1. Asia Financial/Currency Crisis: 1997 - 1998 Hot money – capital flight Vicious circles  Debt burdens  Bankruptcies  Depression Asset price collapse Currency depreciation Lender of last resort Conditionality: Tight money/austerity Unorthodox policy Exchange controls (?)

2. Financial Crises: East Asia 1997-1998 Financial liberalization in the early 1990s: – Lending boom/weak supervision/lack of expertise. – Banks accumulated losses/net worth declined. Uncertainty increased – stock market declines and failure of prominent firms Domestic currencies devaluated (1997). Rise in actual and expected inflation.

3. Subprime-Triggered Financial Crisis of 2007 - 2009 Financial innovations in mortgage markets: – Subprime and Alt-A mortgages – Mortgage-backed securities – Collateralized debt obligations (CDOs) Housing price bubble forms – World savings glut  Increase in liquidity from cash flows surging to the US – Subprime mortgage market  housing demand and prices up. Agency problems arise – “Originate to distribute”  principal (investor) agent (mortgage broker) problem. – Commercial and investment banks/rating agencies …weak incentives to assess quality of securities Information problems surface… A “Minsky Moment” Housing price bubble bursts/Crisis spreads globally http://www.nytimes.com/interactive/2009/04/29/business/2009-wide-housing-graphic.html

4. Easy Money Policy Capital Inflows Eager Home Buyers Innovative Banks Rating Agencies Ambitious Mortgage Brokers Securitization  MBSs Escalating House Prices Gov’t Sponsored Enterprises Developer Clout Bank Regulators The best of times A “Global Saving Glut”

5. Easy Money Policy Capital Inflows Eager Home Buyers Innovative Banks Rating Agencies Ambitious Mortgage Brokers Securitization  MBSs Escalating House Prices Gov’t Sponsored Enterprises Developer Clout Bank Regulators The best of times

6. House Price – Foreclosure Spiral Demand – Jobs – Wages – Income – Spiral Deleveraging – Debt Deflation Spiral Government Revenue – Cutback Spiral Global Repercussion Spiral Macroeconomic Linkages and Feedbacks Vicious Spirals Unleashed

7. Financial Crisis of 2007 - 2009 (cont’d) Banks’ balance sheets deteriorate – Write downs – Sale of assets and credit restriction High-profile firms fail – Bear Stearns (March 2008) – Fannie Mae and Freddie Mac (July 2008) – Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund (MMMF) and Washington Mutual (September 2008). Fed pumps up bank reserves: TARP/TALF,etc. – Lend and lend freely Bailout package enacted – House votes down the $700 billion bailout package (9/29/08)  Stock market slumps  Bailout passes on October 3. – Congress approves a $787 billion economic stimulus plan on February 13, 2009. Recession deepens

8. Responses Lender of Last Resort / Spender of Last Resort Tax Rebate $124 bil. Fed Fund Rate Cuts Fannie/Freddie $200 bil. Bear-Stearns $29 bil. AIG $174 bil. Fed “Facilities” Primary Dealer Credit Facility (PDCF) $58 bil. Treasury Security Loan Facility (TSLF) $133 bil. Term Auction Facility (TAF) $416 bil. Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil. Money Market Investor Funding Facility (MMIFF) $540 bil. More Fed Fund Rate Cuts … Hold At ~0% Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil. Term Asset-Backed Securities Loan Facility (TALF) $200 bil. Emergency Economic Stabilization Act/TARP $700 bil. Government Loans Government Equity Stimulus Package $787 bil. aka The American Recovery and Reinvestment Act TARP II Stress Tests

9. House Price – Foreclosure Spiral Demand – Jobs – Wages – Income – Spiral Deleveraging – Debt Deflation Spiral Government Revenue – Cutback Spiral Global Repercussion Spiral Macroeconomic Linkages and Feedbacks Vicious Spirals Reversed? Tackle them all together! Stimulus Program Infrastructure Spending Tax Cuts Federal Aid To States Refinance Mortgages Revive dual banking system Cash for Trash Recapitalize banks Revive securitization G – 20 Coordinated Stimulus Macroeconomic Linkages and Feedbacks Vicious Spirals Unleashed

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

12. Off Balance Sheet Assets/Activities Structured investment vehicles (SIVs) Loan sales Fees for Foreign exchange trades for customers Servicing mortgage backed security Backup lines of credit/overdraft privileges Standby lines of credit guaranteeing securities/commercial paper Trading activities  Principal – agent problem Bond markets Foreign exchange markets Financial derivatives

