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July

July, 2018

FINANCIAL MARKETS
GROUP WORK PROJECT
2018/07
FINANCIAL MARKETS
Philip Appau
[email protected]

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1 Introduction
The financial crisis of 2007 started as a subprime crisis in the US mortgage market, turned
into a crisis in the banking sector and evolved eventually into a global financial crisis. The
period preceding the crisis is characterized by increased credit extension, particularly to the
real estate sector, and excessive leverage in the financial system favored by historically low
interest rates, abundant liquidity, low financial market volatility, increased risk taking
behavior and loose credit standards (FSF, 2008, Lechner, 2009). In such conditions the
demand for housing and housing investment escalated to a boom and caused a continuous rise
of the prices of the real estate (Lechner, 2009). The housing bubble eventually burst in 2007
and unleashed a crisis which spread very fast in the interconnected banking world and
throughout the real economy.
A key factor fostering the housing boom was the remarkable growth in innovative financial
instruments such as asset-backed securities (e.g. mortgage- backed securities -MBSs) and the
related securitization process which enabled the development of the so called “originate and
distribute” model.
2 Causes
Following is a few some of the factors that played major roles in not only allowing the subprime-
mortgage bubble to inflate, but also in allowing its deflation to wreak such havoc.
? Mark-to-market accounting. In the early 1990s, the Securities and Exchange Commission and
the Financial Accounting Standards Board started requiring public companies to value their
assets at market value as opposed to historical cost — a practice that had been discredited and
abandoned during the Great Depression. This pushed virtually every bank in the country into
insolvency from an accounting standpoint when the credit markets seized in 2008 and 2009,
thereby making it impossible to value assets.
? Infighting among financial regulators. Since its inception in 1934, the FDIC has been the most
robust bank regulator in the country — the others have, at one time or another, included the
Office of the Comptroller of the Currency, the Federal Reserve, the Office of Thrift Supervision,
the Securities and Exchange Commission, the Federal Savings and Loan Insurance Corporation,
and an assortment of state regulatory agencies. But thanks to infighting among regulators, the

FDIC was effectively excluded from examining savings and investment banks within the OTS’s
and SEC’s primary jurisdiction between 1993 and 2004.
? Securitization of loans. Banks traditionally retained most of the loans that they originated.
Doing so gave lenders incentive, albeit imperfectly, to underwrite loans that had only a small
chance of defaulting. That approach went by the wayside, however, with the introduction and
proliferation of securitization. Because the originating bank doesn’t hold securitized loans, there
is less incentive to closely monitor the quality of underwriting standards.
? Off-balance-sheet risk. No one knew what financial institutions were up to because most of the
risky assets weren’t reflected on their balance sheets. They had been securitized and sold off to
institutional investors, albeit with residual liability stemming from warranties that accompanied
the sales, or were corralled in so-called special-purposes entities, which are independent trusts
that the banks established and administered. Suffice it to say that all of the residual liability
flooded back onto the banks’ balance sheets only after the you-know-what hit the fan.
? Basel II bank capital rules. Any time an economy experiences a severe financial shock, one of
the biggest problems is that undercapitalized banks will be rendered insolvent. That’s true in part
because of the absurd application of mark-to-market accounting during periods of acute stress in
the credit markets, and in part because banks are highly leveraged, meaning that they hold only a
small slice of capital relative to their assets. The so-called Basel II capital rules, which took
effect in 2004, accentuated this reality. The rules allowed banks to substitute subordinated debt
and convertible preferred stock in the place of tangible common equity. The net result was that
tangible common equity at certain major U.S. banks declined to less than 4% on the eve of the
crisis.
? Shadow banking. While hundreds of traditional banks failed in the wake of the financial crisis,
they share little responsibility for what actually happened. That’s because shadow banks — i.e.,
investment banks and thrifts that didn’t fall under the primary regulatory purview of the Federal
Reserve, FDIC, or, to a lesser extent, the Office of the Comptroller of the Currency — caused
most of the damage.

3.1 Major Policy and Regulatory Responses
The international policy response to the crisis included four key areas for regulatory reform, that sought
to harmonize some existing standards and create new ones where gaps were identified. The first area for
reform addresses the riskiness of financial institutions by strengthening prudential regulatory standards,
led by banking reforms known as Basel III. The second addresses the problem of an institution being
‘too big to fail’, where the threatened failure of a systemically important financial institution (SIFI)
would leave authorities with no option but to bail it out using public funds. The third limits the scope for
contagion arising from interconnections between counterparties in OTC derivatives markets. The fourth
addresses risks arising from shadow banking, which encompasses entities and activities outside the
regular banking system that are associated with credit intermediation and maturity/liquidity
transformation.
3.1.1 With the Group of Twenty (G20) providing political impetus, international reform efforts have
mainly progressed through the Financial Stability Board (FSB) and its member standard-setting bodies,
including the Basel Committee on Banking Supervision (BCBS), the International Organization of

Securities Commissions (IOSCO) and others. The credibility of these reforms has been enhanced by
expansions to the memberships of these bodies and the involvement of G20 Leaders. The FSB, of which
Australia was already a member, extended membership to major emerging market economies in 2008,
and in 2009 the BCBS expanded its membership to 27 jurisdictions. In 2008, G20 countries also started
meeting at Leader level in response to the financial crisis.
There are global benefits from the adoption of well-designed, internationally agreed reforms. A broadly
consistent set of regulatory requirements gives authorities, counterparties and customers alike some
comfort that international entities operating in their jurisdiction are suitably regulated and supervised at
the group level as well as locally.
3.1.2 Strengthening prudential regulatory standards: Basel III
The financial crisis revealed that banks in some countries were not holding enough loss absorbing
capital for the risks they were taking. This was despite these institutions meeting minimum capital
requirements in the periods immediately prior to, and even during, the crisis.
In response to international regulatory shortcomings, the international bank standard-setting body, the
BCBS, developed Basel III, a comprehensive set of reform measures that aim to strengthen the
regulation, supervision and risk management practices of the banking sector.
The Basel III capital framework aims to strengthen banks’ ability to withstand losses (BCBS 2011).
Minimum capital ratios have been raised, capital has been defined more strictly to refer to genuinely
loss-absorbing instruments, countercyclical capital add-ons are now available if needed and a simple
constraint on overall leverage is to be added.

