What was the Global Financial Crisis, and what were the major policy and

regulation responses to it?

1. The primary causes of the Global Financial Crisis (also known as the
financial crisis of 2007/8).

It began with mortgage dealers who issued mortgages to borrowers, who were often families
that did not qualify for ordinary home loans. Some of these subprime mortgages carried low
“teaser” interest rates in the early years that ballooned to double-digit rates in later years.
Some included prepayment penalties that made it prohibitively expensive to refinance.
In 2007, when sky-high home prices in the United States finally turned decisively downward,
housing bubble burst, more and more mortgage holders defaulted on their loans.
Excessive financialization without understanding the connected risks was another primary
reason for the crisis. Instruments such as MBS (mortgage backed securities), CDSs( Credit
Default Swaps) were being traded extensively, but few people understood the complexity
behind these instruments. A lot of these were connected to the same underlying risks, and
when the risk materialized, all the instruments connected with them saw a collapse as well.

2. The market features and conditions that constitute a financial crisis in

general.

● Widespread failures in financial regulation and supervision: widely accepted faith in the
self-correcting nature of the markets and the ability of financial institutions to effectively
police themselves effectively stripped away key safeguards, opened up gaps in oversight of
critical areas.
● Dramatic failures of corporate governance and risk management at many systemically
important financial institutions: Too many of these institutions acted recklessly, taking on
too much risk, with too little capital, and with too much dependence on short-term funding.
They took on enormous exposures in acquiring and supporting subprime lenders and
creating, packaging, repackaging, and selling trillions of dollars in mortgage-related
securities, including synthetic financial products.

The leverage was often hidden in derivatives positions, in off-balance-sheet entities, and
through “window dressing” of financial reports available to the investing public. The kings of
leverage were Fannie Mae and Freddie Mac, the two behemoth government-sponsored
enterprises (GSEs). For example, by the end of 2007, Fannie’s and Freddie’s combined
leverage ratio, including loans they owned and guaranteed, stood at 75 to 1.
● Systemic breakdown in accountability and ethics: these breaches stretched from the
ground level to the corporate suites. Some borrowers likely took out mortgages that they
never had the capacity or intention to pay.

3. How the primary causes of the Global Financial Crisis which led to the
features of a financial crisis

Collapsing mortgage-lending standards and the mortgage securitization pipeline lit and
spread the flame of contagion and crisis: From the speculators who flipped houses to the
mortgage brokers who scouted the loans, to the lenders who issued the mortgages, to the
financial firms that created the mortgage-backed securities, collateralized debt obligations
(CDOs), CDOs squared, and synthetic CDOs: no one in this pipeline of toxic mortgages had
enough skin in the game. They all believed they could off-load their risks on a moment’s
notice to the next person in line. They were wrong. When borrowers stopped making
mortgage payments, the losses amplified by derivatives—rushed through the pipeline.
Loose financial regulation and supervision: The enactment of legislation in 2000 to ban the
regulation by both the federal and state governments of over-the-counter (OTC) derivatives
was a key turning point. In October 2004, the Securities Exchange Commission (SEC)
relaxed the net capital requirement for five investment banks - Goldman Sachs, Merrill
Lynch, Lehman Brothers, Bear Stearns and Morgan Stanley, which freed them to leverage up
to 30-times or even 40-times their initial investment. Policy makers and regulators could
have stopped the runaway mortgage securitization train. The 1999 repeal of the Glass-
Steagall Act effectively removed the separation between investment banks and depository
banks in the United States.
Credit rating agencies and investors failed to accurately price the risk involved with
mortgage-related financial products, and that governments did not adjust their regulatory
practices to address those risk.

