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Banking Role in 2007-2008 Financial Crisis
- 1. BANKING AND IMPACT ON FINANCIAL CRISIS (2007-2008) PRESENTED BY: SRAVAN BATCHALA DATE: 09/09/2023
- 2. CONTENTS Banking History Types of Banking Functions of Bank Commercial Bank Funds Flow Banking Regulations Regulation of Banking Operations Regulations of Capital How Regulators Monitor Banks? Central Role of Banks in Financial Crisis Trigger of Financial Crisis before 2007-2008 Timing and Key Events in the Financial Crisis 2007-2008 Protest for Government Funding for Banks References BANKING AND IMPACT ON FINANCIAL CRISIS 2
- 3. BANKING HISTORY Banking is one of the oldest business in the world and it is backbone of most successful economies. First bank of United States (1791- 1811) Second bank of United States (1816- 1836) “Free Banks” (1837- 1863) National Banks (1863- 1913) Panic! (1873,1893, 1907) Groundwork (1908-1912) Federal reserve (1913- Present) • Intent to facilitate governmen t finances and war debt • Vision for Commercia l banking • Introduced uniform currency across all banks • Acted as a second bank and clearing house • Banks started operating with less onerous charter • More banks opened and circulated free notes • Uniformed national currency across US • Issue governmen t printed bills for war support • 1893- Worst depression, depositors panic to pull money caused systematic crisis • Reconsider centralized bank • Emerge as the Federal reserve act of 1913 • Decentraliz ed central bank • Holding deposits and serving as “bankers bank” • Developme nt of monetary policy BANKING AND IMPACT ON FINANCIAL CRISIS 3
- 4. TYPES OF BANKING Retail banks • Offer services to general public and provide services such as checking and savings accounts, loan and mortgage services, financing for automobiles and short-term loans • Examples- TD bank and Citibank Commercial or Corporate banks • Offer services to businesses from small business owners to large corporations • Credit services, cash management, commercial real estate, employer services and trade finance • JPMorgan and BOA are examples of commercial banks Investment banks • Provide corporate client on complex services and financial transactions such as underwriting and assisting with merger and acquisitions • Large corporations, pension funds, government and hedge funds are their major clients Central banks • Is an independent institution authorized by government to oversee the nations money supply and monetary policy • U.S. Federal Reserve Bank is the central bank of U.S. BANKING AND IMPACT ON FINANCIAL CRISIS 4
- 5. FUNCTIONS OF BANK Functions of Bank Primary functions Accepting deposits Granting advances Secondary functions Agency functions Utility functions • Saving deposits • Fixed deposits • Current deposits • Recurring deposits • Overdraft • Cash credit • Loans • Discounting of bills • Transfer of funds • Periodic payments • Collections of cheques • Portfolio management • Other agency functions • Drafts • Lockets • Underwriting • Project reports • Social welfare programs • Other utility functions BANKING AND IMPACT ON FINANCIAL CRISIS 5
- 6. COMMERCIAL BANK FUNDS FLOW BANKING AND IMPACT ON FINANCIAL CRISIS 6 Bank Transaction deposits Savings deposits Time deposits Money market deposit accounts Federal funds purchased Borrowing from Federal reserve banks Repurchase agreements Eurodollar borrowings Bonds issued by bank Bank capital Cash reserves Bank loans- Consumer, business, real estate Investments in securities Federal funds sold Repurchase agreements Eurodollar loans Fixed assets Proprietary trading C a s h i n f l o w s C a s h o u t f l o w s
- 7. BANKING REGULATIONS-1 Banking functions are regulated to ensure safety of Financial system and maintain public confidence. It prevent banks from taking excessive risks that could cause them fail Regulatory structure • A charter is required from either a state government or federal government to open a commercial bank in US • Bank that obtain state charter is considered as state bank and bank that obtain federal charter is considered as national bank • National banks are regulated by Comptroller of the Currency and State banks are regulated by respective state agency • Banks that are insured by Federal Deposit Insurance Corporation (FDIC) are also regulated by FDIC. • National banks must be members of Federal reserve and must hold FDIC • Comptroller of the Currency is responsible for conducting periodic evaluations of national banks • FDIC holds the same responsibility as Comptroller of the Currency for conducting periodic evaluations • Commercial banks can be either independently owned or owned by a bank holding company (BHC) BANKING AND IMPACT ON FINANCIAL CRISIS 7
