Lecture 5 - Banking Crises Flashcards

1
Q

Other than losing money through bad
loans i.e., customer failing to pay back a loan, how can a bank lost money?

A

Banks can also sometimes make bad investments in other assets such as stocks or bonds.

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2
Q

Why is an Asset fire sale (bank selling off non-liquid assets quickly) bad for a bank?

A

this often requires a bank to sell assets for less than if they had been sold in amore orderly manner

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3
Q

Are bank runs contagious?

A

Yes. Northern Rock’s problems were triggered by US banks with similar-looking business models getting into trouble rather than clear problems with the value of its assets

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4
Q

Loans =

A

Deposits + Other Borrowings and bank cash and securities holdings, all of which lead to a lower quantity of loans

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5
Q

What is a Credit Crunch

A

when banks are no longer in a position to lend to borrowers and financial intermediation breaks down - both banks and customers contribute to a credit crunch

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6
Q

Additional Complications in Modern Banking Crises:

A
  • Non-deposit funding: many modern banks obtain substantial non-deposit funding via bond markets or inter-bank money markets. These provider are more prone to “run” than depositors, who are often viewed as a “sticky” source of funding
  • Interbank Linkages: Funding links between banks can mean that the failure of one bank can directly threaten the failure of other banks.
  • Financial Assets and Negative Feedbacks: Many banks now have very large holdings of financial assets, whose valuation (unlike loans) are set in the market every day. During crises, we can se negative feedback loops involving banks selling assets, which then decline in value, thus making bank solvency problems even worse.
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7
Q

Why more non-deposit funding?

A
  • Deepening of Financial Markets: Modern financial systems contain more options than in the past for people to channel their savings towards. Two that are relevant for banks are pension funds, which commonly buy bonds issued by banks and money market mutual funds, which commonly make shorter-term loans to banks
  • Financial Globalisation: In closed economies, savings must equal investment. Banks that are provided with savings from depositors must make loans within their own country. In an open economy, savings do not need to equal investment. In a country that has high savings but low investment, banks will often lend funds to banks in other countries.
  • Deregulation: Regulations about where banks get funds from, and who they can loan these funds to, have generally been loosened over time.
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8
Q

Who do modern bank runs come from?

A

mainly from those who lend money t banks through interbank markets and bond markets deciding not to continue to supply a ban with funds

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9
Q

Why do interbank market make easier?

A

Interbank markets make it easier for banks to cope with reserve requirements (by lending and borrowing short-term funds) and allowing banks with lots of deposits but without good loan opportunities to lend to bank with good loan opportunities but limited deposits. - they also contribute to making the banking system unstable

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10
Q

Systemic Risk

A

Due to banks borrowing from other banks if one bank goes insolvent this can have a knock-on effect for other banks

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11
Q

Why have modern banking regulations required banks to “mark their tradable assets to market” as much as possible?

A

So if the failure of one bank leads to the prices for some financial markets falling, then other banks have to mark down the value of their assets also

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12
Q

The Bank-Sovereign “Doom Loop”

A

The euro crisis of 2011/12 illustrated a new form of systemic risk. The interaction between banks and governments

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13
Q

Sub-prime mortgage lending

A

borrowing by people with poor credit records

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14
Q

securitisation

A

when banks would bundle together a set of mortgages and use their repayments to provide the income flows for securities that would be purchased by investors. These Mortgage-backed securities (MBS) were risky

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15
Q

Why were mortgage-backed securities risky?

A

If people defaulted on the mortgages, then the investors who bought these securities would lose money

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16
Q

Why did banks and other investors buy sub-prime MBS given the risks involved?

A
  • Confidence in House Prices: There was recognition of higher default risk but confidence that high and rising house prices would mean no losses when units were foreclosed (reprocessed)
  • Geographic Diversification: MBS were backed by mortgages from all over the US. There had been regional house price booms and busts but the modern era had not seen simultaneous falls in house prices all over the country
  • Credit Ratings: Many of the MBS - even many of those backed by subprime mortgages - had been rated AAA by ratings agencies, so they seemed safe
  • Fraud: Many of the subprime mortgage applications featured incorrect or fraudulent documentation of salaries, property values, owner occupancy and second liens. It is not clear how much investors knew
  • The Great Moderation: Macroeconomic fluctuations since the mid-1980s had been much smaller. People believed they were living in a “great moderation” period with limited macroeconomic risk
17
Q

When did Subprime mortgage originate?

