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Report: The Global Financial Crisis

Financial markets’ role in the Global Financial Crisis (GFC) and the impact of the GFC on financial markets

The Global Financial Crisis of 2007-2010 is generally considered to be the worst global financial crisis since the 1930s Great Depression (Schlisserman, n.d.). The GFC is generally defined from bank liquidity problems that happened at the start of 2007 (Crouhy & Turnbull, 2008). The banks were concerned about the inability of other banks to repay money market securities and tried to keep as much cash as possible for protection against future losses. The collapse of the US housing bubble in late 2006 and the subsequent increase in delinquency rates caused the value of mortgage-backed securities to collapse resulting in bank failures, notably Northern Rock, Britain’s first bank run in 140 years, and Bear Stearns, the fifth largest US investment bank. The liquidity contagion spread internationally and created a global problem. Banks holding on to cash decreased the levels of credit available for consumers, spreading the problem from the financial markets into broader society.

In 2001, the Federal Reserve, under the leadership of Alan Greenspan, responded to 9/11 attacks by dropping interest rates rapidly to 1% (Federal Funds Rate). This low interest rate environment was a contributing factor in US housing price increases (Crouhy & Turnbull, 2008). Changes to mortgage lending practices was the main factor (Hull, 2008). Underwriting standards degraded significantly from 2004 to 2007.

Financial innovation allowed institutional investors, both in the US and abroad, to invest in the US housing market through the purchase of Collateralized Debt Obligations (CDOs). CDOs are a type of asset-backed security (ABS) that are issued by a special purpose vehicle (SPE) that holds a pool of mortgage-backed-bonds, loans or other debt instruments. The CDO’s were underwritten by major investment banks and then sold to institutional investors. Mortgage-backed bonds are also sold in the bond market. Due to the complexity of the product, purchasers relied on ratings agencies’ risk assessments. Many CDOs were issued at AAA grade. The ratings of these products did not reflect the bond’s true credit risk (Crouhy & Turnbull, 2008). The fact that lenders were no longer exposed to the risk of default lead to high agency costs (Hull, 2008).

As Treasury bond rates were low, investors looked for instruments that offered higher yields. (Crouhy & Turnbull, 2008). Subprime borrowers typically pay 2-3% more than standard. The large amount of capital investors looking for higher rates lead to the growth of the subprime mortgage market. In 2003, subprime accounted for $332 Billion in outstanding loans; by 2007, this number had increased to $1.3 trillion, a 292% increase (A Snapshot of the Subprime Market, n.d.).

The Basel II Accords, published in 2004, specified risk weights for certain types of assets and the amount of capital required to be held as a percentage of the asset by the banks. AAA-rated securities where able to be used as capital. Investment grade value declines of these products immediately meant that the banks were undercapitalised. This coincided with large increases in cost of borrowing on the interbank lending market. After the US government decided not to bail out the investment bank Lehman Brothers, the LIBOR-OIS spread (a measure of money market stress) blew out by over 350bps (LIBOR-OIS spread). This liquidity crisis lead to a dramatic meeting on September 18, where Ben Bernanke famously stated, “If we don’t do this, we may not have an economy on Monday”. Legislators proposed a $700 billion USD emergency bailout that was signed into law on October 3, 2008.

In the second week of August 2007, the US Federal Reserve reported that the total corporate bonds outstanding fell more than $90 Billion USD from the previous week (Crouhy & Turnbull, 2008). The lack of demand for corporate bonds made it very difficult for borrowers to roll over debt. In Australia, this lead to the collapse of RAMS Home Loans that was unable to refinance $10 billion in debt (Washington, 2007) and Centro Group that was unable refinance $4 billion in loans (730 Report, “The Fall out from the Centro Collapse”, 2007).

Investors fled to safe investments. The ASX 200 dropped from 6782 to 3170. The gold price rose from $560 USD/ounce (September ’07) to $1010 USD/ounce (March ’08). The yield on US Treasury bonds fell from 4% to 3.4% and demand pushed down the price. The effect on retirement savings was devastating. The one year loss for superannuation in 2008 was 17.6% (Graham, 2009).

The unwinding of foreign currency carry trades caused dramatic alterations in currency exchange rates. The yen appreciated 11.5% against the Australian dollar and 2% against the US dollar (Crouhy & Turnbull, 2008).

Regulatory Responses to the GFC

In response to the growing financial crisis, individual governments took quick and decisive regulatory action to try and prevent an escalation of the financial crisis and possible depression. There were multiple factors involved in this financial crisis; the liquidity crisis affecting the banking industry, the “credit crunch” affecting business, the downturn in consumption due to reduction of available consumer credit. Immediate regulatory action was needed to address all of these factors.

