t/10/2024

Markets: Primary Functions

-,Fi,nancial
Financial markets have five primary functions:
(1) facilitating the flow of funds
MSL310 Flnancial lnstitutions and Markets (2) providing the mechanism for the settlement of transactions
Global Financial Crisis
(3) generating and disseminating information that assists decision-
making
(4) providing means for the transfer and management of risk, and
(5) providing ways of dealing with the incentive problems that arise
in financial contracting

.l

1 2

,,.].nt.rod!ction
The financial crisis of 2007-2009 is an example of what happens Few concepts/definitions
when the efficiency of the financial system disappears
Discuss global financial crisis
. Actual risk and perception of risk
The crisis began when so-called subprime mortgages began to
. lnterest rates and borrowing levels
default in the United States . Bank lending
This quickly spread across the globe as a crisis of confidence in the . Role of credit rating agencies
system emerged, with banks not lending to each other and spiraling
. Risk-taking incentives
credit defaults shrinking the pool of funds available in the global Onset of the crisis
financial system (credit cris/s)
This led to a rapid unwinding of investment and credit positions
across the globe as financial market participants fled risk for cash
safe havens

3 4

Actual Risk and Perception of Risk Actual Risk and Perception of Risk
Time Value of Money Time Value of Money
Cannot compare cash flows that occur at different points in time Why compound interest?
FV : PV (7 + i)11

Rs 100 FY: Future value

t=0
PY: Present value

i: lnterest rate

Rs 100

5 6

t
 L/1.0/2024

jlual Risk and Perception of Risk Actual Risk and Perception of Risk
Time Value of Money Time Value of Money
Say you have Rs 100 Savings Account:

How much money you will have after one year if you FV = lso11.Or, = Rs 102
(a) Put Rs 100 in a savings account at 2 percent interest Term Deposit:

(b) Put Rs 100 in a term deposit that gives 8 percent interest Flz = 100(1.08) = Rs 108
Corporate Bonds:
(c) lnvest Rs 100 in corporate bond that offers 10 percent yield
FY = 100(1.10) = Rs 110
(d) lnvest Rs 100 in shares which gives you return of 15 percent
Shares:
Rs 100 Rs ???
t-0 t. t FY = 100(1.15) = Rs 115

1 B

Risk and Perception of Ilisk Actual Risk and Perception of Risk

"-.Actual
Time Value of Money Time Value of Money
[]ow much you invested one year ago if the current value of your
investment is Rs 100 and
PV =-:\r+i I'r
(

(a) Got 2 percent interest by putting money in a savings account FV: Future value

(b) Got 8 percent interest by putting money in a term deposit PV: Present value

(c) Bond offered 1.0 percent yield i: lnterest rate

(d) Earned 15 percent return by investing in equities

/r\ ljrscount tactor
\--r:
Rs??? Rs 100
t=0 t-1

9 10

Ilisk and Perception of Risl< Risl< and Perception of Risk

-,1}-ctu,at .39!ual
Time Value of Money Time Value of Money
Savings Account: Assume that you invest $10,000 today and expect to receive two
roo = pv(7.02) annual payments of S6,000 each

ov =:+= Rs ee.o4 lriln: 0

\crr I
|
\..rr l
I
t...1
Term tleposit: : #: Rs 92.59
PY (:rrh I Jo\r 9l{r,(x)ll \6ti{l)
I
X(0tO

Corporate
' Bond: PV - L10
'9u-- -- 1?s 90.91

Shares: ,t, : i|q = Rs 86.96

11 1.2

2
 t/10/2024

Actual Rlsk and Perception of Risk Actual Rlsk and Perception of Risk
Time Value of Money Time Value of Money
PV of Yeor 7 cosh flow PV of Yeor 2 cosh flow
\i'a! I n'ar 2 \t,rt 1 v&,r 2
l).n: O I ) I)at. 0 I )

Crr! I'l,N
l_______,t__
1l{1,{1fl0 $(nX)0 $(ilXxl (la!h
t---i--1
|1tr$ Sll),i)lt0 56000 l6{!q)

FV : PV(1* i)n =+ 6000 = P7(1 + 0.10)r FV : PV(l* i)" + 6000 : PY(1 + 0.10)2
py = -!!- =e pV = 6nol ,rr- FV +prz-9999
(l+i)" 1.1r (l+i)n t.lz
pV of year 1 cash flow = 949! = 5,454.55 PY of Year 2 cash flow = 4,958.68
1.1
= #

13 t4

*Agl*lts1* and Perceptlon of Risk :\gtjg!"Bisk and Perception of Risk

Time Value of Money Bonds
Net present value (NPV) of your lnvestment Coupon (interest) rate = 5 percent
NpV = pV(Benef its) _ pv(Cosrs) Face value = Rs 1,000

\.ir I \P:r : Term to maturity = 5 years

I)nt. 0 I ?

