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Financial Crises

George Bulkley
This course will cover the causes, consequences, and appropriate policy relating to
the recent credit crisis of 2007 and the current sovereign debt crisis in Europe:
The causes of the crisis of 2007.
Why this crisis belongs to a general pattern of such crises.
How should governments respond?
Can we design regulation to reduce the chances of another crisis?
What are the causes of the Greek crisis and what are the policy options. Is
Grexit a solution?
Methodology: This term is a course that requires reading, thinking and judging rather
than quantitative and statistical analysis. It will be examined by essay type questions.
The course is examined by a 2-hour exam.
Study notes and tutorial questions. Demonstrate reading from reading lists and for
higher marks critical reading of own material, including real life examples.
Exam is 4 questions where you choose from 3.

Topic 1: Why are banks vulnerable to liquidity and solvency crisis? The
Business Model of banks.

The business model of banks and the role of quantitative easing. Role of
equity and leverage in model of a bank where there is default. Equity
needed to augment textbook mode of deposit creation because textbook
does not allow for default.

The Banking System is at the heart of a financial crisis. Banks are vulnerable to
two very different problems: A liquidity crisis and insolvency crisis.
In order to understand these we need to understand the business model for a
bank. Banks may be commercial banks or investment banks or commonly both
rolled into one. Few banks do not have an investment bank component.
The Commercial bank business model is as such. Borrow short, lend long at
higher interest and makes a profit. The sources of funds lent are: equity issued,
bank borrowing (borrowing on capital markets, including issuing bonds and
inter-bank lending at LIBOR rate) and retail deposits (deposits are short-term
commitments typically withdrawn on command).
These funds raised are used: to buy government and corporate bonds and to
make loans to firms and households (typically long term and measured in
years). Traditionally (before securitisation) banks hold these loans to maturity.
One-to-one loans that is not marketable. This means that banks have incentives
to carefully evaluate risks in each loan since they bear the costs of default.
Summarise in Balance sheet of bank:
Assets: cash + long term loans + bonds.
Liabilities: Deposits+ short term borrowing

This channelling of funds from short term lenders to long term borrowers is vital
to investment and the economy.
This mismatch of borrowing and lending horizons is known as maturity
This model works because depositors only demand back as cash at any moment
small fractions of their total deposits. And when one depositor closes account
and withdraws all another new depositors arrives. So banks can safely lend say
90% of all money deposited. Profitable because rate paid to lenders is less than
that charged to borrowers. This profit is distributed to the equity holders.

BUT 2 risks with this business model:

1st Risk: Liquidity Crisis.
A crisis of confidence can lead to all depositors trying to withdraw. Impossible
for all to withdraw because bank cannot quickly call in loans. So fear of a crisis
can be self-fulfilling. All depositors simultaneously try to remove cash but this is
Suppose a rumour spreads that a bank is insolvent and going to collapse. This
leads to panic withdrawals but not all depositors can withdraw. So a rumour can
be self-actualising. A perfectly sound bank can be brought down by a rumour.
This happened frequently in the US in 19th century.
A perfectly solvent sound bank with good quality loans can be subject to this
and collapse, as shown by Diamond and Dybvig (1983). Their analysis suggests
that any entity that uses short-term borrowing to fund holdings of illiquid assets
can be vulnerable to crises of confidence (runs).
This is a liquidity crisis.
1. Deposit insurance means no need to panic. Problem with deposit insurance is
depositors no longer monitor quality of bank because no risk. Moral hazard.
Hence put money in Iceland.
2. Central Bank provides liquidity. Borrowing from central bank means banks can
always pay. CB offers loan of cash in return for the good quality loans as
collateral. Charges mark up on Monetary Policy Committee fixed short rate.
In 19th century US bank crashes were very frequent. This leads to a role for a
central bank as lender of last resort. Federal Reserve set up in US. Provides
confidence and simply fact it is there means it will not be needed.
Crisis of confidence was well founded at Northern Rock in 2007. Depositors all
wanted their money out because they rightly feared it was insolvent. Initially
Bank did not agree to offer cash to Northern Rock depositors because it did not
have good quality collateral. Forced to relent after photos of queues!
2nd risk: Insolvency

Borrowers default. More serious. Bank can become insolvent. Skill of banks is
evaluating risk of borrowers. Rewards to bankers may give incentive to take on
too much risk if bankers share up side of risk but not downside. The less the
owners equity the more incentive to gamble.
Solution is banks have equity that absorbs this risk.
Some of the money lent is the equity of the banks owners. But how much is
key? A current debate that we will discuss later in tutorial 1.
Then incentives not distorted towards risk taking and if mistakes are made
losses not borne by taxpayers.
So to set up a bank you need to raise equity capital that will pay dividend if
profit but can be lost if loans do not perform. This is not in textbook model.
Before deposit insurance was introduced banks could not attract deposits
without equity capital because depositors would fear the bank could not repay if
loans went bad. In UK in 19th century equity would be a large, often 50% of the
total value of loans. Effectively 50% of any loan came from bank equity and 50%
from depositors.

If a bank has 50% capital ratio it means that it can lose 50% of all loans and still
absorb the loss and depositors will be able to withdraw in full. But insolvent if
more than 50% lost.
Now we have more like 3% equity.
Systemic risk arises because of interbank lending. If one bank becomes
insolvent and defaults this may make other banks that have lent to it insolvent
also. So governments have to intervene.
There is much misunderstanding about capital requirements in Basel III.
Capital requirements refer to how banks are funded and in particular the mix
between debt and equity on the balance sheet of the banks.
Banks complain that increased capital requirements will increase their costs of
lending and this will raise charges they make to borrowers, which will ultimately
be bad for industry, through increasing the cost of capital.
BUT there is no sense in which capital is idly set aside by the banks.
Liquidity requirements relate to the type of assets and asset mix banks must
hold. These may force banks to hold lower yielding assets than they would
Capital requirements address the funding, or liabilities side of the balance sheet.
Since they address different sides of the balance sheet, there is no immediate
relation between liquidity requirements and capital requirements.

Quantitative Easing

How does this work in this model? Government wants banks to lend more to
firms. So it buys government bonds, driving up price and down yields to give
banks incentive to substitute lending to firms for government bonds.
In theory this should not work according to the expectations model of the term
structure. That it drives long yields down suggests market segmentation. Has it
resulted in more lending? Hard to say what would have been lent in its absence.
Many say problem is lack of demand by good quality borrowers.
Some claim QE has not led to more lending but instead fuelled the increase in
equity prices over the last 4 years and buy to let lending.

Investment Banks Business Model:

Difference is in sources of funds and types of assets bought. No retail current

Funds by borrowing on capital markets and institutional, but not retail, deposits.
Broader class of assets may be purchased
Proprietary trading, investing on its own account, in capital markets and all
derivatives and all kinds of structured products.
Over the counter products (i.e. tailor made) and may make markets for some
Manages wealth for private and corporate clients.
In practise commercial and investment bank models merged for many banks. An
important proposal is that they should be separated.
Idea is that investment bank activities are riskier and banks that take retail
deposits should not use those deposits for risky investments. Since investment

banks do not take retail deposits we do not need to intervene to protect retail

Topic 2: The Efficient Markets Hypothesis

- Can we reconcile the EMH with the idea of financial crisis? Most of
your work on asset pricing assumes efficient markets. Recent events
cast doubt on the macro-rationality of markets. We review evidence on
the EMH.

Many observe that belief in the efficient markets hypothesis contributed to the
recent credit crisis. It encouraged politicians and regulators in the US and in
Europe to refrain from regulating too strictly or even to deregulate the financial
industry. It was often said that it was Greenspans belief in the efficient market
that caused him to ignore the risk posed by securities linked to real estate.
If financial markets price assets correctly then there are no bubbles and there is
no reason for policies aimed at damping asset prices.
New financial products, like complex derivatives reflect rational decisions and
increase welfare through risk sharing. Therefore no reason for regulations of
these new products.
How markets respond to government policy can be taken as a rational
evaluation of that policy.
The crisis made many then doubt the EMH, for example the highly respected
money manager and financial analyst Jeremy Grantham wrote in his quarterly
letter in 2009: "The incredibly inaccurate efficient market theory [caused] a
lethally dangerous combination of asset bubbles, lax controls, pernicious
incentives and wickedly complicated instruments that led to our current plight.
The EMH, states that the prices of securities reflect all known information that
impacts their value. There are various forms of the definition, depending on the
amount of information assumed, e.g., whether it is past prices, publicly available
information, inside information, etc.
For many the crisis is taken as prima facia evidence against the EMH. We need
test no more: the EMH is dead. Is this right?
First note, no matter what definition is used, the hypothesis does not claim that
the market price is always right. If we were given all present and future
information, the true ex post rational price would almost always differ from
the current market price. Nevertheless, the EMH does imply that at any given
moment, it is not easily determined whether the market prices are too high or
too low. In other words there are good economic reasons why prices are where
they are, despite the fact that subsequent history may show that these prices
are very wrong.
Should we have been able to identify pre 2007 that problems were coming?

