling basis by short-term funds.

• While an outright bank failure was avoided, this first stage of the crisis left
the financial system severely weakened. Large overhangs of credit
exposures weighed on markets, while banks struggled to replenish their
capital positions.
Financial Crisis - Recap
• Stage two: events leading up to the Lehman Brothers bankruptcy (mid-
March to mid-September 2008)

• Investor attention thus turned increasingly from questions about funding

liquidity to those about bank solvency, putting particular strains on those
institutions known to be highly leveraged and exposed to impaired
assets.

• Although the Bear Stearns rescue ushered in a period of relative stability

and rising prices for financial assets, interbank markets failed to recover.

• Pressing concerns about banks’ capital positions resurfaced in June,

following negative news about the troubled insurance sector on which
Moody’s and Standard & Poor’s had taken negative rating actions.
Financial Crisis - Recap
• Confidence in the continued solvency of Fannie Mae and Freddie
Mac vanished, and the US government formally took control on
Sunday 7 September.

• This action served as a reminder of additional losses to come on top

of the $500 billion or so in global write downs that had accumulated
by the end of August 2008. It also suggested that central bank
efforts aimed at substituting for market-provided funding had
probably run their course, with investors increasingly focusing on
issues of solvency.

• Investor attention returned the bank balance sheet figures this, in

turn, added to banks’ problems in replenishing their capital bases
and satisfying their funding needs.
Financial Crisis - Recap
• Stage three: global loss of confidence (15 September to late October 2008)

• The tipping point came on Monday 15 September, when Lehman Brothers

Holdings Inc filed for Chapter 11 bankruptcy protection: many had hoped
that this would merely be a year of manageable market turmoil then
escalated into a full-fledged global crisis.

• The resulting crisis of confidence quickly spread across markets and

countries, making it obvious that policy action would have to shift from
liquidity support to broader-based measures, including system-wide bank
recapitalisations.

• The markets now came under pressure from losses on exposures of

money market mutual funds to short- and medium-term notes issued by
Lehman.
Financial Crisis - Recap
• The resulting turmoil quickly spread through the global financial system.
With banks hoarding liquidity, movements in other markets such as
those for euro and sterling funds, showed similar signs of disruption.

• The ultimate proof of the depth and breadth of the crisis came on
Monday 29 September. That day, authorities in a number of European
countries were forced to counter threats to the stability of individual
institutions within their national banking systems.

• Following the Lehman event, emerging market assets weakened further

on a broad basis as fears about the stability of banking systems in the
major economies triggered a combination of concerns about collapsing
global growth, lower commodity prices and the availability of external
sources of funding.
Financial Crisis - Recap
• By mid-October 2008, with the flurry of unprecedented policy
initiatives taken across countries increasingly adding up to a joint
approach, markets were finally showing signs that the crisis of
confidence had been arrested.

• On 8 October, the authorities in the United Kingdom announced

comprehensive measures to recapitalise UK banks.

• The move was followed by the first ever round of coordinated cuts
in policy rates by six major central banks, including the ECB, the
Bank of England and the Federal Reserve.

• Efforts to implement additional, broad-based policy measures

continued in the following weeks
Financial Crisis - Recap
• Stage four: investors focus on the global economic downturn (late
October 2008 to mid-March 2009)

• The global crisis of confidence had come to an end, policy action

continued on an international scale as governments sought to
support market functioning and to cushion the blow of rapid
economic contraction.

• However, when the scale of the global economic downturn became

fully apparent in January 2009, prices for financial assets were
dragged lower once again. Against the background of weak fourth
quarter data that suggested that economic activity was in the midst
of the worst slump in decades (see Chapter IV for details), markets
resumed their earlier slide.
Financial Crisis - Recap

• Stage five: first signs of stabilisation (from mid-March 2009)

• A key factor behind improving asset valuations was the

confidence effect from announcements by major central
banks of expansions of both the range and the amount of
assets that they would be prepared to purchase outright.

• The Bank of England announced plans to purchase private

sector assets and government bonds.

• The Federal Reserve followed with news that it would

acquire up to $300 billion worth of longer-term Treasury
securities.
References

• Casu, Barbara, et al., Â Introduction to Banking. Pearson, 2006.

• Greenbaum et al., Contemporary financial intermediation.,

Academic Press, 2019

• Banking of England, “The financial crisis – 10 years on”, 2018,

https://www.bankofengland.co.uk/news/2018/september/the-
financial-crisis-ten-years-on

• BIS, “The 79th Annual Report”, 2009, https://www.bis.org/publ/

arpdf/ar2009e2.pdf