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Financial Crisis

Terms in this set (27)

Nature of Sub Prime Crisis
Financial crisis became an economic crisis and is still being felt particularly in Europe today. Named subprime because of its origins of sub prime lending in housing market in US. Institutions came under lots of political pressure to expand home ownership and so were lending to NINJAs. These then defaulted because they couldn't repay which led to the market crashing.
Contagion
Spread to the UK through securitisation and closure of interbank market. Securitisation of retail mortgage backed securities is a pack of securities containing retail mortgages. Once the value of asset declined then whoever owned them was sitting on a loss. Problem spread across Atlantic because securitisation is a global feature in financial markets. Overseas investors were buying securitised products and embedded within that were US retail mortgages. Call this slicing and dicing - bit of housing lending/ automobile lending to form a very sophisticated/ very complicated product. Overseas investors/banks who bought the securitised products were hit. However, main hit was a result of the consequences of these exposures which led to closure of interbank market. Eventually bank system lost trust in itself and in each other. Interbank markets shut off. Stopped lending to each other and then stopped lending to individual/corporates. The reason was they didn't know who was sitting on losses and the scale of those losses for individual institutions.

Without transparency banks were reluctant to reveal its exposures and took it upon them self to minimise damages and would not lend.

Closure of interbank markets caused a contagion not just securitisation.
Macro-Economic Factor that led up to Crisis: Global Financial Imbalances
Extreme surplus and deficit countries. Balance of payments Surplus- China, Deficit - USA. Gets away with it because world all wants to hold dollars. Still have massive payment imbalances after the 70s OPEC crisis. Trend was coming back. Wasn't OPEC induced.
Macro-Economic Factor that led up to Crisis: Long periods of low real interest rates
1990s- 2004 historic low real interest rates - because Green span put would always slash i/r in USA when something bad on the horizon. In attempt to sustain economic momentum and normality to stock market. If keep doing that you introduce distortion into financial markets and real world.

The low real interest rates stimulated borrowing and not saving. Making things worse in the west by reducing incentive to deal with problems. Everyone borrowing- individuals/ corporates/ governments.

These factors were creating asset bubbles. Financial assets such as property/ housing were hitting their peak in terms of prices and the stock market hit its peak.- waiting for crash.

As i/r increased slowly people started to default in the housing market as they could not repay- in the states. Losses were made and then the contagion occurred.
Micro-Economic Factor that led up to Crisis: Consumer Inertia
Consumer laziness where proper due diligence were not conducted - trusted financial people/ accept what we are told about financial products. Didn't ask questions about securitised products - nor did professional investors. If NINJA you were shocked to get loan in first place you would just take it and not ask questions.
- Products became so complicated and even people issuing them had trouble understanding what they were.
Micro-Economic Factor that led up to Crisis:
High levels of Corporate leverage
Ratio of debt to equity. Corporates and governments highly levered - seemed a good idea to incur debt when i/r was so low. Too many people were too highly indebted. Banks in particular had no leverage restriction. Highly leveraged bank is a high-risk institution.

Now have a new leverage requirement minimum in the new Basel accord.
Micro-Economic Factor that led up to Crisis:
Compensation Schemes and Volumetric Targeting
Many brokers were incentivised to bulk sale as no one is looking at risk and they were rewarded on the number of loans made.
-All remuneration schemes should've been risk adjusted but they weren't. Too many people had perverse incentives (from societal view).
Micro-Economic Factor that led up to Crisis:
Rating Agencies
A body that the issuer goes to for a rating. If you want to issue security you have to obtain a rating for people to buy it. Pay a fee for rating. They will rate on the likelihood of default over the next time period. You go market with the best AAA - likelihood of default is 0. Yet during crisis they were giving high ratings to securitised products that became worthless in a short period of time. Got it very wrong. There was a conflict of interest as it was the issuer who pays, not the investor. Therefore, Issuer has incentive to get best rate because it minimizes cost and as such they can go elsewhere if they do not get the rating they want.
Micro-Economic Factor that led up to Crisis:
Risk Measurement Techniques & Regulation
Pre-crisis we thought banks were good risk managers and we used to trust them. One problem was linked to regulation as we believed we were well supervised/ regulated.
Regulation allowed, in respect to capital adequacy assessment, some banks to use internal models to generate minimal capital charges. Models based around VaR.

-Value at Risk model designed to convey what the maximum amount can lose over a given time period at a given level of probability if prices move against them. Time period looking at is 1 month, 3 months? Level of probability we want is 99% as want almost certainty in a prediction. Want to be 99% certain that if buy this product, not going to suffer as a result.

