Running Head: FINANCIAL CRISIS AND ITS IMPACTS ON FINANCIAL INSTITUTION

Portfolio Project – Option #1

Flavia Bates

FIN 550 – Financial Market and Institutions

Colorado State University – Global Campus

Dr. Steve Syrmopoulos

September 6, 2020
FINANCIAL CRISIS AND ITS IMPACTS ON FINANCIAL INSTITUTION

Financial Crisis and Impacts on Financial Institution

Introduction

The financial crisis that began in 2007 – sometimes also referred to as the great recession -

was primarily triggered by the excessively risky behavior of financial institutions, especially in

the mortgage-backed security market (Andrew, 2009). The crisis affected many organizations,

including financial institutions and markets. This paper will discuss the factors that can be linked

to the financial crisis, as well as its impact on market liquidity, and the manner in which risk was

managed during this period.

The Financial Crisis and Factors that Led to it

The global financial crisis of 2007-2009 was caused by many different factors which are

often disputed among experts, however there is a general agreement that deregulation in the

financial industry played a major role in the way things played out. Twight (2015) lists five

critical elements that were critical as the crisis unfolded: (1) Irresponsible risk taking by banks,

which were encouraged by government actions; (2) government guarantees to banks believed to

be “too big to fail”; (3) government “affordable-housing” initiatives that supported home

ownership regardless of borrowers’ incomes and credit histories; (4) flexible Federal Reserve

(Fed) monetary policy, which supplied liquidity that sustained imprudent borrowing and lending;

and (5) erosion of the rule of law resulted from overbroad discretionary federal power.

Now, going deeper on how the aforementioned factors were detrimental for the crisis, we can

start by discussing the Fed’s role. Fearing a recession, between May 2000 and December 2001,

the central bank of the U.S. reduced interest rates 11 times, from 6.5 percent to 1.75 percent

(Duignan, 2019). This allowed banks to offer consumer credit at a lower rate to low-risk

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customers, but also encouraged them to go after subprime customers. The cheap money caused

the demand for houses to skyrocket and house prices to spike up, leading to the creation of a

housing bubble. Subprime lending became a highly profitable investments for many banks, so

they started offering loans to customers with poor credit or few assets, knowing that those

borrowers could not afford to repay the loans and often misleading them about the risks

involved.

Another practice that contributed to the growth of subprime lending was securitization, which

allowed banks to bundle a high number of subprime mortgages and other, less-risky forms of

consumer debt and sell them in capital markets as securities (bonds) to other banks and investors,

including hedge funds and pension funds (Duignan, 2019). This appeared to be a great deal, as

banks that sold these mortgage-based-securities (MBS) increased their liquidity, while investors

that purchased them were able to diversify their portfolios. However, this caused the risk to

spread throughout the economy.

In 1999 the Glass-Steagall Act, which separated the powers of commercial and investment

banking, ensuring that banks would not take too much risk with depositors' money, was partially

repealed. This opened the door for the formation of banks that were “too big to fail”. The de-

regulation allowed banks to use customer deposits to invest in derivatives and encouraged these

financial institutions to take excessive risks, as they knew they would be provided with a safety-

net in case of insolvency.

Finally, the confidence brought by a long period of global economic stability, combined with

an ideological climate that emphasized deregulation and the ability of financial firms to police

themselves, caused most of them to dismiss clear signs of an imminent crisis and, in the case of

bankers, to continue reckless lending, borrowing, and securitization practices (Duignan, 2019).

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History is here to show that the financial crisis could have been prevented, had not the

warning signs been ignored or discounted by the involved parties. Regulators could have been

stricter about implementing rules to the complex financial operations in which financial

institutions were engaging. But instead, no one did anything. Following the recession, the United

States Government introduced enhanced oversight and regulation through the landmark Dodd-

Frank Wall Street Reform and Consumer Protection Act (Mankad, Michailidis, & Kirilenko,

2019). According to Docking (2012), the Act directly addressed five areas: reestablishing

financial stability, reorganizing regulatory structure, regulatory supervision and enforcement

powers, protecting consumer and investor, and improving operations.

