Econ 330
Dynamics of Financial Crises:
1. Initial Phase 2. Banking Crisis 3. Debt Deflation
Impact of Crises was felt in five years:
1. Residential Houses Prices: Boom and Bust 2. Financial institutions Balance sheets 3. Shadow Banking system 4. Global Financial markets 5. Failure of Major financial industry firms
24. In what year did the economy return to normal conditions following the Great Depression?
1945
28. By the summer of 2008, about what percent of subprime mortgages were overdue by at least 30 days?
25%
• Macroprudential supervision:
: focuses on the safety and soundness of the financial system in the aggregate • Seeks to mitigate system-wide fire sales • Analyzes if the entire financial system has liquidity • Standard following the great recession of 2007-2009
Bank Panics
Are the result of depositors lack of information about the quality of bank assets
26. Describe the debt-deflation process.
As banks are forced to sell assets, the price of the assets decline, causing others who hold these assets to suffer a decline in net worth, which may result in other banks and investors going bankrupt. The process repeats itself. This worsens the economic downturn, resulting in deflation.
Contagion effects occur because of_______________.
Asymmetric information
Bank panics
Bank failure happens when multiple banks go out of business because they are unable to pay depositors and other creditors, causing bank panics. Depositors are unclear of why the bank fail therefore quickly try to withdraw all their deposits.
At its peak during the 1920s, bank failures are so _______ that _________ happened on average per year.
Common, 600
Financial consolidation
Creates complex Financial organizations, ie the too big to fail"--> more challenge for regulation Financial institutions consolidate with other services which would require more coverage for new activities from the insurance against failure and creates moral hazard in these areas.
Dodd-Frank Act of 2010
Direct response to financial crisis beginning in 2007, called "the most sweeping change to financial regulation in the U.S. since the Great Depression."Key provisions include: consolidationof regulatory agencies; establishment of oversight council to evaluate systemicrisk; more comprehensive regulation of financial markets, including markets for derivatives; additional protection reforms for consumers and investors; Includes a weakened version of the Volker Ruledue to Paul Volker (Fed Chair 1979-1987). NOTE: Original Volker Rule re-instated prohibition against combining commercial banking and securities activities that was included in Glass-SteagallAct of 1933 but overturned by the GLB Act of 1999.
Disclosure requirements
Ensure the best information possible is in the market place Requires financial institutions to adhere to standard accounting principals Disclose a wide range of information to assess the institution's portfolio and risk exposure Allows market to monitor bank's activities to deter risky behaviors.
Assessment of risk management
Examination of focusing on the present and future risk taking activities Sound risk management includes: Quality of provided oversight by board and senior management Sufficient policy limits for significantly risky activities High quality risk management and monitoring system Sufficient internal controls
safety nets
Federal Deposit Insurance Corporation (FDIC) Guarantee current depositors will be repaid up to 250k in the case of bank failures
1. What was the purpose of the stress test administered by the Treasury in 2009?
Gauge how well the largest financial firms would fare if the recession deepened.
15. Which of the following is NOT an accurate description of the recession that accompanied the financial crisis of 2007-2009?
Inflation rose at nearly twice the rate as the average recession.
Types of financial regulation 2. Set capital requirements on the followings:
Minimum leverage ratio= capital/total assets needs to be more than 5%-->reduce moral hazard because banks have more to loose when they have higher capital and higher capital means higher collateral for the FDIC. Off-balance-sheet-activities, which are risky activities that expose bank's assets to but are not reflected on the balance sheets. Basel Accord: the agreement that bank needs to hold more than 8% of their risk-weighted assets as capital-->Regulator arbitrage: occurs when bankers take advantage of loopholes and get around the Basel Accord's requirements.
o (Aftermath: Cleaning Up the Mess)
Reform Legislation 1989-1991 •More stringent bank capital (i.e., net worth) requirements •Closer supervision •Reform of regulatory authorities 1994 Until 2002: Restructuring •Riegle-Neal Act of 1994 : Response to movement underway by states since 1985 to get around branching restrictions imposed by earlier legislation ; Overturned McFadden Act of 1927 prohibiting interstate branching Established basis for a true nation-wide banking system Gramm-Leach-Bliley Act of 1999 •Sarbanes-Oxley Act of 2002
Types of financial regulation 1. Restrictions on asset holdings
Regulation on bank includes the reduction of risk taking activities and investments---> reduce moral hazard Encourage bank to diversify Limit the types of investments bank can take. For example, prohibit bank to hold common stocks.