For example, should the house price bubble have been spotted in 2006?

If it had this would have significantly increased the risk of assets where house
value served as collateral.
Many that warned that market prices were too high, e.g. Shiller: During the
housing bubble in US in the first decade of the 2000s, the inflation-adjusted
price of the median single family house doubled after being flat for the entire
past century.
Shiller noted pre crash that from 2000 through 2006, national home prices rose
by 88.7%, far more than the 17.5% gain in the consumer price index or the 1%

rise in median household income. Home prices jumped far ahead of prices and
incomes. In the UK the ratio of house prices to incomes rose to 5.5, when the
average post WWII was less than 4.

Source: Reinhart and Rogoff

But there were many who reasoned that a shift in fundamentals justified higher
Some argued the conditions that led to the 2007 crisis low risk premiums and
high real estate prices had a good economic basis, as seen at the time.
Economists called this period following the early 1980s, the "Great Moderation"
and attributed the increased stability to better monetary policy, a larger service
sector and better inventory control, among other factors. The economic
response to the Great Moderation was predictable: risk premiums shrank and
individuals and firms took on more leverage. Housing prices were boosted by
historically low nominal and real interest rates and the development of the
securitized subprime lending market. Thus the house price rises were
For the US:

Source: MoneyGame Chart of the Day

Markets assumed risk had been permanently reduced, with measures of

expected volatility derived from financial market prices falling sharply.
On the other hand Stock and Watson (2002): most of the reduction seems to be
due to good luckwe are left with the unsettling conclusion that the quiescence
of the past 15 years could well be a hiatus before a return to more turbulent
economic times; This time its different was a common statement at the
time. This refers to the idea that there has been a structural break, so past data,
e.g. historic risk premia, are not a good guide to the future. Thus the observed
risk premia, low by historical standards in 2006, might nevertheless be rational.
The high house prices in the UK were explained at the time by immigration and
shortages of building land.

Consider problem of judging whether stock and house prices are rational in
Are we seeing a bubble in stock prices in 2014? On one hand Shiller's cyclicallyadjusted price-earnings ratio (CAPE) says US stock market is overpriced.
CAPE is calculated by taking the S&P 500 and dividing it by the average of ten
years worth of real earnings. If the ratio is above the long-term average of
around 16, the stock market is considered expensive. Currently, September
2014, it is 26.
On the other hand Siegal argues: I believe the Cape ratios overly pessimistic
predictions are based on biased earnings data. Changes in the accounting
standards in the 1990s forced companies to charge large write-offs when assets
they hold fall in price, but when assets rise in price they do not boost earnings
unless the asset is sold. This change in earnings patterns is evident when
comparing the cyclical behaviour of Standard and Poors earnings series with
the after-tax profit series published in the National Income and Product Accounts

For the 2001-02 and 2007-09 recessions, S&P reported earnings dropped
precipitously due to a few companies with huge write-offs, while NIPA earnings
were more stable. Yet before 2000, the cyclical behaviour of the two series was
similar. Downward biased S&P earnings send average 10-year earnings down
and bias the Cape ratio upward. In fact, when NIPA profits are substituted for
S&P reported earnings in the Cape model, the current market shows no
With hindsight one or the other will be proved right. But if it is Shiller can we
infer this was a bubble? Reasonable economic thinking yields the view that
prices are currently reflecting fundamentals.

Overview of evidence on EMH

In 1992 Roll wrote: I have personally tried to invest money, my client's money
and my own, in every single anomaly and predictive device that academics
have dreamed up.... I have attempted to exploit a whole variety of strategies
supposedly documented by academic research. And I have yet to make a nickel
on any of these supposed market inefficiencies.... But, I have to keep coming
back to my point that true market inefficiency ought to be an exploitable
opportunity. If there's nothing investors can exploit in a systematic way, time in
and time out, then it's very hard to say that information is not being properly
incorporated into stock prices.... Real money investment strategies don't
produce the results that academic papers say they should.
Roll is talking about returns, but really he should have talked about economic
But its certainly a sensible way to think about testing the EMH: Can we find
systematic economic profit opportunities? i.e. Are there excess return, after
controlling for risk.
Risk is measured by how much adding a bit of the asset to a diversified portfolio
increases the volatility of the portfolio. Investors care about portfolio returns,
not about the behaviour of specific assets.
The problem in testing is we have no agreed measure of risk. For example: What
is the relevant portfolio? What horizon should co-variances be measured over?
Should monthly or daily data be used?
Very different measures of risk will be found, depending on these decisions.
Despite these reservations there does seem to be significant evidence against
the EMH in the last 20 years, since Roll wrote that comment.
For individual stocks, average returns are not explained by their beta. Size and
the book to market value explain them. But as an example of the problem of
ruling out a rational explanation, consistent with the EMH, believers in the EMH
note both of these results can be explained by risk premia, and its simply that
CAPM is not the correct model of risk pricing. Risky stocks have a low price,
given earnings, so will have small size, and high B/M, and these variables
forecast returns because they are identifying risky stocks.
There are excess returns to a Contrarian strategy. Each month, allocate all NYSE
firms to 10 portfolios based returns from 5 years ago to 1 year ago. Then buy
the worst-performing decile portfolio and short the best-performing decile
portfolio (Source: Fama and French (1996, table 6).

This strategy subsequently delivers 0.74% a month: reversals. There are excess
returns to momentum strategy.
Each month, allocate all NYSE firms to 10 portfolios based returns from 12
months ago to 2 month ago. Then buy the best-performing decile portfolio and
short the worst-performing decile portfolio (Source: Fama and French (1996,
table 6). This strategy subsequently delivers 1.31% a month: momentum
BUT: Momentum does require frequent trading. Carhart (1997) concludes that
momentum is not exploitable after transaction costs are taken into account.
Moskowitz and Grinblatt (1999) note that most of the apparent gains from the
momentum strategy come from short positions in small illiquid stocks.
Event studies also offer evidence against EMH.
Ball (1978) found that stock-price reactions to earnings announcements were
not complete. He found that abnormal returns could be earned in the period
after the announcement date. Rendelman, Jones, and Latan (1982) also found
that unexpected earnings announcements were not immediately reflected in
stock prices and that abnormal returns could be earned by purchasing shares of
companies with positive earnings surprises. (These studies of sluggish
adjustment (or under reaction) support the momentum arguments referred to
Aggregate returns are predictable by price scaled accounting variables, e.g. by
the dividend/price (d/p) ratio
E.g. Cochrane runs OLS regressions of excess returns (value-weighted NYSE
Treasury bill rate) on value-weighted price/dividend ratio, and finds slope
coefficients, with SEs in brackets:
Over a 1 year horizon slope coefficient= 1.04 (0.33)
Over a 2 year horizon slope coefficient= 2.04 (0.66)
Over a 3 year horizon slope coefficient= 2.84 (0.88)
Bond returns are predictable. An upward sloping yields curve means that
expected returns on long-term bonds are higher than on short-term bonds for
the next year.
Foreign exchange returns are predictable. If you put your money in a country
whose interest rates are high you expect to earn more money even after
converting back to your home currency.
Although one can explain away most of these results individually, in sum there
does seem evidence against the EMH.

High Frequency Trading and the EMH


Theme of Michael Lewis recent book Flash Boys. Most money made in HFT by
front running trades. E.g. Buy order placed on one exchange will raise prices
on all exchanges. But only after perhaps 10 microseconds using conventional
fibre optic cable following standard routes. If you can lay better cable using
better route can get this down to 2 microseconds. (Currently developing laser
technology that is much faster than fibre optics using line of sight transmitters
in atmosphere. (Balloons proposed to use over Atlantic! Also rain slows lasers
badly) Thus you can buy before the price rise and sell after it. Risk free profit.
Should this be illegal? Is it insider trading?
Whatever the view this arms race ultimately is paid for by investors. And what
can economic value of 8 microseconds be?

Whatever the view about insider trading its very costly to society and should be
Simple solution to slow up all trade to only occur every 100 micro seconds. Then
the faster trade would not be executed until the info had arrived. A new
exchange has been recently set up in the US where exactly this happens.
Topic 3: The 2007 Crisis

- We examine the UK Credit Crisis and look at the background and discuss
who the players were. To what extent were bankers, the regulators or the
government responsible? What were these securities that precipitated the
crisis and why did the markets in them collapse leading to a crisis of
Background to the 2007 Crisis: Summary
1. Global Savings glut in conjunction with lax monetary policy, and low interest
rates on government debt led to lack of caution in search for yield.
2. Banks became excessively innovative in exploiting this situation.
3. Regulation was weak and Basel II badly flawed.
4. Houses/property became very widely used collateral so that systemic problems
when property bubble burst.

