Lecture 7
Banking/Financial Crises and Regulation
1) Crises – Regulation – Sector Response – Re-regulation
a. In general, a crisis occurs, regulators and congress wake-up and place new
regulations on the industry in response
b. The financial sector then attempts to circumvent new regulations
c. Regulators respond by enacting more rules
2) Great Depression—Stock Market Crash of 1929
a. Prior the Glass-Steagall (1933) Commercial and Investment Banking
operations could be conducted under one roof:
i. Led to a conflict of interest between Bank Management and
Depositors—an Agency Problem
ii. Investment Bankers earn commissions through the sale of new
security issues—have incentives to sell as many issues as possible
iii. High quality issues (known companies) were easy to sell to the
public, speculative issues are hard to place (but earn very high
spreads)
iv. Banks used Deposits to purchase these low quality issues that they
could not sell otherwise, thereby increasing profits
v. Thus, Deposits were invested in issues most likely to default
b. Crash created by several factors
i. Stocks Bought on Margin (leveraged purchases) resulting in a
Market Overvaluation
ii. Firms reinvested profits from over production in unnecessary
production stock
iii. Commercial banks made loans to security dealers/brokers and had
purchased questionable assets to underwrite deposits
iv. Very little Regulation of financial reporting—stock market
rampant with fraud
v. Market Panic resulted in revaluation of stocks in a single day
vi. Savings accounts were wiped out when issues defaulted—financial
disaster
c. Transmission through the financial system
i. Loss of Liquidity—Resulting in Banks Closing Doors
ii. Loans called in to fulfill Obligations—transmitting effects through
the rest of the economy
iii. Can firms replace their financing? If not what happens and why?
iv. Is there a problem with the underlying operations of these firms?
v. How about issuing debt or equity – why don’t these firms just go
to the capital markets?
vi. How about home-owners, what’s happened to their loans?
d. Effect on the Economy
i. Firms and businesses forced to close doors because they cannot get
financing
ii. Workers laid off and Assets from the Businesses sold to pay off
debts
iii. The result is the complete destruction of viable US Businesses
iv. Management and Worker teams broken up, machinery and hard
assets liquidated at cents on the dollar—will never be reconstituted
v. Moreover, workers thrown out of work can no-longer make
mortgage payments, and are made homeless as their houses are
foreclosed on
vi. What is the material difference between this financial collapse
and a military attack that destroys manufacturing capacity and
housing—there are no dead bodies
vii. The Country has take an Economic Blow equivalent to that of
having fought a major war—it is a Permanent Financial Loss
e. This is what is called Disintermediation: A break-down of the financial
sector and resulting inability to connect those who wish to lend with those
who wish to save.
f. What didn’t the FED do?
i. Failed to properly supervise industry (Deposits require goodquality assets as collateral)
ii. Failed to act as a lender of last resort to support otherwise solvent
banks—thereby allowing the system to collapse
g. Regulatory Response
i. Glass-Steagall Act (1933): Separation of Commercial and
Investment Banking Operations
ii. Creation of FDIC (1934): Insure depositor accounts, monitor and
regulate Commercial Banking operations—prevent bank runs (loss
of liquidity)
3) S&L Crisis (1979-90)
a. Cause of the Crisis – high inflation
i. S&L industry relied heavily on long-term mortgages paying 8-10%
to finance Depositor Obligations
ii. S&L’s make money on the spread between the mortgage rate and
interest paid on deposits
iii. Double-digit Inflation resulted in the Market Interest Rate on
Demand Deposits exceeding that of the Assets (Mortgages)
iv. This resulted in Depositors moving money to other investment
vehicles
b. Response by Congress
i. Deregulation – Allow other investments
ii. Increase insurance ceiling on Deposits
iii. In theory, S&L’s would be able to compete against the banking
industry
iv. Intervened to prevent closure insolvent S&L’s (political reasons)
c. Change in Regulations resulted in Contagion
i. S&L industry inexperienced with non-real estate investments
ii. Agency Problems—many S&L’s in financial trouble had nothing
to lose by taking excessive risks (Zombie S&L’s)
iii. Zombie S&L’s began offering high interest rates attracting
depositor dollars from solvent S&L’s—investing in speculative
investments
iv. Dollar deprived solvent S&L’s hurled into financial distress
v. No investor scrutiny because of the increased Deposit Insurance
vi. Resulted in an industry collapse
d. What was the real problem?
