final

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The causes of Bank Failures in Germany 1930 and
Recent U.S.A. and measure to prevent Bank Failures
Student no. 1101584R
Supervisor :- Dr. Vasilios Sogiakas

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Acknowledgement
I would like to express immense thankfulness to all those who gave me the
possibility to complete this dissertation. I would like to thank the library staff of
the University of Glasgow for their relentless effort in making access to research
data and literature possible. I am bound to all our lecturers for their motivating
effort in transferring knowledge. In addition, my most profound gratitude goes to
our parents, friends, and relatives for their unconditional love and steadfast
support always. Especially, I am deeply indebted to my supervisor Dr.Vasilios
Sogiakas, whose support; interest, encouragement, and stimulating suggestions
helped me during the research and writing process of this dissertation.
Above all, thank you Almighty God for all your mercies.

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Abstract
The following dissertation provides an analysis of the banking crisis, which took place in
Germany in 1931, and the recent U.S. crisis. The analysis would be looking into the
significance of the banks in the economy. To understand the causes, this dissertation would be
using the Knoop Model of the banking crisis. This model would allow the understanding of
two different crises that took place in different time. Additionally, this paper would be looking
into Basel Accord, which is essential for the banks and role played by this accord in relation to
the crisis.
The analysis suggests that the causes of the crisis are related to the macroeconomic conditions
prevailing in the countries. The macroeconomic condition reduces the net worthiness and
profitability of the banks. The key causes of the crisis that have been identified are role of the
authorities and banks involvement in wrongful activities. Even though, the crisis took place in
different time, it seems that the causes are common for both.

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Contents
1. Introduction……………………………………………………………………………….6
2. Theory……………………………………………………………………………………..8
2.1 Belief Based Model………………………………………………………………….8
2.2 Fundamental Basel Model…………………………………………………………9
3. The German Crisis 1931……………………………………………………………….10
4. The U.S.A Crisis………………………………………………………………………...17
5. The Basel Accord……………………………………………………………………….28
5.1 Basel I………………………………………………………………………………..28
5.2 Basel II……………………………………………………………………………….33
5.3 Basel III……………………………………………………………………………...35
6. Prevention…………………………………………………………………………….…37
7. Results…………………………………………………………………………………...41
7.1 Germany…………………………………………………………………………….41
7.2 U.S.A………………………………………………………………………………...43
8. Methodology…………………………………………………………………………….46
9. Conclusion………………………………………………………………………………46
10. Bibliography……………………………………………………………………………..48

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List of Figures and tables
Figure 3.1:- Bank Assets On 30 November(million RM)
(James,1984)………………………11
Figure 3.2 Germany ‘s Foreign Debt (Billion
Reichsmark)(James,1984)…………………….13
Figure3.3 Money Supply in Germany 125-1934(James,1984)…………………………….....13
Figure3.4 Determinants of Money Supply in Germany 1925-
1934(James,1984)…………….15
Table 3.5 Consolidated German Bank Statistics 1913a, 1929, 1938 (in millions of
marks/reichsmarks)…………………………………………………………………………….1
6
Figure 4.1 Number of commercial banks and savings institutions, 1934–2007……………..18
Figure 4.2. Profitability of commercial banks and savings institutions, 1934–2007
(A) Return on assets (%); (B) return on equity
(%)……………………………………………19
Figure 4.3 US Home and equity release mortgages outstanding 1990-2007…………………22
Figure 4.4 US Securitization trends total and mortgage
backed……………………………....23
Figure 4.5 US Exchange rate 2000-
2008………………………………………………………24
Table 4.6 Summary of Policies and Laws and the impact on residential and estate
prices……24
Figure 4.7:- Mortgage-related Security holdings by investors:2000-2010……………………25
Figure 4.8:- Loans by category per commercial bank:2000-2011…………………………….25
Figure 4.9:- Private Label MBS ratings Deals:2002-2008……………………………………26
Figure 4.10:- Leverage Ratios of U.S. investment banks,2004-2007…………………………26
Table 5.1:- Constituents of Capital……………………………………………………………29
Table 5.2:- Risk
Weights……………………………………………………………………….31

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1. Introduction
The banks are in the business of the borrowing and lending. This role helps is creating credit,
which allows the real economy to grow and expand. This credit creation is based on an
inherent fragility of the banking system (Grawe, 2008). Over the years, banks have been
involved in selling insurance, underwriting securities and carrying out securities transactions
on behalf of their clients (Benston, 1994).
A problem in banking sector raises a widespread concern because it disrupts the flow of credit
in the economy, which further gets aggravated as the viable firms is forced into bankruptcy
(Detragiache et al, 1998). Such crisis may jeopardize the function of payments system and by
undermining the domestic financial institutions, may lead to a decline in the domestic savings
and a large capital outflow (Detragiache et al, 1998). Fieldstien (1991) states that “The
banking system as a whole is a "public good" that benefits the nation over and above the
profits that it earns for the banks' shareholders. “
The significance of banks in the economy makes essential to find the causes of the crisis. To
investigate the causes of crisis, this paper would be using Belief based model and
Fundamental based model to examine the reasons (Kindlesberger, 1977). These models would
present an opportunity to put the various reasons of banking failure under an umbrella for
better understanding.
The bank failures driven by the expectations of the people come under the Belief-Based
Model. Calvo (1995) describes that investors deem unworthy investment, therefore, no funds
are available. A collective movement of distrust among the depositors may lead to
withdrawals of the funds at same time; banks are unable to satisfy these withdrawals as their
assets are illiquid which leads to a liquidity crisis, which can bring down a sound bank also.
James (1984) described a false confidence by the creditor states U.S.A and France to Germany
in 1930 has provided an opportunity to exercise influence on the German Policies. These
policies had excessive importance attached to the foreign lending. The foreign withdrawals in
1930’s played role in the deposit contractions, which provoked panic in Germany.
The other model used is the Fundamental based Model, which focuses on the changes in the
financial institutions. The deregulation of the banking system in U.S. during the 1980 saw

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Lehmann Brothers using the collateral for further lending which had lethal combinations of
credit and liquidity risk involved. The liberalization of the exchange rate allowed predicting a
currency crisis when a banking crisis is underway. The banking crisis reaches its peak after
the currency crisis because of which existing problems are further aggravated and the high
interest rate starts defining the exchange rate. Mishkin(2013) argues the devaluation weakens
the banks if the large share of the liabilities is dominated in the foreign currency. The
governance of the banking system has been found a major cause in German Crisis of 1930 is
where weak supervision and a lack of viable business model prevented banks from generating
profit.
By raising the efficiency of the banking system by restructuring the system and ensuring a
level of playing field between savings banks and privately owned banks, a bank failure could
be prevented. Additionally, it should be making sure that the banks are adequately capitalized.
The portfolio diversification allows a bank to diversify its investments allowing to reducing its
risks. The banks have started using the screening of the customers when providing them with
loans in order to reduce the risks and defaults on the payments. Deposit freeze and bank
holidays during the crisis allows buying some time for the banks while deciding the best
policy to get the bank on right track as seen during the Great Depression in U.S.

