Slide 1

Asia Financial/Currency Crisis: 1997 - 1998Hot money capital flightVicious circles Debt burdens Bankruptcies DepressionAsset price collapseCurrency depreciationLender of last resortConditionality: Tight money/austerityUnorthodox policyExchange controls (?)Financial Crises: East Asia 1997-1998Financial liberalization in the early 1990s: Lending boom/weak supervision/lack of expertise.Banks accumulated losses/net worth declined.Uncertainty increased stock market declines and failure of prominent firmsDomestic currencies devaluated (1997). Rise in actual and expected inflation.Subprime-Triggered Financial Crisis of 2007 - 2009Financial innovations in mortgage markets:Subprime and Alt-A mortgagesMortgage-backed securitiesCollateralized debt obligations (CDOs)Housing price bubble formsWorld savings glutIncrease in liquidity from cash flows surging to the US Subprime mortgage market housing demand and prices up.Agency problems ariseOriginate to distribute principal (investor) agent (mortgage broker) problem. Commercial and investment banks/rating agencies weak incentives to assess quality of securitiesInformation problems surface A Minsky MomentHousing price bubble bursts/Crisis spreads globallyhttp://www.nytimes.com/interactive/2009/04/29/business/2009-wide-housing-graphic.html

Easy MoneyPolicy

Capital Inflows

Eager Home Buyers

InnovativeBanks

Rating Agencies

AmbitiousMortgage Brokers

SecuritizationMBSs

EscalatingHouse Prices

Govt SponsoredEnterprises

Developer Clout

Bank Regulators

The best of timesA Global Saving Glut 4

Easy MoneyPolicy

Capital Inflows

Eager Home Buyers

InnovativeBanks

Rating Agencies

AmbitiousMortgage Brokers

SecuritizationMBSs

EscalatingHouse Prices

Govt SponsoredEnterprises

Developer Clout

Bank Regulators

The best of times

House Price ForeclosureSpiral

Demand Jobs Wages Income Spiral

Deleveraging Debt DeflationSpiral

GovernmentRevenue CutbackSpiral

Global Repercussion SpiralMacroeconomic Linkages and FeedbacksVicious Spirals Unleashed Financial Crisis of 2007 - 2009 (contd)Banks balance sheets deteriorateWrite downsSale of assets and credit restrictionHigh-profile firms failBear Stearns (March 2008)Fannie Mae and Freddie Mac (July 2008)Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund (MMMF) and Washington Mutual (September 2008).Fed pumps up bank reserves: TARP/TALF,etc.Lend and lend freely Bailout package enactedHouse votes down the $700 billion bailout package (9/29/08) Stock market slumps Bailout passes on October 3. Congress approves a $787 billion economic stimulus plan on February 13, 2009. Recession deepensResponsesLender of Last Resort / Spender of Last ResortTax Rebate $124 bil.Fed Fund Rate CutsFannie/Freddie $200 bil.Bear-Stearns $29 bil.AIG $174 bil.Fed FacilitiesPrimary Dealer Credit Facility (PDCF) $58 bil.Treasury Security Loan Facility (TSLF) $133 bil.Term Auction Facility (TAF) $416 bil.Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil.Money Market Investor Funding Facility (MMIFF) $540 bil.More Fed Fund Rate Cuts Hold At ~0%Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil.Term Asset-Backed Securities Loan Facility (TALF) $200 bil.Emergency Economic Stabilization Act/TARP $700 bil. Government LoansGovernment EquityStimulus Package $787 bil. aka The American Recovery and Reinvestment Act TARP IIStress Tests

House Price ForeclosureSpiral

Demand Jobs Wages Income Spiral

Deleveraging Debt DeflationSpiral

GovernmentRevenue CutbackSpiral

Global Repercussion SpiralMacroeconomic Linkages and FeedbacksVicious Spirals Reversed? Tackle them all together!StimulusProgramInfrastructure SpendingTax CutsFederal AidTo StatesRefinanceMortgagesRevive dual banking systemCash for TrashRecapitalize banksRevive securitizationG 20Coordinated StimulusMacroeconomic Linkages and FeedbacksVicious Spirals Unleashed

December, 2008)8%10%12%13%31%7%3%7%9%6%37%31%10%16%http://www2.fdic.gov/sdi/main.asp

10

Off Balance Sheet Assets/ActivitiesStructured investment vehicles (SIVs)Loan salesFees forForeign exchange trades for customersServicing mortgage backed securityBackup lines of credit/overdraft privilegesStandby lines of credit guaranteeing securities/commercial paperTrading activities Principal agent problemBond marketsForeign exchange markets Financial derivativesShadow Banking SystemFinancial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees.Finance companiesAsset backed commercial paper (ABCP) conduits Limited purpose finance companiesStructured investment vehicles (SIVs)Credit hedge fundsMoney market mutual funds (MMMFs)Securities lendersGovernment sponsored enterprises (GSEs)Interconnections with each other and traditional banking systemABCPAsset backed securitiesCollateralized debt obligations (CDOs)Repurchase agreements Liabilities of shadow banking system = $16 trillion vs. $13 trillion for banks.http://www.ny.frb.org/research/staff_reports/sr458.pdf