i. High inflation—too much government spending and an oil
embargo
ii. Industry was designed for a stable interest rate environment
iii. Congress did not address this problem
e. Follow-up Government Response
i. FIRREA—Financial Institutions Reform, Recovery, and
Enforcement Act
ii. Altered regulatory structure putting FDIC in charge of monitoring
S&L’s
iii. Restricted S&L Investments and Increased Capital Requirements
iv. Formation of RTC (Resolution Trust Corporation)—to close
insolvent S&L’s and sell assets
v. Cost to tax-payers of delayed response—approximately 150 Billion
in 1990 dollars
4) Market Crash of 1987
a. Black Monday, October 19, 1987—Dow and S&P indices plummet 20%
in one day and 10% in preceding week. Cumulative losses approaching
30% of market value.
i. Market collapse follows a 5-year bull market, and nearly 30% runup in stock indices over preceding 10 months
ii. Collapse shakes market confidence, corporations unable to raise
funds or sell stocks
iii. Led by sell-off in futures market relating to Portfolio Insurance
Programs, also related to Program trading
b. Causes
i. Overvaluation—Stock Market Runs up 30% over preceding 10
months, in excess of predicted fundamentals
ii. Sharply increased use of Portfolio Insurance and Program Trading
coincides with Run-up during
iii. Technical Problems in executing Buy/Sell Orders—several orders
outstanding from previous Friday precipitate sell-off
iv. Disintermediation—dealers fail to maintain buy/sell positions
(insufficient capital), will not trade at market price
v. Sell-off may have been precipitated by index-future sales dictated
by Program Trading and Portfolio Insurance programs
c. Regulatory Response/Solutions
i. Circuit Breakers Instituted—If the S&P drops by more than 10%,
trading is halted until the next day—interrupts irrational trading
precipitated by investor herding
ii. Increased Capital Requirements for Dealers and Market Makers—
Ensures Dealers are standing ready to Buy at the market price, in
theory, preventing a panic
iii. Transaction Taxes—NOT IMPLEMENTED—the idea was to slow
order-flow and trades by establishing artificial economic hurdles.
The drawback is that such taxes will reduce market efficiency.
Volatility may actually increase because it will force more
simultaneous trades from discrete price changes.
5) Orange County Investment Pool Bankruptcy (1994)
a. Summary of the Crisis
i. Local Government Investment Pool announces unrealized losses of
$1.6 Billion on a $7.5 Billion dollar investment portfolio
ii. Funds deposited from cities, school districts, and other
municipalities within and outside the county
iii. Many of the municipalities borrowed short-term funds (1-year or
less) for investment in the pool, and were unable (or unwilling) to
roll these public borrowings because of the unrealized losses
iv. The result was that the Pool Declared Bankruptcy
v. Total losses rose to over $2.2 Billion as assets were hastily
liquidated and sold below market value
b. Causes
i. Bob Citron borrowed funds with an average duration of three
years, but invested in a portfolio with an average duration of five
years
ii. Effectively, the Orange County Investment Pool was borrowing
short and investing long
iii. The Investment Strategy would pay-off handsomely if interest
rates stayed low, but the Fed increased interest rates
iv. Why are rising interest rates a danger to fund value?
v. To accomplish the increase in duration, Citron used REPO
agreements and Inverse Floaters (Structured notes who’s payoff
varies inversely with the prevailing interest rate) see:
http://www.gsm.uci.edu/~jorion/oc/case.html
vi. Many of these agreements were tailored for the needs of the
County, thus illiquid
vii. How would that affect liquidation value of these securities?
c. Regulatory Response and Ramifications of Bankruptcy
i. Increased restrictions on Municipal Investments
ii. Stronger reporting standards, disclosure requirements and
monitoring for municipalities
iii. Forced bankruptcy and losses in a number of municipalities that
resulted in increased taxes, and reductions in infrastructure
spending and services—Orange County is still paying the debt off
6) Long-Term Capital (1998)
a. Massive Hedge Fund declares Bankruptcy
i. Highly leveraged—120 billion in assets, 4.8 billion in equity
ii. 40% rate of return in 1997
iii. Fund would make money by betting on bond “spreads”
iv. Market upheaval created financial losses that reduced asset value
to 80 billion, and fund equity to 600 Million
v. Several Major Banks and Financial Institutions invested with fund
b. Causes
i. Initially specialized in high-value arbitrage trades in the bond and
bond derivatives markets
ii. Fund made large bets on bond spreads: e.g. The fund would buy a
go long on undervalued bonds maturities and short over-valued
bonds with slightly shorter maturities to hedge—the bet is that the
spread narrows over time
iii. Russian Crisis and spillovers caused spreads to widen, causing
huge losses
iv. Problems further exacerbated by portfolio illiquidity
v. What characteristics are similar to the Orange County Investment
Pool Bankruptcy?
