Group Work Project – MScFE 560 Financial Markets

Global Financial Crisis

Kausik Sen Muhammad Sadiq and Gaurav Gambhir

Abstract:

The global financial crisis is an important lesson for all of the financial industry. It is argued that
emergence of innovative financial instruments and changes in regulations around the beginning of
the century created the way how big financial players would conduct their business. It is also often
argued that key regulatory changes is the centre of reasons for the crisis because it allowed banks to
take on more risks without increasing proportional capital, not making credit rating agencies
responsible for their role in the crisis and letting the growth of products such as mortgage backed
securities, CMOs, & other complex derivatives without understanding the risks behind them.

Keywords: Basel accord, financial regulations, global financial crisis, options, mortgage backed
securities, leverage.

1. Introduction
The development of financial markets follows a repeating boom-bust cycle. Boom usually starts with
deregulation, followed by periods of unabated growth. Then a crisis unfolds which is responded to
by a strict regulatory regime. However, strong regulations often weigh in on the economic growth,
which subsequently leads back to deregulation.

The severity of the financial crisis and the trillions of dollars losses in taxpayers capital, led to various
reforms.

This paper investigates the reasons of financial market collapse in general, and the Global Financial
Crisis (GFC) of 2007 in particular. It looks into the regulators actions and their reasons - while also
taking a perspective as how regulations sometimes negatively serve the very reason of their
existence.

2. The Global Financial Crisis

2.1 The Primary Causes & how it led to the crisis

The cause of the GFC cannot be attributed to one event. There are multiple reasons which are
discussed below:

2.1.1 Deregulation
At a fundamental level, the crisis can find its roots in 1999 when the historical “Glass-Steagall Act” of
1933 was repealed by “The Gramm–Leach–Bliley Act”. It allowed banks to use deposits to invest in
derivatives. In 2000, the Commodity Futures Modernization Act allowed banks to take riskier
positions in the derivatives markets.
2.1.2 Securitization
Securitization refers to pooling of various debt instruments of specific type such as mortgage, credit
cards and other consumer loans and converting them into securities which are then sold to various
institutional investors such as pension funds, sovereign wealth funds. It helped transferred the risk
from originator to other players in the financial markets and produced the systematic risk.

2.1.3 Policy Mistakes

In 2004, the Fed Funds rate was as low as 1% which created a credit bubble and prompted sub-prime
borrowers to have mortgage and take advantage of real estate boom. Lenders were happy with
lending to even sub-prime borrowers as they would anyway sell the loans to investment banks for
the purpose of securitization.

2.1.4 Credit Ratings Agencies

Credit Rating Agencies (CRA) were found to be important contributors of the GFC as they had rated
riskiest of the underlying sub-prime assets AAA in the name of securitization. There was always a
conflict of interest in CRA and Issuer as those who are seeking the rating is the one who’s paying for
it.

2.2 The Market Features and conditions

One prominent feature of the GFC is that the financial markets were not necessarily driven by
rational decision-making. Instead, they were driven by fear and somewhat by greed.

Below are some of the important features that constitute the GFC:
I) Innovative Products: The Originate-and-distribute banking model was a turning point in the growth
of securitization as new complex products were created which were sold to investors as risk free or
highest rated securities without knowing the underlying risks. This allowed originators to lend more
without thinking about borrower’s ability to pay back.

II) Risk Appetite: Before the market collapse, the risk appetite of various financial players was at its
high. The traditionally conservative players such as pension funds, sovereign wealth funds etc. were
under pressure from investors to deliver high returns in the bullish market. Hence the behavioral
aspect of the investors was also a key feature of the GFC.

III) Increased Correlation among various assets: As in any other financial crisis, correlation among
various asset classes increased which reduced the diversification benefits for investors. In 2008-09,
the correlation between Equities and Bonds, which generally is not very high, increased which
reduced the diversification benefit for investors.

IV) Bankruptcy: Another important feature of 2007-08 GFC was bankruptcy of large players such as
Lehman Brothers and Bear Stearns which were considered to be “Too Big to Fail”. It was clear that
no financial institution in the market could consider itself to be “risk free”.

2.3 Response and their intended effects

The regulatory response to the Global Financial Crisis along with their intended consequences can be
summarized as follows:
1. Basel III Capital adequacy norms: To counter systemic risks, capital requirement includes a
countercyclical capital buffer and a surcharge for globally systemically important financial
institutions (G-SIFIs), both of which are intended to be an international macro prudential tool.

