Securitisation & the global financial crises systemic risk

Question 1

Process of pooling credit-sensitive assets and transforming them into tradable securities

Answer 1

• Frees up bank balance sheets (Originate-to-Distribute model)
• Transfers credit risk out of the banking system

Question 2

Securitization Process

Answer 2

🔹 Step 1: Pooling assets and transferring them to a Special Purpose Vehicle (SPV)

🔹 Step 2: The SPV issues structured tranches (Senior, Mezzanine, Equity) based on risk absorption

Question 3

Tranche Structure

Answer 3

Senior Tranche (AAA-rated): Paid first, lowest risk
Mezzanine Tranche (BBB-rated): Paid after senior, moderate risk
Equity Tranche: Highest risk, absorbs first losses

Question 4

Loss absorption percentages

Answer 4

• First 5% of losses → Equity Tranche
• Beyond 5% → Mezzanine Tranche
• Beyond 20% → Senior Tranche

Question 5

Role of Rating Agencies in ABS (Asset-Backed Securities)

Answer 5

Senior Tranche = AAA-rated (easy to find investors)
Mezzanine Tranche = BBB-rated (harder to sell, led to ABS CDOs)
Equity Tranche often retained or sold to hedge funds

Question 6

Securitization & Financial Crisis timeline

Answer 6

Subprime Mortgages → Loans to borrowers with poor credit
2000s: Increased subprime mortgage securitization
2006-07: Rising interest rates led to defaults, foreclosures, and house price crashes
2007: Subprime mortgage market collapsed

Question 7

Systemic Risk

Answer 7

Risk of financial system collapse due to bank defaults

Question 8

systemic risk causes

Answer 8

1. Bank size & concentration
2. Riskiness of individual banks
3. Interbank interconnectedness

Question 9

Contagion Effect

Answer 9

Chain reactions in banking due to distress in one institution
Triggered by:
* Common risk exposures

• Interbank lending networks

Question 10

Systemically Important Financial Institutions (SIFIs) Key characteristics:

Answer 10

1. Large size
2. High interconnectedness
3. Risk exposure to common factors

Question 11

Systemically Important Financial Institutions (SIFIs) Risk Measurement

Answer 11

• Evaluated under normal & crisis conditions
• Banks with high contribution to systemic risk are labeled SIFIs

Question 12

Central Banks as Lenders of Last Resort

Answer 12

Function: Provide emergency liquidity to banks in distress
Borrowing Mechanism: Banks access funds at the discount rate
Potential Issue: Moral hazard (banks take excessive risks, expecting a bailout)

Question 13

The Discount Rate- lowering and rising effects

Answer 13

Lowering the rate → Expansionary: Encourages borrowing & spending
Raising the rate → Contractionary: Discourages borrowing & spending

Question 14

Unconventional Monetary Policies need

Answer 14

Conventional tools (interest rate cuts) have limits in deep crises

Question 15

Quantitative Easing (QE)

Answer 15

Central bank creates money to buy assets (bonds)

• Increases money supply & lending

Question 16

Bailouts vs. Bail-ins

Answer 16

Bailout:
* Government/taxpayer-funded rescue of failing banks

• Used extensively in 2007-08 crisis
  Bail-in:
• Forces creditors/shareholders to absorb losses
• Unsecured depositors affected last