-Problem with VaR there is not capture tail risk. Events such as Interbank market shutting for months. Probability for this in advance would be extremely low.
Bank could believe that from its estimate could lose x amount but reality could mean they lose much more than that in that type of market place. Despite this, regulators thought banks were sophisticated enough to use internal models to set capital requirements.
How the UK authorities attempt to stabilise the UK financial system and as such the global economy.
Failure Resolution in the UK would be to increase pressure on 'redrawing' the rules of the game to try and ensure no institution is 'TBTF' or 'TITF' e.g. impose 'living wills' on financial institutions or force the adoption of some form of 'narrow bank' proposal on existing institutions.
Brokered 'takeover-rescues' of weak institutions. (Uk/USA)
Seen as a 'low cost' option for dealing with weak institutions as no public money is at risk.
Weak ones bought out by bigger ones. -Costless solution to society.

1. Santander saw that this bank was for sale at a cheap price (The Alliance and Leicester) and they would like to gain exposure in the UK. Cheap way into UK housing market. Why A&L in trouble:
- as an ex building society it was heavily involved in property and housing market was crashing.
- Bad exposure in wholesale market.
- Share price had fallen.

2. HBOS taken over by Lloyds TSB. Highly controversial because Gordon Brown prime minister knew chairman of Lloyds.

3. (USA) Bank of America took over Merrill Lynch
Assisted 'takeover-rescues' / Assisted Mergers (UK/ USA)
Again, a fairly 'low cost' option as little direct financial assistance may be needed (e.g. in the US it has been common to provide a 'regulatory' benefit as a bribe to facilitate a take-over rescue).
Part- Nationalisation (UK/ USA)
UK government unveiled a comprehensive £400 billion bailout/rescue plan for the UK banking sector designed to restore financial confidence, stability and credit flows to UK businesses and individuals.

This follows a state-financed capital injection of a sufficient size to ensure continued viability but without eradicating private shareholders.

Potential costs:
-loss of taxpayers' money if equity investment is not subsequently retrieved
-how much management control is secured?

Biggest banking groups were bailed out by the state investing in them on taxpayer's behalf to keep them sound.
RBS = 58% gov stake. HBOS & Lloyds TSB combined (Lloyds banking group) = 43.5% gov stake.

USA:
-$250bn of $700bn. 'TARP' troubled asset relief programme funds used to recapitalise US banking system, with the 8 biggest recipients being:
Bank of America (including Merrill Lynch), $25bn.;
JP Morgan Chase, $25bn.;
Citigroup, $25bn.;
Wells Fargo, $25bn.;
Goldman Sachs, $10bn.;
Morgan Stanley, $10bn.;
Bank of New York Mellon, $2bn.; and
State Street $3bn. [October, 2008]

-under a further bailout of Citigroup, another $20bn. of Trouble Asset Relief Programme money is used to buy preference shares in the bank, while the bank has to provide another $7bn. of preferred stock to the government in return for having its potential losses on $306bn. of toxic assets capped [November, 2008]
-Bank of America receives an additional $20bn. of TARP money [January, 2009]
-Fed pledges an additional $250bn. of loans to Citigroup [January 2009]
Full Nationalisation (UK)
This situation represents the case where the bank becomes 100% owned by the state, on behalf of taxpayers. Existing shareholders are usually wiped out, financially.

Potential problems:
- taxpayers put at high risk
- who will run the bank?
- danger of bank being run for political reasons and not as a commercial enterprise

Nationalisation of the Bradford and Bingley (Sep 2008) - costly because taxpayer has to cover. Supposed to be temporary management of the bank by the gov.

Reasons for B&B collapse:
- crash in profits due to exposure to UK property market (another former building society), especially with respect to buy-to-let (buy to let it out to someone else e.g. student housing) and "self-certified" mortgages ask lender to loan. Opportunity to lie.
- downgrading of its credit rating;
- a precipitous fall in its share price, which destabilised its rights issue process (issue shares to existing shareholders at a discount)
- a failure to find a "White Knight' from the UK banking community. No other bank wanted to take it over/ rescue it.
- Nationalised because rightly or wrongly it was deemed too big to fail, its failure would do too much damage to economy.

Structure of the nationalisation process: Way B&B was nationalised:
- Government takes over the £42 billion mortgage book, to be wound down in due course;
- The bank's branches are sold to Banco Santander for £612 million
- The UK banking industry is asked to (eventually) fund the £14 billion transfer of the insured deposits to Banco Santander.
Bridge Bank (USA)
This represents the case where a new bank is created by the public authorities to take over the operations of an existing bank (Temporarily takeover a failing bank). With a view to "cleansing" the balance sheet before selling back to the private sector (a long-standing option for the FDIC in the US and the JDIC in Japan)
Insurance of Banks toxic assets (UK)
For a "fee", which may involve the provision of an equity stake to the government, the authorities agree to insure banks' most toxic assets on a loss-sharing basis. [The idea is to add some certainty to a bank's solvency, thereby stimulating bank lending, both between banks and to the private sector].

