„Prone to Fail: The Pre-crisis Financial System“ Duffie, Darrell Flashcards
What is the main idea?
Explains why the financial system failed to absorb the property market crash.
What triggered the financial crisis in 2007?
Over-leveraged homeowners and a severe downturn in US housing markets.
In short, what happened during the crisis?
The core financial system ceased to perform its intended functions for the real economy at a reasonable level of effectiveness. As a result, the impact of the housing-market shock on the rest of the economy was much larger than necessary.
In other words, instead of absorbing the shock, the financial system became the channel of “propagation and magnification of losses”
What led to the crisis?
o Reliance on market discipline + failure of SEC to prioritize financial stability –> large financial firms undercapitalized
o Artificially low costs of debt financing causing huge leverage
o Creditors thought firms are too-big-to-fail
More financial supervision (by SEC) would’ve made it less severe
What is the most important factor of the crisis?
Flawed financial sector regulation and supervision
What were the key sources of fragility?
- Large dealers relied inadequately on short-term funding (weakly supervised balance sheets of the largest banks and investment banks – most important) (Tri-party repos & commercial paper are sources of s.t. funding)
- Run-prone designs (contracts that are easy to walk away from)
- Weak regulation of the markets for securities financing and OTC derivatives
- The unreasonable reliance of regulators on “market discipline” (belief that markets fix themselves and aggressive regulation is unnecessary)
What did regulators do wrong and why was the supervision so ineffective?
The largest US financial intermediaries were permitted by regulators to have insufficient capital and liquidity.
Supervision ineffective because:
◦ Financial regulators had inappropriate goals (instead of financial stability focused on protecting customers of financial firms)
◦ Too difficult for regulators to detect excessive build-up of risk
◦ Underestimation of risk
◦ The unreasonable reliance on “market discipline”
◦ Political choice of decentralized banking system
What were the 5 main investment banks responsible for the crisis?
Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley.
They were supervised by the U.S. Securities and Exchange Commission (SEC).
What are repos?
Repos (repurchase agreements): on each repo, a dealer transfers securities as collateral to its creditor, and in turn receives cash.
Tri party-repo: 3rd party is a bank that safekeeps and transfers the securities and cash
Tri-party repo system was one of the main sources of short-term funding.
What happens is a major dealer can’t roll over their tri-party repo?
o Tri-party agent banks could have an incentive (or could be forced by regulations) to sell the collateral securities
o Tri-party agent bank could easily stop offering tri-party clearing services or intra-day financing to other major dealers
o The entire system depended on parties trusting that others will stay liquid
What were the main issues of OTC derivatives?
o No regulations on margins, clearing or reporting, often poorly collateralized
o Novation – transferring derivatives from risky dealer to safer dealer
o Terminating contract whenever counterparty becomes insolvent, failure to pay or change of control (More problematic) – bypassing bankruptcy rules of forcing contracts to stay if problems
o Derivatives runs drain liquidity and eliminate hedges that are needed to manage risk, can cause ordinary creditors to run
How to lower counterparty default risk?
Central clearing (now used) – protects counterparties from others’ default risk, enforces transparency and uniformity
What is the current biggest threat to financial systems?
Majority of derivates risk is now forced into clearinghouses, which could fail (the new “too big to fail” financial firms).
Fading memories of the GFC will get some of the practices back to the table.
What 2 misconceptions existed before GFC?
o Banks can be relied upon to provide thorough risk control
o Markets will always self-correct
What is a moral hazard? Who experienced it?
Situation where a party lacks the incentive to guard against financial risk due to being protected from any potential consequences.
Moral hazard applied to creditors, as they thought debtors were too big to be allowed to fail.