Possible ReformsIncrease/tighten capital requirementsTrade derivatives only on public exchanges tranparencyMark to funding accountingValue assets relative to date their funding must be repaidRapid resolution of TBTF institutionsMake bankruptcy crediblePut creditors at risk eliminate moral hazard of TBTF

McFadden Act (1927) and Douglas Amendment (1956) limit interstate branchingInterstate Banking and Branching Efficiency Act (1994) deregulates branchingGramm-Leach-Biley Financial Services Modernization Act (1999) repeals Glass-Steagall16Regulating Finance: Regulation and Its DiscontentsLots of bases to coverCover one by regulation or deregulation Unintended ConsequencesReactions to regulatory policies frustrate regulator intentRegulate bank balance sheets off-balance sheet activitiesEmplace a safety net bankers become skydiversRegulation spreads to cover innovations complexity ineffectivenessWin by gaming the system

Primary Supervisory Responsibility of Bank Regulatory AgenciesComptroller of the Currencynational banks chartered by Federal government since 1863 Federal Reserve and state banking authoritiesstate banks that are members of the Federal Reserve SystemFed also regulates bank holding companiesFDICinsured state banks that are not Fed membersState banking authoritiesstate banks without FDIC insurance18Innovations: Response to Interest Rate VolatilityAdjustable-rate mortgagesFinancial DerivativesInnovations: Response to Information TechnologyBank credit and debit cardsElectronic bankingATM/Home banking/ABM/Virtual bankingJunk bondsCommercial paper market backed by banksSecuritizationInnovations:Avoiding Regulation/Loophole MiningSweep accounts reserve requirementsMoney Market Mutual Funds Regulation Q19Decline of Traditional BankingDecline in cost advantages in acquiring funds (liabilities)Rising inflation rise in interest rates and disintermediationLow-cost source of funds, checkable deposits, declined in importanceDecline in income advantages on uses of funds (assets)Information technology less need for banks to finance short-term credit and issue loans IT lower transaction costs for other financial institutionsBank Responses: Riskier Lending Commercial real estate, leveraged buyouts, takeoversOff balance sheet activities

20

Size Distribution of Insured Commercial Banks, September 30, 2008 ????3,0464,039 486 867,640

39.952.9 6.1 1.1

1.3 9.710.079.021Bank ConsolidationBenefits of bank consolidationIncreased competition close inefficient banksEfficiencies from economies of scale and scopeLower chance of failure -- diversified portfoliosCostsFewer community banks less lending to small businessBanks in new areas increased risks/failuresSkirting branch restrictionsATMs, Bank Holding Cos.Interstate Banking and BranchingEfficiency Act, 1994Pre-Crisis Findings:Net interest margin upROA, ROE up for big banksIntrastate deregulation more positive for all but big banksInterstate deregulation helps big banks mostNon-performing loans down for biggest banks but up for smaller banksState of economy has stronger impact on bank performance than branching deregulation Geographic deregulation

Skirting branch restrictionsATMs, Bank Holding Cos.2223The U.S. regulatory regime: In need of reform? Sources: Financial Services Roundtable (2007), Milken Institute.

Asymmetric Information and Bank RegulationGovernment safety netDeposit insurance and FDICShort circuits bank failures and contagion effectPayoff methodPurchase and assumption methodFed as lender of last resort: Too BIG to FailFinancial consolidation Exacerbates Too Big to FailSafety net extended to non-bank financial institutionsSafety Net Moral Hazard Problems Depositors dont impose discipline of marketplaceBanks have an incentive to take on greater riskSafety Net Adverse Selection ProblemsRisk-lovers find banking attractiveDepositors have little reason to monitor bank24Attempted solutions: Constrain banks from taking too much riskPromote diversificationProhibit holdings of common stockSet capital requirements Capital as cushion Minimum leverage ratioBasel Accord: risk-based capital requirements but theres regulatory arbitragePrompt corrective action: Close em down when capital inadequateMonitor CAMELSCapital adequacyAsset qualityManagementEarningsLiquiditySensitivity to market riskDisclosure requirements mark-to-market issueRestrictions on competition make banking boring25

http://www.fdic.gov/regulations/resources/directors_college/sfcb/capital.pdf

27Failed Banks UpdateYearNumber20002200142002 1120033200442005/20060200732008 QI+Q242008 Q3 102008 Q4 122009 Q1 212009 Q2 242009 Q3 50