A

2005 and 2006, with mortgage rates rising and some evidence mounting of the poor credit quality of recent loans, the financing boom ended
Thus, house prices began to fall in Spring 2006

18
Q

people found themselves with negative equity. what is this?

A

when the value of houses was below what they owed to the bank

19
Q

what are “non-recourse” mortgages?

A

You can give the keys back to the bank and tell them to take the house (so called “jingle mail”), so the bank takes a loss if the house is sold for less than the value of the mortgage

20
Q

rather than supplying a steady stream of repayments ot service the MBS

A

many of the mortgages became “salvage operations” as the mortgage server repossessed the house and hope to sell them for as much as possible

21
Q

The riskiness of banks became exposed

A
  • many global banks had purchased large quantities of MBS
  • some of the banks that were selling the MBS also ended up holding large amounts of their own products in 2008
  • many leading banks were also engaged in lots of proprietary trading activity
22
Q

Capital and Funding Weaknesses:

A
  • leading banks were highly leveraged, with insufficient capital to absorb large losses
  • the heavy reliance on short-term non-deposit funding ended up triggering a series of liquidity crises
23
Q

Bank bailouts timeline

A

August 2007 - UK authorities were slow to help Northern Rock, because of concerns about moral hazard. They only stepped in to nationalise the bank after a full-scale run had taken place. Northern rock shareholders lost all their money
- March 2008 - there was a non-deposit run on Bear Stearns. JP Morgan bough Bear Stearns with the US government insuring them against the losses on Bear
‘s mortgage back security
- September 2008 - MBS issuers Fannie Mae and Freddie Mac were put into conservatorship
- When Lehman Brothers investment bank suffered the same kind of non-deposit run that Bear Stearns had, the Fed and the US Treasury made the decision to not help and Lehmans filed for bankruptcy on September 15, 2008 - US authorities felt the previous bailouts had been politically unpopular and had set a bad precedent

24
Q

What happened after Lehman brothers filed for bankruptcy in September 2008?

A
  • Financial markets panicked
  • faced with uncertainty about institutions could survive to pay back their debts and which couldn’t, many financial markets effectively collapsed in the weeks and the months after,
  • saw the world economy plunge into its worst recession since the 1930s
  • around the world, authorities decided that they simply could not afford to let any more banks fail for fear of further disruptions
25
Q

The US passed the Troubled Relief Programme bill. Which was?

A

a $700 billion package of measures to restore stability to the banking system

26
Q

Why did it become a Global Banking Crisis?

A
  • the exposure of European banks through their holdings of subprime MBS. However, losses on MBS represented only a small fraction of the equity of European banks
  • Complexity: The complexity of MBS and the widespread use of off-balance sheet vehicles to purchases these securities made it difficult to identify the exposure of counterparties to subprime. This led to generalized retreat from lending and risk
  • Short-term funding: reliance on short-term funding such as repo or asset-backed commercial paper was also widely using in the European banking system. The US crisis exposed the fragility of this model
    Reassessment of risk: Beyond the exposure to subprime, the US crisis exposed many bad practices that were also in use at European banks such as excessive leverage, excessive dependence on credit ratings, inadequate risk management and lax oversight by supervisors
27
Q

What were the three principle drivers of the recession?

A
  • Direct effect of falling house prices:
    As the value of people’s homes declined, households spent less money. The “home equity release” source of money disappeared. House construction collapsed as it became much less profitable
  • Debt Crisis: Governments, businesses and households that had taken on large amounts of debt prior to the crisis had to tighten their belts. This led to reduced consumption spending, less business investment and fiscal austerity
  • Financial Conditions: It is well known that the financial sector weakness exacerbates recessions. Banks were required to reduce the size of their balance sheets and this lead to big declines in lending to households and firms
28
Q

Why was the recession greater in advanced economies?

A

most likely due to their greater reliance on large financial systems

29
Q
A