hj, t:b$ sla.ro{t

I -- sdr0o
l- ---l .16000
lnterest annually compounded
Yield on similar f ive-year bonds = 10 percent
NPlz = -10,000 + 5,454.55 + 4,958.68 = $473.23 sol sol sol sol so r loool
ollzl:l+lsl

15 16

l)gt-u-al Risk and Perception of Risk *A!!yal Risk and Perceptlon of Risk
Value of a Bond Eond Prices and Yields
Value of a financial security = Present value of all future cash flows Suppose there are two bonds A and B, both issued bythe same
company
FV:PV(7+t)tt
The two bonds have same coupon rate, frequency of compounding,
50 : PY(1 t '
0.1)2 + PV :2 face value, and term to maturity
l.7z
Only difference between the two bonds is that Bond A has
sol sol sol sol so+ loool
underlying collateral whereas Bond B does not
u . Therefore, Bond A is less risky than Bond B

50*-*-*-*-=810.46
PV:-1.1 50 50 50 1.050 l'rr r: rri r:ririr:lr iror rl ,.rill lrr lrill lt i
l.7z 1.1r 1.14 1.1s

11 1B

3
 L/tol2024

Risk and Perception of Rlsk Actual Risk and Perception of Risk

-"49!--!-gl
Bond Prices and Yields Bond Prices and Yields
lnvestors will pay lower price for risky bond and higher price for less lnvestor pays Rs 96,618 to get Bonci A and will receive Rs 100,000
risky bond after one year
Su ppose: or--- !
Suppose both bonds A and B will pay lnvestor Rs 1.00,000 after one Rs 96,6181 Rs 100,000

year
ltv:PV(t+i)n
Price of Bond A is Rs 96,618 (less risky)
Calculate yicld (or return) for rhe investor
Price of Bond B is Rs 90,000 (more risky)

19 20

Actual Risk and Perception of Risl< Risk and Perception of Risk

".$"g!.u,.t
Bond Prices and Yields Bond Prices and Yields
100,000 = 96,618(1 .r y) lnvestor pays 90,000 to get i ,r'rr t1 and will receive 100,000 after
one year
Y = 0.03s
0 1l
Yield (or return) for the investor is 3.5 percent
Rs 90,000 --l
Rs 100,000i

{'t/ ii.ttil t i'tn

100,000 = 90,000(1 +y)1
/: 11.11 percent

ZT LL

-Actual Risk and Perception of Risk Actual Risl< and Perception of Risk
Bond Prices and Yields Bonds
Bond A (less risky): Price is Rs 96,618, yield is 3.5 percent Coupon (interest) rate = 5 percent
Bond B (more risky): Price is Rs 90,000, yield is 11.11 percent Face value = Rs 1,000
lnverse relationship between bond prices and yields Terrfl to maturity = 5 years
lnvestors will pay lower price for riskier bonds lnterest annually compounded
lii ri<i.:r l.ror rr i:, it,rv,:: itil.ji rrr yir :lrir Yield on sirnilar five-year [tonds. i[0 perccnt

1)
24

4
 LILO/2024

Actual Risk and Perception of Risk Actual Risk and Perception of Risk
Bond Prices and Yields Bond Prices and Yields
Coupon rate, frequency of compounding, face value, time to Suppose a 5 percent coupon paying bond was issued 3 years ago, it
maturity determined at the time of bond issuance has term to maturity of 5 years

Bond prlces and yields change because of several factors such as Now, market interest rates have gone up
market interest rates, inflation, riskiness
Bonds with similar risk and five-year maturity have yield of 8 percent
50 50 50 50 1,050
D
-_I_a_.!_f,_ e Demand for 5 percent coupon bond will decline and therefore
prices will fall (and yields will rise)
50 f 50 50 50 1,050
+y)2 ' (l +y-): ' (l+y;r '
D L- !- f,.
(l+y) '
: _
(1 (1 +y;s

2l) Z6

Actual Risk and Perception of Risk
When times are good, perceptlon of risk diminishes
When the cycle turns, risk aversion increases again, often far beyond
normal levels
lnvestors' perception of risk changed in the years leading up to the
financial crisis of 2007-2009
Actual Risk and Perception of Rlsk
Role of the Financial System: Financial Markets (Topic 1)
P rovision of i nfor motion
Credit rating agencies play an important role in the provision of
information on companies, governments and other organizations,
and the financial instruments that they use
They publish itrit,i,rrlij ir','
.r"rrrr)rrf i about the financial standing of
securities and institutions using a standard scale
. For example, 5&P credit ratings AAA, AA, A, BBB (investment grade) and
BB, B, CCC, CC, C, D (speculative/noninvestment grade or junk or high
yield bonds)

21 L6

Actual Risk and Perception of Risk ..AS}V, I

fl*.S!9".!3 rce ptio n of Risk
Actual Risk and Perception of Risk FnED ,. ,,,.' $|r,6\'kd,, k *'

'. lo-Year US Government and High Yield Bonds

lnvestment grade bonds - Very low chance of default, low yields Yields on iunk ,i .,
bonds narrowed ,,..1 ,'r'''r i'i
lunk bonds - Higher chance of default, high yields ri i
relative to those .,. . ../,'i
on US .r
government : '" /'.1" \."',1;r..
_.,r,..,,,.._.
bonds and other
' 't.......
.^.
securities that are , ...-/v'\;-r.rJ.\r.*
seen as very safe -..,r.-_.,1.2../a__
i.- r,.-.J -...