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2. Theory
Knoop (2004) describes a banking crisis as a situation in which numerous banks fail
simultaneously, leading to a significant reduction in bank credit along with other forms of
financial intermediations. Banks traditionally borrowed at short term and lent out at long-term
basis, which possessed a risk. This risk included the rise in short term interest rates relative to
long-term interest rates, which would be making depositors withdrawing their money and the
creditors reluctant to purchase more of their IOUs when they are matured (Kindlesberger,
1978). To understand, the model by Knoop allows understanding the causes of the banking
crisis and its prevention.
The model has two categories:-
1. Belief-based model of banking crises
2. Fundamental- based model of banking crises
2.1 Belief- Based Model of banking crisis
In this model, the failures are driven by the changes in expectations of future financial and
macroeconomic conditions or by the changes in the expectations of the rational depositors
(Knoop, 2004). These changes in expectations are not necessarily linked to any change in
economic fundamentals. Kindlesberger (1978) describes banking sector as inherently unstable
because people often act irrationally, changing their behaviour not when anything real has
changed in the economy but when they see others changing their actions. This makes Banking
crises are self-fulfilling, once the belief that banking will occur becomes widely accepted, a
banking crises occurs regardless of the real financial fundamentals of the banks. To overcome
his issue, the governments have implemented a provision of deposit insurance that aims to
protect the bank depositors from losses caused by a bank’s inability to pay off its debt.
The major issue with this model is that it cannot measure accurately the causes of the crisis
due to involvement of the expectations. The involvement of expectations makes inconsistent
relationship between the measurable variables (Knoop,2004).Despite of every country having
deposit insurance provision, the crisis have occurred such in Japan, Argentina(Knoop,2004).

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2.2 Fundamental Based Model of Banking crisis
This model focuses on the changes in the financial fundamentals of the banks. In this model,
the banking crisis are both created and caused by the fluctuations in the net worth, cash flows
and bank profits that take place over the business cycle (Knoop, 2004).There are two types of
shocks in the financial fundamentals of the banks that initiate banking crises.
1. Negative shocks to the net worth of the banks- This could occur when the inflations typically
falls and bankruptcy risk rises during the recessions , this increases the real value of debt
relative to asset which reduces the net worth of the banks(Knoop,2004).The probability of
bank failures and banking crises fluctuates with the business cycle.
2. Shocks reducing the profitability of the banks- This shock reduce the return on bank assets
relative to the rates paid on liabilities (Knoop, 2004). This shock includes an unexpected
increase in short-term interest rates (when the return on bank assets are fixed, higher real
interest rates which increases default rates by increasing moral hazard, an unexpected increase
in inflation , a decline in aggregate growth and an unexpected depreciation of the exchange
rate(Knoop,2004).
These cases points out that if the banks lack a proper management strategy then the
profitability suffers and insolvency may occur (Knoop, 2004). Since these shocks are
associated with the macroeconomic changes, they provide additional explanations as to why
the likelihood of banking crises rises during recessions and falls during expansions (Knoop,
2004)
The causes of the banking crises are different in both these models; their policy prescription
regarding the prevention of the crisis is different. In belief-based model, the bank runs are
alone the cause of the crisis, therefore, there is a need of deposit insurance or a stronger lender
of last resort (Knoop, 2004). However, in fundamental model, the deposit insurance and crisis
lending might actually increase the probability of the banking crises by encouraging moral
hazard (Knoop, 2004). Instead, the fundamental model argues that the strict regulations of
banking system aimed at reducing the riskiness of the banking crisis is the most reliable way
of prevention(Knoop,2004).This could be done by putting limits on the amount of loans
allocated to single borrower, restrictions on risky asset holding, etc. Basel II is closely linked

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to the model regarding the riskiness of specific assets to the amount of capital that must be
held to the back these assets. It also provides more detailed information on the keeping
regulations by appointing supervisors.
3. The German Crisis 1931
The German Crisis of 1931 was a result of the failure of the Vienna Creditansalt to publish its
annual accounts, which were made public on 11th May 1931(James, 1984). This difficult
situation in Austria led to a panic in Germany. Despite German Banks remained uninvolved in
the Austrian businesses. The foreign creditors of the Austrian businesses were not committed
to the Austrian cause, resulting in withdrawal of funds from elsewhere as well in order to
maintain their own liquidity (James,1984). The German government was secretly involved in
supporting the business activities across its borders in the neighbouring
nations(Rechendres,2013).This was to avoid the influx of Germans living in the foreign.
Reichsbank became more accustomed to high percentage of foreign deposits at big banks that
were withdrawn in the serious crisis than the domestic deposits (Kooper, 2011).The
commercial deposits fell in every country in 1931, but it had largest percentage in Germany
due to some serious solvency problems (Allen.2011).The change in the expectations of the
investors created the bank runs in Germany.
The demand deposits did not fall during the crisis. This shows that there was no panic among
the depositors at the great banks. The time deposits fell only in the June. This shows that the
depositors were repositioning their assets in anticipation of the currency problems as the
Weimar government made increasingly rash statements(Temin,2007). The domestic
depositors were not frightened instead, the foreigners appear to make adjustments. The
demand deposits in 1929 were not greater than those of the saving banks because one-third of
those were foreign deposits(Balderston,1991).
The first stage of the crisis took place between June 1930 and 1931 due to monetary
contraction (James, 1984). This reduced the money supply (Currency + Bank Deposits) by
17%. Banks tried to improve their deposit/reserve ratio in an attempt to keep up their nominal
liquidity in face of withdrawals. Because of which from June 1930, the banks cut their loan to
stock up reserves, in addition to the fall in demand of loans. This fall was reflected in the

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falling interest rate. The instability of the banking system was increased by the prominence of
the short-term debt, which is noted in the contemporary account (James, 1984).
The weak liquidity position of the banks left them in vulnerable. From 1924 onwards, all
German credit institutions witnessed a decrease in liquidity. The dramatic expansion of the
money supply between 1924 and 1930 was based on relatively small base of cash (James,
1984). Laeven(2008) points out that the macroeconomic conditions are often weak prior to the
crisis as the fiscal balances tend to be negative, current accounts in deficit and inflations often
runs high at the onset of the crisis. Most of the money in the economy was put in unproductive
use in the public sector (Ritschle, 2012).After 1929. Deflation had been common. This was
due to the Central Banks having to defend their gold cover ratios, which transmitted this
deflation from one major country to other. This discouraged investment activities and
structurally weakened the economic balance sheet (Buchheim, 2009).
Schnabel (2004) analysis based on the monthly balance sheet of all the German credit banks
pointed out that the withdrawals were driven by the run on the currency, but were also related
to the liquidity position of the banks. The effect of the currency depreciation on Banks’
balance sheet raised the value of the foreign currency debt in terms of the local currency,
which led to the erosion of the firms and banks capital. Even the drop of loans from
November to December 1931 was due to the depreciations of banks annual statements
(Kooper, 2011).The banks tried their to prevent themselves from the falling expectations, but
the change in the macroeconomic conditions in Germany over the last decade reduced their
net worth .This had increased the real debt value to the assets making the banks more prone
during the recession. Banks were failing to earn a profit due to unexpected depreciation of
their currency, causing reduction to the return on bank assets relative to the rates paid on
liabilities.
Figure 3.1:- Bank Assets on 30 November (million RM) (James, 1984)
The anticipation of the bailouts leads to the excessive inflows of the capital to the country
especially the banking sector. Eventually, the accumulation of implicit government liabilities
became unsustainable which led to reversal of capital flows with detrimental effects to the