2. Adoption of LCR (Liquidity Convergence Ratio): It requires banks to have adequate liquidity.
Liquidity is defined as having on balance sheet certain 'High Quality Liquid' to cover 30 days of
outflows.

3. Enhancements of securitization model. It was mandated that credit rating agencies should
disclose their rating methodology more transparently.

4. Similar treatment of international and US accounting standards - GAAP and IFRS: This was done to
reduce confusion, promote simplicity and transparency-thereby garnering more confidence in the
financial markets.

5. Over the counter derivative regulations: Over the counter derivatives (like Credit Swaps) are
traded outside exchanges and hence are prone to information asymmetry issues. Introduction to
central counterparty (CCP) requiring compliance of standards set by the Committee on Payments
and Settlement Systems and the International Organization of Securities Commissions.

2.4 Downsides & unintended consequences of regulation

There is a thin line that the regulators must maintain to prevent the perils of overregulation.

1. After almost all financial crises, the knee jerk reaction of leaders is to increase government
ownership in financial institutions through bailouts. While it is intended to stabilize financial
markets, it may be seen from a political angle. This may lead to weak management, misallocation,
corruption and finally instability.

2. Financial regulations should be taken as a whole - in a system wide manner given the
interconnected nature of the market. This systemic approach is often absent in regulations which
tend to focus on parts of the financial market separately – like banks, equity markets etc. Addressing
systemic risk is often missing in regulations.

3. Financial crisis will recur, there should be more focus on quick resolution which is absent in
regulations, which rather tend to avoid crisis altogether.

4. Financial markets are inherently risky in return. Any regulation that tries to curb the risk is actually
shifting the risk to another place. The regulatory exercise should incentivize discovery of risk and
settling it properly, rather than avoiding it.

5. Capital cannot be the remedy of all possible risk exposures. As for example, liquidity risk cannot
be mitigated by illiquid capital - it requires hedging through a long term funding asset.

2.5 Features of financial markets requiring regulations

Though regulations may have negative and even unintended consequences, financial markets have
some unique features, which make regulations mandatory for this sector. These features are
discussed below:
a. High impact of failure: Financial market failures have much more devastating consequences than
any other market failure - both in geographical spread and in total value. As for example, the
financial crisis triggered by problems in the U.S. subprime mortgage market in 2007, led to German
GDP contraction by 6 percent. Further, recovery from the financial crisis is longer and more painful.

b. Information Asymmetry: Most customers buy products like a mortgage, insurance etc. once in a
lifetime - but each such transaction has a deep impact on their lives. Thus, the buyer may discover
that they have purchased a bad product many days after the transaction is over. Hence one aspect
of regulation is customer protection.

c. Connected nature: Financial markets are strongly interconnected, banks lend to banks and a huge
mesh is created within the different players of the market. Failure of one bank cascades into another
and soon spreads to the entire economy.

3. Evaluation of Regulatory Response

3.1 The Basel Accords

The ability of a bank to reduce its losses is known as “Capital”. The first and original Basel Accord or
Basel I was established in 1988 to determine the minimum levels of capital required for globally
active banks with banking supervisors being able to set higher levels.

The Basel I defined the main principles of a bank’s capital and its importance; establish risk
weightings for bank’s assets and the minimum capital required by a bank to keep according to its risk
weighting’s percentage and set up a transition stage for banks to build up the required minimum
capital.

Basel III’s primary function is to enhance and improve financial stability. It was published by an
association of banks from twenty-eight countries in 2009 in response to the credit crisis from the
economic recession in 2008. It is an international regulation designed to improve the supervision,
regulation and risk management in the banking sector to mitigate the risk in the banking sector by
mandating banks to maintain set leverage ratios and maintain proper levels of reserve capital at all
time.

These rules also introduced the bucketing method, where banks are grouped according to their
scope and overall economic structure. Leverage and liquidity requirements were also introduced to
prevent excessive borrowing.

3.1.1 Minimum Capital Requirements by Tiers

1. Tier 1 refers to a bank's core capital, equity, and the disclosed reserves as shown on the financial
statements. This capital allows banks to continue operations in an event where the bank experiences
significant loss.

2. Tier 2 refers to a bank's supplementary capital, such as undisclosed reserves and unsecured
subordinated debt instruments that must have an original maturity of at least five years.

3.2 Perspective and intended effect of regulations

Before the economic recession of 2008, there was a period of excess liquidity which led banks to
believe there was no liquidity risk. However, when liquidity became limited, banks realized they had
insufficient liquidity reserves to meet their requirements.

Furthermore, due to lack of transparency and underestimation of risk concentrations, when trading
counterparties defaulted, the whole financial system was damaged due to its interconnectedness.