29 30

5
 L/to/2024

Actual Risk and Perception of Risk a nd Borrowi n g Levels

_.111j9191t-R-ates
lnvestors did not perceive "risky bonds" as risky and were willing to Borrowing - Magnifies Returns (and Losses)
pay high prices to purchase them
Suppose you purchase an asset for Rs 100
=+ Risk-return mismatch (low price of risk)
There is a 50 percent chance that the asset value will increase to 120
Likely cause: Funds were available cheaply and easily and 50 percent chance that it will fall to 90

1.20 (+#):20 percent

100 ,

eo (+#) : - ro percent

31 32

*lnterest Rates and Borrowlng Levels -]$efes-t

Rates and Borrowing Levels
Borrowing - Magnifies Returns (and Losses) Borrowing - Magnifies Returns (and Losses)
Suppose you borrow Rs 40 to finance this purchase at an interest Suppose you borrow Rs 70 to finance this purchase at an interest
rate of 10 percent (and Rs 60 using own funds) rate of 10 percent (and Rs 30 using own funds)
After one year, repay principal (P = 40) and pay interest (/ = pit) After one year, repay principal (P = 70) and interest
= 40 + 40(0.10)(t) = +q = 70 + 70(0.10)(t) = tt
Your returns Your returns Do - 77 = 43 (T, ) = 43.33 percent
. L2o - 40 - 4= 76 (#) = 26.67 percent
100 100
60{Ownfund\l /a. i,\\ J0 {Own lundsl
'tJ
ao (ao,,o*i 90 - 40 - 4= 46 (=ffJ = -23.33 percent ao ieo',o*1 90 -71 - 13 (t .,, = -56.67 percent

JJ 34

lr-t_g-Lust Rates and Borrowing Levels

*.lnterest Rates and Borrowing [.evels
Borrowing - Magnifies Returns (and Losses) Borrowing - Magnifies Returns (and Losses)
Suppose you borrow Rs 90 to finance this purchase at an interest Borrowing to purchase assets is attractive when asset prices are rising
rate of 10 percent (and Rs 10 using own funds)
But when times are bad and asset valuations are falling, investors,
After one year, repay principal (P = 90) and interest losses are magnif ied by leverage
= e0 .+ 90(0.10)(r) = ss
Equity Debt Debt /Asset Value Return - When asset Return - When
YoLrr returns
' 1.20 99 ..21, (a;,.t] = 110 percent value increases asset value falls
100 100 0 0 20 -10
I0 {Own funds) / o',,-.)
,,, \ 60 40 o.4
90 - ee = -9
26.67 -23.33
.o ie.,,"*) t = - l9() percent 30 70 0.7 43.33 -56.67
10 90 0.9 110 -190

)r
36

6
 L/LO/2024

lnterest Rates and Borrowing Levels lnterest Rates and Borrowing Levels
lf interest rates are low, borrowing will increase fi8r,r{1 1,?. l;orlisan.rir', iurtio{r<.
"{xl
Inr$hohi.rrx)rDreltxlii..lo"(il),'
1.1
Households
1.0

I nvestors 0.9
o&
t.t
t.6
0.5
0i
0.1
r!$? 1945 196S rtSl irlj ii)r, ?0d, 2ir.,x rtt6 2

3t JO

ll_"!Stu:l Rates and Borrowing Levels lnterest Rates and Borrowing Levels
FRED Monetary Policy
Central banks conduct monetary policy by controlling the level of
Short-term
funds in the money market and the level of interest rates
interest rates in
the US To slow down economy - increase interest rates
. lndividuals and businesses borrow less funds and spend less
Policy rates were
To stimulate economy - decrease interest rates
historically low . lndividuals and businesses borrow more funds and spend more
in early 2000s
i-\,rIi1,11,,rllini{'r(r.,1I,r1i,:i,ir.irii,r i),rIl(',allir'ilti)iioiirirnJl(l
irlrr r r)\'nir lr, (,,trri rt-.rt;tdilli) ili .li r,t .)liol r\/ I