The US Federal Reserve (Fed), the Reserve Bank of Australia (RBA) and central banks globally had taken steps to increase the supply of money to avoid the risk of deflation. These approaches can be classified as open market operations.

Open Market Operations

The Fed conducted open market operations to ensure liquidity. The $700billion TARP act was designed to “buy back-mortgage securities and provide short-term stability” (Barro, 2009). In Australia, the government directed the Australian Office of Financial Management to purchase a maximum of $4 billion of residential mortgages (Swan, 2008).

The RBA increased the ability of banks to borrow from the RBA as a “lender of last resort”. The RBA significantly increased the Aggregate Exchange Settlement (ES) balances from $1 billion to $10 billion. The following graph shows the increase in demand for RBA deposits.

Monetary Policy

The RBA dropped the overnight cash rate by 425 base points to an “emergency level” of 3%. All other developed nations took similar steps, as you can see in the graph below.

The dramatically reduced interest rates increased the disposable income by increasing consumption, and therefore GDP. The increase in disposable income after the reductions in interest rate can be seen in this graph.

(Australian Bureau of Statistics, 2011)

The RBA also altered the definition of acceptable capital to relieve liquidity pressures associated with the aforementioned credit rating decline with assets held by banks as part of their capital adequacy ratios.

Treasury guaranteed Australian banks’ money market borrowings, removing the counterparty risk associated with these debts and enabling Australian banks to raise money internationally (Guarantee Scheme for Large Deposits and Wholesale Funding, n.d.).

To increase depositor confidence and prevent bank runs, the Treasury guaranteed bank deposits of up to $1 million (Guarantee Scheme for Large Deposits and Wholesale Funding, n.d.). At the same time, Australian households started to deleverage. See the below graph showing the increase in the savings rate.

(Australian Bureau of Statistics, 2011)

This increase in savings rate led to Australian banks requiring marginally less overseas capital.

Fiscal Policy

Many government, including the US and Australian government, enacted large fiscal stimulus packages. The Chinese Government introduced a $4 trillion Yuan ($586bn, 12% of GDP) stimulus largely focused on infrastructure. In the United States, Congress passed the $787 billion USD fiscal stimulus package (The US $787 Billion Stimulus Package, n.d.). The Australian government delivered two separate packages: the $10.4 billion Economic Security Strategy package, and the $42 billion Nation Building and Jobs Plan (Nation Building Economic Stimulus Plan, n.d.). The Stimulus Plan was broken into two parts: cash payments made to individuals and infrastructure spending. The cash payments were designed to fund consumption. While the Rudd Government was criticised for cash payments, retail spending figures compiled by Westpac clearly showed the effectiveness of the measures.

(Westpac, 2010)

Coordinated Action

In reflection of the fact that the GFC was a global crisis and that global financial systems are more interconnected than ever, the G20 nations held a summit on November 14, 2008, generally referred to as the Washington Summit or Benton Woods II. German Chancellor Angela Merkel and French President Nicolas Sarkozy said that the summit should bring about “genuine, all-encompassing reform of the international financial system” (Economic and Financial Affairs, 2008). The G20 nations stated that they “are determined to enhance our cooperation and work together to restore global growth and achieve needed reforms in the world’s financial systems” (G20, 2008). The G20 made a declaration following the summit, identifying issues that the leaders agreed upon.

  • The root causes of the current crisis
  • Actions taken and to be taken
  • Common principles for reforming their financial markets
  • Specific mention was made of the need to protect against adverse cross-border developments affecting international financial stability
  • Launched an action plan to implement those principles and asked ministers to develop further specific recommendations that would be reviewed by leaders at a subsequent summit
  • Commitment to an open global economy

It is generally accepted that in the GFC financial regulation and prudential oversight of financial innovation were insufficient. The development of off balance-sheet vehicles and derivatives operated, and some would argue, were designed to evade banking regulations. There was a fundamental failure to understand the large agency cost present in the mortgage-backed securities model.

The action plan identified several immediate steps.

  • Global accounting standards bodies should work to enhance guidance for valuation of securities
  • Accounting standard setters should significantly advance their work to address weakness in accounting and disclosure standards for off-balance sheet vehicles
  • Regulators and accounting standard setters should enhance the required disclosure of complex financial instruments by firms to market participants.

In the medium term, countries pledged to review and report on regulatory systems to ensure compatibility with a modern and increasingly globalised financial system.

After the summit, both the US and Australian government passed laws reforming the financial sector. The US passed the “Dodd-Frank Wall Street Reform and Consumer Protection Act”, the largest change to financial regulation in the United States since the Great Depression (Damian Paletta, 2010). Reform in Australia has been relatively modest, partially due to the fact that the Australian banking and finance industry weathered the GFC very well. Treasury Secretary Dr Ken Henry stated that “Australia’s banking industry has emerged from the GFC in a comparatively strong position” (Henry, 2010). The Australian government passed the National Consumer Credit Protection Act (NCCP), the Personal Property Securities Act (PPS) and the Bankruptcy Legislation Amendment Bill 2009. The Australian government has proposed a “Banking Reform Package”; however, it has still not been tabled.

