Category: Financial Crisis

After the 2008 financial crisis, legislations like the Volcker Rules to inhibit big banks from behaving like hedge funds. They are no longer allowed to engage in any forms of trading or financial innovation which leads to excessive multiplying of money supply leading and excessive leveraging within the banking systems.

Their income is thus restricted to investment banking commissions and net interest incomes.

Related references

Long-Sought Volcker Rule Revisions Land on a Changed Wall Street

This book documents the series of regulatory missteps from the 1980s to the 1990s that lead 50% of savings and loans in the US to insolvency. During this period the total number of savings and loans decreased from 3,234 to 1,645.

Operating mechanism

The savings and loans are a special group of banks that are encourage to grow by the US government to enable affordable housing after the world depression.

They take in short term savings deposits at lower interest rates and lend out long term mortgages at higher interest rates. They profit through the net interest income generated between the short term interest rates and the long term interest rates. If you think you’ve become a victim to such practice, then you can always get help here in order to extricate yourself from the situation.

Events leading to massive failure

• During the Vietnam war, inflation which drove short term interest rates increase. This cannibalized SnLs’ profit margins.
• De-regulation of short term interest rates which lead to increased competition by other banks for deposits.  This lead to the inability to attract deposits at feasible rates to finance SnL’s long term illiquid mortgage loans.
• The US government instead of recapitalizing these insolvent SnLs opted to de-regulate by allowing them to enter into other high yield investment instruments. This is in hopes of they will be able to rebuild the capital and thus minimize the amount of burden to be imposed on tax payers
• Entrance of new entities
  • mutual funds competed for deposits
  • Freddie Mae and Freddie Mac competed for mortgages
• SnLs ventured out of their areas of expertise and started buying into high yield corporate junk bonds and unsecured commercial loans.
• With minimal equity stake in the game due to years of erosion and an implied government guarantee for a bail out in case things go south, SnLs began aggressive leveraged into these positions.
• The US government reversed it stance and past regulation against SnLs holding high yield investment instruments. The forced liquidation of relatively illiquid positions further exacerbated the situation.

Lessons learned

• Government meddling in market mechanism to further political agenda is generally a recipe for disaster
• Venturing beyond circle of competence in search of high yield is generally a recipe for disaster
• Overt or implied guarantee of government bail out is a source of moral hazard that leads to excessive leverage by operators which is definitely a recipe for disaster

“Panics do not destroy capital, they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”, John Stuart Mill

Overviews on crisis

Crisis tends to only be obvious in hindsight. People tend to be biased towards optimism even in the darkest times.

Crisis are generally triggered by a momentary lack of liquidity which leads to  a whole cascade of events. This sends the entire system into a negative tail spin. A loss of trust in the system is the fundamental problem.

Types of crisis

• Banking crisis:
  • usually triggered by rapid deregulation leading to excessive levels of volatility within system
  • A single bank or the entire banking system experiencing a shortfall of liquidity which deteriorates into a massive bank run.
  • takes place before financial crisis
  • reaches highest point after financial crisis
• Financial crisis
  • country whose currency is not a reserve currency experiencing a shortfall of liquidity triggering off rapid exit of funds trying to avoid the negative currency exchange dip
• Twin crisis
  • when both bank crisis and financial crisis occur together resulting in cross feeding.
  • economic fundamentals are deteriorating in periods preceding twin crisis

Bank failure cause by banking crisis

• Quality of management plays a very important role in averting such crisis
• If bank is too big to fail
  • government will attempt to step in.
  • To restore trust
  • Relatively rare
• Smaller banks
  • will get absorbed by larger banks
• government interventions
  • when seen as too ready to step in will encourage moral hazard
  • results in banks taking excessive risk
  • want the funds to restore liquidity to come as much as possible from the private

Indicators for banking crisis

It is generally difficult to assess banks due to information asymmetry. Banks and government will want to delay the release of bad news to prevent deterioration of an already bad condition

Spreading the financial statements across different banks will help analysis risk

• Leading indicator:
  • Non-performing loans/assets as a percentage to total loans/assets
  • Non-performing loans as ratio to loan-loss reserves
• Lagging indicator: net interest income falls

Risk assessment method

• CAMEL model
  • Capital
  • Asset quality
  • Management
  • Earnings
  • Liquidity

Roles of Banks

Generalfunctions

• Hubs of financial networks that connect supply and demand for money
• Intermediary to smooth out friction in the flow of money
• Spread risk of loaning money
• Ease of liquidity
• Securitization to move loans off balance sheets
• Underwriting

Special functions

• Support national payment system
• Providing backup liquidity to non-banks
• transmission belt for monetary policy

Types of Banks

• Large banks – extensive network able to pull in consumer deposits at relatively low cost
• regional banks – has deep relationships with local territory and is able to meet the needs of local business better than large banks

Types of capital

• Consumer deposits – very sticky but small in amount
• Commercial deposits – very volatile but large in amount

Types of banking instruments

• Negotiable Certificate of Deposits
• Letters of Credit
• Derivatives
• Futures

Credit risk

The possibility of not getting the loan and interest back due to inability or unwillingness of the borrower. Assessed qualitative and quantitative elements

external factors

• sovereign risk
• cyclical risk

Components to model credit risk, a.k.a. Expected Loss

• PD – probability of default
• EAD – exposure at default: percentage of the amount of loan that will be affected by a default event
• LDG – loss given default
• Time horizon – the longer the time horizon the more likely the default

Risk assessment method

• general – Value at Risk (VaR) model
• fixed income analysis – fundamental and technical analysis

Currency risks triggered by sovereign/country risk

• policy lending – subsidizing industries through banking industry
• state-owned enterprises – encourages inefficiency

Components to consider

• GDP growth – a growing GDP will help buffer shocks to the system
• Fiscal deficit
• Monetary conditions
• Balance of trade

leading Indicators

• consumer confidence index
• manufacturers index
• money supply
• yield curve

lagging Indicators

• unemployment rate
• inventories to sale
• consumer credit to personal income

Risk management

• liquidity risk
• solvency risk
• market risk
• credit risk
• credit spread risk
• currency risk
• operational risk

Risk assessment method

• general – Value at Risk (VaR) model
• Stress test

Further Readings

• Managing banking risk, Eddie Cade
• The dollar crisis, Richard Duncan
• A failure of capitalism, Richard A Posner
• Bank restructuring, Andrew Sheng
• When genius failed, Roger Lowenstein
• Manias, panics and crashes, Charles P. Kindleberger and Robert Aliber