- 8. REGULATIONS OF BANK OPERATIONS BANKING AND IMPACT ON FINANCIAL CRISIS 8 Regulation of Bank Operations Regulation of Deposit Insurance Regulation of Deposits Regulation of Bank loans Insurance limits Risk based deposit premiums Deposit Insurance Fund Bank deposit insurance reserves DIDMCA Garn-St. Germain Act Interstate banking Act Regulation of Highly leveraged transactions Regulation of Foreign loans Regulations of loans to single borrower Regulations of loans to community
- 9. REGULATIONS OF BANK OPERATIONS BANKING AND IMPACT ON FINANCIAL CRISIS 9 Regulation of Bank Operations Regulation of off-balance sheet transactions Regulation of Accounting process Regulation of security services • Regulate banks on excessive involvement of off-balance sheet activities • It includes like letter of credit, interest rate swaps and derivatives • Sarbanes-Oxley Act was enacted in 2002 to ensure more transparent process for financial reporting • Improve internal control and centralized database of financial transactions • Banking act of 1933 (Glass-Steagall Act) separated banking and security activities • Financial Services Modernization Act (Gramm- Leach-Bliley Act) repealed Glass- Steagall Act and allows bank holding companies to engage in all activities*
- 10. REGULATIONS OF CAPITAL BANKING AND IMPACT ON FINANCIAL CRISIS 10 Regulation of Capital BASEL1 Accord BASEL II Framework BASEL III Framework • Assist bank regulators in setting their own requirements • Banks with greater risk are required to maintain a higher level of capital which discourages banks taking excessive risk • Reinvesting the measurement of credit risk- Assigning risk by weight categories • Explicitly Accounting for operational risk- Improving internal controls and techniques for operational risk • Maintenance of extra layer of Tier 1 of at least 2.5% of their risk weighted assets • Increased liquidity so that banks can meet short term demands for cash
- 11. HOW REGULATORS MONITOR BANKS BANKING AND IMPACT ON FINANCIAL CRISIS 11 Capital adequacy Bank regulators typically conduct on-site examination of each commercial bank at least once in a year. Addition to on-site examination, regulators monitor commercial banks with computerized monitoring systems that analyze data provided by the banks on a quarterly basis. Regulators rate bank on the basis of six characteristics constitute the CAMELS ratings. • Banks needs to maintain adequate capital based on BASEL III framework • It is one of the major criteria where regulators closely monitored • Evaluations of bank assets including loans and securities based on the credit risk criteria • Regulatory examination is not based on the past performance of the assets, but rather to detect any problem that could cause the bank to fail in future Asset Quality
- 12. HOW REGULATORS MONITOR BANKS BANKING AND IMPACT ON FINANCIAL CRISIS 12 Managemen t • Regulators rate bank’s management based on their administrative skills • Ability to comply with existing regulations and ability to cope up with changing environment • Bank fails when their earnings are consistently negative • Regulators use return on assets ratio to evaluate profitability i.e., after tax earnings divided by assets Earnings • Banks obtaining frequent funds raises from federal market a concern for regulators about bank liquidity crisis Liquidity • Regulators also assess the degree to which a bank might be exposed to adverse financial market conditions Earnings
- 13. CENTRAL ROLE OF BANKS IN FINANCIAL CRISIS BANKING AND IMPACT ON FINANCIAL CRISIS 13 Every individual has a relationship to banks in one or other way • Regular income placed in a bank account • Paying for goods and services by bank credit or debit cards • Taking bank loans for purchasing automobile or house or apartment Same applies to business relationship to banks • Accounts payable and Accounts receivable by banks • Finance their investments for long term projects, infrastructure projects • Banking services utilized for business like Auto bank reconciliations, international payments etc., Important questions to banks • If banking collapses so much damage, could we manage with out banks? • Must banks be so unstable, so why? • How can society can improve the stability of banking system? • Why do banking crisis lasts so long?