Global Savings glut. Global imbalances. Funds seeking returns originated

a) Money fleeing Asia after the 1997-98 Asian crisis
b) High oil prices
c) Current account surpluses of Asian countries, China surplus in 2007 were 11% of
GNP. US deficit was 6% of GNP in 2006. These funds were searching for
Fear of recession in US led to US interest rates falling sharply in 2000s, from 6%
in 2000 to 1% in 2004. (Though short rates increased sharply to 5% by mid
2006, long rates, 10 year, actually fell from 4.7 to 4.5 between 2004 and 2006).
Funds seeking better yields flowed directly and indirectly into property. New
fixed interest products looked like reasonably like government bonds.
New products were perceived as safer than corporate bonds because of pooling.
Banks exploited this situation
Changing Banking practises


Maturity transformation was traditional role of Banks. Savers lend short (short
term demand deposits) investors borrow long. Like a moneybox. Key expertise
of bankers was risk assessment because lending was to maturity; self interest
required careful risk assessment. With securitisation banks cared little about
risk, since new loans only on books for a short time.
Lend to maturity became originate and distribute; when lenders make loans
with the intentions of selling them to other institutions and/or investors, as
apposed to holding the loans through to maturity.

Commercial banks became more like investment banks, borrowing in wholesale

money markets and investing in wide range of marketable assets and creating
new securities-proprietary trading.
Banks developed new products, particularly securitised ones, to meet the
demand for yield.
Securitised products, which seemed to reduce risk and allocate it more
efficiently, actually made global financial system riskier because so many
products were similar and secured on the same asset, property. If the property
bubble burst all would fail. New products were exposed to systemic risk on a
scale not realised at the time.
Securitization describes the process of pooling financial assets and turning them
into tradable securities. A complicated sector of the fixed-income market.
Because the value and cash flows of the new asset are based on its underlying
securities, these investments can be hard to analyse.

Introduction to Securitization and Structured Products.


Securitisation is the creation of asset-backed securities (bonds secured against

specific assets).
Since the 70s bankers had bundled mortgage loans into securitized products,
CDOs (Collateralized Debt Obligations). But into 90s only prime could be
bundled like this, known as conforming mortgages. New forms emerged when
applied to corporate loans in early 90s.
Traditionally individuals/companies borrow from bank in a 1-1 transaction, a
loan, where cash payments are made to the initial lender until maturity, 30
years in the case of mortgages. These loans would not be tradable. They would
be on the lenders balance sheet to maturity.
Securitization is the process whereby assets- claims to a stream of future cash
flows (the interest on and repayment of loans, e.g. like loans, bonds, and
mortgages)-are bundled up into large pools and sold.
Securitisation more generally can therefore be seen as a way of selling off a
stream of future cash flows. So banks could lend money and instead of waiting
to be repaid in years they immediately sell, for approximately the PV, the
repayments on the loan.
Subsequently there is usually the issuance of a prioritized capital structure of
claims, known as tranches, against these collateral pools.
Buyers of these securities are entitled only to these asset cash flows. They have
no further recourse against the issuer if the cash flows prove insufficient/default.
They then have recourse to the collateral.
For example a bank issues a mortgage to an individual homeowner, and bundles
a 1000 of these loans, and sells them in the market. The buyer gets the claim to
the mortgage repayments and the bank gets a lump sum (slightly more than the
money it has just lent, hopefully). Previously a mortgage was a non-tradable
loan between the bank and the householder. Now when the householder pays
the interest and repayments on the mortgage, the payments go into the pool,
and the pool then pays out interest and principal to the owner of the security.
In theory securitisation has benefits for all.

It widens the choice for investors of available investments and so risk can be
more widely spread. Greenspan said 1999 said (GT 86) CDOs differentiate risks
and allocate it to investors most able and willing to take it.set of products
better calibrated to the value preferences of consumers
It brings a new class of lenders into say the mortgage loan market. E.g a wider
range of institutions and individuals can participate in lending to homeowners.
They can also resell at any time in the market (That was the theory!)
Banks that have liquidity problems can sell securitized assets, but not individual
loans (because of moral hazard).
The assets most often securitised are loans of one kind or another that
appeared, when pooled, not individually, to be a low risk investment.
Securitisation is attractive to banks because it saves tier 1 capital by getting
loans off balance sheet. Known as regulatory arbitrage; a practise whereby
firms capitalize on loopholes in regulatory systems in order to circumvent
unfavourable regulations.po
Model of Shlieffer (2009) where securitisation allows banks to make more loans.
In his model they have a fixed supply of capital so if loans sold on they can
make 2x as many loans. So if they have expertise in lending they make more
Often banks would not directly sell the securitized asset to the ultimate holder,
but via a special purpose vehicle (SPV - a company created specifically for a
financial transaction).
Assets cash flows to be securitized, by say a bank that has made mortgage
loans, are first usually sold to a SPV thus isolating the ultimate issuer, e.g. the
bank, from any claims for repayment in the event of default. The SPV then sells
asset-backed securities, Collateralized Debt Obligations, CDOs, or Collateralized
Mortgage Obligations, CMOs. The SPV then uses the money raised by to pay the
bank that originally made the loans and created the security.
Securitization allows banks to make loans without having the cash. They borrow
in short term money market (thereby increasing leverage as we discuss below)
to initially make loans and then sell CMOs to pay off their short-term borrowing.
Traditionally building societies lent money that had been deposited with them
by savers. Now banks like Northern Rock could lend money that they did not
have because they would immediately sell the loans on as CMO. (until August
Known as originate and distribute model.
SPVs sometimes hold on to the CDOs they bought from the sponsoring bank,
financed the purchase by short commercial notes (the wholesale money
market). i.e. Banks did not really distribute but instead banks indirectly held
CMOs, via their sponsored SPV, and financed by commercial paper issued by the
When the wholesale money market dried up in 2007 banks had to step in and
support their SPVs and this is where huge losses developed.

Prioritization of the tranches


The holders of these bundled loan securities face repayment risk. The mortgage
pool is split up into tranches, which have different priority claims on the interest

and principal. Typically three tranches: senior, mezzanine, junior: A, B and C.

These tranches all earn the same rate of interest, but differ in the order in which
they are retired. Tranche A is paid 1st and so on. Prices much higher for safer
Idea was that investors differ in relation to their attitude to repayment risk and
different tranches would appeal to different classes of investors.
Problem: Lack of transparency/complexity. It would be very difficult to actually
realize the collateral in the case of default.
Prioritization means many of the tranches are far safer than the average asset
in the underlying pool. This repackaging of risks to create safe assets from
otherwise risky assets led to a dramatic expansion in the demand for structured
securities. The safer tranches were viewed by investors to be virtually risk-free
and certified AAA by the rating agencies.
BUT: The Market and the rating agencies underestimated the correlations
between the underlying cash flows and their exposure to systematic risks as we
now discuss.

The problems of pooling and creating tranches:


The assumptions about default correlations were critical to the construction of

safe tranches. To see this consider a two bond example. Assume two identical
bonds both of which have a probability of default of 0.1, and pay $0 conditional
on default and $1 otherwise. Suppose we pool these securities in a portfolio,
such that the total notional value of the underlying fund is $2, and then issue
two $1 tranches against this fund. A junior tranche can be written such that it
bears the first $1 of losses to the portfolio; the junior tranche pays $1 if both
bonds avoid default and zero if either bond defaults. The second, senior claim,
which bears losses if the capital of the junior tranche is exhausted, only defaults
if both bonds default.
To compute the expected cash flows (or default probabilities) for the tranches,
we need to know the likelihood of observing both bonds defaulting
simultaneously, the default correlation.
The probability of both bonds defaulting simultaneously=1% if uncorrelated, but
10% if perfectly correlated.
For example, if the defaults are uncorrelated, the senior tranche will only have a
1 per cent chance of default. However the junior tranche defaults if EITHER bond
defaults, p=0.19.
(prob either defaults = sum of the probabilities each defaults minus the
probability of them defaulting together )
This basic procedure allows risky securities to be repackaged, with some of the
resulting tranches sold to investors seeking only safe investments.
Junior tranches are sold to risk tolerant investors like hedge funds. As the
number of securities in the underlying pool gets larger, a larger fraction of the
issued tranches can end up with higher credit ratings than the average rating of
the underlying pool of assets.
For example: Extend the two-bond example by adding a third $1 bond, so that
now three $1 claims can be issued against this underlying capital structure.
Now, the first tranche defaults if any of the three bonds default, the second
tranche defaults if two or more of the bonds default, and the final, most senior
tranche only defaults when all three bonds default. If bonds default 10 per cent


