1

International Macroeconomics

Chapter 1: The Global Financial Crisis

1.1 Introduction
1.2 Triggers and Amplification Mechanism
1.3 Policy Responses
1.4 Summary

Literature: Blanchard et al. 2010, Chapter 20

 The financial crisis – A failure of economic theory? 2

 With late 90’s, large house price increases in US and other countries.
• Increase cannot be explained by fundamentals (population growth, construction costs,
income growth,…).
• When boom collapsed, house prices began to fall (in US 30% from 2006-2009).

“At this point, the troubles in the subprime sector seem unlikely to seriously
spill over to the broader economy or the financial system.” (B.Bernanke, June 2007)

 Severity of the financial crisis of 2007-2008 came largely unexpected

• Similar experience: Stock market crash of 1997 (Dow Jones fell by 20.4% on a single day)
had almost no impact on consumption and growth.
• But after the crisis of 2008, US unemployment more than doubled, worldwide recession.
• Questions:
• „Why did nobody notice it?“ (Queen Elisabeth II, Nov 5, 2008)
• How could such a limited and localized event in the US cause a world wide
depression?

2
Real estate booms were a worldwide phenomenon 3

Fig: House price movements in 8 countries since 1980

3
Fundamental explanation 4
Efficient markets, the theory of market failure and the regulation of financial markets

 Beginning in the 80s, financial markets were deregulated worldwide.

 Adam Smiths “Invisible Hand” or the First Fundamental Theorem of
Welfare Economics: A competitive market equilibrium is efficient.
• Widespread perception in 80s and 90’s: market allocations are always efficient ⇒
minimize the impact of government interventions (deregulation, privatization, …)

 Problem: Several assumptions must be fulfilled for the FFToWE to hold.

• Complete markets
• Perfect competition – price taking behavior
• Perfect information
• No externalities, no public goods

 If these assumptions are not fulfilled, market failure is possible. Then a

government intervention may improve the market allocation.
• Possible interventions: regulation of markets, using policy instruments like standards,
taxes, subsidies, tradable pollution rights, …

4
Fundamental explanation 5
Market failure and government failure on financial markets

 Typical market failures on financial markets:

• Incomplete competition, oligopolies
• Widespread asymmetric information, e.g. between buyers and sellers of assets about the
quality of assets, especially those created through financial innovations (MBS, CDOs,
CDSs,…). Asymmetric information causes
- adverse selection or “lemon problems”: bad quality assets may crowd-out good quality
assets
- moral hazard: people change their exposure to risk if they do not have to bear the
consequences - innovations in risk management changed incentives to monitor risk
- principal-agent-problems: linking payment of bank managers to short-run indicators of
success distorted incentives
• Externalities: Interrelatedness of asset markets within and across countries (systemic
risks)

 Problem: A government intervention is not always welfare increasing -

government failure is possible
• Failure of regulation policy: deregulation and incomplete regulation facing market failure
• Failure of monetary policy: prevent asset price inflation (bubbles)
5
Triggers and amplification mechanisms 6

 Blanchard (2009, 2010) distinguishes two triggers and two

amplification mechanisms:
 Triggers:
(1) Financial innovations
(2) Increasing leverage of financial institutions

 Amplification mechanisms:
(1) Modern version of bank runs - the international connectedness through
interbank markets

(2) Need of financial institutions to maintain adequate capital ratios

6
 7

International Macroeconomics

Chapter 1: The Global Financial Crisis

1.1 Introduction
1.2 Triggers and Amplification Mechanisms
1.3 Policy Responses
1.4 Summary
Why did house prices rise in the US after 2000? 8
House prices were riding a bubble
 Problem: How to define a bubble
• ” I don't even know what a bubble means. These words have become popular. I don't
think they have any meaning.” Eugene Fama (2010).
• Theory of asset pricing: The price of an asset represents the expected present value
of future income streams (interest payments, dividends, rents,..).

