Financial Crash

Question 1

Costs of Financial Crash

Answer 1

2008-2011: EU govt spend 1.6tn euros (13% EU GDP)

US Govt Accountability Office (GAO) estiated cost to US of $22tn (2014 US GDP = $17tn)

Question 2

Cost of FC - Ball (2014)

Answer 2

OECD Average GDP 7.1% lower than estimated non shock case for2013

OECD Ave GDP in 20115 8.4% lower than non shock case

Question 3

Diamond-Dybvig (1983)

Answer 3

Models bank runs in game theoretical framework
Simple 3 period model w/ 2 players (depostors)

t=0 Each player deposits 1 in a bank=> band inv 2 into LR asset, yields in t=2

t=1. Each depositor has the choice to request repayment of investment only yields 1 (0.5 each)

t=2. Each depositor can request repayment if they didnt in period 1, asset is liquidated yield = 3 (1.5 each)

Nash Equilibria (stay, stay) and (run, run) - Prisoners dilemma, coordination failure. Neither depositor trusts the other to stay so both run=> fire sale of assets

Question 4

Bank Runs

Answer 4

Banks borrow ST and lend LT
=>improves risk pooling and returns
=> vulnerable to bank runs
=>liquidity risk rather than insolvency, doesn’t have cash to fulfil SR obligations but have the assets
=> Bank runs turn liquidity issue into solvency issue as bank unable to meet SR obligations
=> attempt to increase liquidity triggers fire sale of assets
=>contagion puts downward pressure on other asset prices=> animal spirits investors sell to limit losses

Question 5

Bank Deposit Guarantees

Answer 5

Potential Solution to Bank Runs
No need to run, uncertainty removes so equilibrium at (Stay, Stay)
=> no bank run, gov’t doesn’t need to interfere=> cost = 0
=> In UK govt guarantees 75k of all deposits

BUT Moral Hazard
Guarantee, reduces bank risk, incentive to gamble
Invest in riskier assets=> if it fails no SR insolvency due to guarantee

Also incentivise high D/E to maximise returns

High up side, low downside

Question 6

Bank Funded w/ cap on Guarantee

Answer 6

Like insurnce with banks paying a fee ex-ante for cover of its deposits

doesn’t address risky behavior as fee is effectively a lump-sum=> banks accumulate as much risk as possible once risk has been transferred to govt

Question 7

Too Big To Fail

Answer 7

Banks are critical component of global economic infrastructure and are interdependent - generally creditors to each other

=> total deadweight loss associated with letting large bank fail greatly outweighs cost of bail out

=> significant social/economic/political pressure to bail out banks

=> allowing bank to fail is incredible threat.

Question 8

Bank Run Solutions

Answer 8

Regulation of deposit taking banks (Retail banks)
=> Glass-Steagall seperated IB from retail banking after 1929 crash
=> repealed gradually over time leading to introdcution of Gramm-Leach-Bliley Act, 1999

Capital requirements

Question 9

Glass-Steagall Act

Answer 9

seperated IB from retail banking

Question 10

Gramm-Leach-Bliley Act

Answer 10

Allowed insurance firms, IBs, and retail banks to consolidate

Question 11

Risky Behaviour not exclusive to IB side

Answer 11

Retail banks can engage in excessive lending
Japanese crisis due to excessive real estate lending
Norther Rock Failed in 2007 b/c of excess mortgage lending and falling liquidity in debt market due to CMO fallout

Question 12

Min Levels of Capital

Answer 12

Fed requires Tiew 1 cap-RWA ratio of 4%

Basek III accord requires Tier 1 cap-RWA raioof at least 4.5% of all EU banks

Question 13

Causes of Crisis - Morris ad Shim (1998)

Answer 13

Speculative Attacks depend not on the amount of info available but on the the transparancy of the system (symmetry ia what counts)

Even if depositiors know intrinsically that it is best for everyone to stay to achieve highest payoff they dont know whether everyone elso knows this

Asymmetry creates uncertainty=> may trigger speculative attack

Question 14

Financial Instability Hypothesis (Minsky, 1992)

Answer 14

Financial crises are endemic under capitalist structure
prosperity=> raises confidence=> borrowers/lenders take more risk

Excess confidence > financial bubbles > asset prices rise > borrower/lender risk appetite increases > asset prices rise > irrational exuberence > banks become more speculative > ponzi lending > regulatory capture > RAs underestimate risk > inflated asset prices unsustainable > asset prices plateu > lenders over exposed > speculative lending leads to liability greater than assets > banks cant meet SR obligations > asset fire sale to achieve liquidity > contagion drives asset market down > erosion of bank capital > credit crunch

Question 15

Hubris

Answer 15

Bankers overestimated their ability to control risk

Question 16

Systemic Myopia and excess risk

Answer 16

Compensation structure encouraged risky behaviour
=> bonus culture, pyramid hierarchical organisational structure=> performance based metrics used as a direct motivator but also indirect as a source of social capital

=> little conflict between management and shareholders, both have limited liability w/ high upsides

Question 17

Government Policy

Answer 17

Community Reinvestment Act (CRA) introduced in 1966 strengthened in 1990s by Clinton => mortgages backed by Fannie Mae in 2000s
=> Effect is debatable more than half of subprime mortgages issued were not regulated by CRA
=>wealth effect fed into asset bubble, drove confidence in mortgage industry

