the financial crisis sse homecoming 2012 10 04

8/12/2019 The Financial Crisis SSE Homecoming 2012 10 04

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THE F INANCIAL C RISIS

SSE and SIFR, October 4, 2012

Pehr Wissn

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Source: Schleifer 20092


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THE S HADOW B ANKING S YSTEM

Regulatedcommercial banks

Regulatedcommercial banks

Shadow banks;Investmentbanks, SIV:s,hedgefunds. Partlyregulated or not regulated.


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A T RADITIONAL B ANK

BankBorrower

Lender


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THE TRADITIONAL BANK

Active in a local market. Keeps borrowing and lending on the Balance

sheet.

Capital Regulation. Deposit guarantees. Has a Lender of Last Resort.


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THE S HADOW B ANKING S YSTEM

A chain of transactions. Geographically diversified. Loan moved out of the traditional banking system

into the shadow banking system. Many different balance sheets involved.


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SBS - E XAMPLE

Lehmans keeps tranches of the CMO in their ownbalance sheet.

Lehmans funds the CMO over-night

Borrows interbank from Bear-Stearns and Citigroup Some tranches of the loan are sold to a Germanbank


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SBS THE G ERMAN B ANK .

Could increase its RoE by putting the CMO:s in aSIV.

Typically gave a liquidity line to the SIV.

Recieved a AAA-rating on a large part of the SIV. Funded the SIV by issuing ABCP.


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P OSITIVE ASPECTS OF THE SBS.

The local bank in Florida could concentrate onacquiring lending. Specialization. Good.

The financial sector grew very rapidly. Good?


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W HICH WERE THE PROBLEMS CREATED ?

Huge risks were built into the system in the form of:- Large liquidity risks- Very high leverage

- Counterparty risks.


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THE RISKS WERE NOT CLEARLY UNDERSTOOD . The rating agencies failed to properly assess the

risks in the structured products. The banks and other firms underestimated the

systemic risks. There were cultural and organizational problems

with respect to risk management in a number oflarger banks ( i.e. UBS, Citigroup, Merrill Lynch )


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C OUNTERPARTY RISKS .

Credit Default Swaps. Who had invested large amounts in CMO:s? How were the risks hedged off-balance sheet?

A very non-transparent system.


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LIQUIDITY RISKS .

There was excessive mis-matching in the system. Investment banks and SIV:s ran very mis-matched

books.


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P OSSIBLE EXPLANATIONS TO THE CRISIS

1. Pricing bubbles - housing2. Inadequate rules and regulations3. Macroeconomic imbalances

4. Inadequate risk controls in the private sector5. Institutional deficiencies6. The shadow banking system broke down


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1.P RICING BUBBLES

A bubble in the US housing market ( and UK andSpain )

Excess-liquidity in the markets


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2. I NADEQUATE RULES AND REGULATIONS

Too low capital requirementsGenerally too little capitalSpecifically, eg trading portfolios,

structured products Insufficient liquidity in the banks Inefficient regulatory system; too many

regulators Low transparency Assymetric regulation of different

institutions.


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3. M ACROECONOMIC IMBALANCES

Savings deficit in the US, surplus in China, India andoilproducing countries.

Long period with low interest rates and highliquidity


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4. I NADEQUATE RISK - CONTROL

Inefficient incentive systems ( bonuses ) Shareholder value Herd behaviour Inadequate risk control Procyclical leverage in financial sector Banks transaction driven

Corporate Governance problems? Moral hazard


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5. I NSTITUTIONAL FAILURES

Ginnie Mae and Fannie Mae Too many regulators Rating agencies

AIG


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THE RATING AGENCIES .

The Shadow Banking System was dependent onthe Rating Agencies.

The business model was problematic. Structured products were rated on the same scale

as normal credit. Correlations were most likely underestimated.


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CDO credit rating vs. Collateral rating (3,912 tranches)

0

50000000

100000000

150000000

200000000

250000000

AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ NR

CDO Rating

Collateral Rating

Source: Benmelech 200827


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6. T HE S HADOW B ANKING S YSTEM B ROKE

D OWN .

When the SIV:s collapsed it started a massive waveof forced selling.

Also, the banks had to honour their liquidityguarantees either by funding the SIV:s or byconsolidating them in their balance sheets.

Gave huge losses for the banks and started thedownward spiral.


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SEQUENCE OF EVENTS .

Increase in interest rates in the US. Sub-prime mortgages fell. Not considered a threat to systemic stability SIV:s failed ABCP-market disappeared. Hedge funds went under. Forced selling of assets.


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SEQUENCE OF EVENTS

Central bank lowered rates. All central banks liquidized the banking systems Central banks bought mortgage bonds and sold

Government bonds Bear Stearns went under Forced selling went on and on and on and on


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FROZEN INTERBANK MARKETS

When no banks borrow or lend with each other theall have to transact with the Central Bank.

The balance sheets of the Central Banks explode. This is what is meant by increasing the liquidity in

the system.


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International comparison between central banks'balance sheet totalsIndex, January 2007=100

50

100

150

200

250

300

350

400

jan 07 apr 07 jul 07 okt 07 jan 08 apr 08 jul 08 okt 08 jan 09

50

100

150

200

250

300

350

400ECB

Bank of EnglandFed

The Riksbank

Sources: The respective central banks 33


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Pehr Wissn Page 34Fall 2009

W HAT DID G OVERNMENT DO ?

Central banks increased liquidity. In some countries Government bought bad assets

from the banks Supplied equity to the banks ( US, UK and parts of

EU ) The Swedish Model .


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Pehr Wissn

THE E UROPEAN D EBT C RISIS

Often financial crisis are followed by soverign debtcrisis

Different stories in different countries : Ireland,Portugal, Greece, Spain, Italy, France.

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BUDGET DEFICITS FUNDED BY ISSUING BONDS

The various countries have issued bonds that havebeen sold to commercial banks and to the ECB

There are large losses on the holdings of thesebonds

Stress tests to determine the size of the losses

the financial crisis sse homecoming 2012 10 04

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