Contributors:

1. Maunik Desai – maunik.desai17@gmail.com

2. Muhammad Salman Shah – immortal678@hotmail.com
A financial crisis occurs when there is an extreme cash shortage and the primary lenders of money
no longer have control over its liquidity. A significant large number of bankruptcies of the financial
institutions especially banks during the recent financial crisis is due to the difficulty in estimating the
required funds to be secured against major risk (Verick & Islam, 2010). This situation generally arises
when over-valued assets are sold off like tickets to a Superbowl. The rapid string of sell off can
reduce the underlying value of assets thus creating a sense of fear among the investors and
consumers. That in turn results in a highly volatile stock prices which elaborates on the fluctuations
of underlying financial instruments. The collapse of a financial institution may lead to a domino
effect (systemic failure) in the market it operates in, thus may have the potential to expand in to the
crisis of whole economy if not solicited by some external funding. Since both the magnitude and
consequences of such a systemic failure are substantial, governments must intervene with some sort
of quantitative easing programs to reduce the spill over effects (too big to fail). Therefore, it just not
necessitates the supervision but also the implementation of prudential rules for the global financial
system to operate safely.

The primary causes of the Global Financial Crisis of 2007/08 are as follows:

1) The primary trigger of the systemic failure was the bursting of housing bubble of United
States of America which became into existence on the first place due to the easy availability
of credit from banks and large inflows of large foreign funds (Allen & Carletti, 2010). The
mortgage payments and capital appreciation of the housing sector were re-engineered,
occasionally called financial innovation into a huge number of financial agreements i.e.
mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). The average
price of homes in America increased by 124% (The economist, 2008) which lead to the
increase in the value of financial agreements (MBS and CDOs) which were held by a wide
array of investors from the whole world.
2) Subsequent fall in the pricing resulted in homes worth less than the mortgage leaving the
sub-prime mortgages very unattractive to the home owners, therefore triggering the early
closure or default. The early closures or the defaults deprived significant wealth from
consumers i.e. $4.2 trillion (Estimate of household wealth loss, 2016). This phenomenon of
default on mortgages had a ripple effect over other sectors that resulted in the loss of many
trillion U.S. dollars internationally.
3) It is important to understand the financial innovation and complexity involved in the
underlying instruments. The usage of these products increased manifolds in the years
leading up to the crisis. The pricing of these contract presented a significant challenge as
there was a lack of transparency in the banks’ risk exposures. The increase in complexity is
partially attributed to the number of players involved in single mortgage including brokers,
security writers, trading desk, insurers and eventually investors. The whole process of this
credit intermediation is known as shadow banking. As a result, these players had to rely on
the indirect information which provided the opportunity for unethical behaviour,
misjudgements and eventually market crash (Langley & Paul, 2015).
4) The technological advancements also had a great role in 2008-09 global financial crisis by
increasing the interconnectedness of the markets and thus magnified the snowball effect
often called contagion.
 5) Increase in subprime mortgage loans - Higher loans were made to subprime borrowers who
may have difficulty in repaying this debt. It could be because of unemployment, divorce,
medical emergencies, etc. These loans are characterized by higher interest rates & poor-
quality collateral. To increase their loans, banks lowered lending standards & gave interest-
only loans to subprime borrowers which resulted in their default when housing prices
crashed.

6) Easy regulatory environment – Lack of separation between commercial & investment

banking & allowing banks to rely on their internal risk models without enough supervision
were also causes for the financial crisis

2) The market features and conditions that constitute a financial crisis in general are:

A financial crisis is often associated with one or more of the following phenomena:
 Substantial declines in credit volume and asset prices i.e. the boom and bust cycles;
 Severe disruptions in financial intermediation and the supply of external financing to various
actors in the economy;
 Large-scale defaults (of firms, households, financial intermediaries, and sovereigns);
 Large-scale government support (in the form of liquidity support and recapitalization).

Financial crises sometimes appear to be driven by “irrational” factors, including sudden runs on banks;
contagion and spill overs among financial markets; limits to arbitrage during times of stress; the
emergence of asset busts, credit crunches, and fire sales; and other aspects of financial turmoil.