The Dodd-Frank Act aimed to address several of the issues identified as causes of the GFC, reduce the amount of speculative investments on banks’ balances sheets, increase transparency through the establishment of a “swaps” exchange or clearing house (The Dodd-Frank Act Commentary and Insights, 2010), improvements to the regulation of credit ratings agencies, through the creation of an Office of Credit Ratings to provide oversight, mortgage reform, the establishment of mortgage standards and property appraisal requirements (Dodd–Frank Wall Street Reform and Consumer Protection Act, n.d.).

The NCCP’s goals were rather modest, which included comprehensive licensing regime providers of consumer credit, established responsible lending requirement of licencees, and expanded the definition of consumer credit to include and finance related to residential property (The National Consumer Credit Protection Reform Package, 2009). The PPS established a national registrar of personal property used as security for a loan, replacing previous state based registrars. The Bankruptcy Legislation Amendment Bill aimed at protecting consumers from bankruptcy by increasing the protections offered to bankrupts and increasing the penalties for those found to have defrauded their creditors (Bankruptcy Legislation Amendment Bill, 2009).

The National Consumer Credit Protection Act

In the immediate period following the collapse of Lehman Brothers, it became obvious that at the heart of the problem lay underwriting standards and poor prudence on behalf of lenders. In Australia, political pressure developed for the Commonwealth to assume responsibility for consumer credit and to legislate for increasing consumer protection. At the Council of Australian Governments (COAG) meeting in 2008, it was decided that the Commonwealth would assume responsibility by legislating a national credit code, replacing state-based codes. The legislation, known as the National Consumer Credit Protection Act, was enacted by royal accent in December, 2009 (Attorney Generals Department, 2009).

The legislation introduced a comprehensive licensing scheme for all those who deal in consumer credit. It introduced minimum training requirements, continuing professional development, management of conflicts of interest, risk management processes, financial requirements, insurance requirements, data security and storage requirements, and annual compliance checks. The licensing affected everyone from finance brokers to authorised deposit taking institutions. This sought to address the evidence from the US that Finance Brokers where responsible for many of the subprime mortgages originated and much of the predatory lending practices (Berndt, Hollifield and Sandas, 2010).

The legislation also put into place responsible lending conduct obligations. The obligations included the following:

  • A prohibition on the charging of fees by licencees where finance was not secured
  • A requirement that licencees make all reasonable enquiries about the consumers ability repay the loan without due hardship
  • That the credit contract cannot be “unsuitable”

This put into place a series of remedies for situations in which a financial product is unsuitable, including the following:

  • Criminal proceedings against licencees
  • Compensations orders against licencees

The implications of the NCCP

Under the NCCP, a lender needs to assess a borrower’s ability to complete the loan contract without undue financial hardship. Dramatically altering loan products available to borrowers, this legislation has had certain ramifications and implications; for example, lenders are no longer able offer loan products that extend beyond the term of the persons’ employed life (e.g. if entering into a 30-year mortgage, a borrower’s age cannot exceed 35. Since due hardship is generally defined by living below the Henderson poverty line (Department of Families, 2003) and all government benefits are given to those under the Henderson poverty line, another consequence is the prevention of all lending to those on benefits.

Fundamentally, the NCCP has transferred responsibility for determining if finance was suitable from the borrower to the lender. This has diminished the individual’s responsibility for determining what is affordable. The lender needs to make all “reasonable enquiries”; they cannot rely on the borrower’s declarations. A study by Veda Advantage identified that 18% of Australians have made misleading statements in their credit applications (Vainauskas, 2009). The implication that remedy could be made against the lender for not making “reasonable enquiries”, even in a situation where the borrower has made misleading statements, led a tightening of lending criteria (Lekakis, 2010) and reduced loan volumes (please refer to the graph below showing reduced loan volumes).

Source:, ABS figures

It also prevented banks from increasing credit card limits without making “reasonable enquiries”. The following graph shows the reduction in owner-occupied finance commitments following the introduction of the NCCP. The following graph shows the growth in credit card debt above an exponential trend line through the financial crisis but the decline below trend following the introduction of the NCCP.

(RBA, 2011)

ABS figures identify the level of securitised mortgages in December 2010 as $135,756 million of a $1,100,000 million market. Securitisation represents approximately 8% of total mortgages. Given the low percentage of total mortgages that securitisation represents, the agency cost associated with potential poor underwriting is quite small. Clearly, the NCCP has already stifled credit availability. The NCCP may also have impacts on asset prices and consumption.


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