 Demand side: A long period of low interest rates made borrowing

to buy a house very attractive.
• Recession after the burst of the dot.com bubble and 9/11, low inflation.
• Expectation: Due to recent experience – house price will rise forever.

 Supply side: Deregulation and financial innovations implied a

change in the rules banks follow to approve a mortgage.
• Deregulation: Restrictions on bank lending and equity requirements were relaxed.
• Financial innovations (MBS, CDO, CDS) allowed banks to shift their risks.
8
Changes in the behavior of banks 9

 Old days: Prudent behavior – loans were only given to prime

clients
• Reliable credit history, high down-payment, low loan-value ratio (on average
50%), fixed interest rate mortgage
• Reason: Banks kept mortgages in their books - risk that the mortgage is not
repaid – strong incentives to control quality

 Since 2000, mortgages were increasingly given to subprime

clients
• Subprime: Poor credit history, no secure income, high loan-value ratio (on
average 80% in 2006), variable interest rate mortgage (teaser rates)
• Share of subprime mortgages rose from 9% in early 2000’s to 30% in 2006
• Reasons:
- Banks were able to sell the risk by selling the mortgages to out-of-balance institutions - this
reduced both capital requirements and incentives to control quality of mortgages
- Buyers hoped that the value of their property will increase forever

9
Trigger 1: Financial innovations 10
Transforming efficient risk sharing institutions into weapons of mass destruction

 Securitization describes the creation of a new asset which is backed by

other securities (“derivatives”).
“In my view, derivatives are financial weapons of mass destruction, carrying
dangers that, while now latent, are potentially lethal.” Warren Buffet (2002)
 Problem: Are derivatives always bad?
 The bundling of mortgages to mortgage backed securities (MBS) was
not a new business model, but two innovations in the 2000’s.
• Innovation 1: The income streams of these securities were further bundled and sold
(CDOs).
• Innovation 2: Creation of synthetic CDOs (CDS: bets whether a referenced portfolio
will perform or not)
 What explains the increase in securitization?
• New models of risk assessment

• Expectation before the crisis: The USA will be better able to handle decreasing
housing prices, since the risk is borne by many investors.

10
Securitization Step 1 11
Creating a MBS (Mortgage Backed Security)

Borrowers Banks SPV • A MBS is secured by a pool

of mortgages
• All interest and principal are
simply transferred to the
mortgage 1 investor.
MBS
• Typical investors: pension
mortgage 2 funds, insurance
companies

mortgage n

 The effect on economic welfare is positive: Securitization improves the

risk allocation
• Relational diversification: Risks in the borrower-bank relationship (interest rate changes)
are transferred to institutional investors with a long time horizon.
• Portfolio diversification: Institutional investors gain access to new asset class.
• Regional diversification: Regional risks (e.g. due to banking regulation) can be pooled.
11
How securitization works 12

 Securitization describes the creation of a new asset which is backed

by other securities.
• As long as mortgages are kept in the books of a bank, it needs capital to protect
itself against the risks – this limits the possibilities to give new loans.
• The bank sells mortgages to an out-of-balance financial institution (SPV =
Special Purpose Vehicle) – this decreases capital requirements for the bank.
• The bundling of mortgages reduces the average risk of default of the mortgage
pool if the individual risks of default are not (too much) correlated.
• The SPV finances the purchase of mortgages by issuing bonds to investors
( = MBS: Mortgage Backed Security).
• The SPV gets the money for the interest payment on the bond from the stream of
income of the mortgages it holds.