- 14. CENTRAL ROLE OF BANKS IN FINANCIAL CRISIS BANKING AND IMPACT ON FINANCIAL CRISIS 14 • Between January 1930 and March 1933- US Industrial production fell by 46 percent and unemployment rose to 25 percent • In Great Britain, unemployment raised to 25 percent and 29 percent in Australia • In Germany , Industrial production almost halved and more than one third of the workforce was out of work • In Chile, national income fell by 33 percent between 1929 and 1932 • This caused great depression and resulted in deep economic downturn and banking crisis. • Everywhere bank collapsed, people were forced to leave their homes and widespread starvation even in relatively rich countries Economy crisis linked to Bank crisis in global
- 15. CENTRAL ROLE OF BANKS IN FINANCIAL CRISIS BANKING AND IMPACT ON FINANCIAL CRISIS 15 • Depression began with a fairly normal recession in 1929, but in 1930, it developed into banking crisis • Economic crisis developed concerns in depositors and worried about banks survival • Depositors rushed to banks to withdraw all their savings • If enough people do this simultaneously, bank reserves cannot cover all withdrawals and forced to conduct fire sale of assets at potentially huge losses. • This drives the banks to bankruptcy • Number of banks halved in three years and in many cases due to bank runs What caused Economic crisis linked to Banking crisis
- 16. CENTRAL ROLE OF BANKS IN FINANCIAL CRISIS BANKING AND IMPACT ON FINANCIAL CRISIS 16 • How banks raised as Financial intermediaries: • Households make direct investments in banks and use when the money for need arise. Bank use money for investment projects by corporations that need financing. These will be profitable during long run, but if terminated early, the returns will be very low. If banks were not there, house holds must make direct investments in projects and money need in short notice must terminate the projects. • Banks creates money: • Banks is an intermediary that transform assets with long term maturity into bank accounts with short maturity. This is called maturity transformation • Vulnerable to rumors: Depositors rush to bank to withdraw money in reference to rumors on bankrupt. • Bank monitor borrowers: Bank checks credit worthiness of borrowers at a certain cost and regulators monitors the banks • Diamonds model explains how the existence of banks leads to reduction in the cost of transferring savings to productive investments known as cost of credit intermediation Diamond and Dybvig’s model
- 17. TRIGGERS OF FINANCIAL CRISIS BEFORE 2007-2008 1992 Fannie and Freddie • Congress passed legislation that requires government sponsored mortgage giants Fannie and Freddie to devote a percentage of their lending to affordable housing • Lead to increase in overall number of loans being pooled and securitized and sold as financial instruments • J.P. Morgan introduces first credit default swap, a credit derivative that can act as kind of insurance • CDS market proves to be a major source of systemic risk to the U.S. financial system 1995-1999 Subprime mortgages grow • In 1995, changes to the community reinvestment act passed to end discrimination against low-income borrowers and allowed mortgage lenders to buy subprime securities to fulfill their affordable housing lending • In September 1999, Fannie Mae ease credit requirements to encourage banks to extend loans to people whose credit is lower than what is required for conventional loans. • This triggered growth in Subprime lending industry BANKING AND IMPACT ON FINANCIAL CRISIS 17
