Financial Crisis Examples (GFC/COVID)

Question 1

How did the Banking Crisis impact the Euro Area?

Answer 1

• Conversion of Interest rates across 10 year Govt. bonds meant that Italian bonds “=“ German bonds
• Perceptions of the bonds change, which increases the spreads
• Markets perceived bug default risks in specific nations due to market inefficiency and no bailouts
• Sovereigns faced the mismatch of long-term assets and short-term liabilities
• Any Govt.could be immediately insolvent if investors decided refused to buy bonds

Question 2

Why do banks hold Government bonds?

Answer 2

• Banks don’t have to hold any capital Vs Government bonds
• Liquidity requirements favour Govt bonds
• No limit on concentration of sovereign risk, for banks. there is a limit of exposure of 25%
• Banks can hold more Govt bonds
• European banks exposed to bonds of the home Govt
• Free market in EU, therefore small adverse shift and expectations can trigger less demand for sovereign debt
• Interdependence between sovereign credit and bankings system- LOOO

Question 3

What is each transmission mechanism? Give examples of each

Answer 3

• Financial Sector risk can be transmitted to sovereign risk (Ireland, Spain)
• Sovereign risk can be transmitted to the financial sector

Question 4

What is the Diabolic Loop with sovereign risk? What would trigger this?

Answer 4

• Sovereign risk increases, which reduces loans to firms so bank risk / equity risk increases
• This increases the bailout probability and thus sovereign debt increases
• Similarly, if sovereign risk, this reduces growth and taxes and sovereign debt increases
• The trigger was either a banking or financial crisis

Question 5

What happens to house prices on average during a financial crisis?

Answer 5

• Takes 6 years to recover
• -35.5% effect on house prices

Question 6

What happens to equity prices on average during a financial crisis?

Answer 6

• Fall -55.9%
• Takes 3.4 years to improve

Question 7

What happens to unemployment levels on average during a financial crisis?

Answer 7

• Takes 4.8years to recover
• Rises by 7%, but was 20% in 1930 depression

Question 8

What happens to GDP levels on average during a financial crisis?

Answer 8

• -9% in GDP, but fell by 30% in 1930 depression
• Takes 1.9 years to recover

Question 9

What happens to real public debt levels on average during a financial crisis?

Answer 9

• Up 86.3% in the following 3 years

Question 10

What caused the GFC? What happened as a result?

Answer 10

• A rise in Sub-Prime mortgages defaults
• In 2007, more than 40% of adjusted rate SPMs defaulted, whilst 20% of fixed rate SPMs
• All that were securitised defaulted
• Decline in mortgage CDSs, as AAA price rated fell by 60% on the ABX

Question 11

What is the ABX? When ABX index falls, what happens?

Answer 11

• ABX: Basket of 20 CDS referencing ABS containing SPMs
• When ABX index falls, the up front fee rises and previous sellers of CDS suffer losses

Question 12

What is an ABCP? What happened to Asset-Backed Commercial Papers (ABCPs) across a 6 month period?

Answer 12

• ABCP: collateralised, short-term debt in the form of commercialised paper
• $1.2trn to $700bn

Question 13

What is the TED spread? What happened and why was this a shock?

Answer 13

• The TED spread is the difference between the interbank lending rate and treasury bill rate, which measures counterparty risk
• This shot up, which was surprising because it was historically very low because of financial liberalisation

Question 14

What is the TAF? How high did the TAF get?

Answer 14

• The term Auction facility was created in December 2007 and allowed banks to borrow short-term against a spread of collaterals
• Reached $500bn in a single day

Question 15

What was the TSLF? What did it aim to achieve and what happened?

Answer 15

• The term security lending facility allowed for swapping MBS for treasury bills for 28 days
• Increased liquidity within the financial markets
• Was very successful, so was scheduled up to $200bn

Question 16

What was the PDCF? What happened?

Answer 16

• The primary dealer credit facility was announced in March 2008 for IB only
• Immediately jumps to $150bn after DW public

Question 17

What happened to the Fed’s balance sheet? What was it made up of?

Answer 17

• Rose from $1trn to $4trn in just 5 years
• Made up of MBS and US treasuries increases

Question 18

How did the US crisis spread to Europe?

Answer 18

• US households use wholesale lending to european banks
• European banks provide shadow banking to US borrowers
• The interconnectivity of the world banking system

Question 19

What was the issue using conventional monetary policy? What was an example of unconventional monetary policy?

Answer 19

• Largely ineffective
• Size of the FIs BS, Central Banks had to increase their BS for FIs
• CBs must borrow at low cost injections
• QE was the best example of unconventional MP

Question 20

Explain QE via portfolio rebalancing

Answer 20

• BoE assets purchase (MBS as well) which increases confidence and it is good policy signalling
• Asset price goes up, return goes down
• Investors have to purchase other assets for higher yield, this would increase the price of other assets and reduce IR on LT assets [Portfolio Rebalancing]

Question 21

Explain Portfolio Rebalancing in greater depth

Answer 21

• Reduces IR and Cost of Borrowing, therefore investment and borrowing increases and therefore GDP growth increases
• This increases asset prices leading to the net worth of investors and increase wealth
• This increases liquidity and reducing uncertainty, which reduces risk of default

Question 22

Was QE successful in the GFC?

Answer 22

• Comparing 1929 recession with 2008, US had a fall of 8% in 2008
• But in 1929 it fell by 28% with a quick recovery
• Hence, QE reduces the downfall but takes longer to recover

Question 23

Briefly outline the impact of the COVID-19 pandemic

Answer 23

• Unemployment jumped to almost 15%, an 80 year high
• Similarly, LFPR declined from 66%-61% (-2%)
• PCE bottomed out at -12%, then jumped to 8% in 3 Quarters
• GDP fell to about -9% and although a jump y-o-y

Question 24

What was the difference between COVID and GFC economic crash?

Answer 24

• COVID had real impacts on the economy
• GFC hurt financial markets more
• Government learned from GFC for COVID

Question 25

What happened to financial markets during the COVID pandemic?

Answer 25

• Investors looked towards cash/liquid assets, as the TED spread liquidity fell
• FED used tried-and-tested unconventional MP, so that the market wasn’t spooked
• Within 3 months of COIV beginning, the FED made the spread completely die down
• Businesses, states and local Govts increased cash holding by selling securities, this covered near-term expenses to avoid a loss/margin spiral

Question 26

What Monetary Policy was used during COVID?

Answer 26

CONVENTIONAL:
- Fed cut rates to near 0% and this was committed until economy was back on track
- Fed BS rose from $4trn to $7trn because of COVID
- Announcement of programmes were enough to establish trust
UNCONVENTIONAL;
- Purchase $2trn of securities
- Introduced liquidity/lending facilities (provided $150bn)
- Lower costs at which banks can borrow from the Fed
- Expectations of Fed as LOLR was enough to restore confidence and break the loss/margin spiral