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banking sector (Schnabel, 2004).Allen (2011) points out that the countries operating under the
gold standard had made it impossible for its central banks to provide liquidity to commercial
banks. The Reischbank ran out of assets with which it monetize the banks’ reserve as its gold
reserves shrank.Despite getting some credit from other central banks, The Reischbank fell
below its statutory requirement of 40% by July 1931 and was unable to
borrow(Temin,2007).Therefore, it was unable to help the banks especially Danat.
Ponzi scheme was designed for financing the economy and the debt service with using of
more debt (Ritschle, 2012).The New York banks were the key ally in the reparations with
their investments in Germany. The Internal foreign Ministry Memorandum stated, “The more
foreign credit we take in, the less we will have to pay out in reparations”. This engineered a
foreign credit risk, which was against the Dawes Plan. The reluctance of the French towards
Germany added more misery to the system which made the investors nervous (Hetzel,
2002).The system required the confidence which could only be achieved under the American
leadership to get financial stability (Hetzel, 2002). The non-cooperative scenario at the
international political relations distorted the system of gold parities (Buchheim, 2012).
Kooper(2011) states that the Reichsbank only had the rights to demand the basic balance
information and no executive powers to enforce the special auditing for the hidden risks. The
banks had insufficient means to control their debtors, which resulted in an asymmetric relation
between them (Kooper, 2011).This was further aggravated by insufficient advantage to
enforce transparency and truthfulness among the debtors. Generally, the banks were in a
weaker position in regarding their big debtors. In a rare case between Deutsche Banks and
Daimler Benz, this was not evident (Kooper, 2011).The banks were lacking a proper
management and strategy during this difficult time. The mismanagement of the debt financed
through improper strategy made it much difficult for the banks. The central banks were having
difficulty in helping its local banks due to the gold standard.
The Reichsbank had the tools to regulate the price and the quantity of bank lending by setting
the discount rate and the amount of re-discounted bills. The Reichsbank received monthly
balance statements from the major banks and quarterly reports about a potentially crucial
portion of their foreign liabilities. However, the powers of the Reichsbank was strictly
confined to the purpose and means of the monetary policies(Kooper,2011). This meant the big
banks as Danat in particular were allowed to engage in providing loans to the big enterprise

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and breaking the common sense rule of lending i.e, a bank with only RM 25 m equity and a
capital reserve of RM 60m lending RM 48m in total to one single debtor ran an irresponsible
risk (Kooper,2011).
The risk of loan default was greater for the bigger debtors with bigger loans than the smaller
(Kooper,2011). The big debtors such as Nordwolle with a belief of ‘Too big to fail’ believed
that the banks instead of defaulting their loans would be allowing them to
prolong(Kooper,2011) . Debtors anticipated this prolongation would be acting as a recovery of
hope for banks.The losses through the defaulting of the loans would have prevented if the
legal framework had obliged the banks to pursue a stricter lending policy.
Figure 3.2 Germany‘s Foreign Debt (Billion Reichsmark) (James, 1984)
This was further enhancing with the competition in the banking sector, as the banks, which
failed to expand, were very vulnerable to the mergers or the takeovers. The intense
competition is better for the monetary supply of non-banking sector but generated problematic
symmetry between banks and debtors (Kooper, 2011).The lack of stricter regulations in the
system meant the bigger banks were able to merge the smaller banks, which had made their
misguided accounts look better. The declining number of the private banks between 1925 and
1929 was marginally due to the failure of the long established houses (Zeigler et al,1994)

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Figure 3.3 No. of Private banking houses 1913-1932(Ziegler et al,1994)
Notes
3'Guesstimate' by Centralverband des Deutschen Bank- und Bankiergewerbes.
b Number of private banking houses having a Reichsbank giro account.

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Figure3.4 Money Supply in Germany 125-1934(James, 1984)

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Figure3.5 Determinants of Money Supply in Germany 1925-1934(James, 1984)

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Table 3.6 Consolidated German Bank Statistics 1913a, 1929, 1938
(In millions of marks/reichsmarks) (Balderston, 1991)

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4. The United States of America Crisis
The current banking crisis in United States have exposed the vulnerability of the banks’
balance sheet despite of reporting extraordinary profits (Tregenna, 2009).The deregulation in
the banking system started from 1980s has been a key issue. Tregenna (2009) describes that
the two aspects of legislative and regulatory are of particular relevance in this regard. Firstly,
the weakening or elimination of previous limitations on activities to be undertaken by single
institutions. Secondly, the removal of geographical restrictions, particularly on interstate
banking. These led to an increase in banking concentration.
The Garn-St Germain Depository Institutions Act of 1982 allowed the banks to purchase the
purchase failing banks and thrifts across state lines facilitating a rise in bank concentration
(Tregenna, 2009). The legislation also abolished statutory restrictions on real estate lending by
national banks and loosened the limits on loans to single borrowers(Tregenna,2009).During
1990s,the key rulings in the court allowed the national banks to sell insurance from the small
towns allowed banks to sell annuities and repealed state restrictions on banks insurance
sales(Tregenna,2009).
The most crucial change proved to be the Gramm-Leach-Bliley Act (GLBA) of 1999 (also
known as the Financial Services Modernisation Act) which repealed the Glass-Steagall Act
(Tregenna, 2009). This allowed different types of financial institutions to merge/affiliate with
one another. Thus,removing key restrictions on conglomeration and facilitating increased
concentration. The specific provisions included the authorisation of bank holding companies
to act as financial holding companies; ending regulations barring the merger of banks,
insurance companies and Securities firms; lifting some restrictions governing non-bank banks;
allowing a national Bank to engage in new financial activities in a financial subsidiary; and
allowing national Banks to underwrite municipal revenue bonds( Tregenna,2009). The
changes in the laws pointed that the authorities failure to learn from their mistakes in the past.
These laws were to ensure the stability of the banking system and prevent the banks from
indulging in the wrongful activities, which might be damaging their net worth.
The legislative developments facilitated an increase in the leverage preceding the present
crisis. The GLBA permitted banks to borrow in order to fund both Traditional and non-
traditional financial investments, largely (Tregenna, 2009). The increased leverage facilitated

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higher bank profits but significantly increased their vulnerability and was a contributing factor
to the current crisis.
Figure 4.1 Number of commercial banks and savings institutions, 1934–2007(Treganna,
2009).
The number of bank mergers was an all-time high in late 1980s, leading to an increase in the
level of bank concentrations. The rate of bank mergers was very high by historical standards
between the mid-1980s and early 2000s.These mergers with the bigger banks ensured survival
of the smaller banks while allowing the bigger banks to increase its net worth and
profitability. However, this was affecting their balance sheet as it brought additional liabilities,
which might be decreasing their net worth in future. However, bigger banks were allowed to
think, as they are ‘too big to fail’.

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Figure4.2. Profitability of commercial banks and savings institutions, 1934–2007.
(A) Return on assets (%); (B) return on equity (%) (Treganna, 2009).