3) How the primary causes of the Global Financial Crisis led to the features of a financial crisis:

 Reduced lending standards to subprime borrowers led to a housing boom & huge increase in
subprime debt which inflated housing prices. When interest rates increased & these
borrowers defaulted on the loans, the asset prices crashed;
 Complex financial instruments like CDO’s were created on bundle of subprime & standard
loans & were sold to investors across the globe who held huge exposures to these assets.
When the underlying loans defaulted, CDO’s became worthless & the investors were unable
to sell these assets leading to illiquidity & contagion in financial markets;
 Lack of regulation enabled banks to trade complex instruments like CDO’s without adequate
risk management or monitoring in place which led to large-scale selloffs & losses to financial
institutions when the housing prices declined;

4) The response of policymakers and regulators to the global financial crisis.

The responses can be categorized as follows:

 The most urgent issue was to stabilize the financial system in order to avoid the risk
of systemic failure. i.e. avoiding a domino collapse of financial institutions due to
bank runs or liquidity crisis in the market. An emergency action plan was adopted at
the G7 meeting held in Washington D.C. on October 10 amid the tense situation
immediately after the Lehman crisis (Guha, 2008).
 The international community responded with macroeconomic policy measures. By the
time of the G7 meeting in Rome in February 2009, the drastic deterioration of the real
 economy had become evident particularly in advanced countries, manifested in
shrunken trade and production and increased unemployment (Jessop, 2008).
 Third, it was also important to support developing countries. Many developing
countries had managed to sustain high growth right up to the crisis, thanks to prudent
macroeconomic policies and expanded global capital flows.
 Finally, to prevent future crises, it is an important task to reform international
financial institutions.

4.1) The Dodd-Frank Act:

On 21 July 2010 the US enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The stated aim of the reform was to promote the financial stability of the United States by improving
accountability and transparency in the financial system, to end "too big to fail," to protect the
American taxpayer by ending bailouts, to protect consumers from abusive financial services
practices, and for other purposes.

The enactment of the Dodd-Frank Reform can be outlined in the following manner:

 Systemic Risk Regulation and Financial Stability Oversight Council: The Act creates a new
systemic risk council of regulators called the Financial Stability Oversight Council to serve as
an early warning system identifying risks in firms and market activities, to enhance oversight
of the financial system and to harmonise prudential standards across agencies. The Council
is charged with the goal of identifying risks to US financial stability that could arise from the
material financial distress or failure, or ongoing activities, of large, interconnected bank
holding companies or non-bank financial companies, or risks that could arise outside the
financial services marketplace
 Resolution Plans: The FDIC and the Federal Reserve must review a company’s resolution plan
to determine whether it is credible and whether it would facilitate an orderly resolution
under the US Bankruptcy Code. If the resolution plan is found to be deficient, the company
must resubmit the plan, including any proposed changes in business operations and
corporate structure to facilitate implementation of the plan
 Concentration Limits: The Federal Reserve must prescribe standards to limit the risks posed
by the failure of any individual company to a systemically important firm. The rules issued by
the Federal Reserve must prohibit credit exposure of a systemically important company to
any unaffiliated company that exceeds 25 per cent of capital stock and surplus, or such
lower amount as the Federal Reserve may prescribe by regulation, of the ‘company’,
presumably the systemically important company
 Risk Committees: The Act requires risk committees for systemically important, publicly
traded non-bank financial companies, as well as any publicly traded bank holding companies
with total consolidated assets of US$10 billion or more.
 Stress Tests: Banks are required to conduct “stress tests,” which are designed to verify
whether they can operate in conditions similar to those that occurred during the financial
crisis. At the same time, large banks are required to develop resolution plans to manage
failure and reduce their chances.
 The Volcker Rule: The Volcker Rule will require bank holding companies to restructure or
divest their proprietary trading and hedge fund and private equity businesses.
 Swaps Pushout Rule: The Swaps Pushout Rule will require US insured depository institutions
and the US branches and agencies of non-US banks to push dealing in certain swaps out of
these banking units and into separately capitalised affiliates
 Bank Capital (Collins Amendment): The Collins Amendment, originally drafted by the FDIC
staff and reflecting the views of Chairwoman Sheila Bair, imposes, over time, the risk-based
 and leverage capital standards currently applicable to US insured depository institutions on
US bank holding companies, including US intermediate holding companies of foreign banking
organisations, thrift holding companies and systemically important non-bank financial
companies.