of the time and all 3 defaults are uncorrelated, the senior tranche will now
default only 0.1% of the time, the middle tranche defaults 2.8% of the time, and
the junior tranche defaults 27.1% of the time. Thus, by including a third bond in
the pool, 2/3 of the capital can be repackaged into claims that are less risky
than the underlying bonds.
Of course the lowest tranche is now even riskier and much riskier than the
underlying bonds.
The key assumption determining the ability to create tranches that are safer
than the underlying collateral is the extent to which defaults are correlated
across the underlying assets. The lower the default correlation, the more
improbable it is that all assets default simultaneously and therefore the safer
the senior tranches.
In the above we assumed zero correlation. Assume now defaults are perfectly
Since now both bonds either survive or default simultaneously, the structure
achieves no risk reduction for the senior tranche. Thus, in the two-bond
example, while uncorrelated risks of default allow the senior claim to have a 1
per cent default probability, perfectly correlated risks of default would mean
that the senior claim inherits the risk of the underlying assets, at 10 per cent.
The junior tranche also defaults 10% of time.
The higher the correlation the relatively safer the junior tranches and the riskier
the safer tranches, for given bond default probabilities.
So if the market underestimated correlations, as it appeared to do, senior
tranches delivered too low a return and junior too high a return.
Generally, as bond defaults become more correlated, the most senior tranches
become less safe.
Investors in senior tranches of collateralized debt obligations bore enormous
systematic risk, and were always likely to experience significant losses in an
economic downturn.
Under the CAPM, securities that are correlated with the market as a whole
should offer higher expected returns to investors, and hence have higher yields,
than securities with the same expected payoffs (or credit ratings) which are less
correlated with the market as a whole. However, credit ratings, by design, only
provide an assessment of the risks of the securitys expected payoff, with no
information regarding whether the security is particularly likely to default at the
same time that there is a large decline in the stock market or that the economy
is in a recession.
If investors in senior tranches do not realise the systemic risk they bear, they
will perceive that they are earning a yield that appears attractive relative to that
of securities with similar credit ratings.
Coval, Jurek, and Stafford (2008) provide evidence for this conjecture, showing
that senior tranches in collateralized debt obligations do not offer investors
nearly enough of a yield spread to compensate them for the actual systematic
risks that they bear. These seemingly attractive yields were in fact too low given
the true underlying systemic risks.
The spuriously low yields on senior claims, in turn, allowed the holders of
remaining claims to be overcompensated, incentivizing rational investors to
hold the toxic junior tranches. As a result of this mispricing, demand for
structured claims of all seniorities grew explosively.
The banks collected large fees for origination and structuring.

The growing demand for the underlying collateral assets led to a reduction in
the borrowing costs for homeowners and corporations alike, and expansion into
subprime, fuelling the real estate bubble. Only when subprime mortgage
defaults started increasing did investors worry that the underlying assets were

Credit Default Swaps (CDS)


Developed in 2000s, initiated by JPMorgan in late 1990s, so investors could

insure against bond default.


Credit derivatives that protect holder against credit risk of a bond. But insurers
(e.g. AIG) did not have funds to pay if systemic failure led to claims.

Sheer scale of these problems:

RBS Balance sheet 1.9 trillion signed off in February 2008. UK GDP=1.76
Types of RBS assets worrying in that RBS balance sheet Derivatives =337bil,
up from 116b in 2007. Treasury bills= 18b. Other debt securities=175b. 40%
of all UK corporate profits in 2006 were banking profits. In 2006 Banking assets
in Switzerland were 800% of Swiss GNP.
Banks were levering their assets to massive extent. Levering is the size of
banks borrowing as a multiple of banks own assets, equity capital. Bank
leverage was huge by 2007.
In 2001 Merrill Lynch leverage was 16. By 2007 it was 32. In 2007 Goldman was
25; Lehman 29.

Role of Rating Agencies:

It is tempting to lay the bulk of the blame for the rise and fall of structured
finance on the credit rating agencies, since it was the agencies that evaluated
and deemed assets created by collateralized debt obligations as safe.
80% of all CDOs were rated AAA.
There is certainly evidence that the rating agencies made some significant
Securities credit ratings provided a downward biased view of their actual
default risks, since they were based on the credit ratings agencies nave
extrapolation of the favourable economic conditions, e.g. the assumption that
house prices would never fall, and the failure to recognise the incentive to
default in this case.
Further, they were used to assessing single company default risk and had no
experience at systemic risk. But AAA is a measure of default risk and says
nothing about correlations.
So why did investors outsource due diligence to rating agencies? Why did they
not think about systemic risk?
Regulators also trusted rating agencies. The minimum capital requirements for
banks set forth in Basel I and II stated that banks holding AAA-rated securities
were required to hold only half as much capital as was required to support other
investment-grade securities.

3. Regulation was weak and poorly designed.

Basel II emphasised Value at Risk.

Regulation under Basel II focussed on ensuring the soundness of individual
banks against the risk of loss on their own assets. It neglected the impact of
individual bank soundness on the soundness of the system as a whole. E.g.
Mark-to-market makes sense for bank in isolation but led to systemic problems,
when fire sales led to collapse in collateral values which led to loans being
called in and break down of inter bank market.

4. The Property market.


The pyramid of liquidity as a result of the process described above led to price
bubbles with mark-to-market raising the value of collateral allowing yet more


Huge problem that for so many products the collateral was property so that if
the bubble burst there would be systemic problems.
In the US house prices start to slide in spring 2006. By August fallen 3% in the
year. Sales of new homes down 10%, and builders start to fail. By October 2006
delinquency rose from 12 to 14%

did funds flow into housing?

Large market able to absorb a lot of funds
In many countries supply could expand easily
Perception of safety in a real asset
New products allowed lending standard to fall allowing many new buyers.

The Crisis: two key events

I The week of Aug 6TH 2007

II Lehmans fails, September 2008

Phase I: Beginning the week of Aug 6TH 2007

Northern rock failed to sell it securitised products when everyone was watching.
August 2007: Bank run on Northern Rock

Equity prices fell 10% in August 2007,

Credit spreads on bonds widened
Valuation uncertainty rises sharply
Spreads on asset-backed securities rise across the globe.
Primary issuance fell sharply in CDOs and CMOs (sub-prime mortgages )
Secondary markets in CDOs & CMOs become extremely illiquid.
Downgrades by ratings agencies and changes in agencies methodologies
further undermines investor confidence, prompting further selling of these
Investment vehicles issuing asset-backed commercial paper (ABCP) find it
impossible to roll over maturing paper. Mismatch between long-term assets &
short term liabilities
Money markets and interest rate and foreign exchange swaps markets become
very illiquid, making it harder for banks to manage their funding
Large losses reported by investment banks on CDOs. Merrill Lynch: CEO resigns
29th Oct 2007. Citigroup: CEO reigns 5th Nov 2007
Spiral of uncertainty: uncertainty causes more uncertainty

It is striking that a market as small as US sub-prime RMBS, with a size of

around $700 billion, had such pervasive effects on much deeper and more liquid
markets, such as the asset-backed securities (ABS) markets (with a size of $10.7
trillion). (Bank of England FSR, page 18)


Phase II 2008

Equity prices fell substantially (particularly of banks). FTSE100 fell by a third

from May 2008 to Feb 2009. Role of short selling.
Banks stockpiled liquidity to fund their balance sheets. Some asset managers
built up precautionary liquidity balances to cover potential redemptions.
Increase in demand for liquid assets resulted in yields on government securities
Costs of interbank lending by banks to other banks over periods longer than
overnight, LIBOR, rises sharply. Interbank lending increasingly concentrated at
shorter maturities
Holders of CDOs marked down values. But uncertainty persists with respect to
valuation methods
Bear Stearns in government assisted rescue Summer 2008
Lehmans insolvent in September 2008, Icelandic banks collapse, AIG bailout
Massive loss of confidence in global financial markets
Governments support banking sectors
Interest rates at historic lows
World economy in recession
Many popular quant strategies delivered massive negative returns. Daily
movements of 10 Standard deviations observed several times. Systemic risks
amplified by overcrowding and leverage. There were too many following the
same strategies and over-levered.

Topic 4: General Features of Financial Crises (2007 is not the 1 st, and will not
be the last, financial crisis)
- Why this recent crisis belongs to a general pattern of such crisis. We
identify the elements in the UK crisis that are common to similar crises
around the world and in history. Is the UK crisis part of a general pattern?
We examine other financial crisis that has been seen in the last century. We
look at problems of bank runs, liquidity, the role of credit in business cycles,
the role of financial intermediation, asset price bubbles and speculation.
Bubbles in Asset Prices


Financial crises often follow what appear to be bubbles in asset prices.