c. Economic Dilemma and Fallout
i. Major financial institutions have investments in fund
ii. FED concerned that fund losses will be transmitted to other
institutions
iii. One of the big concerns what that LTC was the counterparty in a
number of derivatives transactions—financial counterparties would
incur losses
iv. FED orchestrates plan for refinancing—creating a doctrine of “too
big to let fail”
v. What’s the potential Problem with the actions of the FED?
d. Regulatory Response
i. Some increase in Disclosure
ii. However, recognizing that increased regulation will simply drive
funds overseas, the approach has been instead to regulate the
sources of their funds—the other financial institutions
iii. See: http://www.cato.org/pubs/briefs/bp52.pdf
7) Creative Accounting Scandals of 2000
a. Enron, World Com, Tyco, Global Crossing, and Adelphi engaged in
improper financial reporting to inflate reported income, conceal losses,
and increase bonuses to management
i. Management bonuses are usually tied to quarterly net income
targets
ii. Increasing reported income increases contractually paid bonuses—
an Agency problem: Management has incentives to lie
b. Amortizing expenses
i. Expenses occur immediately and should be booked immediately,
amortization delays reporting of these costs thereby inflating net
income, and increasing profitability on paper
ii. Amortization of Investment Spending is Legitimate, Amortization
of Operational Expenses is not
iii. Booking expenses as Goodwill, which gets amortized, is one
variant of this trick
iv. Expenses reduce profitability of operations; since they occur each
year (unlike investment) they should be booked as they occur;
v. Several firms—e.g. Enron, World Com, Tyco, Global Crossing,
Adelphia, used these techniques to inflate reported net income and
profitability
vi. Eventually, losses must be realized
c. Limited Partnerships/Special Purpose Entities
i. Enron used a complex arrangement of financial agreements with
limited partnerships to conceal trading losses
ii. In general, Enron created and owned these partnerships, so it was
trading with itself: http://www.cato.org/pubs/pas/pa469.pdf
iii. However, it reported trades if they were with an outside entity
allowing it to book revenues and inflate profits
d. Improper Revenue Recognition
i. Revenue is normally booked over the life of a transaction as
economic profits are earned
ii. Enron and World Com booked revenues when deals were
consummated, allowing them to increase reported net income
e. Regulatory Response
i. Prosecution of Chief Officers for Fraud
ii. Stricter Financial Reporting requirements consistent with GAAP
iii. Require sworn statements from chief financial officers of 1000
largest firms regarding the truthfulness of financial statements
iv. In summary, Sarbanes-Oxley—drawback is implementation costs
8) Investment Banking Scandals of 2002
a. Merrill Lynch and Salomon Smith Barney accused of manipulating
analyst ratings to support investment banking operations
b. The Problem
i. Investment Banking earns fee’s (spread) for underwriting new
stock issues
ii. Positive analyst recommendations increase likelihood of new
issues by firms, and firms often engage banks because of coverage
iii. Analysts don’t earn fees
iv. This results in an Agency problem: the Bank has incentives to
give firm’s positive ratings to increase sales to investors
v. Investment Banking management began to pressure analysts for
positive coverage for client firms
c. Fallout and Regulation
i. Litigation and fines by the State of New York
ii. Signed agreements guaranteeing the autonomy of analysts
iii. Isn’t this similar to the problem that Glass-Stegall was supposed to
protect against?
9) The World Trade Center 2001
a. What was the event?—what got destroyed?
b. Why was 9/11 significant to the financial markets?
c. What industries were affected directly? What were the effects?
d. What was the effect on the US financial system? Why did it impact the
financial markets? Should this be considered a Financial Crisis?
e. What was the effect on the Economy?
International Crisis: http://www.stern.nyu.edu/globalmacro/
10) Mexico 1994 – What happened?
a. Mexico losing reserves, why?