12
Securitization Step 2 13
Creating a CMO (Collateralized Mortgage Obligations)

Borrowers Banks SPV • A CMO has several tranches

• Gives investors a specific flow of
income instead only a pass
through of interest and principal
mortgage 1
CMO
• Each tranche has a specified
claim on the mortgage portfolio,
senior tranche
mortgage 2 the lower tranches are
mezzanine tranche subordinated to the senior
tranche
junior tranche /equity
• The lower tranches are more
risky than the higher tranches -
mortgage n higher interest rate – if
mortgages are not repaid, the
value of the junior tranche falls at
first
 Tranching has further positive effects on economic welfare: It
reduces moral hazard in origination
• if originators were holding the equity tranches
• and if the probability of default of other tranches falls close to zero,
• then moral hazard is negligible.
13
Securitization Step 3 14
Creating a CDO (Collateralized Debt Obligation) = Creating sticks of dynamite

• CDOs used tranches of different CMOs, packed them often with tranches from other
securities (automobile loans, credit card loans … ) and tranched them again
CMO1 CDO CDO2
senior tranche senior tranche senior tranche

mezzanine tranche mezzanine tranche mezzanine tranche

junior tranche junior tranche junior tranche

CMO2
senior tranche

Problems:
mezzanine tranche

(1) Miracle of disappearing risk:

Senior tranches of CDOs, generated
junior tranche

from BB rated mezzanine tranches,

were usually rated as AAA.
CDO
CMO150
senior tranche
senior tranche (2) Risk assessment was based on wrong
mezzanine tranche
models and assumptions, risk went out
mezzanine tranche
of control.
junior tranche
junior tranche (3) Welfare effects – second (and third) layer
of securitization does not further improve
the risk allocation.
14
Moral hazard 15
Problem: Who controls the risk?
 Old days: The originator of a MBS kept the most risky tranche in its books ⇒
strong incentives to control the risks in the mortgage portfolio.
 New days: The most risky tranches were sold at first, because they provided
the highest interest rate.
• Banks had no longer an incentive to control quality of mortgages, since even very
risky mortgages were easily sold.
• Outside investors who bought the tranches had no information about the quality of
thousands of mortgages in the pool.
• Rating agencies had to evaluate the risk of the pool. E.g. the senior tranches typically
were rated as AAA (very secure, default risk almost zero), the equity tranches
received no rating (= extremely risky).
• Problem: The models rating agencies used were based on wrong assumptions about
correlations and on short time series only (with ever increasing house prices).

 Consequences:
• The risks of pooling mortgages and other securities were severely underestimated.

15
Consequence 16
Risk went out of control

Fabrice Tourre:
“More and more leverage in the system,
The whole building is about to collapse
anytime now…Only potential survivor, the
fabulous Fab[rice Tourre]…standing in the
middle of all these complex, highly
leveraged, exotic trades he created without
necessarily understanding all of the
implications of those monstrosities!!!”

(Email by Fabrice Tourre, GoldmanSachs, to a colleague

in January 2007)

16
Trigger 2: Increasing leverage of financial institutions 17

 Beginning in the 80’s, banks financed their activities with a decreasing

amount of equity.
• The high leverage of the banking system explains its vulnerability to shocks.
• The high leverage was accepted by regulators.

 Reasons:
• Banks: Internationalization, competitive pressure
• Regulator: Strong faith in efficiency of markets? Political objectives? Regulatory
capture?

 Further regulatory failures: Banks could reduce equity requirements by

transferring assets to out-of-balance institutions (e.g. structured
investment vehicles, conduits).
 Consequence: During the crisis, the value of assets declined
• The higher the leverage, the higher the likelihood of insolvency

17
Since the 80’s, leverage of banks increased dramatically 18

Figure: Leverage of banks in the UK and US (1960-2014).

18
 Amplification mechanism I: Bank runs 19

• Traditional bank runs were a common feature of earlier financial crises…

Los Angeles, 1910 Tokyo, 1927 Berlin, 1931

…but happened only once in the GFC.

 Expectation: Deposit insurance

makes banks safer.

London, 2007
19
Amplification mechanisms at work 20
International contagion through increased connectedness

 The main channels of transmission: Collapse of the interbank market.