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An upward trend in profitability over time is evident. The major exception is
The downturn in profitability during the bank and thrift crisis of the second half of
The 1980s and early 1990s: both measures of profitability for both types of institutions
Fell sharply after 1985, reaching the lowest point in 1987.Both measures of thrift
Profitability were negative between 1987 and 1992, whereas commercial bank profitability
Apparently approached zero in certain years. However, by the early 1990s profitability
Reached a new historical high, only beginning to decline (and dramatically so) in 2006 and
2007 as the current crisis began. It remains to be seen how much lower bank profitability
has since fallen, and will still fall, and whether it will recover to pre-crisis levels.
The extent of banks’ vulnerability exposed through the crisis, certainly questions the banks’
‘real profitability’ in the pre-crisis period. One aspect of this is that it is not clear to what
extent the profits that the banks recorded in their balance sheets were manipulated through
accounting methods, for example, the expected future earning rather actual current earnings
booked in the current period (Treganna, 2009).The second issue is about the solidity of the
foundations of the banks high profit in the pre-crisis period. The nature and the pricing of
banks’ assets, some of which have since been exposed as toxic, means that bank profits were
built on a flimsy basis (even if such profits were ‘real’) and were not sustainable in the
medium- to long-term, as has been revealed with the breaking of the crisis(Tregannna,2009).
Many households in US actively leveraging their borrowing from what are termed “home
equity lines of credit” and this has further increased the value of outstanding mortgage
debt(Anderson et Al,2009). A home equity line of credit is a form of revolving credit in which
your home serves as collateral(Anderson et al,2009).The growth in outstanding household
mortgages, relative to GDP growth, in the US reflects the combined effects of: Increased
demand for housing, compound price inflation and equity release mortgages. The value of US
household mortgages outstanding has, since the early 1980s, run ahead of GDP growth . From
a position where outstanding home mortgages were equivalent to one-third (in 1963) than one-
half (in 1990) of GDP, they are now roughly equivalent to US annual GDP. The break
between GDP and value of mortgages outstanding coincides with changes in banking

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regulation and accounting practices in the mid-1980s the composition of the mortgage market
changed from a system based on deposits to one of securitized assets. Until the early 1980s,
the majority of the US mortgage market was structured by deposits (70%) but by 2005, this
picture had reversed with securitized assets accounting for 60% of the market (Anderson et al,
2009).
Recent US house price appreciation also helped to enlarge the size and scope of secondary
markets for securities backed by non-prime mortgage loans at a time when the system of US
housing finance changed profoundly (Frankel, 2006; McCarthy and Peach, 2005).The sharp
rise in US home prices also coincides with a competitive pressure on lenders to develop non-
traditional loan products, such as Adjustable-Rate Mortgages (ARM), and the Pick a Payment
loan(s) where non-agency mortgage under-writers took an increasing share of US housing
finance and especially that for sub-prime borrowers (Anderson et al, 2009). Another
development in the mortgage market was the emergence of intermediary brokers and use of
technology for rapid decisions, for example, automated underwriting systems with credit
history scoring for pricing of mortgages and default risks.
The banking executives were encouraged to pass on more complex collateralized products to
investors to value skim, improve banking returns and their own bonuses(Anderson et
el,2009).The Financial incentives focused attention on the construction of financial products
that modified credit rating, risk, and financial return to the banks at the expense of liquidity.
The complexity of the web of financial transactions surrounding the process of asset
securitization makes it difficult to assess risk exposure from household payment default and
counterparty risk with the result that banks are holding on to cash balances to protect liquidity
even after Government bailout(s)(Anderson et el,2009).

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Figure 4.3 US Home and equity release mortgages outstanding 1990-2007(E. Heilpern et
al.2009)
Another financial innovation was Securitization, allowing banks to remove and repackage
assets that have built up on a bank’s balance sheet and sell these on in a secondary market.
Credit risk is removed from the banks’ balance sheet and cash reserves increased as loans are
sold on. In turn, the reduction in both credit risk and increased cash in hand on balance sheet
provides banks with the regulatory ability to raise additional loans for new or existing
customers. This securitization was favoured by the banks as it allowed banks to remove from
their balance sheets more of the credit they themselves originated thereby earning income
without tying up significant amounts of regulatory capital(Anderson et al,2009). Additionally,
Banks could obtain a relatively cheap wholesale funding by packaging up their mortgages and
selling these off, while simultaneously raising further funds in the capital markets through
issuing asset-backed securities where the assets that are physically backing the securities
issued are the “packaged” mortgages themselves.

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Figure 4.4 US Securitization trends total and mortgage backed (E. Heilpern et al.2009)
The rise in house prices was due to the mixture of state, federal, and regulatory policy
(Hendrickson, 2013) These provided a negative shock to the net worth of the banks. As the
house price, inflation was high early in the century, but as the crisis seemed to occur, this
started falling, leading to bankruptcy rises during the recession. Lehman Brothers also
collapsed during this time. The real value of the debt relative to the assets of the banks
increased which deteriorated the profitability of the banks. Also, the US dollar depreciated
during the crisis, which might be pointing outwards the other shock. This was supported by
the decline in the growth as the economy went into the recession.

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.
Figure 4.5:-U.S Exchange Rate 2000-2008.( Board of Governors of the Federal Reserve
System (US), U.S. / Euro Foreign Exchange Rate [DEXUSEU], retrieved from FRED,
Federal Reserve Bank of St. Louis )
.
Table 4.6 Summary of Policies and Laws and the impact on residential and estate prices
(Hendrickson, 2013)

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Figure 4.7:- Mortgage-related Security holdings by investors: 2000-2010(Hendrickson, 2013)
Hendrickson (2013) points out that the Basel capital requirements provided an incentive to
reduce capital holdings by altering their assets to minimize the requirements. The risk weights
created a pecking order for preferences with lower risk- weighted assets at the top. This
pecking order created strong incentives for bankers to extend mortgages over other loan types
and to hold MBSs over mortgage loans. At the same time, as bankers conform to capital
regulation, the inclination to diversify is reduced since the regulation rewards some activity
and punishes other forms. The incentive for banks more generally means that bank balance
sheets become more homogeneous as bankers seek lower capital requirement activity.
Figure 4.8:- Loans by category per commercial bank: 2000-2011(Hendrickson, 2013)
Bond rating agencies played a pivotal role in the significant rise in house prices. These
agencies provide important information to those investing in corporate or government debt
instruments, including bonds and ABSs.In 1975; the SEC established capital requirements for
securities firms and wanted the regulation to be tied to the firms’ portfolio quality

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(Hendrickson, 2013). The portfolio quality was to be determined by the bond ratings. The
Securities and Exchange Commissions (SEC) decided that it needed to designate whose bond
ratings would be acceptable. This led to the designation of “nationally recognized statistical
rating organizations” (NRSROs).In the aftermath of the crisis; a common narrative is that the
rating agencies generated unwarranted high credit ratings on MBSs and other financial
products (Hendrickson, 2014)
Figure 4.9:- Private Label MBS ratings Deals: 2002-2008(Hendrickson, 2013)
A financial institution’s leverage can be defined as the ratio of its total assets or its total debt
to its equity or capital(Thomas,2011)Note that Merrill Lynch, which exhibited the most
dramatic increase in leverage from 2004 to 2007, experienced severe problems and was
subsumed as part of Bank of America in September 2008. Lehman Brothers went bankrupt at
about the same time. The company that appears most conservative in regards to leverage,
Goldman Sachs, is arguably the strongest of the firms today. The key point is that financial
firms engaged in a major increase in risk- taking after 2003, and the nation was still paying the
price in 2012 and 2013.