Question 18

Crisis and Financial Theory

Answer 18

Existence of bubbles appear to be inconsistent with models

Bubbles=/= EMH is false

Bubbles still possible w/ RE once we add animal spirits and infor asymmetries
=e.g. noise traders/momentum traders may reinforce bubble to capitalise on “irrational behaviour

Question 19

Savor & Wilson (2012)

Answer 19

Share price excess returns are higher on the days of importanct macro announcements
=> 11.4 basis points per share vs 1.1 basis points

Question 20

Increasing Leverage - RWAs

Answer 20

Banks used RWAs to reach nominal capital requirements despite having much lower actual Capital/asset ratios

E.g. Bank for International Settlements have cap target of 8%=> Northern Rock met target with RWA despite having Cap/Asset ratio of 2.7%

~2.7% fall in prices wouold leave Northern exposed to insolvency risk

Question 21

Securitisation and SIVs

Answer 21

Securitisation allowed banks to pool loans and sell on the related cashflows

Some banks used Structured Investment Vehicles
=> Non financial institutions established to earn credit spread between LR assets held in its portfolio and short-run liabilities issued w/ high leverage and guaranteed by parent bank (used to finance purchase of LR assets).
=>Off balance sheet till post crisis

Question 22

Impact of Securitisation

Answer 22

Most Investment Grade Securities (BBB+) issued in 2005-7 were either downgraded or defaulted

ABS market collapsed
=> Mrkt cap from 300bn/Q in 07 to 424m/Q in 09

Crash of US MBS market eroded bank asset base, increased insolvency risk=> Bear Sterns failed, ripple effect (Lehmann, RBS, UBS)

AIG insured CMOs over-exposed=> essentially nationalised $40bn cap injection form US Govt and $85bn credit facility from Fed

Question 23

Credit Rating Agencies

Answer 23

Normally independent of pressure groups
=>fixed fees accross agency to limit differentiation/manage incentives

But huge tranches pf MBS at high volumes meant repeat sales were profitable=> banks now had leverage, engaged in forum shopping

Question 24

Mathis et al (2009)

Answer 24

CRAs competed on reputation=> incentive to relax standards as products become more complex to capture future business

=>increased pressure on analysts to give good ratings

=>once issues discovered rating methodology (gaussian Copula), they could game system by manipulating tranches of CDOs

Question 25

Conflicts of interest

Answer 25

M Brokers compensated on commission basis=> incentive to maximise income

Subprime mortgages most lucrative
7/8 2004-2007 of all subprime mortgage borrowers had FICO score less than 700

Question 26

Jiang et al (2011)

Answer 26

Liar’s loans= low documentation brokered loans, borrower has incentive to falsify info, less due diligence

16-19% of Liars Loans based on falsified income

correlation between % of liars loans and delinquency rate

securitisation allowed banks to transfer risk onto investors

Question 27

Gaussian Copula (li, 2000)

Answer 27

Allowed banks to price multiple securities based on the correlation between their default probabilities at a given time
=>condition probability that House A defaults given that House B defaults (very simplistic)

=>assumed subprime investors were diversified by pooling mortgages from different geographies
=> reasonable assumption under normal circumstances

BUT doesnt account for macro shocks that affect all prices at once

Allowed complex relationship risky mortgages to reflected as simple correlation measure
=>used historic prices from CDS market as proxy for risk
=> relied on assumption that markets could price risk effectively
=>CDS market for MBSs less than a decade old during period of rising asset prices, correlations all biased upwards

This made Gaussian Copula very sensitive to house prices=> when real estate prices fell = default correlation spiked => value of CMOs crashed as ratings quickly decended to junk status

Gaussian Copula also allowed CDOs formed of pooled CMOs to be priced (CDO^2)
=> more removed from underlying asset, more susceptible to mispricing, too complex

Question 28

Regulation - Basel III

Answer 28

Tier 1 Cap/RWA has to be at least 6% since 2015

Also mandatory capital conservation buffer of 2.5% in 2019

BUT limited by fact that firms allowed to use internal measure of credit risk to form Risk weightings

discretion likely to lead to understating of risk, potential alternative is to just use broader debt measure but Risk Weighting is useful info, Leverage ratio will just incentivise banks to restructure debt to increase % of risky assets

Doesnt address inconsistency between CRA rating methodologies, forum shopping played large role in driving MBS bubble

Also seen as not strict enough,

Question 29

Holdane (2012)

Answer 29

no significant correlation between cap-RWA ratio in 06 and survival after crisis

Stronger evidence of positive correlation with % equity

no conclusive though

Question 30

Devereux (2013)

Answer 30

Introduced progressive tax levy on leverage=> more leverage higher tax

Successfully reduced leverage ratio

BUT risky firms closer to Basel 3 constraint just increased % of risky assets

Firms far from constrain did not change risk profile

Safe banks got safer, risky banks stayed risky

suggests its a deeper incentive issue

Question 31

Potential Solutions

Answer 31

Equity Requirements
=> better than bank levy, priced by market on case-by-case basis not subject to gov’t failure

=>less likely to be distortionary

Tax Reforms to limit tax shield incentives
Introduction of caps on deductible interest payments, could make it dependent on equity %

Nationalisation
=>Bank losses will be backed by government
=>Fixed Wages
=>Term Limits
=>Less risk of moral hazard
=>Could reduce efficiency, more subject to political =>influences

Forced Recapitalisation (Adamati et al, 2011)

Question 32

Regulatory Capture

Answer 32

Where a regulatory agency, created to act in the public interest, instead advances the commercial and political interests of the the special interest groups that dominate the sector/industry it has been charged to regulate.