The following were the intended effects:

(1) Improve the capital base to ensure that banks are in a better position to absorb losses;
(2) strengthen risk coverage by improving the capital requirements for counterparty credit risk
exposures;
(3) introduce a leverage ratio as a supplementary measure to the Basel II risk-based capital;
(4) Introduce a set of procedures to stimulate the build-up of capital buffers during profitable time
that can be used in times of stress

The objectives are to reduce systemic risk, which is the breakdown of one financial institute will
instigate the failure of other institutions, taking down the complete financial system.

The core of banking regulation is promoting and maintaining the stability of the international
banking system by reducing systematic risk and by equalizing international banks’ competitive
positions.

3.3 Possible downsides and/or unintended consequences of the regulation

3.3.1 Capital-based regulation

Basel norms prior to the financial crisis i.e. Basel 2 were mainly capital based regulation. It is true
that regulatory capital requirements are supposed to protect financial institutions from insolvency,
but the crisis has shown no relation whatsoever between capital ratios and the incidence and
severity of losses. It is not that financial institutions with lower capital ratios collapsed while those
with high capital ratios survived.

3.3.2 Wrong kind of regulation

There were some flaws in the regulation itself. For example, capital requirements for low-quality,
high-risk instruments were significantly lower under the standardised approach than under the
foundation internal ratings based approach (IRBA), which means that banks using the standardised
approach have an incentive to specialise in high-risk credits, therefore increasing the overall risk of
the banking system.

3.3.3 The treatment of liquidity and leverage

Liquidity and leverage was more important than capital in the financial crisis of 2007-08. Low
liquidity hampered business and induced a run on bank deposits. High leverage means that the
effect of an adversative market movement will be enlarged, initiating the destruction of the
underlying firm. Basel regulations were inadequate to capture risks arising from liquidity and
leverage.
3.3.4 The use of internal models

The models used in risk management created complacency among risk managers as they predicted
losses which could only happen once every million years. In reality these extreme events are quite
common. Regulations allowed use of such models which helped banks to reduce capital
requirements even though risk was not reduced.

3.3.5 Reliance on rating agencies

The reliance on rating agencies misguided the regulators because rating agencies do not provide
consistent estimates of creditworthiness. By giving them supervisory recognition, Basel II has
enhanced a certain faith in rating agencies, allowing them a free hand and a significant contribution
to the crisis.

3.4 Comparison of intended effects of regulation and how it fits into the general theme
and rationale of financial regulation.

3.4.1 Impact on the Emerging Market Banking Sector

A significant proportion of the businesses in the emerging market economies are in agriculture, rural
and small businesses that need different kinds of risk. management tools and methods. There is a
requirement to re-define the collateral in cases as well. The risk management practices in a modular
format, as given by the standardized methods of Basel norms, and applicable to all banks across the
globe, generates a competitive disadvantage for these banks.

3.4.2 Impact of implementation of the advanced internal risk assessment Methods

Basel also incentivizes the use of internal rating based approaches as they give the way to self-
surveillance. Assessing and quantifying one’s own risk is the best procedure. Here convergence is
obtained by proper disclosure and transparency. It has been observed that most of the Basel
compliant countries have modified their capital adequacy positions based on their respective
requirements. The banks have underestimated their exposure under these methods, which led to
the unintended consequence of the global financial crisis.

3.4.3 Deviation from a Bank’s role as a key player in the Economy

Banks’ attention towards their main economic functions is a core requirement for durable financial
stability and sustainable economic growth. Risk-weighted regulation shifts banks’ attention and
resources away from conventional lending. In contrast, regulation based on non-risk-weighted total
assets places the same emphasis on loans as on other bank assets. Unless a risk weight based
measure of assets is supplemented by some non-risk weight based measures, the banks
unnecessarily indulge in designing innovation to circumvent regulatory requirements.

4. The Role of Mortgage-backed Securities and Option Pricing

4.1 A detailed and specific outline of mortgage-backed securities
If one is buying a house by taking a housing loan, she is getting the loan amount from a bank or a
lending agency, and would pay back every month with the interest. The house property is kept as
collateral, which the lender can take control of in the occasion of non payment of the principal
and/or interest by the borrower. This is a mortgage loan in simple terms.

The interest rates on these mortgages are much higher as compared to the risk free rates yielded by
the government bonds or other similar safe investments. But the mortgages are not accessible to
the investors directly, who are interested to take advantage of these high returns.