Chartering includes proposals for new institutions that are screened to prevent risk-lovers controlling the bank-->Reduces adverse selection problem
Requires periodic financial disclosures; call outs On-site CAMELS ratings
• Fire sales:
assets that may cause their prices to decline so much that the bank becomes insolvent, even if the resulting contagion can then lead to multiple bank failures and a full-fledged bank panic
Purchase and assumption method
bank does not usually "fail" because the FDIC forces the failing bank to merge with an established bank. This way all deposits are insured to be repaid. -->Government intervention -->Lender of last resort -->Problems with the Government safety needs
Payoff method
bank is allowed to fail and depositors are paid off by FDIC. Depositors are paid back 100% of their deposits up to 250k. After that, they will typically be paid 90% of the money.
8. The process by which simultaneous withdrawals by a particular bank's depositors results in the bank closing is known as a
bank run.
o Volcker Rule:
banks can now hold only a small amounts of hedge and private equity funds. If banks take advantage of FDIC insurance, they are more likely to take large trading risks
Phase two: Banking Crises • Insolvent banks:
banks who see their net worth dwindle to nothing or negative.
11. Regulations that reduced competition between banks included
branching restrictions
Stress tests
calculate potential losses and need for more capital adjustment
o Systematic risk regulation:
created financial stability oversight to monitor markets for financial risks
Fair credit billing act of 1974:
creditors have to provide information on the method of assessing finance charges and handle billing complaints quickly
o Derivatives:
derivatives products need to be traded through clearing houses to reduce the risk of losses if a counterparty in the transaction goes bankrupt.
• Microprudential supervision:
focuses on the safety and soundness on individual institutions separately. • Standard before the great recession of 2007-2009
Microprudential supervision does all of the following except
focusing on financial system liquidity.
Equal credit opportunity act of 1974:
forbids discriminations based on age, gender, race, marital status or national origin
Contagion effect
happens when the failure of one bank hastens the fialure (ie runs) on other banks
12. The original intention of the Fed's role as lender of last resort was to make loans to banks that were
illiquid, but not insolvent.
19. Microprudential supervision focuses on the safety and soundness of
individual financial institutions.
13. The era of bank panics in the United States was effectively ended by
introducing deposit insurance.
Value-at-risk (VAR):
measure the size of the loss on a trading portfolio over a timeframe of 2 weeks/months
6. The primary reason for the recent reduction in the number of banks is
mergers and acquisitions
25. During the early 1930s, the Fed was reluctant to rescue nonsolvent banks out of fear of encouraging:
moral hazard
• 1982-1989: U.S. Bank Crisis 1989:
o U.S. Bank Crisis (General Economic Context) •Worry about inflation in late 1970s led Fed (Chaired by Volker) to sharply tighten the money supply starting in late 1979. •Resulted in high interest rates and sharp deep recession in 1981-1982. •Rapidly rising costs of funds for Savings and Loans (S&Ls) not matched by higher earnings on principal assets (residential mortgages) whose rates were fixed in the past. •By some estimates, over half of S&Ls in U.S. were insolvent by end of 1982.
7. The creation of a lender of last resort in the United States
occurred in response to banking panics
• Debt Deflation:
occurs when price levels falls and deteriorate firms' net worth due to asset price levels fallings.
Community reinvestment act of 1977:
prevents lending in one geographic area but not another.
• Credit Default swap
provides payments to holders of bonds if they default.
o Consumer protection:
requires lender to verify borrowers' income, credit history, and job status
4. A common element in all of the banking crisis episodes in different countries is
the existence of a government safety net.
Too big to fail
the government cant let big banks fail because that would cause potential financial crisis--> Increases moral hazard incentives for big banks
Adverse selection
the riskiest bank managers and owners are those who most likely to use the insurance. Risk-lovers find banking attractive; Depositors have litter reason to monitor bank
9. A bank panic occurs when
the situation in which many banks experience a bank run simultaneously.
Financial supervision (scheduled unscheduled)
to monitor capital requirements and restrictions on asset holding to prevent moral hazard
22. The recession that became the Great Depression began
two months prior to the stock market crash of 1929.
Phase two: Banking Crises -Fire Sales
when assets are liquidated (sold) quickly causing asset price devaluation.