The Impact of the Financial Crisis on Market Liquidity

Market liquidity generally refers to how easy it is to exchange assets for cash at a fair price.

Under effective liquidity management, banks assess and plan for cash demands over several

periods and then consider how funding requirements may change in case different events happen,

including adverse conditions. In order to meet liquidity demands, financial institutions need to

maintain adequate levels of cash, liquid assets, and prospective borrowing lines (FDIC, n.d.).

Liquidity risk specifies the ability of a financial institution to obtain funds to accommodate

decreases in liabilities or to fund increases in assets (Chen, 2018). When banks fail to properly

manage their liquidity risk, it can quickly lead to undesirable consequences, despite strong

capital and profitability levels (FDIC, n.d.). Banks are usually more susceptible to liquidity risk

than other financial institutions, since they convert short-term deposits into long-term loans. As a

result, they can end up not having enough liquid assets on hand when deposits need to be

withdrawn or other commitments come due, which is what happened during the financial crisis

(Deely, n.d.).

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FINANCIAL CRISIS AND ITS IMPACTS ON FINANCIAL INSTITUTION

During the financial crisis of 2007-2009, liquidity played a predominant factor. There was an

increased uncertainty over banks’ solvency, which led funding sources to diminish and many

banks found themselves unable to fulfill their obligations (Bordeleau, & Graham, 2010).

Moreover, as banks’ balance sheets deteriorated, they had to “de-lever” by getting rid of assets,

storing cash, and being stricter with risk management. This distressed the interbank funding

market and caused the liquidity issues to quickly spread (Pedersen, 2008). When big banks such

as Lehman Brothers started collapsing, that caused money markets to withdraw funding from

banks all over the world, resulting in a market freeze (Coppola, 2017).

In response to the liquidity crisis, the Fed took an aggressive stance to increase the market’s

money supply and cut interest rates until they approached zero percent by late 2008. The

excessively low interests enabled private equity companies to raise large amounts of cash to

invest in young companies that would have otherwise gone public. This caused the number of

initial public offerings (IPOs) in the stock market to drop (Pisani, 2018).

Risk Management

The financial crisis of 2007-2009 revealed a number of limitations related to risk management

by institutional investors. The crisis started because financial institutions overlooked one of the

most fundamental types of risk there is: Credit risk. Many other risk management failures

followed.

According to Flaherty Jr., Gourgey, & Natarajan (2013), a major mistake that risk managers

did during the crisis was only considering past events, when in fact, “the greatest risks are those

that have never been experienced and thus cannot be seen and measured”. Another factor that

became evident is that many of the risk management systems used by financial institutions were

not programmed to accommodate the magnitude of the issues that surfaced during the crisis.

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Models that had previously been viewed as robust and trustworthy were found not to be well-

suited to handle the complexity of new financial instruments (Open Learn, n.d.). Furthermore,

investors relied too much in traditional risk markers, such as Value at Risk (VaR), which was a

good tool for “normal” market environments, but during the unprecedented situation posed by

the financial crisis, it did not work very well (Flaherty Jr et al., 2013). Another critical practice

that depicted the poor risk management utilized during the crisis was the misguided

compensation structures used by many financial institutions, which encouraged excessive risk

taking in exchange for higher reward. Finally, many financial institutions, while attempting to

create an independent risk management function, ended up creating an isolated team that did not

understand much of the investment process and therefore had little ability to influence others

around them (Flaherty Jr. et al., 2013).

Regulation

In order to restore consumer confidence in the financial industry after the recession, the

United States Government introduced enhanced oversight and regulation through the Dodd-

Frank Wall Street Reform and Consumer Protection. According to Docking (2012), the Act

directly addressed five areas: reestablishing financial stability, reorganizing regulatory structure,

regulatory supervision and enforcement powers, protecting consumer and investor, and

improving operations.

Richardson (2012) discusses that “the Dodd–Frank Act emphasized macroprudential

regulation as an important component of the financial regulatory system” (p. 87). Specifically,

the Act created the Office of Financial Research (OFR) to measure and provide tools for

measuring systemic risk. Furthermore, the Financial Stability Oversight Council (FSOC) was

created to identify and respond to emerging financial system risks posed by large, complex

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institutions before they affect the country's economic stability. In addition, the act also

implemented the Federal Deposit Insurance Corporation (FDIC) to examine insurance-related

operations of financial entities (Docking, 2012).