3.1.3 Addressing the ‘too big to fail’ problem: Crisis management and resolution
3.1.3.1 Systemically important financial institutions (SIFIs)
Following the financial crisis, there has been a push in international forums to address the potential for
taxpayers to be exposed to losses from government solvency support for systemically important
financial institutions (SIFIs). This emphasis on ‘too big to fail’ institutions is understandable given the
experiences of the financial crisis, particularly in the light of the large injections of government capital
that were needed to stabilize systemically important banks, and the ‘sovereign-bank nexus’ in which
undercapitalized banks degraded the solvency of their sovereigns, and vice versa.
As defined by the FSB, SIFIs are ‘institutions of such size, market importance and interconnectedness
that their distress or failure would cause significant dislocation in the financial system and adverse
economic consequences’ (FSB 2013, p2). These institutions are considered ‘too big to fail’ because
public authorities are assumed to be left with no option but to recapitalize SIFIs using public funds if
their viability is threatened. Regulatory developments in this area aim to reduce the probability that a
SIFI will fail, reduce the impact of failures when they do occur and eliminate any competitive
advantages in funding markets that SIFIs might hold due to their ‘too big to fail’ status.

3.1.3.2 Crisis management and resolution
A further key focus of the ‘too big to fail’ work agenda is addressing cross-border contagion risks.
Cross-border crisis management groups have been established for the SIFIs, and one of their key tasks is
to improve recovery and resolution plans for these firms. At the Seoul Summit in 2010, G20 Leaders
endorsed FSB recommendations for improving authorities’ ability to resolve SIFIs in an orderly manner,
without exposing taxpayers to loss, while maintaining continuity of their vital economic functions (FSB
2010).
3.1.3.3 Bail-in
The FSB has highlighted bail-in as an area where many FSB jurisdictions need to take further legislative
measures to fully implement the Key Attributes (FSB 2013i). Bail-in is a resolution strategy where the
unsecured and uninsured liabilities of a failing financial institution are written-down or converted into
equity to recapitalize the firm.
3.1.4 Reforms to OTC derivatives markets
International policymakers have also sought to strengthen practices in OTC derivatives markets. The
focus on this market reflects the rapid growth in the value of outstanding contracts over the decade
preceding the crisis, and risk management vulnerabilities in some products, such as credit derivatives,
revealed during the crisis.
A particular policy concern has been the lack of transparency of market activity and the scope for
contagion arising from counterparty exposures between participants in OTC derivatives markets. An
international policy consensus has emerged for the greater use of centralized infrastructure – trade
repositories, central counterparties (CCPs) and trading platforms – in OTC derivatives markets to help
address some of the concerns of regulators and market participants.
3.1.5 Shadow banking
Shadow banks are non-bank financial intermediaries that perform some of the traditional functions of
banks including maturity and liquidity transformation and extending credit (Pozsar et al 2013). Unlike
banks, however, shadow banks do not have access to central bank liquidity support, are not covered by
deposit insurance schemes and are not prudentially regulated to the same extent.
The FSB presented a package of policy recommendations to strengthen oversight and regulation of
shadow banking entities to the G20 Leaders’ Summit in September 2013 (FSB 2013g). The
recommendations, developed by the FSB in conjunction with IOSCO and BCBS aim to mitigate risks
posed by the shadow banking system while not inhibiting sustainable non-bank financing models that do
not pose such risks.
3.1.6 Other areas of reform
Regulatory reform has extended beyond the four key areas already outlined. Other areas of reform which
have been agreed include regulators taking greater account of macroprudential risks across the financial

system and enhancing the effectiveness of supervision, as well as addressing misaligned incentives
across a range of areas such as credit rating agencies and bankers’ remuneration (FSB 2013b, 2013e).

REFERENCES
Ellis L (2013), ‘Macroprudential Policy: What Have We Learned?’, Speech to the Bank of England
Workshop for Heads of Financial Stability, London, 6–7 March.
Ergungor O (2007), ‘On the Resolution of Financial Crises: The Swedish Experience’, Federal Reserve
Bank of Cleveland Policy Discussion Paper No 21. Available
at.
FCIC (Financial Crisis Inquiry Commission) (2011), ‘Financial Crisis Inquiry Report’, January.
Available at.
Frankel J and G Saravelos (2012), ‘Can Leading Indicators Assess Country Vulnerability? Evidence
from the 2008–09 Global Financial Crisis’, Journal of International Economics, 87(2), pp 216–231.
FSA (Financial Services Authority) (2009), ‘The Turner Review: A Regulatory Response to the Global
Banking Crisis’, March. Available at .
FSB (Financial Stability Board) (2010), ‘Reducing the Moral Hazard Posed by Systemically Important
Financial Institutions: FSB Recommendations and Time Lines’, October. Available at
.
FSB (2011), Key Attributes of Effective Resolution Regimes for Financial Institutions, October.
Available at .
FSB (2012), ‘Identifying the Effects of Regulatory Reforms on Emerging Market and Developing
Economies: A Review of Potential Unintended Consequences’, June. Available at
.

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