Bubbles definition: Sustained increases in asset prices that cannot be explained
by movements in fundamentals.
Bubbles can be explained by:
Rational Bubbles
Psychology, or sentiment driven bubbles (summarized as behavioural models
of bubbles. More on these below).
Boom-bust cycles can be driven by the fluctuations in the price of risk. Shin
(2008 Clarendon lectures)
Bubbles driven by the incentives in financial institutions.

5. Fluctuations in liquidity. Liquidity is a public good that comes from the diversity
of trading positions. But when all follow the same strategies they all become
consumers, not providers, of liquidity.
1. Rational Bubbles. These are bubbles where a rational investor will hold the
asset. The usual PV formula for a share price can be augmented with a
bubble term:

Pt =

1 i
( d t +i ) + Bt

( )

This first-degree difference equation can be iterated forward to reveal the

solution such that

Et ( Bt +1 )=(1+r )Bt

NB Bubbles can burst with probability =p so B(t+1) =0 with probability p so long

as with probability =(1-P) the bubble is even bigger next period so that:

B t+ 1=

(1+r ) Bt

A special case of the solution that pins down the asset price is Bt= 0, which
implies that the value of the bubble is zero at all times.
The reason the price of the asset may exceed its fundamental value is that
agents expect that they can sell the asset at an even higher price at a future
Multiple bubble paths. The path of the bubble (and consequently the asset
price) is not unique. There is a different path for each possible value of the initial
level of the bubble. An additional assumption about Bt is required to determine
the asset price.
2. Psychology, or sentiment, known as Behavioural biases contributes
to a bubble.


The Law of Small Numbers (LSN) describes the belief that a randomly drawn
sample of data will reflect the characteristics of the population from which it is
drawn more closely than sampling theory would predict.
This is related to the bias known as sample size neglect, which describes the
finding that subjects overestimate the statistical relevance of information that is
contained in the sample (see Tversky and Kahneman, 1971). This causes
subjects to overweight (compared to a Bayesian) the importance of a given
sample of data when drawing inferences about the population from which it is

Example: If tossing a coin expect a head with probability greater than 50% after
a tail observed.
Implication for inference/learning: Seeing 3 heads in a row too quickly leads to
the inference that the coin is biased.
So in the boom there is extrapolation of recent trends. A couple of recent
positive return surprises lead investors to infer an upward trend. Investors
assume that if prices have risen recently they will continue to rise in the future.
Seeing patterns too quickly when its just random chance.
This learning causes further buying in the boom as a result of other behavioural
In boom many investors are making money. Investors who make money when
prices rise take this as confirmation of their clever behaviour and buy more. This
is consistent with the bias known as "Biased self-attribution" which means
that investors attach too much significance to signals that confirm their prior
beliefs and too little significance to signals that contradict them. People
attribute success to their skill and failure to bad luck.
And tell others of their success. Which leads to: Prices rise and this draws in yet
more investors who fuel further price increases. Culture: following behaviour of
others who are perceived to be making money. Shiller talks about the culture of
real estate excitement. Everyone talks about how much money they have made
on their houses and stock prices and this draws new investors in.
Falling risk premiums, which I documented before the 2007 crisis, further
reinforces this price rise. Risk premiums falling, as investors feel more confident
feeds rise in prices. Risk premiums fell sharply on subprime in 2000s.
Sometimes assumed there are 2 classes of investors trend chasers and
This can play a role in explaining bursting as we see below.
3. Incentives in financial institutions.

So far we have talked about irrational biases. But there are rational reasons for
money managers to participate in bubbles.
Portfolio managers who share upside but not downside eg Hedge funds
who typically take 20% of gains, but still get 2% management fee when losses.
This payoff schedule encourages risk taking. This concern has led to many
proposals to reduce this incentive to risk taking.
Portfolio managers in large firms who are judged relative to peers. If
you make an investment and it turns out to be a bad investment when peers
make the same investment you cannot be fired. But if you do not buy when
everyone else is buying AND it turns out profitable you will look relatively bad
and may be fired.
Terrible to be wrong when everyone else is right but not so bad to be wrong
when everyone else is too.
This leads to copycat investing.

Financial institutions follow very similar strategies.


This leads to common fluctuations in liquidity. Liquidity is a public good that

comes from the diversity of trading positions. But when all follow the same
strategies they all buy together and want to sell together. They become
consumers, not providers, of liquidity.

Bubbles can be fed by the banking system

Investors use money borrowed from banks to invest in risky assets, which are
relatively attractive because investors can avoid losses in low payoff states by
defaulting on the loan. Massive property investment in Ireland and Spain before
2007 fueled price bubble. Then banks left with property when property market
and developers crashed. This risk shifting leads investors to bid up the asset
prices. Risk can originate in both the real and financial sectors. Financial fragility
occurs when positive credit expansion is insufficient to prevent a crisis.
Banks have large exposure to asset markets so when these prices rise bank
assets and collateral they have taken for loans rises too. As Shin points out this
allows banks to lend more so financing further asset purchases financed by
bank borrowing.
Mark to market plays a key role in amplifying bubbles.
It implies that when shocks hit all banks act in the same way to restore balance
sheets. This drives asset prices irrespective of fundamentals. D curves slope up
( prices rise >collateral value up>more lending>asset demand up)and supply
curves down. A very unstable situation.
In boom, Asset prices rise, measured risks fall, so mark to market leads to
increased capacity of banks to lend. Also higher bank profits increase the banks
Shin: a bank with surplus capital is like a manufacturing plant with idle
Expanding lending means finding new borrowers. When all the good borrowers
already have a mortgage, the bank has to lower its lending standards: subprime.
Banks owners and managers suffer from over-optimism and over-confidence
and biased self-attribution that individual investors exhibit.
Further the same relative performance metrics that influence employees affect
CEOs. A bank that does not lever as much as other banks and copy profitable
strategies of others will see lower stock prices. Warren Buffet came under great
pressure in 1999 for not participating the Internet bubble of 1999, although he
was eventually proved right.
Related to another problem encourages participation in bubbles: excessive
short termism. You may have to wait several years to be proved right if you do
not participate in a bubble. If you sell out early you may watch peers making
money for years.

Why do bubbles burst?


Rational bubbles bursting is just chance in the basic model.

A negative shock to fundamentals draws attention to fundamentals. In 1929 a
fall in dividends broke the optimism about stocks.

More generally prices move so far from fundamentals that:

Fundamental traders realise that prices have got so far above fundamentals
that they short the market, betting on a correction.
In the case of property new buyers who are buying for homes rather than
speculation, cannot afford to buy because prices so far above fundamentals,
ability to pay off the loan.
Income from assets, rents or dividends, which are the fundamental become
such a small % of price investors get nervous as all return has to be the capital
gain. As soon as growth in prices slows these investors get nervous because all
their profits depend on capital gains. When property rent income is less than
interest on loans this is very dangerous. This leads to higher risk premiums and
lower prices, bringing about the very outcome that is feared..
Once prices start falling investors become more nervous and risk premiums
start rising and this leads to further falls in prices.
Borrowers get into negative equity and cannot repay loan even if property is
Widespread defaults as assets market price falls below value of loan. Leads to
financial crisis.
Final stage after the burst is the spill-over of the crisis into the real economy.
This occurs as:
Banks curtail lending for real investment and consumption to rebuild balance
sheets after losses on bubble assets.
Consumers wealth falls leads to increased saving to rebuild balance sheets and
so reduced consumption.
Problems of Savings Imbalances:

See Reinhart and Rogoff NBER March 2008, Fig 3 Countries experiencing
sudden large capital inflows are at a high risk of having a debt crisis.