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Figure 4.10:- Leverage Ratios of U.S. investment banks, 2004-2007(Thomas, 2013)
The proper management is crucial for the system. However, the management was involved in
making more bonuses. Such incentives made the managers taking the banks in the wrong
direction. The management should be providing right data to the investors, which they failed
to the competition in the market. The competition in the market should be making a market a
better place, but it turned out to be making it more unstable.

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5. The Basel Accord
The breakdown of the Bretton Woods system of managed exchange rate in 1973 led to a
number of casualties. On 26 June 1970, West Germany’s federal banking Supervisory office
withdrew Bankhaus Herstatt’s banking license after finding about bank’s exposure to the
foreign exchange amounted to 3 times its capital (International Convergence..., 9). This led to
banks outside Germany take huge amount of losses on their unsettled trades with Herstatt. In
October same year, the Franklin National Bank of New York closed its doors after racking up
huge losses on foreign exchanges (International Convergence..., 9).. In response to these
international financial disruptions in the market, the central governors of G10 countries
established a committee on banking regulations and supervisory practices, which was later
renamed as the Basel Committee on banking supervision. The aim of the committee was and
is to enhance financial stability by improving supervisory knowhow and the quality of
banking supervision worldwide.
5.1 Basel I
The committee published its regulations governing the capital adequacy of international banks
in 1988 in its report International convergence of Capital Measurements and Capital
Standards, which is commonly known as Basel I. This sets out framework for measuring the
capital adequacy and minimum standard to be achieved which national supervisory authorities
represented on the committee intends to implement in their countries
Basel I is based 3 pillars:-
1. Constituents of Capital
Kindlesberger (1993) believes that the irrationality behaviour of the people is at the heart of
the crisis. The publication of the constituents of the capital could prove damaging as it could
be providing an incentive for people to act irrationally. However, since every major country
has deposit insurance to cover the bank run in relation to this factor. Basel I ask for
constituents of capital in order to make the banks more transparent.

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Tier 1
(a) Paid-up share capital/common stock permanent shareholders' equity (issued and
fully paid ordinary
shares/common stock and perpetual non-
cumulative preference shares)
(b) Disclosed reserves (created or increased by appropriations of
retained earnings or other surplus,
e.g., share premiums, retained profit, 2
general reserves, and legal reserves).
Tier 2
(a) Undisclosed reserves Includes unpublished reserves, which have
been passed through Profit and Loss Account
and are accepted by the Supervisory
authorities.
(b) Asset revaluation reserves Some countries, under their national
regulatory or accounting arrangements, allow
certain assets to be revalued to reflect their
current value, or something closer to their
current value than historic cost, and the
resultant revaluation reserves to be included in
the capital base.
(c) General provisions/general loan-loss created against the possibility of future losses.

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reserves It is not possible in the reality for create such
reserves.
(d) Hybrid (debt/equity) capital instruments The precise specifications differ from country
to country.
(e) Subordinated debt includes conventional unsecured subordinated
debt capital instruments with a minimum
original fixed term to maturity of over five
years and limited life redeemable preference
shares.
Deductions from Capital
Goodwill
Investments in subsidiaries engaged in
banking and financial activities, which are
consolidated in national systems.
Table 5.1:- Constituents of Capital (BCIS,1988)
The banks misused this pillar as they found loopholes and started exploiting the constituents
of the capital. This misuse proved lethal as the banks gathered toxic assets. These toxic assets
led to the crisis in the U.S.A. Also, the authorities had limited powers during this time,
therefore, the banks were becoming heavily involved in this misusage.Also, the committee’s
failure to provide a common method for the asset revaluation reserves led to manipulation of
the accounting standards.
2. Risk Weights
There are 5 risk weights used by the committee which are 0%, 10%, 20%, and 50% and
100%.The risk weights pillar allows the bank to associate different risks weights with
different assets which is aimed at reducing the banking crisis caused by the fundamental based
model. This pillar prevents the reduction of the net worthiness of the bank and profitability of
the bank.

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0% 1. Cash
2. Claims on central governments and central
banks denominated in
national currency and funded in that currency
3. Claims collateralised by cash of OECD
central-governments securities or guaranteed
by OECD central governments
4. Claims on domestic public-sector entities,
excluding central government, and loans
guaranteed by such entities
20% a. Claims on multilateral development banks
(IBRD, IADB, AsDB,
AfDB, EIB)5 and claims guaranteed by, or
collateralised by
securities issued by such banks
b. Claims on banks incorporated in the OECD
and loans guaranteed
by OECD incorporated banks
c. Claims on banks incorporated in countries
outside the OECD with a
residual maturity of up to one year and loans
with a residual
maturity of up to one year guaranteed by
banks incorporated in
countries outside the OECD
d. Claims on non-domestic OECD public-sector
entities, excluding
central government, and loans guaranteed by

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such entities
e. Cash items in process of collection
50% Loans fully secured by mortgage on
residential property that is or
will be occupied by the borrower or that is
rented
100% (a) Claims on the private sector
(b) Claims on banks incorporated outside the
OECD with a residual
maturity of over one year
(c) Claims on central governments outside
the OECD (unless
denominated in national currency - and
funded in that currency -
see above)
(d) Claims on commercial companies owned
by the public sector
(e) Premises, plant and equipment and other
fixed assets
(f) Real estate and other investments
(including non-consolidated
investment participations in other companies)
(g) Capital instruments issued by other banks
(unless deducted from
capital)
(h) all other assets
Table5.2:- Risk Weights (BCIS,1988)

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The risk weights allow the off-balance sheet exposures to be incorporated easily into the
measure. Such measurement allows the banks to defend themselves during the crisis. The
international banking system has seen different structures, but having the common criteria for
the risk allows a fair basis. However, it allows fails to take into account that different
countries have different risks, which questions these weights for that country. The accord only
discussed about the credit risk and it failed to take into the account the different risks each
country possessed. This has been taken into account in the next Basel II.
3. A Target Standard Ratio
The committee requires the standard target ratio to be 8% to the weighted risk assets of which
core capital element would be at least 4%.
The accord does not distinguish between customers in business areas with various levels of
risks, which led to the adverse incentive effects, as the profit-maximizing managers are
tempted to replace low-risk customers with high-risk customers (Kirsten, 2002). Therefore,
there was a regulatory arbitrage in place, which had dangerous consequences. The accord was
implemented all over the world despite being made specifically for the developed economy
because of which it was oversold. The regulations were not easily available in the
nonprofessional terms.
5.2 Basel II
Basel II is also known as international convergence of Capital Measurements and Capital
Standards. This was implemented in 2008. The scope of Basel II defines it as the best means
to preserve the integrity of capital in banks with subsidiaries by eliminating double gearing.
The Model favours the Basel II because it is believed that the strict regulations in practice
allow preventing the crisis. It has been witnessed that the places where liberties have been
given to the banks, those banks have fallen to crisis and the nation’s economic contraction for
a long time like in U.S (the panic of 1873) (Todd,2008).The new reforms allows the banks to
develop under the supervisor getting more powers .Basel II has 3 pillars:-
1. Regulatory Capital