So0(e: hilps://ted.illoiLred.orglse.ie!/Fa0FUNDsd0

39 40

lnterest Rates and Borrowing Levels l-lleJ"gst Rates and Borrowing Levels
Monetary Policy Monetary Policy
Sally puts her money (71) in a term deposit for one-year at 5 percent Banks borrow short-term and lend for long-term
interest rate
Bank lends funds to caf6 owner, to be repaid over next five years
Bank lends 251 to caf6 owner, which needs to be repaid over a
a=0 i=l t-2 i=3 t=4 t=5
period of five years at 8 percent interest rate Borowr {undr Borows flnds Borows flnds Botrows irnds Bo(ows tunds Rcceives
for one year 3nd for one ye.r, .sain for one yea4 again for one yeai .gain for ohe principat tiom
londs rhese 3nd pays o,f the and pays otf the .nd pays olI lhc ye.r, and paye the cat6 owne.
funds at hi8har loan (boiiowed toan (botrowed at toan (botrowed ar ofI rhe toan and pays oft the
intere*ratefor att=O) r=1) t=2) (borowedatr to.n(borowed
iive yea6
= 3) ar I = 4)

By increasing short-term interest rates, central banks try to control

supply of funds in the market

41. 42

7
 t/10/2024

lnterest Rates and Borrowing Levels

J-!e"..lg:! Rates and Borrowing Levels
Short- and long-term interest rates Short- and long-term interest rates

,
-'.
.,

/'
./)

/il.lrrro.ii6ilry:nr!i) i)ld.fib tsilrrrsl.r lrFdrntj A(!yrty.il 2r"trr'a rrlv!f, 5r.,r&

na" ili InrJir: t.r:!h:itr !!rl.rrhlrta!,eir.t.5it:)ijrrrcr!no.rnln
r1.'.. .-ltrll"llJl.:l*J*l]*-i.:Ji_
source: htps://cana.abank..om/User oaae.asox?orhllnk-9

43 44

* !nf erest Rates and Borrowing Levels lnterest Rates and Borrowing Levels
Policy rates started to increase from 2004, however, borrowing
did not reduce
Policy rates started to increase WHY? Funds
from 2004

redd4!di!10.60P Rtio,
['lowever, borrowing did not
red uce

I nterest Rates

45 46

lnterest Rates and Borrowing Levels
Types of Financial Markets (Topic 1)
Money ond copitol markets
Financial markets are sorted into money and capital markets on the
basis of the term to maturity of a given financial claim
Securities traded in these two markets are based on the
requirements of the users and providers of the funds
A wholesale short term to maturity claim (less than 12 months to
maturity) is classified as a money-market transaction
lnterest Rates and Borrowing Levels
Types of Financial Markets (Topic 1)
Money morkets
ln the money markets:
. Financial institutions adjust their liquidity position by borrowing, lending
or investing
' Leillrdl b!nks (onducL []onetdry l)olitty (co|[rolliill] tltt lcvcl of fuIrl: i0
thar [rark.]l Jn(l tiJo l.tvcl oi jntorC!t t altcs)
. Businesses, governments and sometimes, individuals borrow or lend
funds

47 4t3

8
 L/10/2024

lnterest Rates and Borrowing Levels lnterest Rates and Borrowing Levels
Policy rates started to increase from 2004, however, borrowing did
not reduce
Though short-
\l\/! i Y i term rates started
Even though short-term interest rates started to increase from 2004, to increase from
long-term interest rates were still very low 2004, l(rrfi iLrnrl
intrr{l'!i ratcl
wr:rc rtill vrrry lorv
Low yields
+ High prices

sour..r htlps://,red (louBled

49 50

Interest Rates and Borrowing Levels

Short- and long-term interest rates Long-term interest rates
Low short-term interest rates could not explain crisis on their own
Market for short-term interest rates Market for long-term interest rates

(* l-"'
Possibly,unusually'.lrrrtrtlirtvt'.1rrtrlt't;trxltottll,l()v{'rlr irirl
oemand I
supply
l,lrrl', pushed long-term rates down (high prices, low yields)

This remained the case even when policy rates started to rise in 2004

_).<: __>!_*

5t 52

.1"!!g1"9.!t
Rates and Borrowing Levels lnterest Rates and Borrowing Levels
Long-term interest rates
lrorr i1r,",ilr' Iot l]', i;orrL't Ill)r{lrl lrllrii:. - Cgntfal
f,i'irt11i rlt'tp.r1r1 (irl bilrio'rs dolli.!)

banks and other government agencies in emerging and industrialized *Japan -.'China
economies were accumulating US government securities
lnverse price - yield relationship
High demand - price increases - yield falls
.+ Low level of interest rates
8€ 3 B 83r 8 -q 6 3E a;;
;;5in.1'-c;;+x-,r
-i)- )

53 54

9
 1./Lo/2024

lnterest Rates and Borrowing Levels Rates and Borrowing Levels

Jll.erest
Long-term interest rates Foreign Holdings of US Treasuries (in billions dollars)
Foreign Holding5 of US frea5uries -