- 18. TRIGGERS OF FINANCIAL CRISIS BEFORE 2007-2008 1999 Glass Steagall Weakend • In 1999, Congress passed the Financial Services Modernization Act which allows affiliations between banks, securities firms and insurance companies • Since the passage of this act, financial institutions are able to offer all types of services through their various subsidiaries • This consolidation improved financial stability 2000-2001 Federal reserve cuts interest rates • Prompted by the burst of dot com bubble and the resulting recession, Fed introduced to lower its interest rates eleven times. • Falling interest rates lead to an easy credit environment • This ensuing credit bubble plays a larger role in run-up to the Financial crisis 2004 Wallstreet places riskier bets • In April 2004, the Securities and Exchange Commission loosens the net capital rule which investment banks to 12-to-1 leverage ratio on investments BANKING AND IMPACT ON FINANCIAL CRISIS 18
- 19. TIMING AND KEY EVENTS IN THE FINANCIAL CRISIS 2007-2008 BANKING AND IMPACT ON FINANCIAL CRISIS 19 2007 April 2007 Aug 2007 Sep 2007 Mar 2008 Sep 7,200 8 Sep 15,2008 Sep 16,2008 U.S. Housing bubble bursts Subprime Bankrupt proliferate Subprime woes go global Fed slashes rate and market peaks Fire sales of Bear Stearns Fannie and Freddie nationalization Collapse of Lehman Brothers Federal bails out AIG • Boom in U.S housing prices in 2006 reversed and declines accelerated in 2007 • Largest single year drop in U.S. home sales in more than two decades • This downturn triggers the collapse of U.S. subprime mortgages who offered loans to consumers having poor credit history or having multiple loans or bad debts • More than twenty- five subprime lending firms declared bankrupt in beginning of 2007
- 20. TIMING AND KEY EVENTS IN THE FINANCIAL CRISIS 2007-2008 BANKING AND IMPACT ON FINANCIAL CRISIS 20 2007 April 2007 Aug 2007 Sep 2007 Mar 2008 Sep 7,200 8 Sep 15,2008 Sep 16,2008 U.S. Housing bubble bursts Subprime Bankrupt proliferate Subprime woes go global Fed slashes rate and market peaks Fire sales of Bear Stearns Fannie and Freddie nationalization Collapse of Lehman Brothers Federal bails out AIG • Subprime mortgage is a type of loan granted to individuals with poor credit scores who wouldn’t qualify for conventional mortgages. • In April 2007, New Century Financial corporation, the largest U.S. subprime lender filed for Bankruptcy. • It triggered analysts about the impact who had invested heavily in securitized debt from subprime loans • In July, Bear Stearns one of the largest U.S. investment banks announces two of its hedge funds lost all the capital
- 21. TIMING AND KEY EVENTS IN THE FINANCIAL CRISIS 2007-2008 BANKING AND IMPACT ON FINANCIAL CRISIS 21 2007 April 2007 Aug 2007 Sep 2007 Mar 2008 Sep 7,200 8 Sep 15,2008 Sep 16,2008 U.S. Housing bubble bursts Subprime Bankrupt proliferate Subprime woes go global Fed slashes rate and market peaks Fire sales of Bear Stearns Fannie and Freddie nationalization Collapse of Lehman Brothers Federal bails out AIG • Subprime mortgage spread worldwide as hedge funds and global banks have substantial holdings of mortgage- backed securities • France’s BNP announces on Aug 9, that there is no liquidity in the market for the assets held by three of its hedge funds • Other European banks followed same pattern and steps in to offer low interest rates • As lending markets drying up- U.S. , European Union, Australia, Canada and Japan coordinated to inject liquidity into credit markets
- 22. TIMING AND KEY EVENTS IN THE FINANCIAL CRISIS 2007-2008 BANKING AND IMPACT ON FINANCIAL CRISIS 22 2007 April 2007 Aug 2007 Sep 2007 Mar 2008 Sep 7,200 8 Sep 15,2008 Sep 16,2008 U.S. Housing bubble bursts Subprime Bankrupt proliferate Subprime woes go global Fed slashes rate and market peaks Fire sales of Bear Stearns Fannie and Freddie nationalization Collapse of Lehman Brothers Federal bails out AIG • Corporations borrow money from Federal bank to satisfy their short-term needs • Interest rate charged in the federal funds market is called federal funds rate • It is quoted on annualized basis and is typically close to treasury security • In September, the Federal Reserve makes its first in a series on interest tax cuts, lowering the federal funds rate from 5.25 percent to 4.75 • In January 2008, Fed cuts its benchmark rate by three quarters of a percentage point
