2008 Crisis Slides Flashcards
Bank Runs
Very common through American History. Not a focus in the press but was critical in the most recent financial crisis.
Traditional Banking
Creating short term trading backed by longer term assets. Checking accounts are a perfect example of the securities they have
-minimum reserves set by regulators shortfalls can borrow from central bank (interest rate on deposits)
-Loans on balance sheet
-Deposit insurance in 1934 eliminated panics as it made deposit information insensitive.
Threats to Traditional Banking
Regulation Q- in 1933 banks cannot pay interest on demand deposits (repealed in 2011) maximum interest rates on savings accounts (gone in 80s)
- Money market accounts introduced to give more attractive yields (open ended mutual fund that invests in safe assets)
-Junk bonds
Move to Securitization
-As banks became more unprofitable they had to change.
-They kept passive cash flows on the balance sheet from loans became unprofitable moving to securitization
-with securitization the bank keeps the equity portion of the securitized loans with more tranches
-Traditional banks sells their loans to parallel banking system or the shadow banking system
-Need to keep some high quality assets to fund repo (limited number of T-bills)
Repo
Institutions want a safe place to deposit money. The repo market is a large market (about 12 trillion before financial crisis)
This is a key element of securitized banking (similar to collateralized lending) A form of borrowing with a sale and repurchase agreement
Assets sold are high quality.
Haircuts- people demand collateral greater than the value of the sale.
Banks or other securities provide needs to have this collateral
Panic in the shadow banking system
Contagion led to withdrawals in securitized banking with unprecedented high repo haircuts with cessation of repo lending on some kinds of collateral.
Banks had to sell off assets to meet these withdrawals sold the least information sensitive assets like AAA rated bonds.
LIB-OIS
OIS- Overnight Index Swap: LIBOR based banks can borrow at a fixed IR payments are the difference between assumed fed funds rate and effective fed funds rate
LIBOR
Banks estimates as to what rate they think they can borrow at. This is the average
LIBOR-OIS Spread
LIBOR minus assumed fed funds rate
Bank 1 loans bank 2 10 million for 3 months at LIBOR
Bank one funds this loan by borrowing 10 million each day in the overnight fed funds market
Bank 1 hedges the interest rate by entering into an overnight indexed swap where bank 1 agrees to pay a counterparty the difference between fixed rate and overnight fed funds rate for the next 3 months. LIBOR is dead now so people look at BSBY to get bank credit risk
Why did spreads on non-subprime assets rise dramatically?
As lenders began to fear about banks stability banks were forced to raise repo rates and haircuts. The rise in haircuts led to the run on repo. A bank run while ex-post default rates among AAA debts was relatively low suddenly people started to worry