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A. Calculation of minimum capital requirements is calculated by using the definition of
regulatory capital and risk weighted assets. The total capital ratio must not be lower than
8%.Tier 2 capitals is limited to 100% of Tier 1 capital.
B. Credit risk is calculated by following approaches:-
1. IRB also known as Standard Approach- the banks are required to use the external credit rating
agencies for quantify for the credit risk.
2. Foundation IRB Approach –the banks are allowed to develop their own empirical model for to
estimate the probability for of default for individual or group of clients. This approach for
usage is subjected for approval from the respective local regulators.
3. Advanced IRB Approach- the banks are allowed to develop their own empirical model for the
required capital for credit risk. This approach for usage is subjected for approval from the
respective local regulators.
C. Operational risk has 3 components :-
1. BIA (Basic Indicator Approach) is recommended for banks without significant international
operations.
2. AMA (Advanced Measurement Approach)-Under this bank is allowed to develop its own
empirical model to quantify required capital for operational risk and could be used by bank
subject to approval from the local regulator. Once adopted by a bank, it cannot revert back to
simpler approach without supervisory approval.
3. Standardized Approach falls between BIA and AMA in terms of complexity. To qualify for
using this Approach, a bank must satisfy its regulator at a minimum:-
1. Its board of directors and senior management, as appropriate, are actively involved in the
oversight of the operational risk management framework.
2. It has an operational risk management system that is conceptually sound and is implemented
with integrity.
3. It has sufficient resources in the use of the approach in the major business lines as well as the
control and audit areas.
4. Market risk is calculated by the value at risk.

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The implementation of IRB approach involved high costs which prevented all banks to reduce
the capital to the same extent leading to competition distortion(Schnabel et Al, 2010).This
resulted in destabilization in the banking systems as the banks were to reduce their capital
buffers. Underestimating the credit institution’s capacity to accurately measure the major risks
(Sbareca, 2014). Some of these judgements tend to underestimate the risks in good times and
overestimate in bad time leading to Pro-cyclicality (Wigwall,2010).Also, presenting different
methods where the banks have been given freedom to develop their own method for
calculating credit risk further allowed the banks to act irresponsibly.
2. Supervisory Review
The 2nd pillar aims at giving regulators better tools for managing the financial system. It
allows them to review their risk management system. Internal Adequacy Assessment Process
(ICAAP) is a result of this pillar. Overestimating the true nature of the assessments provided
by the rating agencies in absence of some minimum professional standards and supervision
(Sbareca, 2014). The committee failed to significant emphasis on the supervisory review as
only 15 pages have been dedicated to this section.
3. Disclosures
The aim of pillar is to complement the minimum capital requirements and supervisory review
by developing a set of disclosure requirements, which will allow the market participants to
determine the capital adequacy of the institution. The aim of the pillar is to allow market
discipline to operate by requiring institutions to disclose details on the scope of applications,
capital, risk exposures, risk assessments processes, and the capital adequacy of the institution.
These disclosures are required to be made twice in a year.
5.3 Basel III
The reforms in the Basel II are known as Basel III: International Framework for liquidity risk,
measurement, standards, and monitoring issued in mid-December 2010. This framework is
schedule for implementation by 2018 due to no. of revisions. The aim of the pillar is reduce
the fluctuations in the economy to prevent the reduction in net worthiness of bank and
profitability.

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The key pillars of Basel III are-
a. Capital Requirements
b. Leverage Ratio
c. Liquidity Requirements
1. Capital Requirements
Basel III introduced 2 additional ‘capital buffers’- a mandatory capital conversation buffer of
2.5% and a discretionary counter-cyclical buffer to allow national regulators to require up to
an additional 2.5% of capital during periods high credit growth.
2.Leverage ratio
The ratio is calculated by dividing tier 1 capital by bank’s average total consolidated assets
(not risk weighted). The banks are expected to maintain a leverage ratio in excess of 3%.
3.Liquidity Requirements
Basel III introduced 2 required liquidity ratios, which are-
a. Liquidity Coverage Ratio-a bank required to hold sufficient high –quality liquid assets to
cover its total cash outflows over next 30 days.
b. Net stable funding ratio-a bank required the available amount of stable funding to exceed the
required amount of stable funding over a one-year period of extended stress.
Basel III aims to reduce the risk of systematic banking crisis by enhanced capital and liquidity
buffers.However,International Arbitrage may continue if different jurisdiction implement in
different ways.
Todd (2008) points out that, the poor fundamentals in the system could be leading to the
banking crises, which could be the result in poor macroeconomic conditions for a longer time.
The regulations allow keeping a check on the banks. The Committee has framed its
regulations while keeping in mind the increase in the competition influence on the banks,
which made the banks to get involved in the unhealthy practices like Lehmann Brothers.
These regulations are banks to be aware about the debt exposure of the potential borrowers
(Bonn, 2005). However, Barth (2008) argues that there is no best practice for the well-

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functioning of the banks as some of the regulations set for U.S.A may not serve in the
developing countries. To overcome these changes, the Basel Committee has been making
necessary amendments in the pillars.
6. Prevention
The German Banking crisis started due to the failure of the Vienna Creditanstalt that led to
panic in Germany (James, 1984).Despite of a large number of banks remained uninvolved in
the Austrian market. The government failed to deal the situation with an appropriate action.
The government’s failure to make the system sound as stable led to collapsing of the banks.
The authorities failed in their role to make sure the banks were stable. The Basel Accord puts
emphasis on the role of the supervisors with an aim to make sure the banks are monitored
correctly and appropriate action taken. The Accord also states that a bank should be
maintaining maintain total capital ratio, which must not be, lower than 8 %( BCIS,2005).In
German context, it seems the banks were unlikely to be keen in maintain the total capital ratio.
During the Crisis, it has to be noted that there is lack of coordination on the international
market among the countries. The failure of United States to take the leadership at the
international level was making the crisis worse. The non-cooperative scenario (Hetzel.2002).
The reluctance of the French drove the investors nervous during this time (Hetzel,2002).This
contributed in enhancing the failure of the system, as the countries were not able to coordinate
to make the system stable. The countries political interests distorted the system of gold parities
(Buchheim,2012). The Accord aims to make developed country's banking system coordinated.
The coordination is essential especially when it involves international settlements among the
banks.
The German bank’s balance sheet of all the credit banks pointed out that the withdrawals were
driven by the run on the currency, but also related to the liquidity position of the banks
(Schnabel,2004). The currency depreciation led to increase in the value of foreign currency
debt in terms of local currency, which led to erosion of the capital. The Accord clearly aims to