Phase two: Banking Crises -Bank Panic
when more than one bank fails simultaneously
Financial crisis
• A financial crisis occurs when there is a particularly large disruption to information flows in financial markets, with the result that financial frictions increase sharply and financial markets stop functioning. Often characterized by sharp declines in asset prices and firm failures. • Financial frictions : the asymmetric information problems that as a barrier to efficient allocation of capital
Failure of High-Profile firms
• Bear Stearns - the fifth largest investment bank was forced to sell to JP Morgan for 10% of its worth a year prior • Fannie Mae and Freddie Mac were taken over by the government • Lehman Brothers → the fourth largest investment bank filed for bankruptcy
Run on the Shadow Banking system
• Credit spreads widened, increasing costs of credit and tighter lending standards. • Consumption expenditure and investment both as a result of the housing bubble being burst.
Debt Deflation:
• Deflation occurred at a 25% rate • Led to an increase in unemployment (reached as high as 25%) Decrease in demand for foreign goods causing a worldwide depression.
Phase three: Debt Inflation
• Deflations makes assets worth less, but does not lower the amount owed on loans borrowed to pay for the assets. Therefore, liabilities increase, and net worth falls. • Creates adverse selection and moral hazard problems for lenders; economic activity suffers in the long-term.
Height of 2007-2009 Financial Crisis
• Emergency Economic Stabilization Act was passed in 2008 • Credit Spreads were at 5.5% (550 basis points) • Real GDP fell significantly for three consecutive quarters • Unemployment topped 10% in 2009
Deterioration of Financial institutions' balance sheets
• Failing home prices led to higher mortgage default rates. • Banks holding mortgage-backed securities incurred a lower-net worth as the mortgages were worth less.
Phase two: Banking Crises
• Fewer banks operating leads to diminished informations and more borrowers are deemed uncreditworthy due to the lack of information • Once a bank is insolvent, they are sold.
10. The Dodd-Frank legislation of 2010 permanently increased the federal deposit insurance to
) $250,000.
2. When prices of new houses rise significantly faster than rent prices, this is evidence of a:
) bubble
5. The evidence from banking crises in other countries indicates that
) deregulation combined with poor regulatory supervision raises moral hazard incentives.
21. Macroprudential supervision policies try to prevent a leverage cycle by changing capital requirements so that they ________ during an expansion and ________ during a downturn
) increase; decrease
3. Most of the TARP funds were used to
) make direct purchases of preferred stock in banks to increase their capital
17. During the Great Depression, unemployment peaked at
) over 20%.
18. Overseeing who operates banks and how they are operated is called
) prudential supervision.
Tarp: will taxpayers ever get paid back for these relief funds? 14. Congress created the Federal Reserve System
) to serve as a lender of last resort.
16. Why do banking panics normally lead to recessions?
Bank failures can directly affect the ability of households and firms to spend by wiping out some of the wealth they hold as deposits. Shareholders of banks also suffer losses to their wealth when banks fail. Households and firms that relied on failed banks for credit will no longer have access to the loans they need to fund some of their spending. Finally, by destroying checking account deposits, bank failures can result in a decline in the money supply.
contagion effect
Bank panics happens when lack of information about bank's assets results in mass withdrawn from depositors and lead to many bank failures simultaneously
Moral hazard
Banks have an incentive to take on greater risk with deposits (iie lending to risky business)
Competition restrictions
Banks will take more risk to get higher profit level when facing greater competition. The US Have had 2 restrictions on banking competition but have be repealed
27. Which investment bank avoided bankruptcy by being purchased by JP Morgan Chase in March 2008?
Bear Stearns
Types of financial regulation 3. Prompt corrective action
There are 5 groups of banks: Well-capitalized: leverage ratio is much higher than minimum requirement and can complete significant underwriting Adequate-capitalized: meets minimum requirement--> no corrective action, no privileges like those well-capitalized. Under-capitalized: Fails to meet requirements Significantly and critically undercapitalized-->need prompt corrective actions to restore capital and restrictions on asset growth, seek regulatory approval to develop new lines of business.
23. What happened to real interest rates during the early 1930s?
They rose due to deflation.
The Global Financial crisis of 2007-2009
Three main factors led to and exacerbated the financial crisis of 2007 to 2009. 1. Financial Innovation in mortgage markets 2. Agency problems in mortgage markets 3. The Role of asymmetric information in the credit-rating process
o Resolution authority:
U.S. Government now has authority to take over financial firm that are failing
3. All of the following are common to banking crises in different countries except
a dual banking system
• Dodd-Frank Wall Street reform and Consumer Protection Act of 2010:
address 5 major categoris of regulation
Consumer protection act of 1969:
all lenders have to provide information to customers about the cost of borrowing including the total finance charges.