13. Shadow Banking System Financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees. – Finance companies – Asset backed commercial paper (ABCP) conduits – Limited purpose finance companies – Structured investment vehicles (SIVs) – Credit hedge funds – Money market mutual funds (MMMFs) – Securities lenders – Government sponsored enterprises (GSEs) Interconnections with each other and traditional banking system – ABCP – Asset backed securities – Collateralized debt obligations (CDOs) – Repurchase agreements Liabilities of shadow banking system = $16 trillion vs. $13 trillion for banks. http://www.ny.frb.org/research/staff_reports/sr458.pdf

14. Possible Reforms Increase/tighten capital requirements Trade derivatives only on public exchanges  tranparency “Mark – to – funding” accounting – Value assets relative to date their funding must be repaid Rapid “resolution” of TBTF institutions – Make bankruptcy credible – Put creditors at risk  eliminate moral hazard of TBTF

16. McFadden Act (1927) and Douglas Amendment (1956) limit interstate branching Interstate Banking and Branching Efficiency Act (1994) deregulates branching Gramm-Leach-Biley Financial Services Modernization Act (1999) repeals Glass-Steagall

17. Regulating Finance: Regulation and Its Discontents Lots of bases to cover Cover one by regulation or deregulation  Unintended Consequences Reactions to regulatory policies  frustrate regulator intent Regulate bank balance sheets  off-balance sheet activities Emplace a safety net  bankers become skydivers Regulation spreads to cover innovations  complexity  ineffectiveness Win by gaming the system

18. Primary Supervisory Responsibility of Bank Regulatory Agencies Comptroller of the Currency—national banks chartered by Federal government since 1863 Federal Reserve and state banking authorities— state banks that are members of the Federal Reserve System Fed also regulates bank holding companies FDIC—insured state banks that are not Fed members State banking authorities—state banks without FDIC insurance

19. Innovations: Response to Interest Rate Volatility Adjustable-rate mortgages Financial Derivatives Innovations: Response to Information Technology Bank credit and debit cards Electronic banking – ATM/Home banking/ABM/Virtual banking Junk bonds Commercial paper market … backed by banks Securitization Innovations:Avoiding Regulation/Loophole Mining Sweep accounts … reserve requirements Money Market Mutual Funds … Regulation Q

20. Decline of Traditional Banking Decline in cost advantages in acquiring funds (liabilities) Rising inflation  rise in interest rates and disintermediation Low-cost source of funds, checkable deposits, declined in importance Decline in income advantages on uses of funds (assets) Information technology  less need for banks to finance short-term credit and issue loans IT  lower transaction costs for other financial institutions Bank Responses: Riskier Lending … Commercial real estate, leveraged buyouts, takeovers Off balance sheet activities

21. Size Distribution of Insured Commercial Banks, September 30, 2008 ???? 3,046 4,039 486 86 7,640 39.9 52.9 6.1 1.1 1.3 9.7 10.0 79.0

22. Bank Consolidation Benefits of bank consolidation Increased competition  close inefficient banks Efficiencies from economies of scale and scope Lower chance of failure -- diversified portfolios Costs Fewer community banks  less lending to small business Banks in new areas  increased risks/failures Skirting branch restrictions ATMs, Bank Holding Cos. Interstate Banking and Branching Efficiency Act, 1994 Pre-Crisis Findings: Net interest margin up ROA, ROE up for big banks Intrastate deregulation more positive for all but big banks Interstate deregulation helps big banks most Non-performing loans down for biggest banks but up for smaller banks State of economy has stronger impact on bank performance than branching deregulation  Geographic deregulation Skirting branch restrictions ATMs, Bank Holding Cos.

23. 23 The U.S. regulatory regime: In need of reform? Sources: Financial Services Roundtable (2007), Milken Institute.

24. Asymmetric Information and Bank Regulation Government safety net Deposit insurance and FDIC – Short circuits bank failures and contagion effect Payoff method Purchase and assumption method Fed as lender of last resort: Too BIG to Fail Financial consolidation  Exacerbates Too Big to Fail Safety net extended to non-bank financial institutions Safety Net  Moral Hazard Problems – Depositors don’t impose discipline of marketplace – Banks have an incentive to take on greater risk Safety Net  Adverse Selection Problems – Risk-lovers find banking attractive – Depositors have little reason to monitor bank

25. Attempted solutions: Constrain banks from taking too much risk Promote diversification Prohibit holdings of common stock Set capital requirements … Capital as cushion Minimum leverage ratio Basel Accord: risk-based capital requirements … but there’s regulatory arbitrage Prompt corrective action: Close ‘em down when capital inadequate Monitor … CAMELS – Capital adequacy – Asset quality – Management – Earnings – Liquidity – Sensitivity to market risk Disclosure requirements … mark-to-market issue Restrictions on competition … make banking boring

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

28. Failed Banks Update YearNumber 20002 20014 2002 11 20033 20044 2005/20060 20073 2008 QI+Q24 2008 Q3 10 2008 Q4 12 2009 Q1 21 2009 Q2 24 2009 Q3 50