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make sure that the Banks are able to maintain a certain percentage of the capital, which makes
themselves, sound stable (BCIS,2005).
The Accord points a greater emphasis on the role of supervisionIn Germany, the Reichsbank
only had the rights to demand the basic balance information and no executive powers to
enforce the special auditing for the hidden risks (Kooper,2011). The banks were lacking a
proper management and strategy during this time. This mismanagement led to banks in a
weaker position against the debtors.
The smaller banks in Germany were subject to mergers with the bigger banks. The mergers
took place in the environment where the disclosures were not made available. Such
disclosures allowed the smaller banks to misguide their account in order to allow merging take
place. Basel relies on the disclosures as its 3rd Pillar, which is key for the market discipline.
The aim of these disclosures is to allow market discipline to operate by requiring institutions
to disclose the details on the scope of applications, capital, risk exposures, risk assessments
processes, and the capital adequacy of the institution (BCIS,2005).
In Germany, it is evident that there had been a lack of credit rating agencies. This led to the
banks provide debts to the struggling businesses and people with poor credit history. In
addition, they failed in taking account the capability of the repayment of the loan by such
debtors. This was further hampered by the change in the macroeconomic conditions in the
country, which increased the burden of repayment of the debt on these debtors.
Knoop argues that belief based runs could be prevented by having deposit insurance in place
(2004). The deposit insurance aims to protect the bank depositors from losses caused by a
bank’s inability to pay off its debt. If it was in place during this crisis, it could be argued that
the German system would not have fallen..
In U.S.A, the crisis was more related to the changes in the regulations such as The Gramm-
Leach-Bliley Act of 1999, which repealed the Glass-Steagall Act (Tregenna, 2009). These
changes allowed banks to indulge in developing new innovative financial products, which led
to the securitization (Grawe,2008). The securitization led to large increase in the credit
multiplier with the credit expansion remained unchecked with the same money base. In

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addition, The deregulations in the system allowed banks to build up a lethal combination of
credit and liquidity risks.
The competition is viewed as platform, which aims to provide and deliver better results and
products. However, it seems to be untrue in context of the credit rating agencies. These
agencies aim to guarantee a fair and objective rating of the banks and their financial products.
Despite these were independent agencies, they failed achieve their objectives due to massive
conflict of interest (Grawe,2008). The competition in their market made them allow the risky
and unsafe financial products produced by the financial institutes get a favourable rating
(Grawe,2008).
The banks mergers led to increase in the level of bank concentration. Such concentrations
allowed bigger banks to increase their net worth and profitability. Also, it allowed survival of
smaller banks at that time. Nevertheless, it failed to notice that they were bringing additional
burden of liabilities on the balance sheet. The Basel Accord aims to assign risk weights, which
do not deter banks from holding liquid, or other assets, which carry low risks (BCIS,1988)
.These risk weights, allow the banks to function in better way.
However, the banks found loophole in the risk weights assigned. This exploitation of the
loophole allowed them to indulge in the activities, which allowed them to extend mortgages
over the other loan types and to hold MBSs over mortgage loans (Hendrickson, 2013).Such
activities prevented banks from diversification. However, such issues were handled by the
Basel Committee which decided to 2 additional ‘capital buffers’- a mandatory capital
conservation buffer of 2.5% and a discretionary counter-cyclical buffer to allow national
regulators to require up to an additional 2.5% of capital during periods high credit growth
(BCIS,2011).This new rule allowed banks to enhance their capital and liquidity buffers while
it also reduces the systematic risk.
The aftermath of the crisis, Basel III introduced the leverage ratio as one of its pillar. The ratio
is calculated by dividing tier 1 capital by bank’s average total consolidated assets (not risk
weighted) (BCIS,2011). The banks are expected to maintain a leverage ratio in excess of
3%.In US, this financial institutions were engaged in major risk taking after 2003 which is
evident from the fact the leverage ratios of these institutes were higher than the expected ratio.
The Basel Accord pays a greater emphasis on the supervision. The supervision is considered
to be key element for the stability of the financial system. The adequate supervision would

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have prevented the managers heading into the wrong directions. In addition, the supervision
role requires additional powers to make ensure the stability of the system. This power includes
issuing penalty to the banks for failing to comply with its duties, etc.
The Accord aimed to address the problem of the liquidity requirements in context to the
changes in the macroeconomic conditions, which were prevalent in US. Basel III addresses
this issue requiring banks to maintain the required liquidity ratios. These would allow the
financial institutions maintain their liquidity when the economy is witnessing a bubble in one
of its sectors.
The working model of US banks is questionable. The banking model is created on the basis on
making the profits. However, it turns out that the model was not making much profit. This
lack of profit was creating problems in the operations on the banking sector. The disclosures
of the annual accounts allow the investors to get the real insights of the industry. Such insights
could be harmful, but it presents an issue, which has to be addressed at the earliest for the
stability of the system.

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7. Methodology
The model used in this study is the Knoop model of the banking crisis (Knoop, 2004).This
model allows taking into account various reasons under the 2 causes, which are Belief based
and Fundamental, based. This model does not concentrate on only one cause for the crisis. By
this, it means that there could be more than one reason for the banking crisis. Therefore, it
allows us to gather different reasons of the banking crisis taking place in that particular
country and put them under an umbrella, which leads to simpler conclusions.
Although there have been different methods such as Minsky model. However, this complex
nature of this model fails to take into account some key aspects, as it is concentrates only on
the banking nature. It fails to take into account the macroeconomic conditions, which are
prevailing in the country prior to the crisis. Such conditions are essential as they help to
determine the reality of how the banks were functioning in those conditions.
The data collected for this dissertation is secondary data that has been taken from well-noted
journals. It should be taken into account that the bank data is very sensitive which if disclosed
could be catastrophic for the economy. This data allows making certain key conclusions.It has
to be noted that the prior to the crisis, the banks were involved in certain malpractices which
has been evident from their balance sheet. Such data has to be carefully interpreted in order to
come to correct conclusions. The data for the banks is not easily accessible. Therefore, it is
essential to use the secondary data for the interpretation.
The country selected for this study is Germany during 1931 and recent crisis in United States
of America. Both these countries are selected due to the innovations, they have made in the

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financial sector. Also, it allows understanding the crisis in deeper time period as both the
countries had war economy. The war economy means the concentrations of the economy on
the manufacturing defence equipment. There are more similarities in the macroeconomic
conditions of both countries, which allow making better interpretation of the causes and how
to tackle them.
The drawback of taking Germany especially during 1931 is that some of the banks which of
those time have been dissolved. The data for such banks would be difficult to gather. It would
wrongful to rule out that the banks during that time might be involved in malpractices. As the
German government was secretly supporting the business across its border.
The United States had been a leading economy when the crisis took place. However, this
makes it more challenging to find the causes. The country presents with changes in the
macroeconomic conditions along with the legislative changes. It would be allowing
understanding how these could have such an impact on the banks. It raises the question about
the powers of the authorities.
The Basel accord had been formed in 1980s with an aim to make the international settlements
between the banks simpler and smoother. This Accord had shortcomings, which allowed the
banks to get involved in the toxic assets, which deteriorated their net worthiness. Hence, it
hampered the profitability.
This Accord would be used in both the countries, which would be allowing us to determine
how successful it has been. By using this accord, the study would be able to interpret whether
the accord has taken historical crisis into the account. In addition, it would be looking into
how successful has its implementation been. The study would be aiming to address the issues
and challenges the Accord faces in terms of the prevention of the crisis in the future.
The framework of this study would allow identifying the key reasons for the crisis and
allowing understanding the crisis is relation to the prevailing macroeconomic circumstances.
It would be allowing finding the similarities between the different crisis in different countries
despite have limited data. It would allow taking into account the Basel Accord for the
interpretation of the key findings in the study.