Shin (2008 Clarendon lectures)


See his website Hyon Shin at Princeton University, for Ch 1 and 10, free
Boom-bust cycles are driven by the fluctuations in the price of risk.
He emphasises that liquidity is a public good that comes from the diversity of
trading positions. But when all follow the same strategies they all become
consumers, not providers, of liquidity.
When all follow the same strategies they increase endogenous systemic
risk. (left feet on bridge)

Two kinds of systemic risk:

Endogenous risks are generated and amplified within the financial system.
Investors react to news about changes in their environment and individuals
actions affect their environment.
Exogenous risks are from shocks that are from outside the financial system, eg
Unemployment shocks.
E.g. Endogenous risk: Feedback loop where short-term price movements induce
most investors to act in way that amplifies initial price movements. Or simply
anticipation of price falls. When such feedback effects are strong, decisions are
based on the second-guessing of others decisions rather than on the basis of
This leads to actual volatility much greater than fundamental volatility. But not
always a clear distinction. A currency crisis (exogenous) can trigger a banking
crisis because foreign debt becomes much more expensive to repay (in the
domestic currency). This leads to Balance sheet problems for banks that have
borrowed overseas.
Mark to market plays a key role in amplifying endogenous risk. It implies that
when shocks hit all banks act in the same way to restore balance sheets. This
drives prices irrespective of fundamentals. D curves slope up and supply curves
down. A very unstable situation.
In boom, Asset prices rise, measured risks fall, so mark to market leads to
increased capacity of banks to lend. Also higher bank profits increase the banks
Shin: a bank with surplus capital is like a manufacturing plant with idle
Expanding lending means finding new borrowers. When all the good borrowers
already have a mortgage, the bank has to lower its lending standards: subprime.
Late stages of a boom. Compression of risk premium and the search for yield.
Investors move down the asset quality curve as risk spreads fall.
Shin quotes Bank of Englands Financial Stability Review of December 2004.
Financial intermediaries and investors appear to have continued their search
for yield in a wide range of markets, holding positions that could leave them
vulnerable to instability in the pattern of global capital flows and exchange
rates, credit events or sharper-than-expected interest rate rises. A number of
market participants have also discussed the possibility that risk is being
underpriced. In the event of an adverse shock, any over accumulation of
exposures from the mis-pricing of assets may result in an abrupt, and costly,
adjustment of balance sheets.[Bank of England (2004, p. 49)]
In burst: Twin problems: risk increases and willingness to bear risk decreases.
Shin quotes Crocket: risk as increasing during upswings, as financial
imbalances build up, and materialising in recessions.

Minsky cycles


Note this was written in the 1960s. But it reads as if written after 2007. Shin
emphasises financial sector. Minsky introduces consumption and real
investment into the cycle.

The Bubble

Positive Real shock, say to productivity e.g. electricity in 1920s, Internet in

1990s leads to real gains. This leads to asset price up in 1 sector for good
reason spreads to other sectors, where it is not justified by fundamentals.
Consumption rises as increasing wealth leads rationally to increasing
consumption because of the Permanent Income Hypothesis. The problem is that
if this is actually (but not perceived as) bubble wealth it is not permanent! In a
behavioural model: target wealth is achieved through capital gains, freeing
income for consumption.
Financial markets Investment rises because optimism and willingness to bear
risks drives up demand and prices for all risky assets. Risks only seen after the
Real Investment rises because optimism and willingness to bear risks reduces
the WACC (K 146,152 for Japan). Taste and perceptions of risk change over
cycle. Run of successes lead to risks being downplayed. Optimism in boom and
less careful Investment appraisal K155. Complacency trusting in booms, anger
and reading fine print in crash Shiller.
Industrial firms buy real estate and trade in financial markets (Porshe made
more money through derivatives trading than selling cars in 2008)
Boom in real estate construction. Culture of real estate excitement
emphasised by Shiller: every taxi driver talks of property prices. Rents< WACC
in boom but expectation of Capital gains so keep building.
Mark-to-market stimulates bank lending in boom as collateral values rise. Key
part of the problem of the pro-cyclical nature of the financial system.

The Burst

Liquidity crisis hits real economy, e.g. K155 for Japan.

Banks initially face Liquidity crisis but turns into insolvency. Credit even for good
firms dries up, leads to investment constraints.
Consumers rebuild balance sheets leads to sudden increase in saving. In UK
2009 saving=10%, where saving=0% in 2006. UK Government debt in 2009
increased by similar amount to the cut in consumers spending.
Mark to market amplifies bust stage in cycle when property important in
Balance sheet. Collateral falls fast leads to calling in loans or triggering penalty
interest rates. Mark-to-market multiplies lending in boom and damps lending in
Much regulation requires Mark-to-market, for some good reasons, BUT it
amplifies cycle making the financial system pro-cyclical.

Moore and Kiyotake model of the credit cycle JPE 1997

They assume 2 kinds of firms credit constrained and non-credit constrained.
Temporary shock hits.
credit constrained firms have lower cash flow and have to cut back I which was
made out of cash flow.

Lower I means lower cash flow next period.

Leads to lower I next period
And so on.
This lower I demand leads to lower prices for investment goods that also serve
as collateral.
So borrowing ability of constrained firms falls further
Leads to lower I again.

NB The dynamic inter-temporal multiplier much more powerful than the single
period multiplier. Lower future cash flows> lower future I> future P falls expected>
lower P today.
Real cost as production shifted to unconstrained firms who will have lower
productivity but can I more because they have cash. Distortion of production to
less efficient non-constrained firms.
Topic 5: Regulation, what can be done to reduce the chances of a future
crisis? Basel III proposals.

We consider what the government response should be in the short term

and how regulation might be tightened so that in the long run a crisis is
less likely to recur. We pay particular attention to the debate about the
fraction of equity banks should hold.

Role of Government/Regulation

Scale of intervention 2007-2009 $13 trillion of Gov spending world wide, in form
of direct lending loan insurance, asset purchase: 86% of UK GNP, 74% US GNP,
18% EU GNP
This cannot be repeated. What be done to ensure it does not happen again?
Central Banks have 2 roles: price stability and financial stability.
Blair separated these and the FSA took over later.

Aspects of regulation for financial stability:

Ensure banks have sufficient liquidity

Ensure banks remain solvent


Measure of Liquidity:

1. Extent to which assets can be quickly sold without a significant loss of value. Liquid
assets= Cash + deposits at central bank +Short bills. Until 1960s banks had 30% of
assets in government bonds so very liquid. In 2000s this had dropped to 1% because
banks hold more sophisticated assets, like CDOs. But these markets can dry up, as we
saw in 2007. Northern Rock had planned to securitise large tranche of loans in Aug
2007 but could not sell them. Then squeezed when wholesale markets dried up.

2. Relative maturity structure of assets and liabilities. BOTH sides of banks book
have to be viewed to assess liquidity. If long borrowing and long lending then
short-term problems can be ridden out. Eg Borrowing short and lending long
implies poor liquidity. Buying long-term assets using short-term loans is
Distinguishing illiquidity from insolvency can be hard if illiquid markets which
make it hard to see real asset value.
Need to ensure liquidity problems do not lead good firms into insolvency. Eg


Liquidity is a public good and so should be supplied by central bank. Although

ratios of liquid assets/total assets that need to be held plays a key traditional
role in text books its arguable that this ratio should not be heavily regulated
since CB can always provide liquidity providing banks are solvent. CB job is
about liquidity not insolvency. What collateral should a CB accept for providing
liquidity? Problem that borrowing from CB bad for reputation.
Deposit insurance: Important to prevent runs and depositors if bank has to be
wound up. Problem is that depositor no longer cares and so weak banks can still
attract funds.


Insolvency implies NPV of bank is negative, which implies equity valueless.

Externalities imply a bank can be too big to fail. Any institution that is too big to
fail needs to be regulated.
Two aspects to too big to fail. Firstly, the impact on depositors too big and
costly even if insured. Secondly, the impact of suddenly closing out asset
markets positions on prices and hence on the liquidity and even solvency of
traders. Massive dislocation/uncertainty to counterparties when sudden failure.
Unwinding trades can be hugely costly especially OTC trades.
Moral hazard case for non-intervention after problems implies need to forestall
insolvency. Upside full return but downside insured if too big to fail: Greenspan

Regulatory Tools:
Capital requirements.
Basel requires 2% Tier 1 (Basically equity) at all times, proposed 8% Tier 1 or 4%
Tier 1 after stress test. Proposed that idea of contingent capital that can be
converted into Tier 1 at time of stress. But think about systemic risk of this
conversion. See Miles Optimal Capital paper for core reading.
Admati and Hellwig Bankers new clothes argue that banks should be required
to have more equity. A bank's equity is its owners' stake in the bank's
investments. Equity value also called the bank's capital. The value of this equity
is initially funds raised from share issue. It can then be increased or run down by
subsequent profits or losses. It is then computed by adding up the values of all