- 23. TIMING AND KEY EVENTS IN THE FINANCIAL CRISIS 2007-2008 BANKING AND IMPACT ON FINANCIAL CRISIS 23 2007 April 2007 Aug 2007 Sep 2007 Mar 2008 Sep 7,200 8 Sep 15,2008 Sep 16,2008 U.S. Housing bubble bursts Subprime Bankrupt proliferate Subprime woes go global Fed slashes rate and market peaks Fire sales of Bear Stearns Fannie and Freddie nationalization Collapse of Lehman Brothers Federal bails out AIG • Bear Stearns announces major liquidity problems and granted a 28-day emergency loan from New York federal reserve bank • Later it is collapsed and acquired by JP Morgan Chase for pennies on the dollar • JP Morgan chase buys Bear Stearns for $2 per share in rescue deal backed by $30 billion in Fed financing • In February, the British government forced to nationalize Northern rock • Sudden collapse of Bear Stearns one of the most iconic institutions of Wall street spart board fears about the stability of Financial sector
- 24. TIMING AND KEY EVENTS IN THE FINANCIAL CRISIS 2007-2008 BANKING AND IMPACT ON FINANCIAL CRISIS 24 2007 April 2007 Aug 2007 Sep 2007 Mar 2008 Sep 7,200 8 Sep 15,2008 Sep 16,2008 U.S. Housing bubble bursts Subprime Bankrupt proliferate Subprime woes go global Fed slashes rate and market peaks Fire sales of Bear Stearns Fannie and Freddie nationalization Collapse of Lehman Brothers Federal bails out AIG • U.S. government announces to seize control of Federal mortgage insurers Fannie Mae and Freddie Mac • It is considered as the most dramatic intervention in the credit crisis to date • These two firms are riddled with mortgage defaults • Federal regulators scared that collapse would cause to massive collateral damage for financial markets and United States economy
- 25. TIMING AND KEY EVENTS IN THE FINANCIAL CRISIS 2007-2008 BANKING AND IMPACT ON FINANCIAL CRISIS 25 2007 April 2007 Aug 2007 Sep 2007 Mar 2008 Sep 7,200 8 Sep 15,2008 Sep 16,2008 U.S. Housing bubble bursts Subprime Bankrupt proliferate Subprime woes go global Fed slashes rate and market peaks Fire sales of Bear Stearns Fannie and Freddie nationalization Collapse of Lehman Brothers Federal bails out AIG • Lehman brothers, a major global investment bank and a fixture of wall street for more than 150 years, files for bankruptcy • It became signal of the devastation caused by the Global financial crisis • Many investors assumed that U.S. government would intervene to prevent Lehman who is having huge bank size from falling • In contrary, U.S. treasury and Fed leaders fear at the time that bailing our Lehman would create “moral hazard” within banking industry
- 26. TIMING AND KEY EVENTS IN THE FINANCIAL CRISIS 2007-2008 BANKING AND IMPACT ON FINANCIAL CRISIS 26 2007 April 2007 Aug 2007 Sep 2007 Mar 2008 Sep 7,200 8 Sep 15,2008 Sep 16,2008 U.S. Housing bubble bursts Subprime Bankrupt proliferate Subprime woes go global Fed slashes rate and market peaks Fire sales of Bear Stearns Fannie and Freddie nationalization Collapse of Lehman Brothers Federal bails out AIG • American International Group (AIG), had downgraded from credit agencies which had bet heavily in credit rate swap market. • Unlike Lehman, AIG is “Too big to Fail” and a collapse would trigger cascading failures throughout U.S. and global financial systems • Just a day later after Lehman brothers is collapsed, the Fed steps into rescue American International Group (AIG), the largest insurer in United States with an $85 billion loan.