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7. Results
7.1 Germany
The failure of the Vienna Creditanstalt created panic in the German Banking system (James,
1984). Despite the Germans, banks remained uninvolved in the Austrian market, the panic
quickly spread across Germany leading to increasing foreign withdrawals. The investors were
left in a nervous state. The bank runs was driven by the change in the expectations, which
were not linked to the macroeconomic conditions of Germany. To prevent such banks runs, it
is important that there is deposit insurance in place, which allows banks to protect bank
depositors from losses caused by the bank’s inability to pay off its debt (Knoop, 2004)
In addition, it should be taken into account that the crisis was not solely due to change in the
expectations. The macroeconomic conditions in Germany was influential in the causing the
crisis. The currency depreciation led to an increase in the value of the foreign currency in
terms of the local currency, which led to erosion of the capital. This led to reduction in the net
worth of the banks. The probability of the bank failure increased with fluctuation in the
business cycle. The Basel Accord aims to provide banks stability as it looks to make sure that
the banks are maintaining the required capital.
The working model of the German Banks is worth taking a look. The model shows that the
banks were not running on a model, which allowed them to create profits. The banks were
involved in providing bigger loans to bigger debtors knowing the risk involved. Many of these
debtors took advantage of the banks i.e., knowing that the banks would not be default their

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loans. The banks failure to generate profits led to an unexpected increase in the short-term
interest rates, a decline in aggregate growth, and an unexpected depreciation of the exchange
rate.
The authorities played a significant role in the cause of the crisis. They had been investing
across the borders to avoid the influx of the Germans living in the foreign. Their role in the
Ponzi scheme further exaggerated the crisis as the banks struggled with liquidity at a crucial
time. The authorities had to make sure the banks disclosed their statements and they had the
right to penalize the banks, which failed to comply with the regulations. Unfortunately, the
management was involved in improper strategies, which left the banks in a difficult leverage
position. Basel III addresses this issue where the banks have to maintain a leverage ratio,
which allows it to have a stable funding for a year under stress.
The accord aims to provide a platform for the international settlements for the banks.
Additionally, it acts as a leader for the banks from different markets. The crisis was worsened
up when no nation at the international level stepped up i.e. failure of United States to act as a
leader. This accord makes ensure that the banks coordinate at international level especially
during such crisis.
7.2 U.S.A
The U.S. crisis is more due to the fundamental based. The changes in the legislation resulted
in the deregulation in the banking system. This deregulation created a platform for the
involvement of the toxic assets on the balance sheets of the banks. The bank’s balance sheet
seemed to show profit, which were unsustainable on the long run. The worthiness of the
banks’ was based on these toxic assets. The crisis exposed these assets, which provides an
insight that the net worthiness of the banks were comparatively lower than what had been
projected.
The deregulation allowed the banks mergers to take place at a higher rate. Mergers allowed
survival of the smaller banks. However, the bigger banks underestimated the merger effect on
their balance sheets. The bigger bank’s ideology of ‘too big to fail ‘was exposed by the crisis.
The recession during the crisis increased the relative debt to the value of the assets. The risk
weights assigned by Basel Committee contributed in the crisis. These weights allowed the
financial institutions to use them in such a manner that the higher risk was adjusted in terms of
low risk, which were reflected on the balance sheet sounding stable.

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The growth in outstanding household mortgages, relative to GDP growth, in the US reflects
the combined effects of increased demand for housing, compound price inflation and equity
release mortgages. The composition of the household mortgages was changed from deposits to
securitized assets by 2005 which accounted for 60% of the market (Anderson et al, 2009).The
appreciation in house prices contributed in making the lenders getting involved in making new
innovative financial products such as ARM), and the Pick a Payment loan(s) where non-
agency mortgage underwriters took an increasing share of US housing finance and especially
that for sub-prime borrowers (Anderson et al, 2009).
The banking executives were involved in passing on more complexed financial products
which investors to value skim, improve banking returns and their own bonuses (Anderson et
el, 2009).The Financial incentives focused attention on the construction of financial products
that modified credit rating, risk, and financial return to the banks at the expense of liquidity.
The complexity of the web of financial transactions surrounding the process of asset
securitization makes it difficult to assess risk exposure from household payment default and
counterparty risk with the result that banks are holding on to cash balances to protect liquidity
even after Government bailout(s) (Anderson et el, 2009).Basel III address this issue by
introducing the capital buffers and the liquidity ratios which are key. Earlier, the banks had
played with the regulatory capital. However, if Basel III had been introduced, the outcome
would have been different.
The supervisors were not acting responsibly .They got involved in making their own bonuses,
which in return were hammering the profitability of the banks. The failure of Basel II to
penalize the supervisors raises the credibility about the committee.

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8. Conclusion
This dissertation provides a thorough investigation on the banking system in Germany and
U.S.A. A banking system is highly fragile due to the its working role of borrow short term and
lend long term. The analysis shows the significance of the banking system in the economy and
how a banking crisis could trigger the economy into a depression.
Both Germany and U.S.A witnessed high inflation prior to the crisis, leading to the banking
crisis. Such macroeconomic conditions contributed to the crisis by reducing the net worthiness
of the banks.
The further investigation provides an insight of the role played by the authorities. The
authorities contributed to the crisis by deregulations. The deregulation in the banking system
acted as an incentive for the banks to increase the profits in U.S.A. In Germany, the
authority’s failure to keep the account of the foreign money in the German Banks contributed
to the foreign withdrawals.
The Basel Accord has emphasised significantly on the management of the banks. In the Basel
II, they have put Supervisory Review has its 2nd pillar. This is due to the fact the
mismanagement of the banking authorities has often caused the banking crisis. The
mismanagement has allowed the banks to gather the lethal toxic assets on their balance sheets.
Also, it is worth noting that the management of the banks have failed to take into account the

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macroeconomic conditions prevailing in the countries prior to the crisis. This failure has led to
the banking crisis in the most cases.
In the crisis, the international banking system has been criticized due to lack of coordination
and leadership. However, The Basel Accord aims to provide a platform for the coordination of
the banking activities at the international level. It demands the banks to be more transparent in
their activities. The transparency is significant for the banking system because the lethal
combinations of the assets on the balance sheets as seen earlier, eventually puts the economy
into the crisis.
The Basel Accord tries to provide a fairer basis for conducting the banking activities and same
time; it looks to make sure that the banks do not involve themselves in the hazardous
activities. Nevertheless, the banks have been involved in the hazardous activities in order to
make more profit. It seems the Accord has failed to provide a model where the banks could
make profit on a fairer basis without taking higher risk. However, the Banks failure to take
into account the higher risk associated with the higher return into the account when they are
dealing with such activities.
The main concluding remark would suggest that need of banks to develop a model, which
allows them to make profit without gathering lethal assets. The authorities need to be very
strict with the banks and should be considering in the regulating the banks. The role of the
authorities is key for the preventing the crisis.

Page | 49
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