the assets or investments that the banks owns, then subtracting the values of
all the debt liabilities that the bank owes to its depositors and other creditors.
The difference is the value of the equity or capital that belongs to the bank's
Admati and Hellwig report that, early in the twentieth century, banks typically
had equity capital worth about 25 percent of their total assets. That is, each
dollar lent/invested by such banks included 25 cents that actually belonged to
the bank's owners, along with 75 cents borrowed from depositors and other
creditors. If the value of the bank's assets were to decline by up to 25%, the
losses would be borne by the owners, with no effect on the bank's ability to
repay its depositors, until the owner's equity was exhausted. This large value of
equity was needed to reassure depositors that the bank was very likely to be
able to repay them. Without this reassurance, they would not have been willing
to lend their money to the bank at low interest rates.
Two distinct effects of equity on costs to society of bank failure: For any given
level of risk in the bank's investments, the probability of investment losses large
enough to affect the depositors becomes smaller when the bank has more
equity. But more equity also means that the owners who control the bank have
more incentive to avoid risks of such large losses. That is, equity helps to solve
moral hazard in banking.
Banks are subsidised through:
1. Tax shield of debt interest is deductible.
2. With deposit insurance depositors became less concerned about how much
equity their bank had in its total investments, and so banks could borrow at
low interest rates even with less equity. Bank runs that brought on the Great
Depression in the 1930s led to the creation of government deposit insurance
programs in America and elsewhere. But when creditors are publicly insured,
bank default risk becomes a public problem. Thus, the requirement that
banks should have adequate equity has become a responsibility of
3. Too big to fail means bond finance cheap AAA.
Cannot do anything about the last 2. But can reduce debt shield. Banks have
argued that equity is expensive for banks, and that requiring more equity would
increase their costs of lending and cause a decline of economic investment and
Miles shows little evidence for this observing spreads and output growth as
leverage has increased in last 100 years.
Banking sector might be less profitable, (resulting in lower bonuses?)
Related Issues: Risk Weighting of capital requirements? This means amount of
equity greater the more risk on banks balance sheet. E.g. Only require 20%
equity against risky assets. Safe assets can be financed by all bonds. Problem is
how to measure risk. For example use AAA? But failures of rating agencies!
Sovereign Debt not requires capital? But Greek debt?
Regulators agreed in 1996 that capital reserves could be reduced if insured by
CDSs. But CDSs could not insure against systemic failure.
Regulators agreed in 90s that CMOs and CDSs could get AAA ratings. This
opened way to purchase by banks that needed less equity backing.
If super-senior tranche of CMOs taken on balance sheet reserves could be 1.6%
instead of 8%, i.e. 20% of usual reserves. Alternatively it could be insured as AIG
did for JPM. This was big incentive for banks to hold CMOs

This risk adjusting led to investment banks with core Tier 1 capital only 3% of
Balance sheet in 2000 (Or gearing of over 30).
Up to of banks balance sheet in 2000s was financed daily in wholesale
money markets. Worldwide 1 trillion of sub-prime in 2000s.
Stress Testing? Looks at Value at Risk, and likelihood of bank remaining solvent
after big negative shocks. Co-variance in stress testing?
Problem of banks shopping for the country with the most favourable risk
weighting for their portfolio and locating their business there.
How would banks raise the increased equity? Retained earnings. Will this impact
on share prices?

2. Size and complexity limits on banks.

Separate investment and commercial banking?

Glass-Steagall act 1933 made commercial and investment banking separate.
Investment bankers prohibited from using deposits to trade financial securities.
1986 Thatcher allowed banks new freedoms, like own jobbers, in the big Bang.
US bankers then complained that they were becoming uncompetitive with
London. In the US in 1987 5% of deposits could be used for investment banking;
and this was increased to 25% in 1996 (Paul Mason data).
G-S abolished in 1999. (Cost $300m in lobby fees, Paul Mason).
Now something similar has been revived in the US.
A commercial bank taking deposits and lending the money should not get into
same scale of trouble as a bank doing lots of proprietary trading. Therefore
should not be need for government bailouts of commercial banks.
Theory is that the government would not need to step into save investment
It is true that if an investment bank fails there is not the same problem of small
depositors and borrowers. But there is still a systemic problem if a large
Investment bank fails and complex positions have to be unwound. e.g. Lehman
was Investment bank. LTCM was bailed out. Its inter-linkages that is critical.

3. Living Wills


Requires plans about how to:

Recover Capital: how assets can be sold
Recover liquidity, especially under stress
Unwind subsidiaries (complexity often arises to tax avoid, or regulatory
4. Unwind trading book
5. Management policy for trouble
4. Early closure so government takes over bank


Early closure so government takes over bank and floats after couple of years,
like Northern Rock. Favoured by Goodhart and King. Need criteria for take over,
like CAR (capital adequacy ratios).
NB We need to distinguish between solvency of individual bank and of
the banking system as a whole: macro-prudential control
Regulation that ensures survival of individual bank may be different to survival
of all. Eg Basel II emphasised VAR but this ignores systemic issues. Need more
sophisticated co-VAR. Empirical measures of VAR sensitive to recent volatility. A
few quiet years could lead to big drop in VAR. Also diversification good for
individual VAR but if all banks diversify in the same way then regulation can
make things worse.
Leads to idea of macro-prudential control that addresses systemic risk and
contagion. But how to measure this? Sheer size, correlations but note these can
be greater in crisis than in normal times.

International cooperation


If no unified regime we will see international regulation arbitrage. But will

congress ever agree to plan that does not originate in EU? But alternative is
international banks that are holding companies with subsidiaries in different
countries with walls between them, each subject to the regulation of the
particular country they are operating in. Banks will object that this impairs
efficiency. Regulation must become more international OR banks must become
more national.

Wider regulatory ideas/issues

1. Quantity constraints that vary with stage in the boom/bust cycle:
E.G. Maximum loan to collateral value ratios for borrowers or maximum loan to
income ratios for borrowers
2. Should central banks target asset prices in boom?
Not if Rational Expectations/Efficient Markets. But if bubbles? In 2000s words in US
and UK but no actions. Greenspan talked of irrational exuberance in 1996, Krugman P.
203, but little actually done because of confidence in Efficient Markets
Problem of cooling boom without causing bust. Inflation was under control in the UK so
no reason to raise UK interest rates in mid 2000s.
Interest rates alone could not both target asset prices and consumer prices. Asset
prices in UK rising fast but consumer prices steady.
3. General problem of regulation is the Lucas critique.
4. Beware regulation that hurts small banks because fixed costs of regulation
5. Regulation relies on codified info. More regulation can damage behaviour that
is tacit, non-codifiable. Rely on codified is problem because of incomplete
contracts. If ALL info is codifiable no prob. BUT it is not.
6. Regulation can be source of systemic risk. Eg if all banks breach limits and
have to sell assets.
7. Funds may flow into unregulated sector (shadow banking) in boom and exit in
bust causing even bigger problems for shadow banking in bust. Problem of off
balance e.g. special purpose vehicles do/lend what regulators forbid. Should
banks be allowed to avoid regulation by using off-balance-sheet vehicles to
conduct business in structured finance products. Problem of shadow banking is
that investors flock to it in boom but run back for protection in recession so
there is more procyclical destabilization. And when shadow banking gets in
trouble this spills over into regulated sector e.g. by property price falls. Risk
migration to areas where it is less visible.
8. Regulatory errors can lead to systemic problems.
Regulators mistakes 2000-07:

Basel II focussed on CAR, risk weighted capital adequacy ratio. US simply

looked at leverage, without adjusting for risk. Problem with CAR is how to
measure risk. It treats risk as asset specific and misses systemic risk.
Problem of regulatory arbitrage. If regulation reduces profits banks try to find
way around it. Hence SPVs and shadow banking sector e.g. Basel II gave banks
an incentive to find ways to get credit risk off their balance sheet, and save

General Issues:

Greenspan always emphasised believing markets, although sometimes he

doubted, exuberance.
Topic 6: The Sovereign Debt Crisis
Euro zone crisis

1. Was the crisis inevitable?

2. Why particularly bad in the EU?
3. Solutions?

The crisis was highly likely after the 2007 financial crisis.

Common features of current Sovereign Debt problems, whether or not Eurozone:

Carmen Reinhart and Kenneth Rogoff show financial crises are usually followed by
government-debt crises through 2 routes: In the UK Private debt is shifted onto the
balance sheet of the government, through bailouts and purchases of toxic debt.

Scale of intervention 2007-2009 $13 trillion of Government spending worldwide, in

form of direct lending loan insurance, asset purchase: 86% of UK GNP, 74% US

The government-debt problem is exacerbated as the economic downturn leads to

an increase in expenditures in the form of unemployment benefits and stimulus
spending coupled with a decrease in tax revenues as incomes fall.

Finally, just like private bubbles bursting, we find that governments often have
hidden debts that far exceed the better documented levels of debt. E.g. In the
UK PFI guarantees.

Longer term problems:


Reinhart and Rogoff show that high levels of public debt are usually accompanied
by low growth rates for many years.

This makes it harder for government to reduce this newly issued debt quickly. In
the 1990s, the Japanese government socialized private losses through a massive
transfer of private debt (banks) to the national balance sheet. This happened in
the wake of the Japanese asset bubble another boom fuelled by a tidal wave of
easy money from the central bank and led to two decades of slow growth and a
lack of restructuring of the economy.