- 27. PROTESTS FOR GOVERNMENT FUNDING FOR BANKS 2009 • Tea party organized and staged protests through out the United States • They contended that government was spending excessively • This leads to larger budget deficits that could potentially weaken the economy • Proposed solution • Eliminate government funding on bail out banks to reduce excessive government spending 2011 • Occupy wall street movement was organized and began to stage protests • Its criticism was that executives of many financial institutions who has caused the crisis were excessively rewarded • CEO of Lehman Brothers received compensation of $500 million over the 2000-2008 period prior to Lehman’s failure • Financial institutions received government funding during crisis continued to pay large bonuses to executives BANKING AND IMPACT ON FINANCIAL CRISIS 27
- 28. REFERENCES • 1992-2018 The U.S. Financial Crisis. https://www.cfr.org/timeline/us-financial-crisis • Manoj Singh(March 19, 2023). The 2007-2008 Financial Crisis in Review. https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp#toc-august-2007-the- dominoes-start-to-fall • A history of central banking in United States. https://www.minneapolisfed.org/about-us/our-history/history- of-central-banking • Adam Barone (Mar 28,2023). How banking works, types of bank. https://www.investopedia.com/terms/b/bank.asp • The Prize in Economic Sciences 2022. https://www.nobelprize.org/uploads/2022/10/popular- economicsciencesprize2022.pdf • Shauna Carther Heyford (July 28, 2023). The risk of subprime mortgages by a new name. https://www.investopedia.com/ask/answers/07/subprime-mortgage.asp • Jeanne Gobat. Banks at the heart of the matter https://www.imf.org/en/Publications/fandd/issues/Series/Back-to- Basics/Banks#:~:text=Although%20banks%20do%20many%20things,whom%20the%20bank%20lends%20m oney). • https://kalyan-city.blogspot.com/2011/04/functions-of-banks-important-banking.html BANKING AND IMPACT ON FINANCIAL CRISIS 28
Editor's Notes
- https://www.minneapolisfed.org/about-us/our-history/history-of-central-banking
- https://www.investopedia.com/terms/b/bank.asp
- Demand deposit account- customers who desire to write checks and make payment using debit cards Negotiable order of withdrawal- Which pay interest as well as provides checking and debit card services Transaction deposits are mostly originated as electronic transactions Saving deposits are passbook savings account which do not permit check writing or the use of debit or credit cars Time deposits are certificates of deposits or Negotiable certificates of deposits Money market deposit accounts are conventional time deposits in that they do not specify a maturity Business loans are working capital loan or term loans or direct lease loan or revolving credit loan
- Insurance limits are increased from $100,000 to $250,000 as part of Emergency Economic Stabilization DIDMCA- Depository Institutions Deregulation and Monetary Control Act enacted to deregulate the banking industry and improve monetary policy Gran St.. Germain act permitted depository institutions to offer money market deposit accounts
- Activities include- traditional banking activities, securities trading, underwriting and insurance
- Leverage ratio= Ratio of debt to equity
- https://finance.yahoo.com/news/foreclosures-rising-experts-means-housing-180030618.html?guccounter=1&guce_referrer=aHR0cHM6Ly93d3cuZ29vZ2xlLmNvbS8&guce_referrer_sig=AQAAANIoRnGmUWbSBLfJKTRD8GQ1JxI_0N7OGYUe-LYY5tT9635s0GiU9RhBLtj93l6nY65sFYzjuEnsd086BXOAtr1DjXUphhsgXBBz_TBJchdevdQQh05cUjo20kK8L5rByfQjRNwYnR2jw2-9KnJN3l2-MW68eKJNHsMVRZYRvUGX
- https://www.investopedia.com/ask/answers/07/subprime-mortgage.asp
- https://www.globaltimes.cn/page/202210/1276942.shtml
- https://www.theatlantic.com/business/archive/2014/02/how-the-fed-let-the-world-blow-up-in-2008/284054/
- https://baocantho.com.vn/fannie-mae-va-freddie-mac-ton-tai-hay-khong-ton-tai-a6741.html
- http://businessethicscases.blogspot.com/2013/02/aig-from-bailout-to-bonuses-2008-based.html