Multinational business Week 10 workshop Global financial crisis

Agenda Bank based finance vs capital market based finance Global financial crisis Case study reading on Asian financial Crisis

Assignment for workshop Explain why bank-based rather than capital market-based finance has traditionally played the more dominant role in the Asian economic paradigm and why, in the current era of globalization, this continued dominance might be a problem.

Global financial crisis Parties involved Investor Investment banker Federal reserve Broker Borrower

Global financial crisis Investor: people with lots of money Treasury bills (safest instrument to invest) US federal reserve reduced interest rate on treasury bills to 1% after dotcom bust Less return Started looking for other ways

Global financial crisis How bank makes money? Via Leverage What does leverage mean? Debt to equity ratio Bank uses its debt and invest it to make profit

Global financial crisis Investment banks: Deposit rate and lending rate is directly proportional Saw the reduction in interest rate from federal reserve as an opportunity to borrow money and Started borrowing from government at reduced interest Now investment bank need to make profit from various deals Investor saw this as an opportunity

Global financial crisis Connection between house owner and mortgage lender A family wanting to own a house contacts the broker Broker take the family to the mortgage lender who lends money to the family to own a house after receiving the down payment For this the broker gets his commission and the mortgaged lender gets regular instalment

Global financial crisis Investment banker purchases this mortgage deal from the mortgage lender Investment banker further borrows money to purchase more mortgage deal Hires risk adviser to split its pool of mortgage deal into three categories Safe (low rate of return but still better than treasury bills for e.g. 4%) Okay (e.g. 7%) Risky ( higher rate to compensate the risk for e.g. 11%) Named the pool of mortgage deal as CDO: collateralized debt obligation

Global financial crisis These pool of mortgage deal are sold to Safe: investors who are risk averse Okay: other banks Risky: hedge fund

Global financial crisis Saturation point come where all the responsible borrowers (families) have obtained home loan But the investor wants to invest more money So the investment banker contacts the mortgage lender who further contacts the broker Now the loan was offered to less responsible home owners without any credit check or income source verification In case the house owner default, the house would belong to the mortgage lender which was not risky as the house price were always increasing

Global financial crisis Now the investment banker had pool of CDO consisting mostly of risky mortgage deals and sells it in slices Eventually the house owner start to default Instead of instalment, the bank has got the houses and tries to sell it With the increase in default, more houses are up for sale in the market As a result of increase in supply and decrease in demand, the prices of the house goes down Consequently, the responsible house owner also decides not to pay the instalment even though they can

Global financial crisis Investment bank now is carrying a CDO full of worthless mortgage deals Bankers tries to sell to every one but they refused Everyone has their own pool of worthless deals Eventually everyone declares bankruptcy

European debt crisis

After world war reduction of trade barriers Unified Europe Difference in currency After decade have common currency Unified monetary policy but different fiscal policy: major reason for European debt crisis