chapter 3

• 2 key causes of GFC

  global macro-imbalance, financial innovation (securitization)
• global macro imbalance

  large account deficit in US/Uk and large account surplus in Jpn/China. Surplus is used to buy the government debt in us/uk. This reduces the interest rate in UK/US. Low I/r resulted in low inflation rates as low cost imports. the Leo I/r resulted in an expansion of debt. Rapid expansion of mortgage lending by banks fuelled a property bubble as price grew at a very fast rate.
• Financial innovation

  investors wanted to obtain a higher yield to off-set the lower I/r. The desire for higher yield was satisfied by Financial innovation. Securtization allowed banks to diversify risk by try risk to other parts of the financial system.
• consequences of financial system

  banks run down on their liquidity on balance sheet over time,tehy also exposed themselves to market and credit risk. There was inadequate bank capital to cover these risks. FIs collapsed and led to GFC. GFC exposed weakness in regulation, banks were short of liquidity and capital
• lesson learnt from securtization

  focus more on systemic risk, emphasis on macro-prudential regulation where factors that might impact systemic risk is monitored and managed ( Basel 3 in ch5)
• subprime mortgage crisis

  central bank kept I/r low to stimulate the economy and encourage borrowing. this fed into the housing price and led to the US bubble . credit market had an expansive growth due to investors high risk appetite stimulating more unbundling and distributing risk through financial markets. This led to the subprime expansion. The competition among sub-prime originator intensified and therefore there was a weakening of lending standard. loans were made with increasingly high loan-to-value ratio/o full documentation.
• securitization process

  banks set up a special purpose vehicle(SPV) as a separate entity from the bank. Independent of the bank and usually set up as a trust.Bank transfer from the banks to the pool of mortgages that needs to be securitised. SPV arranges for the issue of asset-backed bonds and the banks usually engages a investment bank to do this. Cash flows from original asset passed through to asset-backed bondholders. Bank receives proceeds from sales of bonds.
• advantages

  liquidate assets on balance sheet, regulatory arbitrage, seeking a higher return
• problems

  off balance sheet, shadow banking
• financial bubble

  asset becomes overinflated in value
• financial crisis

  sharp fall in asset prices, occur when there is a large increase in asymmetric information
• 3 phases of the bubble

  1: rapid expansion of credit expansion (everyone buy)

  2: bubble burst, asset prices fall rapidly

  3: increase in loan default, banking crisis may follow
• internet bubble (late 1990s)

  widespread adoption of internet, all investors poured to dot-com,stock prices increase, focus shifts from company's actual value to the belief that stock prices will increase. Investors realised that unsustainable pace, everyone pulled out and bubble bursts, dot-com stocks plummets.