In order to address the above demand, the financial institutions like Fannie Mae and Freddie Mac
created an innovative financial product called mortgage backed securities. Here they bundled
thousands of mortgage loans and repackaged them into what is called as mortgage bonds.

The mortgage bonds are issued to the common investors, who purchased these bonds being
attracted by the high returns and relatively low risk for these being collateralized by the house
properties. Unlike the government or corporate bonds, the cash flows from the mortgage bonds
were generated from the payments of thousands of the borrowers.

The underlying sense of safety was derived from the notion that because the payment was
channelized from a pool of thousands, it is highly unlikely that all the borrowers would default at the
same point of time, thereby eliminating the idiosyncratic risk to a great extent.

The mortgage bonds are classified into several tranches or segments, based on the creditworthiness
of the borrowers – the top tranches were presumed to be the safest with lowest rate of interest,
whereas the bottom ones were viewed as risky owing to the borrowers’ unstable income, poor
credit history, and also to the chances of prepayment of the loan giving rise to the interest rate risk
to the bondholder.

The credit rating agencies like Moody’s and S&P gave high rating (AAA) to the top tranches, and junk
rating (BBB) to the bottom tranches, also called as subprime bonds.

4.2 Why they can be useful financial instruments

The mortgage backed securities are innovative reengineered financial products with the following
benefits:

 High Return: MBS offered investors an opportunity to earn high return generated from the
mortgage loans, which was otherwise not existent directly between the borrowers and
investors
 Comparatively Low Risk: Because of the backing by the collateral, the risk of such bonds are
low, leading to a high risk adjusted return and corresponding high Sharpe’s Ratio
 Secondary Market: The mortgage bonds can be traded in the secondary market, allowing
liquidity to the investors
 Enhance Liquidity of the Banks: Because the banks can offload the mortgage loans through
Mortgage Backed Securities, the cash from the investors generate liquidity for the banks to
issue fresh loans

4.3 Role they played in the Global Financial Crisis

From out earlier discussions, we know that mortgage backed securities implode in the early 2000s as
it helped banks to transfer risks from their balance sheet to institutional investors in the financial
markets. Though it was good for banks, it gradually spread risk from just one part of financial
industry i.e. banks to wider players such as mutual funds, pension funds in the industry who would
invest in these securities. The high volume of issuance of these securities tempted the commercial
banks to issue more mortgages. However, there is only limited prime borrowers who already have
taken mortgage & hence would not be taking more. Hence, banks started issuing mortgages to
borrowers with less ability to pay back than prime borrowers. The ‘sub-prime’ borrowers saw an
opportunity to have a home in the booming market hoping to sell the house at higher price and pay
back the mortgage. It was considered to ‘safe’ bet because the sentiments of the markets were of
the view that home prices would never fall. However, towards the end of 2006, the troubled had
started to loom over the housing market when a lot of home buyers started to default on their
mortgage.

The straight impact of these defaults was on issuers of mortgage-backed securities. The MBS market
was highly concentrated as top five issuers accounted of around 40% of all new issuance. The biggest
of them was Countrywide Mortgage services which fell in 2006 before being sold to Bank of America.
The trouble continued with rest of the biggest issuers. The prices of MBS continued to fall as the
default rates kept going up on the sub-prime mortgage. It was at its peak in late 2008 when Lehman
Brothers collapsed.

4.4 Comparison between how MBS can be useful and the role they played in the GFC

How MBS can be useful Role they played in the GFC

High Return MBS offered investors an opportunity to earn
high return generated from the mortgage loans
Comparatively Low Risk Because of the backing by the collateral, the risk
of such bonds are low, leading to a high risk
adjusted return and corresponding high Sharpe’s
Ratio
Secondary Market The mortgage bonds can be traded in the
secondary market, allowing liquidity to the
investors
Enhance Liquidity of the Banks Because the banks can offload the mortgage
loans through Mortgage Backed Securities, the
cash from the investors generate liquidity for the
banks to issue fresh loans

5. Conclusion
References

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Basel III: International regulatory framework for banks, 14 December 2014,

BIS,[https://www.bis.org/bcbs/basel3.htm]

Basel III, Wikipedia, July 29 2020, [https://en.wikipedia.org/wiki/Basel_III]

Basel III The global regulatory framework for banks, Corporate Finance Institute, c
2015,[https://corporatefinanceinstitute.com/resources/knowledge/finance/basel-iii/]

Books

Ellen L. Marks,C. Mark Nicolaides, 2014, Understanding Basel III

Richard Barfield, 2007, PricewaterhouseCoopers LLP, A Practitioners’ guide to Basel II and

Beyond by