4. The response of policymakers and regulators to the global financial crisis.

The crisis resulted in an acute liquidity and credit crunch. To avoid these from further
leading to a deflationary spiral, various governments and central banks took several
important steps that involved the following:
i. Injection of Liquidity by Central Banks: through mechanisms like lowering of
central bank interest rates, Open Market Operations, special lending windows for
both banks and non-bank financial institutions, massive asset purchases by the
central banks (Quantitative Easing).
ii. Fiscal stimulus by governments: through various packages, which involved tax
cuts and increased spending by the government (for example, through the
American Recovery and Reinvestment Act of 2009 in USA)
iii. Bank Recapitalisation and mergers: Banks’ capital had suffered major erosion
due to losses on their holdings of assets (like Mortgage Backed Securities) during
the crisis. Therefore, deposit and debt guarantees were provided by the
governments whilesomebanks were recapitalised (for example, the Capital
Purchase Program under TARP-Troubled Asset Relief Program), and some were
merged with other banks (eg. Bank of America acquired Merrill Lynch)

5. The intended effects of policymakers’ and regulators’ responses.

The above responses by Central Banks and governments were broadly aimed at treating the
symptoms of the crisis, and help restore normalcy in the system. The specific intended
effects of the above responses were as following:
a) The crisis had created breakdown of normal lending and borrowing operations. By
opening various avenues for lending, central banks allowed the normal working operations
of financial institutions and other businesses to continue.
b) Based on Keynesian economic theory, stimulus packages by the government sought to
prevent job losses, promote economic recovery by investing in some segments of the
economy.
c) Bank recapitalization had to be resorted to because what was initially perceived to be a
liquidity crisis, was moving forward to become a solvency crisis. This was supposed to allow
banks to continue lending, and help prevent a recession from starting.Also, because some of
the banks involved were ‘too big to fail’, and their failure might have created contagion
effects in the global economy, it was considered necessary to support their existence by
measures like recapitalisation and mergers.
Thus, by artificially pumping in more money into the voids created by the financial crisis, the
policymakers and regulators sought to bring back normalcy in the financial markets as well
as in the real economy.

6. The downsides and unintended consequences that can occur when applying
regulation and policy to the financial markets.

Post 2008 financial crisis, various international standard setting bodies such as the FSB and
IOSCO have designed global frameworks as per the need of different jurisdictions. However,
the implementation of internally agreed policies at the country level has been incoherent.
This has broadly resulted into unintended consequences such as market fragmentation,
complex implementation challenges and policy frameworks which are at times contradictory.
Often, while applying regulation and policy to the financial markets, inappropriate data is
analysed along with improper distinction between causality and correlation, resulting in
policy errors. This also has the more serious repercussion of sending the market mixed and
inconsistent signals by the regulators.
As demonstrated in an RMA Journal article titled “Regulators Responsive to Community
Bank Concerns”, dated October 2014, the most important risk facing community banking
institutions is regulatory risk post the crisis. The increased compliance risk also added to the
costs of these community banks, which would reduce their mortgage and consumer lending
business.
Regulations that seek to keep a check on the financial system using some ratios and their
prescribed regulatory values, often miss the big picture. Stringent focus on numbers
incentivises manipulation of the data, thereby allowing problems to continue even though
the numbers may look fine in isolation.
Another unintended consequence of the increased regulations has been the rise of the
shadow banking industry throughout the world. This has not only dampened efforts to
reduce overall systemic risk of the financial sector but also affected central banks’ ability to
influence credit growth.

7. The features of financial markets which often need regulation

The intermediating function fulfilled by the financial markets is primarily the feature
requiring market regulation. The asset transformation function of the financial markets
present a strong case for the need of regulations. This stems from the opaque nature of assets
held by such intermediaries, which hides and true value from stakeholders and causes
information asymmetry.
The cohesion and interconnectedness of financial markets with the rest of the real economy
is another feature which necessitates regulation to manage the systemic risk posed by the
financial markets in times of stress.
The levels of leverage and the risks associated with various financial instruments-both new
and old- need regulation as well, since manipulation of these features is associated with more
profits, and is likely to be abused through creative accounting.

