8 - The Global Financial Crisis

Question 1

Too big to fail institutions role preceding the financial crisis

Answer 1

1. US banks aggressively extending mortgages to people less and less able to pay them.
2. Securitisation and tranching
   These approaches were highly profitable in the upswing, but led to banks to choose too low a capital cushion.
   -placed little weight on the downside risk because of the possibility of state bail outs

Question 2

The assumption that MBs bundled together in CDOs were not highly correlated

Answer 2

• 2000s banks created CDOs from MBs
• evaluating the correlation of the underlying MBs was intrinsically difficult so Credit Rating Agencies (CRA)set the correlation at very low levels
• impeccable credit rating and high return meant they were very attractive to investors and sold all across globe
• the CRAs, banks and investors failed to take into account the similarity of MBs within CDOs

Question 3

Capital regulation based on risk weighted assets (RWA)

Answer 3

Basel II - required banks to put a given amount of capital aside for each asset they held, depending on its risk weight.

• the higher the rating, less capital
• CDOs were safe (triple A) assets
• risk weights were falling whilst aggregate risk in the system was rising
• purchasers of assets were ill informed and relied too heavily on ratings from rating agencies

Question 4

Rising house prices me g banks were more willing to provide mortgages

Answer 4

Financial accelerator

• rising house prices (households net worth increases) increased the willingness of banks to lend without making checks on the ability of borrowers to repay
• belief that house prices would continue to rise

Question 5

The European global banks followed a riskier strategy in the upswing before the financial crisis.

Answer 5

• lack of regulatory restrictions, banks could ‘lever up’
• this allowed them to pursue a riskier strategy
• European banks shifted more of their activities onto the trading book
• helped by lax treatment of risk weighted assets (RWA) by regulators and high ratings on risky assets like CDOs

Question 6

If all financial institutions are attempting to de-lever at the same time…

Answer 6

It is likely the price of assets will fall, because of excess supply, naming it harder to achieve desired level of leverage.

Question 7

Effectiveness of discretion all fiscal policy during downturns depend on a number of factors:

Answer 7

• state of economy
• state of monetary policy
• design of policy measures
• extent to which they are timely, temporary, and targeted
• discretion all fiscal policy may be constrained by high levels of government debt

Question 8

Fiscal stimulus policies introduced in response to the global financial crisis…

Answer 8

Helped prevent countries from experiencing a deeper output contraction and deflation than would otherwise be the case.

Question 9

Policy mistakes made in the Great Depression:

Answer 9

1. Contractionary fiscal and monetary policy following a slump in economic output (IS curve shifts left).
2. A rise in protectionism (restraining trade).
   Great Depression was a negative demand shock - IS curve shifts left.
   Contractionary monetary policy as a rise in interest rates - IS curve shifts left.
   Contractionary fiscal policy - IS curve shifts left and leads to even more pronounced fall in output.

Question 10

Debt overhang

Answer 10

Debt overhang: a debt burden that is so large that an entity cannot take on additional debt to finance future products, even those that are profitable enough to enable it to reduce its indebtedness over time.