Critical current question is whether Eurozone economies are "turning Japanese


Eurozone economies in many ways resemble the post-bubble Japanese economy of

the 1990s. Ultra-loose monetary policy and low demand for credit, combined with
high unemployment and consumer deleveraging, could lead to a prolonged slump.

Why are these problems particularly serious in the Eurozone?


Start from government budget constraint:

G + rB=T+ change in M +change in Bonds


For countries with own currency they can always print money so never need to
default. True this may cause inflation, but monetising debt avoids actual default.
But for countries in Euro they cannot print their own Euros. They can only finance
by tax revenue or selling bonds. If tax revenue does not cover expenditure they
have to borrow. But if investors will not buy then default is the only option.

Important distinction between Insolvent and Illiquid countries.


Insolvent: Means the sovereign government's borrowing from domestic and

external markets is in excess of its capacity to repay, resulting in loan defaults
requiring rescheduling of loans or bailout packages from other countries or
multilateral institutions such as IMF.

Insolvent means no prospect that taxes can cover G+rB. It cannot raise enough
tax to service interest payments on existing debt. The sovereign debt of Greece at
December 2014 was about 180% of GNP. Italy, Portugal, Ireland all under 150%.
Approximately 90% is the EU average.

Unemployment in Greece 1st Qtr 2015= 25%

In 2014 Greece PSBR finally became positive. But since then turmoil means budget
deficit for Greece in 2015.

So debt is actually increasing again.

Greece is insolvent because at December 2015 8.6% interest, debt interest is 8.6%
of 180% of GNP=approx. 15% of GNP.

Greek spreads before 2007 were under 1% but since then has been often 25% in
the different crises. Investors first treated Greek bonds like German but started
demanding a higher premium for holding southern euro zone debt when they
realized scale of Greek borrowing and read the small print that Euro bonds were
not guaranteed.

Contagian: Greek yields hit 34% in 2012 and Italian yields were 7% in 2012 but like
similar southern European countries have fallen steadily to 1.5% in 2015.


Illiquid: Can service debt BUT might not be able to sell new debt in short term
because of market perceptions. As short-term debt matures cannot sell new debt.
ECB can and should help.

Though the two interact. If investors lose confidence r gets very high so rB
becomes very large. A crisis of confidence pushes up R so significantly adding to
the real PSBR.

Spain and Ireland had reasonably low government debt up to 2006, indeed both
had small surpluses. BUT this was because property booms led to high tax revenue
that dried up when the bubble burst.

Debt to GDP ratios in UK and USA, 90% and 85% respectively, but lots of complex
assumptions in calculating these numbers. And less of a problem because paying
1% to borrow.

And QE in the UK has further reduced government debt payments.

Why did sovereign debt get so high in Greece?


Joining Euro meant governments could issue euro bonds at much lower rates than
Greece had paid for Drachma bonds that were perceived to be risky and were
therefore high yield. Investors originally viewed all euro bonds, regardless of who
issued them, as pretty safe, assuming they would be underwritten by Germany.

This meant Greece could borrow at much lower interest rates than before when
with bonds denominated in Drachma the risk was clear.

Cheaper borrowing led to more borrowing and hence more spending and domestic
liquidity. Interacted with the other bubble factors from the 1st credit crisis and the
domestic asset price bubble. Cheap borrowing for governments at same time as
cheap borrowing for private sector.

Greece has the additional problem that it went into Euro at too high exchange rate
from Drachma. This led to a recession that called for more government
spending/lower tax.

Also it concealed true size of its PSBR to GNP ratio, understating it by around 2%.
Not only was the high fiscal deficit a problem, it was also camouflaged by
derivative hedging. Investment banks misled investors into investing in
government bonds of Greece by being secretive about the actual state of affairs.
The rating agencies played accomplice and allegedly 'failed' to assess the correct
fiscal position. When that became clear investors started worry about whether size
of debt could be managed, particularly as Greece went into recession.


1. Austerity
Reduce G and increase T.
Greece reached an agreement with IMF in 2012, the European Commission and the
European Central Bank on a rigorous program to stabilize its economy with the
support of a $145-billion financing package against which the Greek government was
required to implement fiscal measures, structural policies and financial sector reforms.
Some of the points of the reform package were reducing the fiscal deficit to 3% by
2014, pensions and wages to be reduced for three years, government entitlement
programs had to be curtailed and social security benefits cut.
But austerity is no solution.
The austerity program exacerbated recession in Greece, resulting in lower tax
revenues and more government expenditure on social security payments. So austerity
cuts will be offset by these payments changes, known as automatic stabilizers.
2. ECB could totally solve the problem by monetizing debt, just like ordinary
country with its own currency. But this effectively is a redistribution of income towards
Greece. It would mean that Greece had spent money financed by bonds that are
bought with shared EU pool of Euros. A real income transfer to Greece. Within a single
country some groups may have benefited from government spending and are
effectively subsidized when money is printed to buy bonds. But within a country all
kinds of mechanisms exist to redistribute income. So the monetization still arguably
benefits the recipients of government spending. But a democratic process determined
the distribution of spending. No such process in the EU. Greece just spent without
Monetization of debt would solve bond crisis but entail an arbitrary redistribution
between countries that is not underpinned by any democratic political process.
The objections against redistribution now are reinforced by the concern that it would
result in moral hazard. If Greece is bailed out now it is likely to do the same again,
expecting to be bailed out again.
Other countries will not have incentive to be prudent. This is Germanys big concern.
3. Eurobonds
Eurobonds: debt is issued in the name of the euro zone as a whole, thus enabling
those countries experiencing funding problems to continue borrowing from the

markets and at much lower rates. The bonds would be rated triple-A, reflecting the
credit strength of the northern euro zone.
These would be perceived as safe because Eurozone as whole is solvent. But northern
countries, especially Germany would be insuring investors against default on bonds
issued in Greece.
Problem again that Greece would have an incentive to borrow at subsidized rates.
Therefore there would have to be very strict rules about Greek spending. Which
makes it inseparable from:
4. Full fiscal union
This would violate sovereignty.
Also it is very hard to write rules that countries could not get around with expensive
lawyers. It is very hard to write watertight legislation. And how would it be enforced?
5. Establishment of the European Financial Stability Facility, EFSF.
EFSF was established in 2010.
Then Mario Draghi, President of the European Central Bank, in 2012 pledged to do
"whatever it takes" to protect the Eurozone from collapse - including fighting
unreasonably high government borrowing costs.
This led to the European Stability Mechanism that started operations in 2012. It buys
up bonds with very high yields-Greek, Spanish and Italian bonds. Really no substantial
difference to ECB buying bonds/ monetizing. It could solve the problem, but at the
same price described above for monetizing debt. The only difference is that the costs
would be explicit through clear-cut defined payments into the scheme. And the power
would be with a different group to ECB. The difference between the ECB buying and
the EFSF is political.
Some argue that rather than just buying Greek bonds EFSF should target its funds at
saving banks. Difference with CDOs is that sovereign debt is more visible. Very good
chance that in long term countries will be able to repay, unlike CDOs.
EFSF could insure all sovereign debt that is held to maturity. Then that debt on banks
balance sheets would not need Tier 1 capital backing. But around 50 billion of Greek
debt due in next 4 years.

6. Break up of the Euro zone


Huge cost is disentangling contracts written in Euros. Massive dislocation of

trade. Very volatile exchange rates as each currency finds its own level.
Drachma would plummet. Good for exports and stimulate Greek economy. But
much lower standard of living as imports became much more expensive. And
debts in Euros very hard to repay with weak Drachma. European financial crisis
as investors stampede out of all banks as fear of exit from Euro spreads. Mark
would soar. But problem for German exporters.
How would Drachma emerge? If government had no Euros to pay public sector
workers, pay with IOUs/Drachma and gradually these would be accepted as
money. Like patagonias in Argentina (5 Patagonia meals in MacDonalds)

Is it possible to make the zone viable with stricter rules in long run?


Optimal currency areas and convergence. A single currency means a single

interest rate. Yet interest rates are an important tool for managing countries
response to the inevitable shocks, e.g. oil prices. Convergence means countries
have sufficiently similar fundamentals that when shocks buffeted them they
would require the same interest rate response.

Staying converged requires pay rises that reflect productivity gains in each country
otherwise countries will loose competitiveness. But see unit labour costs:

But political convergence overlooked by economists. Countries with different

tastes for work/retirement cannot form fiscal union because they want different
tax/spend policies.
Strict Fiscal rules. But very hard to write rules/ contracts that cover every
contingency. And very hard to enforce even if they do. E.g PFI initiative in UK
effectively shifted government debt onto private balance sheet.
Potential fiscal rules
Debt/GNP< 60%
Judged by European Court.
Fined if violated.
No plans for Eurobonds underwritten by all states.


Will countries agree?

Can it be implemented without cheating?