Submission 2: Evaluation of Regulatory Response

i) a specific outline of the regulation itself

The Dodd-Frank Act of 2010 was a major reform brought in after the 2008 crisis. It
sought to regulate the financial sector better by the following measures:
1. Creating the Financial Stability Oversight Council (FSOC) to better manage
the systemic risks, and ensure inter-regulator co-ordination. Financial firms
that were too big and systematically important were to be more tightly
regulated-i.e. higher capital and liquidity requirements, stress tests, stricter
leverage limits, etc.
 2. Financial institutions were asked to prepare ‘living wills’ where they would
outline their plans for an orderly windup in case of a distress, thereby
avoiding panic in the system and the for need for taxpayer’s money.
3. The Volcker Rule- bringing back the limitation imposed by the Glass-
Steagall Act on banks, i.e. barring deposit taking banks from proprietary
trading and limiting speculative trading. It also minimized banks from
investing in hedge funds and private equity, as well as in derivatives.
4. Derivative trading was to be made transparent by setting up central clearing
houses and regulating the complex OTC derivatives.
5. Creating a Bureau of Consumer Financial Protection to protect individual
consumers from industry abuses. It would look after credit and debit cards,
consumer loans, credit fees, and making the terms and conditions of loans
simpler for consumers to understand.
6. The SEC Office of Credit Ratings was established to oversee credit rating
agencies’ methodologies.
7. Reforms at the Federal Reserve: The Government Accountability Office got
powers to conduct several additional audits of the Fed. The Fed got overall
responsibility for financial stability.
8. Emergency federal assistance to individual institutions was to be curbed or
limited.

ii) the intended effect of the regulation, and some context for why it was
deemed necessary

Context: The 2008 crisis clearly showed the world that the financial sector needed
major reforms. The evolution of the financial system over the years had involved
elements that were supposed to make the system more resilient to shocks. Yet the fact
that a crisis of this magnitude and severity happened despite the existing measures,
proved that further reforms were required in several areas of the financial system.
The Dodd Frank Act was therefore aimed at fixing the loopholes that emerged during
the crisis, as well as putting new safety features that could prevent such events in the
future.

The crisis had its visible cracks in the subprime mortgage sector and therefore
initially, it was expected that things would normalize once the housing market cooled.
However, when the mortgage defaults started, the derivatives and other securities
backed by these mortgages lost value, and institutions could not rely on these as repo
securities anymore. Everyone wanted their money back, and this led to a liquidity
crunch as the financial institutions did not have enough capital and were highly
leveraged. Big financial institutions had to be rescued by acquisitions (for example,
Merrill Lynch), bailout loans (for example, AIG) while others had to file for
bankruptcy (Lehman Brothers).

Intended effect of regulation: It was clear that gaps were seen in the way financial
institutions were regulated-in areas like capital regulation, proprietary trading, hedge
fund investments, etc. Improper use of securitisation, derivatives and the role of
credit rating agencies were some other areas which required attention and reforms.
Dodd Frank Act intended to plug the loopholes in these areas.

The Financial Stability and Oversight Council and the Office of Financial Research
were created to identify and handle the sources of systemic risks. They could label
some institutions as Systematically Important, and subject them to stricter regulatory
norms, so that their probability of failure decreases, and thereby minimise the risks
posed by such large entities to the entire system.
 Bank regulation in general was also tightened significantly, as over 500 banks had
failed during the crisis, and many others had come under stress. For example, capital
regulation for bank holding companies and non-bank financial companies was
brought to the level stipulated for banks. Through the “Volcker Rule”, banks were
prohibited from risky activities like proprietary trading in risky assets and from
associating with hedge funds and private equity funds. Similarly, for derivatives
trading, which is still considered risky by many, the Act tried to bring in some
transparency by mandating that derivatives trades would have to be conducted on
exchanges and settled through central clearing houses.

To manage the resolution of failed financial firms without wasting taxpayers’ money
and creating moral hazard, the Orderly Liquidation Authority was established, but it
was to be applicable only in extraordinary circumstances. All financial firms would
now have to come under the Bankruptcy Code unlike in the past. This was intended
to reduce the moral hazards associated with resolution of financial firms while
managing the stability of the system at the same time.

Indiscriminate securitisation had played a big role in linking the defaults in the
housing sector to the wider financial sector. To curb such linkages of a risky nature,
the Dodd Frank Act required the originator to retain a party of the loan and thereby
maintain their skin in the game, especially if the loan had not been adequately
collateralized.