The intended effects of the regulation itself were as follows:

 It will protect the investing community as well as consumers from experiencing a situation
like that of the 2008 crisis
 It will reduce the likelihood and magnitude of future financial panics, end taxpayer bailouts
of Wall Street, and enhance consumer protection
 The Act would mark the greatest legislative change to US financial regulation since the
explosion of financial legislation in the 1930s, which resulted in the Federal Deposit
Insurance Act, the Securities Act of 1933, the Glass-Steagall Act, the Securities Exchange Act
of 1934 and the Investment Company Act of 1940

Explanation of how these fit into the general theme and rationale of financial regulation in
general:

In the pursuit of achieving the goals stated-to stabilize the financial sector and prevent crisis like the
Great Recession in the future-the act implemented a whole series of critical reforms. In order to
understand the magnitude of the reform and what solutions the act offered to the existing post
crisis problems, from one side, and to evaluate whether the goal was achieved, from another, a brief
outline of some of the major changes concerning the banking sector will be conducted in the part
that follows. Responding to the very low capital held by banks, the act heightened the capital
requirements by setting a minimum leverage capital and risk-based capital requirements, ensuring
that banks are better equipped to absorb losses in the future. The rules of the Collins Amendment
set two qualifications-requirements to be considered well capitalized and to be considered
adequately capitalized. Both are based on two ratios-the total capital ratio, respectively 10% and
8%andon Tier 1 capital ratio-6 and 4% (Malgrange, 2011). Normally, the tier 1 capital consists of
common stock, disclosed reserves, retained earnings, and certain types of preferred stock, while the
total capital is the difference between the assets and liabilities.

The rationale behind the rule was to prevent banks from involving themselves in risky activities for
their own benefit which indirectly endanger the depositors. The act attempted to strengthen the
Section 23A/23B of the Federal Reserve Act, implying restrictions on transactions with affiliates.

However, the FRB’s power to grant exemptions in a form of waivers remained under the Dodd–
FrankAct.9Other changes included the creation of the Bureau of Consumer Financial Protection,
which had broad powers over any person or company, providing financial products or services with
the purpose to protect consumers; the Durbin amendment imposing a limit of the credit card fees
paid to banks by merchants; and many other sections and provisions regulating different areas like
derivatives, municipal securities, credit retention requirements, Credit Rating Agencies, Executive
Compensation and Corporate Governance, etc
Some of the possible downsides and/or intended consequences of the regulation are as follows:

 It was too weak, and did not punish Wall Street enough for causing the panic
 Implementation of this act would result in higher compliance costs for most banks. This
would impact their profitability negatively and might harm their competitiveness compared
to their foreign counterparts
 Some economists predicted that its short-term effect would be to further contract the
supply of credit, reduce GDP and create further upward pressure on already high
unemployment

5) The intended effects of policymakers’ and regulators’ responses (Bussa et al., 2008):
Generally, policymakers’ and regulators’ responses are attempts to mitigate gaps among the
financial regulators. From the view of the affected parties the case of the 2007/8 crisis, some of the
expected effects were:
 Protects consumers against any bankruptcy.
 Prevent banks from taking on too much risk. It lets in the Federal government to lessen
financial institution size for those that end up too big to fail.
 Increase customers' trust in banks – customers will come to see that banks have
independent capability to prevent and manage their own financial issues;
 Provide safeguards for systemically critical banks towards monetary crises, as well as tools
for managing of monetary troubles;
 Provide non-systemically important banks with guidance on how to maintain a good
position, as well as safeguard against special supervision.

6) The downsides and unintended consequences:

 Shadow Banking System - Group of financial intermediaries facilitating the creation of credit
across the global financial system but whose members are not subject to regulatory
oversight. Trading in shadow banking system grew by 7.6% in 2016, to $45.2 trillion.
 Bank failure - Large numbers of banks either closed or forced to merge with other stable
banks during crisis.
 Compliance Cost - Compliance cost refers to all the expenses that a firm incurs in order to
adhere to industry regulations. Compliance costs include salaries of people working in
compliance, time and money spent on reporting, new systems required to meet retention
and so on. This is additional cost incurred to run their business with regulatory framework.

7) The features of financial markets which often need regulation (Eichenbaum, 2010):
 Regulating Shadow Banks entities like Hedge Funds, Private Equity Investors
 Regulation on keeping Speculators away from Market.
 Regulation on Over the Counter Markets
 Regulation on proprietary trading. (Restriction on investing insured depositor’s money for
speculative bets). Volcker rule allows banks to invest 3% of Tier I Capital shadow banking
entities like Hedge Funds and Private Equity Funds
 Regulation on isolating investment banking from Consumer banking (Bring back Glass-
Steagall Act of 1933, which was repealed at the end of 1990 - Dodd-Frank Act)
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