"J ro,"-"'".,-d '"t"

55 50

lnterest Rates and Borrowing Levels lnterest Rates and Borrowing Levels

:;l l,u

*$g-f-est Rates and Borrowing Levels *lnterest Rates and Borrowing Levels
US debt has riser regnrdless of ndnrit)istration

59 60

10
 L/LO/2024

lnterest Rates and Borrowing Levels lnterest Rates and Borrowing Levels
Policy rates started to increase from 2004, however, borrowing did
not reduce
WHY?
US
Even though short-term interest rates started to increase from 2004,
long-term interest rates were still very low
.. ' China Funds were flowing into the US market frorn external sourccs

Japan Monetary policy had little impact on the longlerm interest rates
UK
lnd ia

61 62

lnterest Rates and Borrowing Levels lnterest Rates and Borrowing Levels
Uousehold Debt Payments to Disposable Personal lncome One sector that took particular advantage of low long-term interest
FREO
rates was the US mortgage market
Low interest rates - home ownership
At the time, it was thought it would allow more people to become
home owners

63 64

lnterest Rates and Borrowing Levels ,,san\!e#lilg._ ""

U.S, Home Prices lncrease in leverage (ratio of loan amount to the house value)
l\l)1,:X VA,,tll::.l NllAIiY 2t)01) 1(x) Many people had very little equity in their homes by the time the
'boom peaked
300
, xofhomepurcbasevotume.itt rnlrv :

r gnd$tot6 orCLW>=g7y. LIV: toal to value ratio

250 U.Slotal
'i" cLru: conrbined LTV (ratio ol all
200 '.-----"." ":- ' Non5aodltald
! {Nr f ,o.u,",1 liron, on u prop"rty to
1.50 -
,J
'100
-i
50
u,o. ,.o ',,*..''7.? i
0 t,:!ti P:XErriiiils{8
1945 ?.fx)o ?305 ?0t0

65 66

11
 t/to/2024

9qnk Lending Bank Lending

Why were banks lending so much? Risks faced by financial institutions
Subprime mortgages (.r i',iii i i!l(
lligh loan-to-value lnterest rate risk
Refi na nci ng Liquidity risk
. say property value is 100, borrowed amount is 90
. When prices increase to 200, refinance property, so borrowed amount Foreign exchange risk
0.9(200) - 180
. Additional amount borrowed will require higher debt payments - what Political risk
about income increase? Reputational risk
Environmental risk

61 6B

Bank Lending Bank Lending

Bank: Assets and Liabilities Bank: Assets and Liabilities
Sally puts her money (71) in a term deposit for one-year Bank will receive interest income from cafd loan over next five years
Bank lends 251 to cafd owner, which needs to be repaid over a (similar to earning income from coupon payments on bonds or rent
period of five years (funds obtained from Sally and other depositors) from property)

l>
Bank Balance Sheet: 0
Assets: Caf6 loan (bank wlll earn interest income)
Liability: Sally's deposit

69 10

Lend ing
99 ntl-e nd i ng
n k.
",13a
lnterest (and principal) received over the life of the loan Securitization
Banks design new bonds, cashflows of which depend on the
payments received from loans
Eanl) For example: Borrowed amount to purchase a house is Rs 10 lakhs
Present value of all future payments (interest and principal paid)
= 10 lakhs
Will bank be able to sell this "asset" in the market?
Banks will issue 1000 new bonds, say with face value of Rs 1,000,
Who will be the buyers? and sell them in the market
. Value of these bonds is based on the risk of the underlying mortgages
. Whethcr interest and payments are paid and paid in the timely manner

1L 72

L2
 1./LO/2024

ing
*9-arrk-!end _*Q"g1k.!end 1ng
Securitization - "Creating Security"

-93!9

.From company's
profits _.-_ prinlipal repaymenls of Ihe
underlying loans

011121314lsll f ,g ,g ,€ 6r "securitising a pool

f f of loans"
"S f "S

t3 74

9gllk Lending Bank Lending

Securitization Transferring Funds from SSUs to DSUs: Financial lntermediation
Securitisation converts illiquid assets (mortgages) into liquid I nte r mediotion serv i ce s
securities (for example, bonds with smaller denominations)
ln 'transforming'direct financial claims into indirect ones, financial
These new securities are sold to investors in the capital markets intermediaries perform five basic services:
Denomination divisibility
Currency transformation
Maturity flexibility
Credit risk diversification
Liq u id ity

75 76

*B,g.nk.lgnd ing -Pql"rk

Lendi.ne
Securitization Securitization
New securities are sold to investors in the capital markets Bank's bolonce sheet
Bank receives cash, which can be used for further lending Before securitization:
Assets: Home loan/mortgages
Banks also earn fees on new loans
Liability: Deposits
After securitization:
Assets: Cash (in place of mortgages)
Liability: Deposits