Thus, as can be seen from an outline of the main provisions described above, the
intended effect of the Act was to make the financial system safer and resilient,
without imposing too much burden on the same.

iii) an explanation of how this fits into the general theme and rationale of
financial regulation in general

To understand how the Dodd Frank act fits into the general theme and rationale of
financial regulation, we need to briefly look at the history of US financial regulation.
The Wall Street crash of 1929 and the ensuing panic had weakened many banks that
had speculated in the stock market, and their failures accelerated the Great
Depression. As a response President Franklin D. Roosevelt’s had introduced the New
Deal. The Banking Act of 1933 ("Glass-Steagall") established the Federal Deposit
Insurance Corporation (FDIC) and several other regulations, including preventing
deposit-taking commercial banks from speculating on stocks. These reforms were in
essence similar to parts of the Dodd Frank act. Further, in 1934 the Securities and
Exchange Commission (SEC) was created to regulate securities trading.

President Bill Clinton had signed the Gramm-Leach-Bliley Act of 1999, which erased
the barrier between commercial banks and investment banks introduced by Glass-
Steagall restrictions. In the wake of the 2007 financial crisis, attention turned
towards perceived regulatory failures to curtail excessive risk taking by financial
institutions, thereby posing systemic risks. Thus Dodd-Frank established FSOC to
address such systemic risks and ensure better coordination between regulators.

The general theme has been to address institutions that are "too big to fail," or
perhaps more accurately, "too interconnected to fail." This is ensured by FSOC
flagging such financial firms, included entities other than banks, for stricter oversight
by the fed, including imposition of short-term debt limits, risk-based capital
requirements that include off-balance sheet activities, annual stress tests, and a 15-to-
1 leverage limit.
 Another general regulatory theme was to ensure orderly liquidation of assets of a
systemically important entity, in the event of a bankruptcy, without jeopardising the
larger economy. To this effect, the Dodd-Frank Act established a procedure for
restructuring or liquidating failing financial firms that would pose a danger to the
U.S. financial system if traditional bankruptcy was pursued. Orderly liquidation
authority was granted to regulators to deal with the failure of large, complex financial
institutions.

A major regulatory theme, in the wake of the financial crisis has been to revert to
regulations which restricted the banks risk taking ability and ensured systemic
stability, but had been repealed. The Glass-Steagall Act had barred deposit-taking
banks from conducting proprietary trading. Its repeal with the Gramm-Leach-Bliley
Act (1999) led to proliferation of trading by major banks. In the wake of the financial
crisis, former Fed chairman Paul Volcker proposed banning proprietary trading by
these banks, reasoning that financial firms backed by government deposit insurance
should not be permitted to trade speculatively for their own benefit.

Post 2008 regulations have also focussed on increasing the transparency of the
opaque OTC derivatives market and controlling the risk taking ability of financial
institutions. To this effect, Dodd-Frank brought new regulations to the OTC
derivatives market. Financial firms must use derivatives clearinghouses, where
traders post capital once a contract is open to cover potential losses, thus limiting the
bets a firm can make. The act also mandates that most derivatives that go through a
clearinghouse must be traded through a regulated exchange or on a trading platform
that meets specific requirements. This adds transparency to pricing. Rather than
discussing the price with one dealer, a trader can see the market rate for a particular
contract.

iv) a description of some of the possible downsides and/or intended

consequences of the regulation.

