Financial Crisis

Question 1

Diamond-Dybvig 1983

Answer 1

Simplified model; 2 players – both depositors
Period 0: Each player deposit 1 in a bank Banks invests 2 in long term asset
Period 1: Each depositor can require repayment now If the asset is liquidated, it yields only 1
Period 2: If asset liquidated now, yields 3: 1.5 for each investors

Run | Stay
0.5, 0.5 | 0, 1
——————–
1, 0 | 1.5, 1.5

Question 2

Sinn 2010

Answer 2

Pre-Crisis (2007) levels of equity-asset ratio was under 5% for most major banks

Question 3

Jiang et al. (2014)

Answer 3

2006 has a peak in delinquincies on mortgage payments

Question 4

Transparency

Answer 4

Mortgages packed into MBS
MBS split into tranches (of riskiness)
MBS then packed into CDOs (also with tranches, and which had higher credit ratings)
Or then CDO^2

Question 5

SIV

Answer 5

Structured investment vehicles invested in MBSs (which had AAA ratings, meaning weighted risk was less than half of standard mortgage loans).

Were backed by bank guarantees. This moved MBSs off the bank balance sheet, allowing them to increase leverage without breaking regulations (requiring leverage ratio)

The fact that banks were buying these securities is the main problem. if investors were chief purchasers of those AAA securities , then it would help to diversify the risk and investors will absorb losses themselves. This may not lead to the collapse of the whole financial system. Risk was not spread (just accumulated in banks)

Question 6

Economist 2013

Answer 6

“it is beyond argument that ratings agencies did a horrendous job evaluating mortgage-tied securities before the financial crisis hit”

Huge pressure on analysts to produce positive ratings due to huge tranches of MBS with repeated clients. Banks could shop between big 3 raters

Question 7

Acharya and Richardson (2009)

Answer 7

ABS (asset backed security) had almost 300bn quarterly supply in 2006-2007, dropped to 400mn at the end of 2008.

Question 8

Tier 1 Capital

Answer 8

Tier 1 capital is shareholders’ equity and retained earnings (Basel III ratio = 6%)

Question 9

Tier 2 Capital

Answer 9

Tier 2 capital includes revaluation reserves, hybrid capital instruments and subordinated term debt, general loan-loss reserves, and undisclosed reserves (Basel III ratio for tier 1 + tier 2 = 8%)

Question 10

Key ratio behind Basel

Answer 10

𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 divided by 𝑟𝑖𝑠𝑘 𝑤𝑒𝑖𝑔h𝑡𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠

(how useful is this? Northern Rock had Basel ratio of 15% in 2007.

Question 11

Other Solutions

Answer 11

Regulation of the deposit taking banks
Glass-Steagall separated investment banking from deposit banking (separation of JP Morgan from Morgan Stanley) after 1929 crash
Glass Steagall repealed in stages 1999 Gramm-Leach-Bliley
Though problems may not be in investment banking
Japanese crisis caused by excessive real estate lending
HBOS and Northern Rock failures due to domestic lending, RBS mix of US markets and domestic lending.
Vickers Independent Commission on Banking (2011) proposed ring-fencing retail and investment sides of banks

Question 12

Corsetti, et al., 2009

Answer 12

80% of subprime mortgage’s origination converted in AAA pools versus less than 5% being converted into BBB or lower

Question 13

Difference between Basel 3 and 1

Answer 13

Basel 1 said minimum 8% ratio of risk weighted assets

Basel 3 is Tier 1 + tier 2 = 8%