 Interbank market:
• Banks heavily relied on short-run lending on the interbank market and on the market
for commercial papers.

• Interest rate: LIBOR (London Inter-Bank Offer Rate).

• Usually, the LIBOR is close to the rate at which banks can lend liquidity from the
central bank (Federal Target Rate in the US).

• Beginning in 2007, the LIBOR rose sharply, reflecting the liquidity crisis and the
increase in counterparty risks.

• Consequence:

- Banks were no longer able to refinance themselves on the interbank market

- Worldwide, many loans are based on the LIBOR – a higher LIBOR increases the
borrowing costs of millions of bank customers

20
The increase in counterparty risk is reflected by TED spreads 21

Source: Blanchard (2010)

21
Amplification mechanism II: Need to maintain capital ratios 22

 Starting point: Outbreak of crisis - the losses of banks reduce equity

 Banks have three strategies to increase capital
(1) Raise more capital through issuing new equity
- Almost impossible in times of banking crisis

(2) Reduce the amount of loans to shrink the balance sheet

- to firms: fewer new loans, expiring loans not renewed ⇒ credit freeze:
firms found it increasingly expensive and difficult to finance their investments,
investment expenditures collapsed
- to other banks: the value of assets of other banks was highly uncertain ⇒ interbank
market collapsed
- to households: consumption demand fell

(3) Sell other liquid assets (stocks) at whatever price: Firesales

- Stock market collapsed, worth of households other assets than houses fell,
consumption demand fell

22
International contagion through trade channel 23

• US imports, which accounted for 13% of

total world imports, fell by 46% (from
July 2008 to February 2009), since
consumers and producer stopped
spending.
• The overall contraction in international
trade reached 12% during 2009.
• Global economic activity fell for the first
time since 60 years.
• Contagion was larger in countries that
are more dependent on foreign trade
(e.g. Germany) and that have stronger
trade ties with the US (Mexico, Canada,
China, EU).

23
 24

International Macroeconomics

Chapter 1: The Global Financial Crisis

1.1 Introduction
1.2 Triggers and Amplification Mechanisms
1.3 Policy Responses
1.4 Summary
Policy responses to the crisis 25

 Monetary policy:
• Central banks slashed interest rates close to 0. Aim: reduce the lending costs of firms.
• Problems:
- Zero-Lower Bound: Interest rate cannot become negative.
- Credit squeeze: Banks did not lend to firms to improve their balance sheets.
• Consequence: Innovations in central banking - central banks used unorthodox
methods to affect long term interest (= policy of quantitative easing).

 Fiscal policy
• Governments reacted by increasing their expenditures (public investment programs)
and decreasing taxes to improve the income of households and firms.
• Consequence: Budget deficits surged dramatically

25
Traditional policy analysis 26
The effects of fiscal policy and monetary policy: IS-LM-analysis

 A rise in government spending  An increase in money supply

increases both income and the interest results in a lower interest rate and
rate. a higher level of income.
 Graphically: the IS curve is shifted to the  Graphically: the LM curve is shifted
right to the right

26
Quantitative easing 27
The “Zero-Lower-Bound” and the liquidity trap

 Traditional monetary policy addresses the short-term interest rate

• By changing the refinancing costs of banks, the central bank tries to affect the long-
term interest rate (e.g. for government bonds, corporate loans, corporate bonds,
mortgages, …)

 Problem:
• When the policy rate is close to 0, conventional monetary policy does not work any
more (= breakdown of the monetary transmission mechanism).

- The central bank is no longer able to affect the long-term interest rates
- Despite historically low short-term interest rates, long term rates were still
relatively high and banks were not willing to increase loans

 Theoretical model: Liquidity trap

27
The liquidity trap 28
Revival of an old Keynesian idea

i
MS,1 MS,2 MS,3 IS
MD LM1 LM2 LM3

M Y
B Y1 Y2

At very low interest rates, money demand This limits the effectiveness of
becomes perfectly elastic – if interest conventional monetary policy –
rates are close to zero (like in B), any monetary expansions can increase
increase in money supply is hold as cash. income from Y1 up to Y2 – then the
interest rate has fallen close to 0 and
further monetary expansions have no
effect on income and employment
28
There is not a single cause to explain the crisis 29

 Regulatory failure and market failure interacted

• Deregulation of financial markets encouraged new ways of lending funds and made it
easier for lenders to access funds.