77 ]B

13
 1.lLo/2024

*99nk Lending Bank Lending

Securitization Securitization a.s.r-Brc*qds.cqrtfleorlltsndtry
),,,r,.t!,trn,,,,x':;islr,r{..rJN\4r.:rt;ri<in,t.<\.tt.*r4t..r-;i!tt
Securitization was not something done for the first time
Before crisis also, mortgages were securitised as mortgage-backed
security

79 80

e_1! k t.lld il e',.-,,_.,,,...- Lending

-,Bank
What went wrong? Securitization
A special purpose vehicle (SPV) is created
. SPV is separate from the loan originator

Loan originator sells the SPV a pool of comparable assets (e.g.

mortgages from a particular city, similar maturity)
SPV then creates securities, which are funded with the interest and
principal repayments of the underlying loans
These securities are sold to investors

B1 82

Bank Lending Lendjlg .*._._-.

,,,_?ank
Securitization Securitlzation
Bank's balonce sheet
Before securitization:
Assets: Home loan/mortgages - Exposure to credit risk
Liability: Deposits
After securitization:
Assets: Cash (in place of mortgages) - No credit risk, more cash that
can be used for lending and getlerate more income for banks
Liability: Deposits

B3 84

t4
 L/to/2024

Bank Lending
-"p91,[-lendine
Lending standards were eased Products requiring low or no deposit, or with low introductory
interest rate allowed households to pay the very high housing prices
Borrowers with poor credit history or poor ability to repay loan were
that their own stronger demand was generating
also able to borrow funds for purchasing houses (subprime
mo rtgages) As the US housing sector boomed, lending standards eased further
Mortgages were often guaranteed by the government-sponsored Unlike in many other countries, in US if individual defaults, bank
enterprises (Fannie Mae and Freddie Mac) cannot seize personal assets of the borrower
Rather than shrink their business, US mortgage lenders pursued
riskier segments of the market that the Fannie Mae and Freddie Mac
did not insure
. Subprime mortgages

BI) 86

*9*h*lglojne
Subprime Mortgages Share
*ffi lgnding
t:irl6 ri l-.J$ i4n.^.r!e,lr,r', . :r !rit'll r1,,r,,
P'imc Loi"" Sr6pri6.Lo.ni
xala i0n5 1006 1ca7 zood 2005 1&5 2@7
?,1:\. lt: ,rril, .nr2'( t/7.\tt .!.t1:':,
'ltr"
"

:rtt,;a.

riri:t if,cr . r,ii,r at il ''):.< ,rrrrr. r,:1,.: rif.. "a:,

?$7,..{.a'3tr *1.'3r'rtr({ii, iir;.

87 8B

-_Qan.k
Lending Role of Credit Rating Agencies
Role of the Financial System: Financial Markets (Topic 1)
P rovision of i nfo r motion
&iiEloris srb[iholoars
t&! 2005 ,006 ,007 ltr{ 2005 2006 2oo1 A further role of an efficient financial market is to provide sufficient
economic and financial information to enable participants to make
informed investment decisions
For the markets to be efficient, this information needs to be
available in a timely fashion to all market participants so that all have
equal opportunity to make informed decisions

B9 90

15
 t/10/2024

Role of Credit Rating Agencies Role of Credit Rating Agencies

Role of the Financial System: Financial Markets (Topic 1) Complex financial products
. Mortgage backed securities and other more complex securities
P rov i sion of i nformotion . Tranches
Credit rating agencies play an important role in the provision of Many banks failed to perceive, or appropriately manage, the risks
information on companies, governments, and other organlzations, involved in certain financial products and markets
and the financial instruments that they use ll ,rl'l:r iilil,r.r,,l,rtri l.j
They typically publish informed assessments about the financial Ratings assigned by the rating agencies did not reflect the underlying
standing of securities and institutions using a standard scale riskiness of a security
. For example, S&P credit ratings AAA, AA, A, BBB (investment grade) and
BB, B, CCC, CC, C, D (speculative or noninvestment grade)

91 92

Role of Credit Rating Agencies BisjJa.KFe Incentives

lmp.|rd Seortrlc!
Role of the Financial System: Financial Markets (Topic 1)
,r+*I;ai dal*i.ii, 4din d+r^,.r,!f,^-iJrrudri,, itrr.,.rri rJx, I
.'i.{y,..i;iJws l?,rili,irqn{ si r.nn,}rrd}#,;i tfx.\r}r1.
.r,trt,, vh.,i14*.yi,<i!ir\, Dealing with incentive problems
The financial system also has a role in mitigating incentive issues that
arise in financial contracts
I !r1- '.r Examples:
lnformation asymmetry (contplex securities)
Moral hazard (borrowers little equity and no recourse, invostors
not doing due cliligencc, bank lendinll)

I- I- Agency problems (croclit rating agencies)

-I Undermine the financial system's processes and create risk for

parties to a financial contract

93 94

_.8.1 :_lf^l,gl1i ne I n ce nt ves

i

Structure of remuneration arrangements and the risk-taking

incentives they create

Onset of the Crisis

9_5 96

16
 L/LO/2024

Onset of the Crisis Onset of the Crisis

The easing of lending standards during the boom was especially
marked in the US mortgage markets, and so were its consequences
Fn:D - *'..'-'*
,"\.- - . '.!
/
:,1
/'.