 Political assassinations
 Perceived Instability
 Deficit Spending
b. Were there problems with the financial system?
c. De-regulation of Banks – Zero reserve requirement
d. Short term management of government debt
e. What was the result for the Mexican economy?
11) Asian crisis 1998
a. What countries were involved?
b. What were the banks doing? Were they the cause of the Crisis?
c. What was the effect on financial intermediation? On the economies in
these countries?
d. What happened to the ability of Asian Country’s to raise needed capital?
e. How did industries in these countries respond—did firms reduce
operations, close down, and lay-off employees?
f. How would you compare The Asian Crisis with Black Monday, or the
Great Depression? What are similarities, and what is different?
Banking Regulation
1) Regulatory Approaches Used:
a. Deposit Insurance and FDIC
 Passed by Congress in 1934, guarantees account against losses if
bank fails
 Purpose is to prevent bank runs
 Drawback is that depositors no-longer have incentives to monitor
bank and Banks have incentives to assume greater risks
 Requires additional government supervision to avoid Agency
b. Capital Requirements
 Establishes minimum levels for investor capital (stockholder
capital) as a percentage of total assets
 Purpose is to provide a buffer against asset losses
 Newer requirements reflect the risk of the bank’s assets
 Drawback: creates regulatory arbitrage; banks attempt to
maximize risk/returns, given the requirements
 Bazel Accord provides guidelines for International Standards
c. Restrictions on Asset Holdings
 Designed to limit risk in Bank’s Asset Portfolio
 Can effect capital requirements
d. Bank Supervision
 In United States, conducted by FDIC (Member Banks),
Comptroller of Currency (National Banks), FED (Members of
Federal Reserve System), Office of Thrift Supervision (Thrifts),
and State Regulators (State Banks)
 Authority is often overlapping
 Banks given a rating: CAMEL (capital adequacy, asset quality,
management, earnings, liquidity, and market risk)
 Because financial innovations can allow solvent banks to get
themselves in trouble very quickly, banks now being evaluated
on Risk Management Practices
e. Disclosure Requirements
 Increased public disclosure of bank risks
 The purpose is to get public/private entities involved in bank
monitoring, e.g. create bank analysts
f. Competition Restrictions
 Competition previously controlled by limiting charters
 Can lead to an agency problem where competing banks take on
greater risks (unseen by the public) to offer greater returns
g. Too Big to Fail
 Policy implemented by Fed, requires intervention to prevent
failure of large banks
 Perversely, large banks have increased incentives to take on
greater risks
 Has been extended to other financial institutions, e.g. Long Term
Capital, often engaging in very risky transactions
 Creates a bias in favor of larger institutions
2) Major Legislation
a. Federal Reserve Act (1913)—Created FED as lender of last resort
b. McFadden Act (1927)—Branching restrictions across state lines
c. Glass-Steagall (1933)—Separation of Commercial and Investment
Banking Operations
d. Creation of FDIC (1934)—Deposit Insurance
e. Regulation Q—Interest Rate Ceilings
f. Depository Institutions Deregulation and Control Act (1980)
 Phased out interest rate ceilings
 Uniform reserve requirements
 Increased Deposit Insurance
 Widened latitude of Thrift Activities
g. Garn-St Germain Act (1982)
 Widened latitude of S&L investments—deepened S&L crisis
 Power for FDIC/FSLIC to merge banks across state lines
h. Financial Institutions Reform, Recovery, and Enforcement Act (1989),
FIRREA
 Funds to close bankrupt S&L’s
 Eliminated FSLIC
 Created Resolution Trust Corporation to resolve insolvent S&L’s
 Re-imposed restrictions on investing
i. Federal Deposit Insurance Corporation Improvement Act (1991)
 Recapitalized FDIC
 Limited too-big-to-fail-policy
 Creation of risk-based insurance premiums
 Increased supervision and capital and reporting requirements
j. Riegle-Neal Interstate Banking and Efficiency Act (1994)—allows
branch banking across state lines
k. Gramm-Leach-Bliley Financial Services Modernization Act (1999)
 Repeals Glass-Steagall
 Widens Bank investing activities to compete with Europeans
l. Sarbanes-Oxley: Public Company Accounting Reform and Investor
Protection Act (2002)
i. Increased criminal penalties for financial reporting fraud
ii. CEO’s/CFO’s must certify validity of quarterly financials
iii. Costly external supervision of internal audit controls