Financial Crises Flashcards
(12 cards)
What is LIBOR
London Interbank Offered Rate - this is a forward looking rate that is decided by the market (banks) and is forward looking
What is SONIA
Sterling Overnight Index Average - a backward looking rate set by the Bank of England, as it is backwards looking it is not subject to moral hazard and the fixing of rates like with LIBOR
What is mark-to-market
This is a way of valuing assets by their most
recent market price, during the financial crisis this became difficult
for many bank held securities, as the market for them broke down
Types of Financial Crisis
- Banking crisis- Systemic failure of banking system, there
is at least a run on one major bank leading to take over
by the public sector. E.g. Scandinavian banks early
1990s. - Banking crisis II – financial distress but no bank runs.
E.g. Western banks in 1980s following sovereign debt
crisis. - External debt crisis – sovereign default is when the
government fails to meet payments on its debts. E.g.
Argentina 2001 - Domestic debt crisis- similar to above, in that the
government fails to meet payments on domestic debts.
E.g. Mexico 1997.
Indicators of Banking Crises
- Sharp rise in asset prices, especially house
prices. - Sharp rise in domestic credit.
- Capital flows from abroad increase.
- Public borrowing increases before the crisis,
much of which is hidden. - Sovereign debt rises sharply both during and
after the crisis.
What are CDOs
Collateralised Debt Obligations (CDO), this is a
mortgage backed security, which involves securitisation,
where security purchasers are divided into different
groups with different risks. Payments are firstly to the
most risk-averse investors, then to more risk-loving
investors
What are CDS’s
Credit Default Swaps (CDS) these are forms of
insurance taken out against holders of bonds, in which
the bond holder receives payment in the event of the
bond issuer defaulting. The payment is made by the
writer of the CDS, usually an insurance company or
bank
Housing Market crisis causes
Rapid housing market growth (UK, US) from 2000–mid-2000s (e.g. +120% in US, 1997–2005)
Led to speculative bubble—prices above long-run equilibrium
MBSs used for mortgage lending, often off-balance sheet (started by Bear Stearns, 1997)
Banks heavily lent to sub-prime borrowers with low/no income or assets
Rising house prices let sub-prime borrowers re-mortgage to pay interest, fueling MBS returns
How did a lack of regulation cause the financial crisis
Glass-Steagall Act repealed in 1999—allowed mixing of investment & deposit banking
UK introduced tri-partite regulation system in 1997
Weaker regulation contributed to speculative housing bubble
High share of investment-driven home purchases (e.g. 40% in US, 2005)
How did inefficient monetary policy cause the financial crisis
Fed (Greenspan) cut interest rates to 1% in 2002 after dot-com crash
Rates kept low until 2005—boosted borrowing & housing demand
Low rates helped fuel housing speculation and riskier lending
Why and how was Lehman Brother allowed to go bankrupt
To prevent moral hazard, makes sure banks do not involves themselves with excessive risks as otherwise they know the central bank will always bail them out when they fail.
Lehman Brothers collapsed as it had too much exposure to the housing market and was let fail because they were only an investment bank and not a depository bank.
What is TARP
Introduced after Lehman Brothers’ collapse (2008)
US govt bought toxic assets & equity to stabilize bank balance sheets
Key issue: difficulty in accurately pricing toxic assets
Similar bank rescue & recapitalization schemes adopted in other countries
UK partially nationalized several banks, bringing them under public ownership