91 9B

Onset of the Crisis Onset of the Crisis

Irlodgage Delinqlencies by Loin Typc The easing of lending standards during the boom was especially
Liij:,,.i,i i,!,,.,:j iri \i/r.,i,,(rr.r,rr.l *nrr,l{.,rirr! .rri,,;nr
,.::i,r, ^ji,lr;r
ii\.,),t,!,r.ti,...tr, l!a,\-t e !:t,,tt! {in:. !n.\ \)r, !!rr\. marked in the US mortgage markets, and so were its consequences
It was a credit-f ueled boom
The first consequence of this was the failure of a number of US
mortgage lenders
Some of these were brought down by early defaults, where the
borrower didn't even make the first payment

Nr(: ir6. dastrh t4* n#r&r $ eF ! n*t l$r & d Mr r' !#bit
:rrq {i0,tB:*i*}^rs{rdNr-d(kFf }rq

99 100

Onset of the Crisls Onset of the Crisis

Compared to loans in most other countries, US mortgages are moTe lfip.lnd Sdrllhr
,r.:+i,r^rd!,ls,le, rrr(r {ruff.Ll:iJ r..rrr{d .iod ial 1rL <r
likely to be packaged into securities .'l ).:r. .Lr'In{ L rjrr,:l 4,,:{ .r 4 in.t) i n4dr., rtutr, I rDrp,1nl,6
.: d in, !ftIr n !,ri.i,,iir$,, L4

Many investment banks and others with large securities trading and
investment books have been especially affected
ii
The first ma.ior firm that had to be rescued was Bear Stearns, but rr:r j
:
many others had already declared losses by then a.j i tl
t;
i

';i I-
i:
i"
,Ir

101 1.02

L7
 LllO/2024

Onset of the Crisis Onset of the Crisis

After years of underestimating risks on mortgage-related and other Mistrust among banks: The rates at which banks would lend to each
complex securities, banks and other investors started to realize just other in overnight and term money markets started to widen
how risky these securities were
Unwilling to lend to other banks - liquidity crisis
Following a series of loss announcements and suspensions of some
bank-sponsored investment funds in mid 2007, market participants
began to hoard liquidity
They were worried about their own f uture liquidity needs

103 1"04

Onset of the Crisis Onset of the Crisis

Overnight London lnterbank Offered Rate (LtBOR) 3-Month Treasury-Bill and LIBOR
FNEO
FRED * ::;P;1;p1g.f*.t'l*:*o.**,," *

'i.
' \r .,:., -"'-,^

105 106

Onset of the Crisls the Crisis

9tse..!_gf
FtlEa .r "' !'ir'' TED Spread: Difference between the three-month Treasury bill and
the three-month LIBOR

TED Spread: 'l FREN

Difference between I

the three-month .i i
Treasury bill and the ,,i]
three-month [.lBOR t/ii i
t'1.'rt,
(Measure of panic in
the market) l l'iir,n
\^.*"*-^,n'4\*/'A"J-r'i '.'-'L.

t07 1Ott

18
 L/10/2024

Onset of the Crisis Onset of the Crisis

Normallythe money market rates are very close to the policy rates ln this environment, banks'perceptions of risk increased, and they
set by central banks, but that relationship broke down in August started to tighten lending standards
2007
Banks were becoming more risk-averse, but so were their customers
Lenders that had depended on short-term money markets or who started to pull back on spending
securitization therefore started to find it very difficult to obtain
fu ndi ng

lnvestor demand for certain kinds of mortgage-backed securities

dried up in the following months

109 110

Onset of the Crisis the Crisis

*g_ff_ej_-gJ
Prices fell even further when Lehman Brothers failed in September When Lehman failed, it triggered a further increase in risk aversion
2008
There was a flight to the safety of government bonds, and away from
Lehman had been an important player in many of the securities and emerging markets and other assets
derivative markets that were freezing up
Yield spreads on traditionally risky assets widened further, as well as
It even had a subprime mortgage subsidiary, which it shut down in those on newer kinds of complex securities
August 2007
Lehman incurred substantial losses in the quarters prior to its failure

It1. 1.12

Actual Risk and Perceptlon of Risk Onset of the Crisis

FtEt , I ..,r*"a$&^se4 FPED - < *r'+*"*-*-'*

Yields on junk
' 1o-Year US Government and High Yield Bonds
n
spread
Yield
lo-year us Government and High yield Bonds
bonds narrowed -i i,..'r'\\'1i"1\
between i
those . government
relative to \ bonds and junk
i1