Initial Phase of Financial Crises: • Credit boom or bust:
• Financial innovations or financial liberalizations (fewer regulations on financial markets and institutions) are key to the start of a credit boom or bust • Credit Boom: when institutions lower their lending restrictions leading to lend more risky loans. • Deleveraging then occurs as financial institutions cut back on their lending to borrower-spenders • Credit Freezes typically happen when fewer funds lead to fewer loans to fund productive investments
• Asset-Price Boom and Bust
• Fundamental economic values: assets' values based on realistic expectations of future income streams. • Asset-price bubble: occurs when prices rise above assets' fundamental economic values. • Driven by credit booms when large credit increases fund asset purchases, thereby driving up the price of the asset. • When asset bubble bursts, people and institutions see a decline in the asset prices and a decline in their net worth. Severe fiscal imbalances • Asset-price Boom and Bust • Increase in Uncertainty
Bank Panics
• In 1930, stock market had recovered • Ag production in the midwest fell, leading agriculture loans to be defaulted on. • The large loan losses to the ag industry prompted bank withdrawals and an all out bank panic. • From 1930 and 1933, one-third of banks failed.
Continuing decline in stock prices:
• In 1932 stocks were worth 10% of their peak in 1929. • Investment spending fell 90% from 1929 • Credit Spread: the difference between the interest rate on loans and the interest rate on safe assets
Low interest rates were present and driven by:
• Large capital inflows from foreign countries • Congress encouraged Fannie Mae and Freddie Mac to buy mortgage-backed securities • The Fed developed monetary policy to make it easier to lower interest rates Home prices rose, mortgage originators (lenders) made more in fees and standards for mortgages fell further. Result: asset prices rose higher than fundamentals, the bubble burst and suddenly home prices plummeted making many homes worth far less than the mortgage was worth on them.
Agency problems in the Mortgage markets
• Mortgage loan officers did not make valid attempts to evaluate the ability of borrowers to pay the mortgage • Mortgage brokers acted as agents for investors, but were paid a fee and had only their interest in mind. • Mortgage brokers also pushed borrowers to borrow more than they could afford and committed fraud by falsifying information to get borrowers qualified.
Asymmetric Information and Credit Rating Agencies:
• Rating agencies were at the same time helping banks create complex financial instruments while rating such products • Generated conflicts of interest • Conflict of interest lead to inflated ratings and enabled the sale of far riskier than communicated complex financial products Effects of the financial crisis of 2007-2009
Financial innovation in the mortgage markets
• Securitization of subprime mortgages • Structured Credit Products: paid income from a set of underlying assets that appealed to investors with differing preferences (risk tolerances)
Residential Housing Prices: Boom and Bust
• Subprime mortgages → mortgages issued to people that did not have the credit rating to afford a mortgage → raised homeownership rates and served as the democratization of credit • Subprime borrowers could refinance their house with larger loans as their homes appreciated • Subprime borrowers could always sell their home if they were likely to default • Demand for houses rose as did housing prices.
Global Financial Markets
• The global financial market was roiled → some French accounts were suspended. A major in the U.K. failed.
Government Intervention and the Recovery
• Troubled Asset Relief Program (TARP) • $700 Billion invested in subprime mortgages • FDIC Insurance grew from $100,000 to $250,000 • European governments participated in massive bailouts • Economic Stimulus Package of 2008 ($78 Billion) • Individual taxpayers were given $600 • American Recovery and Reinvestment Act of 2009 • $787 Billion • Bull market started in 2009 • Safety net that prompts more riskier behavior
o Early stages:
•Banks in early 1980s faced increased competition for sources of funds (same as thrifts) •Forced to compete by offeringhigher interest rates on deposits (now allowed) •Not matched by earnings on loans made at earlier times with lower interest rates -squeeze! •Banks forced to seek out new riskier sources of profit (real estate loans, junk bonds, stocks...) •Moral hazard between regulators/depositors and banks
o Later stages:
•S&Ls particularly hard hit, but many left as "zombie firms"(operating but insolvent) due to "regulatory forbearance"by regulators. •Zombie S&Ls took on even greater risk in hope of digging out, leading to mounting losses. •By end of 1986, S&L insurance fund (FSLIC) was going bankrupt. •By 1989, thrift losses (S&Ls, credit unions, mutual savings banks) nearly $20 billion, and about 700 Fed insured S&Ls in need of reorganization and liquidation.