The 2014: Living in the Shadow of Regulation? White Paper | The Crash

Part three of our Success Series over regulation white paper continues. This week we look at the crash itself, at the TED spread, quantitative easing, and containing the contagion of collapsing institutions.

On 9th August 2007 banks stopped lending to each other. They were over-extended. Banks lost confidence in the system as a whole.

TED SPREAD MEASURES THE SHOCK

The TED Spread measures the difference, in percent, between the market rate on three-month Treasury Bills, considered the safest in the world, and three-month LIBOR, the rate banks lend to each other in the money markets. In the money markets banks lend to each other with no collateral whatsoever. In the past, when banks trusted one another, the interbank lending rate was the lowest in the market, not unlike the interest rate for government bonds. But a wide gap had developed between the two rates since the crisis erupted. As such the TED Spread was considered the most reliable seismograph of the crisis. The TED Spread was considered the most reliable seismograph of the crisis.

The more recent scandal over LIBOR has led to new measures to ensure that banks lending to each other is controlled, transparent and fair.

As credit default rates continued to rise exponentially, demand for CDS insurance rose sharply. It became apparent to organisations such as AIG, Bear Stearns and Lehman, who were all over-exposed, that they were in deep and unexpected trouble, each requiring central bank intervention and taxpayer assisted bailouts. Lehman was allowed to fail, AIG received an $85 billion taxpayer bailout and the IMF predicted a $1 trillion write-off for banks.

Bear Stearns collapsed on 10 March 2008 after a run on its funding supply by the market and by 16 March 2008 it had been quietly acquired by JPMorgan with the help of a $30 billion
taxpayer bailout.

Banks and investors with exposure to subprime would suffer the greatest losses. The Basel II regulations proved to be wholly inadequate in preventing the failure of banks and no mechanism was in place at that time for orderly resolution of a bank deemed too large to fail. The Basel II regulations proved to be wholly inadequate in preventing the failure of banks and no mechanism was in place for a bank deemed too large to fail.

For a variety of reasons related to central banker policy and regulatory constraints a number of banks did not receive assistance in time, a slowness of response that caused some reputational damage for the likes of Mervyn King and Ben Bernanke, and led to the fire sale of Lehman and Northern Rock, events which many argue were big mistakes.

A key feature of the new regulation will be implementation of measures to ensure the orderly resolution of banks – there will be no too large to fail.

Of course, businesses do fail so we might have asked what was the big deal. However, unlike many businesses, banks are interconnected to the growth and health of the wider economy and when a large bank fails, it can bring everything else down with it.

CONTAINING CONTAGION

The near-collapse of AIG sent tremors through the financial markets that would eventually spill over onto Main Street. It was not possible to contain the contagion! The National Bureau for Economic Research declared that the US recession had officially started in December 2007, based on a series of indicators, such as growth, production and employment. Reports surfaced from manufacturing companies worldwide, warning about a sudden drop in orders. In the US the car industry found itself in trouble. In Europe and Asia too, the crisis suddenly began to reflect the real economy. And at that point it became a political issue. Most economists at that time were still predicting a mild recession, however by November and December 2008, the global economy deteriorated at a pace not seen since the great depression. In three months alone, global trade volumes were down 20%.

Conditions seemed to improve towards the end of the year and policy makers became more hopeful that an economic meltdown could be avoided. But as the year drew to a close and ever more banks disclosed subprime related losses, nervousness increased again. Conditions seemed to improve towards the end of the year but as the year drew to a close and ever more banks disclosed subprime related losses, nervousness increased again.

In an unprecedented coordinated action on 12th December the Bank of England, the European Central Bank, the US Federal Reserve, the Bank of Japan and the Swiss National Bank announced that they were prepared to pour billions into the money markets. This was intended to keep the global economy healthy through a tricky period, but brought only short term relief; central banks found themselves repeating the exercise in March 2008.

Confidence in the banking system was gone, undisclosed losses were mounting on balance sheets and distrust was widespread. Globalisation meant that the banking crisis could not be contained in one market.

From Los Angeles to London banks turned business away, lending limits were cut and rates increased. Overnight it became harder to get a mortgage and available mortgages suddenly became a lot more expensive. Lenders reshuffled their loan portfolios and re-priced risk tracker deals. Trackers linked to the interbank rates rose sharply. LIBOR had decoupled from the official rate by some 200 basis points and special deals all but vanished. Overnight it became harder to get a mortgage and available mortgages suddenly became a lot more expensive.

CENTRAL BANKERS PRINT MONEY

The Fed allowed short term interest rates effectively to fall to zero in November 2008, having hit the “Zero Bound”. Short-term rates cannot go below zero, and at that point alternative strategies were adopted in support of the economy. The Fed commenced a policy of quantitative easing (QE), more commonly known as “printing money”.

The failings of the Basel regulations and the behaviours that led to the crisis were manifold, and this is now reflected in the new regulatory reforms, the exact nature of which is being determined by the jurisdictions within which the banks reside.

Next week: The Regulatory Reform

A look at the Banking Reform Act, the ring-fencing of banking, corporate governance and payday loans.

Written by Eric Bigham. Founder and owner of Bigham Consulting.

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Victoria Walmsley's picture
Managing Director
vwalmsley@morganmckinley.co.uk