Initially supposed to be two recipient groups. Lloyds didn't happen because they managed to raise money in the markets.

RBS scheme happened- gov stake 84% so was almost nationalisation. RBS exceeded size of gross economy: too big to fail but may be too big to rescue? So gov had to intervene.
Since then gov stake has fallen to 62.5% because gov has sold off some of shares. Idea is that it falls to 0.

Gov asked RBS identify extent to most toxic assets = 325bn. How the scheme works is that it provides the incentive that the first loss borne by the bank is 19.5 billion and then after that it only has to pay 10% everything above that.

The fee paid by RBS was 4% of the insured portfolio for the privilege of the insurance contract.
State guarantees of new bank debt issuance (UK)
To stimulate bank lending in the economy in the face of frozen interbank markets, in part due to concerns about the solvency of financial institutions.
Quantitative Easing (UK/ USA)
Quantitative easing is a tool that central banks can use to inject money directly into the economy.
Large-scale purchases of government bonds lower the interest rates or 'yields' on those bonds. This pushes down on the interest rates offered on loans (eg mortgages or business loans) because rates on government bonds tend to affect other interest rates in the economy.
The aim of QE is creating this 'new' money, to aim to boost spending and investment in the economy.
The Banking Act 2009
The act provides the 'special resolution regime' which provides the Authorities with a range of tools to deal with banks in financial difficulties. Needed this in crisis because BoE and others weren't sure of their legal rights and purpose of what authorities can do.

The objectives of the SRR are:
- to protect and enhance financial stability;
- to protect and enhance public confidence in the stability of the banking system
- to protect depositors
- to protect public funds
- to avoid interfering with property rights. (i.e. when government is considering part nationalisation)

The SRR provisions relate to:
- stabilisation options (i.e. selling all or part of the bank's business to a commercial purchaser, transferring all or part of the bank's business to a company which is wholly-owned by the central bank (a "bridge bank") (the norm in USA and Japan not yet been used in UK- prefer not for central bank to clean out bank but government to take it on board - nationalisation), or taking the bank into temporary public ownership)

- 2 exit strategies: bank insolvency procedures; and bank administration procedures. 2 sets of procedures that allow a firm to exit the industry.
Turner Review:
The Turner review, an attempt by the UK's Financial Services Authority to explain how it intends to make banking safe for society after the worst financial crisis in a century. (FT, 2009)
Published in March 2009

Recommended changes to regulation and supervisory approach which are required to create a stable and effective banking system.
TR: Capital adequacy and liquidity
Both issues covered in BASEL (3) which was amended by committee post-crisis. An increase in both the quality and quantity of global bank capital. The capital required against trading book activities should be increased and a fundamental review of the market risk capital regime (e.g. reliance on VaR).
TR: Institutional and geographic coverage of regulation
which institutions do you want to regulate? And how do you regulate the multinational institutions across borders? Both cause problems. Institutional: large number of non-banks that engage with banking activity e.g. shadow banking operations. Mimic what bank does not under same regulation, should they be?
TR: Deposit Insurance
Retail deposit insurance should be sufficiently generous to ensure the vast majority of retail depositors are protected against the impact of bank failure. When Northern Rock got into difficulties, exposed flaws with UK deposit insurance arrangements. Did not get full coverage. Limited protection at the time was £35K per customer per bank. But only got 100% protection on the first 2000 and 90% on the next 33K.
Other problems: liquidity. If you believed you would get 100% back question was how soon. Therefore, deposit insurance was changed and level of protection is now 100% of £85,000.
TR: UK Banking Resolution
A resolution regime which facilitates the orderly wind down if a failed bank. Done via Banking Act
TR: Credit Rating Agencies
Agencies should be subject to registration and supervision to ensure good governance and management of conflicts of interest and to ensure credit ratings are only applied to securities for which a consistent rating is possible.

Rating agencies and regulators should ensure that communication to investors about the appropriate use of ratings makes clear they are designed to carry inference for credit risk
TR: Renumeration
These policies should be designed to avoid incentives for undue risk-taking; risk management considerations should be closely integrated into remuneration decisions. This should be achieved through the development and enforcement of UK and global codes.
TR: Credit Default Swap Market Infrastructure
Form of insurance policy which bank would take out if they have a large exposure. Issue is governing the CDS'. Rescued AIG to save US banks not to save AIG itself. Because it had all the CDS' on behalf of banks.
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