 The risks of financial innovations were underestimated and

wrongly priced.
• Banks in the US increased lending to the sub-prime market at rapid rates.
• The resulting effects on the housing market of easier access to mortgages increased
demand and prices and fuelled the bubble.

 Incentives on financial markets distorted decisions

 Systemic risks were underestimated
• The high leverage of the financial system implied an extreme fragility of the system
and a tight international connectedness.
• Some banks were too big and too connected – their bankruptcy would have implied a
complete breakdown of financial markets, therefore the governments had to bail out
these banks (“too big too fail”, systemic risk).

29
Problems for the new regulation 30

 Problem 1: Too big to fail

• Aim: Address the “too big” part (force large banks to shrink) or the “to fail part” (force
banks to hold more capital, making it easier to wind down bust firms)

• Regulation achieved some success, e.g. Dodd-Frank act of 2010 (e.g. stress tests,
obliged banks to draw up “living wills”, banned deposit banks from proprietary trading
and from investing into hedge funds and private equity)

 Problem 2: Overhauling capital requirements

• Aim: Decrease leverage, force banks to strengthen their capital requirements (e.g.
Basel 3 accords)

 Problem 3: Improving macro-prudential regulation

• Aim: More transparent pricing and trading of assets (i.e. better monitoring of risk).

 Problem 4: Improving international coordination

• Aim: Coordinate regulation & national policies, monitor risk at a global level, organize
multilateral liquidity provision.
• Devise rules of sharing burden of possible recapitalizations, as national approaches
have large spillovers.
30
The current debate about capital requirements 31

 Due to the Dodd-Frank Act in US and similar regulation in Europe,

banks are safer than they were before the crisis.
• In the US, the ratio of the six largest banks’ tier-1 capital (chiefly equity) to risk-
weighted assets was at 8-9% before the crisis; since 2010 it has been 12-14%.

 Basel III is a global regulatory framework on bank capital adequacy,

stress testing, and market liquidity risk.
• It was agreed upon by the members of the Basel Committee on Banking
Supervision in 2010.
• It was scheduled to be introduced from 2013 until 2015; however implementation
was initially extended until 2019.

 Discourse between scientists, regulators and business:

• What should be the basis for capital requirements – total assets, total risky
assets, total risk-weighted assets?
• If risk adjustments are allowed – standard method or bank-based risk
adjustment?

31
The debate about capital requirements 32
Will the new regulation prevent a future crisis?

 Business: Regulation has gone too far

• Gary Cohn (Chief Economic Adviser of President Trump, until 2016 president of
Goldman Sachs) in 2017: “Because banks must hold more and more and
more capital, that capital is never getting out to Main Street America.”

 Scientists: Regulation has not gone far enough

• Admati and Hellwig (2013): Capital requirements necessary to make the banking
system safer should be around 20% of total assets without any risk-adjustments.

 Swedish experience
• After a severe banking crisis (and a partial nationalization of the banking system)
in the early 90s, Sweden has now the strictest capital requirements.
• CET-1 capital ratios of Swedish banks are higher than total capital ratios of most
international banks
• Despite this, Swedish banks are among the most profitable banks worldwide.

32
Total capital ratios and average return on equity 33
Selected international banks, 2010-2015

Source: Wejda 2016 33

Literature 34

Slide 34
Questions Chapter 1 35

(1) Which kind of market failures contributed to the financial crisis?

(2) Which kind of regulatory failures contributed to the financial crisis?

35