I
government ; "1'^,1 t\ bonds widened j ,ii#..,t ji
:

bonds and other

r" \"ja-.-.,, out dramatically, - ..-i' 'r. ,ii t*,\,j";r I
"t
.--,. -r'"t'"t'.i ^ as investors \qr,,. ,. rJ\- wlrr.
securities that ar" '!'"
,",\i'\.,
i,
' \"r "^.t'".- becamemore '/!+:{.\!,u"ua..,,". ^

seen as very safe i -..;-';'''-. ^...'/"r" '' "\./' : ''

risk-averSe ".,.,r'-r^',,...,"'1, ,..

113 1_L4

19
 tlL0/2024

Onset of the Crisis of the Crisis

__9.n.gt
10-Year US Govt Bond and Emerging Market yield As investors and others began to realize the macroeconomic
FFGO
consequences of the turmoil, other asset markets were also affected

Share prices fell sh

t .r+ Ji -a" ."*

"r, . I {i ,il ., .dL
..r'-"."'nJ -*v-or-".,''"J J;r-,,.,

115 1"1"6

_.9f set of the crisis __Global, Financia I Crisis

The major industrialized FRED Cheaply available funds: Risk not priced appropriately (allocational
economies of the United efficiency)
States, euro area and
Borrowers: lligh leverage, low equity in homes
lapan were already
experiencing economic lnvestors: lligh leverage, no due diligence
contractions by the first
half of 2008 Banks: No due diligence when originating loans

Short-term interest Credit ratings: Misleading ratings (informational efficiency)

rates in the US and Risk-taking by managers
other major economies
reached historically low Failure of regulators: Failed to identify the risk and act
levels in early 2000s

117 118

*9tqQu! Financial Crisis .,.Global Financial Crisis

A key ingredient to the stability of the financial system is confidence The role of the regulatory framework, and the authorities that
. Without it, businesses and consumers stop investing and spending, and
monitor, develop, and enforce it, is to manage the financial system
financial institutions stop lending, even to each other
. Available funds in the market dry up and become more expensive and mitigate risks as they arise
The crisis highlighted the importance of having a strong domestic
lnvestments that were once seen as attractive and profitable are no
monetary system that supports economic development while being
longer considered so
able to withstand external shocks
'the 2007-2009 financial crisis led
to the criticism of financial systems
While the regulatory system was not solely to blame, it certainly
around the world and their respective monetary authorities
played a big part
Variety of measures were put in place by governments and monetary
authorities around the world (such as emergency funding and
bailout capital to keep financial instltutions afloat)

119 120

20
 L/L0/2024

Global Financial Crisis Global Financial Crisis

Financial contagion: The spillover effects from a crisis in one market During the global financial crisis, advanced economies suffered steep
that influence other markets due to the interconnections that exlsts and persistent fall in the real GDP
between them
The advanced economies'central banks couldn't rely solely on
Countries operate in an increasingly international economy, in which
they are dependent on, and influenced by, the international financial conventional monetary policy, i.e., reduction in policy rate due the
system zero-lower bound (ZLB) constraint of the policy rate leading them to
introduce unconventional monetary policies to revive the economy
The importance of this internationalization and the enhanced risks it
brings to the domestic financial svstem and its institutions has been Unconventional monetary policy broadly consists of quantitative
highlighted by the financial crisis easing (QE) and forward guidance (FG) measures
It lead to significant change in the structure of the global financial
system, the level of international cooperation and stronger
international regulation

1"21 t22

Global Financial Crisis

Quantitative easing measures refer to the asset purchase programs Global Financial Crisis - lndia
of the advanced central banks', which drastically increased the total
assets as well as altered the composition of assets in the central
banks'balance sheet
The conventional monetary policies had negligible impact on the
central banks' balance sheet
Forward guidance refers to the use of central bank communication
to manage expectations about the future course of policy, thereby
attempting to influence the financial decisions of the household and
firms

L73 L24

Global Financial Crisis - lndia Global Financial Crisis - lndia

FRED ,",: --' .., ,::. '. .,

10-Year US

Emerging
Market Yield

.... ,.
l .

1,25 126

21,
 L/to/2024

Global FinancialCrisis - lndia -

S19.p""9f f inancial Crisis lndia
iii r lirtr\4Jt)r{' i\ i: i,:i, r"/ii ,i !'ri z:: r rz'irri
'r4 lnterest rate
Real GDP growth rate FNED

1,. ..

/ . -,. ._,/. -t. ". tt |

- )

.-' :t i

l
1l :l

:
.)

127 1"28

Global Financial Crisis - lndia

'_ " .,\i.r'.,).,
INR to USD Exchange Rate
lnflation rate
PNED

L29 130

22