As is the case with most regulations, there were some downsides to the Dodd Frank
Act also, even though it was designed to make the system more resilient. The
downsides are as follows:

a) Fewer and bigger banks: Because the legislation will be so costly to comply
with, banks will have more incentive than ever to consolidate into the sort of
"too big to fail" banks the bill was designed to stamp out.
b) Tighter trade credit: One largely overlooked Dodd-Frank provision will
require banks to comply with new liquidity, as well as capital, standards. That
includes backup liquidity lines. This could have a negative effect on the ability
[of banks] to extend trade credit
c) Fewer mortgages: With Dodd-Frank, negative press and pressure to buy back
soured home loans, big banks are becoming increasingly inclined to pull out
of the mortgage business.
d) Small banks which do not fit neatly into standardized financial modeling, will
find it more difficult to obtain credit, which will force community banks to
merge, consolidate, or go out of business. Increased regulatory burden
weakens its competitiveness as compared to other financial institutions
e) Higher consumer costs: With higher regulatory costs, including debit card fee
caps imposed, banks are hiking fees elsewhere.
f) Explicit and implicit government guarantees, such as deposit insurance and
too-big-to-fail, can generate significant moral hazard in the form of risk-
taking incentives. Even without other market failures, this moral hazard can
lead to excessive systemic risk and financial fragility.
v) verdict on how ii) and iv) compare

While trying to weight the intended effects of the Dodd Frank act against the
possible downside and intended consequences of the Act, it is helpful to mention the
2 goals that this act set out to achieve. Its first objective is to limit the risk of
contemporary finance, often called the shadow banking system; and the second is to
limit the damage caused by the failure of a large financial institution. The Dodd-
Frank Act tackles the first task by putting brand-new regulatory structures in place
for both the instruments and the institutions of the new financial world. The
principal instruments in question are derivatives. To better regulate institutions, the
Dodd-Frank Act singled out the financial institutions that are most likely to cause
system wide problems if they fail, and subjected them to more intensive regulation.

Some of the regulatory measures of the Act have been more successful than others.
Increased capital requirements (unlike before the Great Recession when banks held
too little capital) have been a clear success of the Dodd-Frank Act. The creation of
the Consumer Financial Protection Bureau (CFPB) has been another positive move.
The CFPB combined consumer protection under 1 agency, to crease a level playing
field between banks and consumers.

The Act also has its share of imperfections and criticisms. Dodd-Frank has
eliminated the use of some regulatory tools in its restrictions on The Federal
Reserve and Federal Deposit Insurance Corporation (FDIC). During the Great
Recession, The Federal Reserve utilized emergency lending to ensure banks did not
fail and ease investor concerns. Similar to the Federal Reserve, the FDIC effectively
used its Deposit Insurance Fund to aid the banking system by resolving failing
banks. Under Dodd-Frank, the Fed and the FDIC do not have the ability to step in
and act decisively as they did in 2008 and 2009. In the event of another large
financial crisis, there will be no authority with the power to act quickly and
decisively to restore confidence and impose a comeback.

Apart from the clear successes and shortcomings, a few provisions of the act lie
somewhere in the middle with uncertain trade-offs. For these provisions it is yet to
be seen whether the substantial costs at which these have been successfully
implemented, are compensated by the benefits from these provisions. The Volcker
Rule is one such provision, which is very controversial, and falls into the costly
trade-off category. Proprietary trading was outlawed in Glass-Steagall, but those
provisions were repealed in the 1980s and 1990s. Banks have argued that following
the Volcker rule will make doing business more expensive and therefore hurt
consumers. Its proponents argue that eliminating the risk that the proprietary
trading posed to the economic system will be worth it.

Dodd-Frank has affected different individuals and groups in distinct ways. A section
of people, claim that the financial system is more stable because of the act and that
the average American citizen can be more confident that their investments and
savings are safe. While there is no way to know for sure, it seems the added reserve
requirements and the CFPB are two of the strongest pieces of Dodd-Frank and have
almost certainly strengthened the stability of the United States’ financial system.
Whether the costs of this strengthening outweigh the benefits remains to be seen.

Dodd-Frank is also criticised for adversely affecting small community banks (banks
with less than $1 billion in assets). Due to the complex and at times convoluted
portions of the legislation, banks have seen compliance costs rise substantially. This
has made business more difficult for small community banks, which make up 94%
 of all banks in the US. While bulge-bracket banks can afford to have large
compliance departments ensuring they are following the rules, community banks
cannot. Due to the added costs, more community banks have consolidated with
larger banks, which is what Dodd-Frank aimed to prevent. Most market participants
believe Dodd-Frank has been a success in some ways and failed in others.

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