Financial Crisis Flashcards
a. Why do banks hold a range of assets of varying degrees of liquidity and profitability?
To spread financial risks.
b. What are the main causes of the global financial crisis 2007/09?
Shift from low-risk or prime mortgages to high-risk or sub-prime mortgages (which were also adjustable mortgages) encouraged by sharp drops of interest rates in the USA, EMU and Japan; creation of sub-prime debts with high risk of default were strengthened by a large availability of liquidities in financial markets; securitization; the role of credit rating agencies; the fact that the relationship between risk and return gradually became obscured; interconnectedness of international money and capital markets; insufficient risk differentiation impact of Basel II framework.
c. What is meant by securitization and what is the benefit of sellers of securitized products? Explain the example of mortgage-backed securities (MBS).
Securitization involves a financial institution selling some of its assets to financial investors, often other
financial institutions. Future cash flows are turned into marketable securities, such as bonds. Transformation
of non-marketable (illiquid) assets into marketable (liquid) instruments. The sellers get cash immediately and
can use it to fund loans to customers. Hence, securitization facilitates the provision of credit.
Example is MBS, whereby the underlying collateral consists of a pool of mortgages which are sold to mainly
institutional investors.
d. Give a critical element in any securitization process?
Since investors of securitized assets (e.g. MBS) do not originate the loan, they cannot verify the quality of the securitized loan portfolio. Credit rating agencies assess and rate the risk and quality of the securities.
e. Give a beneficial effect and an adverse side effect of securitization?
Beneficial effect: more investor diversification through creation of separate tranches, each with its own risk/return ratio; facilitation of risk management by banks; it enhances liquidity of loan portfolios and it provides price signals which in turn are the basis for more prudent risk management.
Adverse side effects: weakening of origination standards (underlying collateral); encouraging the extension of credit to borrowers unlikely to be able to bear the ensuing burden due to poor risk profile; increasing leverage.
f. Does securitization necessarily involve a moral hazard problem?
No, when banks are able to have enough self-criticism to assess their own financial risks without relying too much on the judgement of the rating agencies or the support from the monetary authorities as a lender-of-last-resort, securitization doesn’t necessarily imply a moral hazard problem.
g. Why do you think banks become reluctant to deposit money with other banks during the global
financial crisis of the late 2000s?
The concern was the exposure of other banks to so-called ‘toxic assets’. Therefore, banks were fearful that if they deposited money with other banks that these other banks might not be able to pay the money back, i.e. they would default on payment.
h. Why is there a potential ‘moral hazard’ in supporting failing banks? How could the terms of a bailout
help to reduce this moral hazard?
Because it might encourage banks to carry on with risky behaviour, knowing that in the last resort the ‘tax payer’ will bail them out. Tough terms of the bailout will help to keep the moral hazard to a minimum. The central bank may only be willing to lend to the banks in return for tighter control over the banks’ activities, such as insisting that bonuses for senior management are cut substantially. The bailout may come in the form of full or partial nationalisation, as in the case of the Royal Bank of Scotland and the Lloyds Banking Group – something that bankers and their shareholders would much rather avoid.
i. What is meant with the question that the Basel II accord is still too pro-cyclical and what can be done to prevent this?
When default risks increase during a recession, capital requirements are likely to rise. A more precise fine-tuning of higher capital requirements in conjunction with fluctuations of the business cycle might reduce this problem.
j. How the global financial crisis has affected the European financial regulatory framework?
It has led to more emphasis on a more advanced infrastructure for EU financial supervision (e.g. the Lamfalussy procedure including a separate European financial conglomerates committee).