The current legislation is much stricter with regards to financial holding companies that

operate in a manner that can threaten the financial stability of the economy. There is no longer

such thing as 'too big to fail'. Thus, failing financial institutions are expected to be resolved

through the bankruptcy process (Docking, 2012).

In order to protect consumers from abusive credit practices, the Consumer Financial

Protection Bureau (CFPB) was established by the Dodd-Frank Act. Lastly, the act addressed the

improvement of operations by implementing different actions, such as limiting a company's

trading in certain financial instruments, and bringing transparency and accountability to the

derivatives market by giving the SEC and Commodity Futures Trading Commission (CFTC) the

authority to regulate all over-the-counter (OTC) derivatives (Docking, 2012).

Conclusion

The financial crisis of 2007-2009 was a catastrophic event that left the world’s economy very

close to a collapse. Excessive risk-taking by banks encouraged by the deregulation in the

financial industry are considered to be the root cause of most if not all the factors that ended up

leading to the crisis and recession that followed it. The Dodd-Frank Act, which was created in

2010 in order to regulate the financial markets and protect consumers, helped the financial

system become undeniably stronger and safer. However, there definitely is work to be done in

order to avoid another crisis. The current government’s extensive deregulation is raising risks for

investors and many of the administration’s priorities are putting financial markets in danger by

reducing corporate accountability and transparency (Lebovitch & Spaid, 2019). One would think

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that the lessons learned during the crisis would be enough to prevent a new one. However, only

time - and perhaps another major crisis - will tell if the current regulations were adequate or not.

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References

Andrew, B. (2009). What the Hell Happened?: The Financial Crisis of 2007-??? Juniata Voices,

9, 30–35.

Bordeleau, É., & Graham, C. (2010). The impact of liquidity on bank profitability. St. Louis:

Federal Reserve Bank of St Louis. Retrieved from https://csuglobal.idm.oclc.org/login?

url=https://www-proquest-com.csuglobal.idm.oclc.org/docview/1697724404?

accountid=38569

Chen, Y.-K., Shen, C.-H., Kao, L., & Yeh, C.-Y. (2018). Bank Liquidity Risk and Performance.

Review of Pacific Basin Financial Markets & Policies, 21(1), 1.

https://doi.org/10.1142/S0219091518500078

Coppola, F. (2017). The great financial crisis, 10 years on: lessons in liquidity. Retrieved from

https://internationalbanker.com/banking/great-financial-crisis-10-years-lessons-liquidity/

Deely, M. (n.d.). 4 Principles For More Robust Liquidity Risk Management. Retrieved from

https://www.bigskyassociates.com/blog/4-principles-for-more-robust-liquidity-risk-

management

Docking, D. (2012). The 2008 financial crises and implications of the Dodd-Frank act. Journal of

Corporate Treasury Management : the Official Publication of the Finance and Treasury

Association, 4(4), 353–363.

Duignan, B. (2019). Financial crisis of 2007–08. Encyclopædia Britannica, inc. Retrieved from

https://www.britannica.com/event/financial-crisis-of-2007-2008

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FDIC. (n.d.). Risk Management Manual of Examination Policies. Retrieved from

https://www.fdic.gov/regulations/safety/manual/section6-1.pdf

Flaherty Jr., J.; Gourgey, G.; Natarajan, S. 2013. Five Lessons Learned: Risk Management After

the Crisis. Retrieved from http://www.europeanfinancialreview.com/?p=894

Lebovitch, M., & Spaid, J. (2019). In Corporations We Trust: Ongoing Deregulation and

Government Protections. Retrieved from https://corpgov.law.harvard.edu/2019/02/06/in-

corporations-we-trust-ongoing-deregulation-and-government-protections/

Mankad, S., Michailidis, G., & Kirilenko, A. (2019). On the formation of Dodd-Frank Act

derivatives regulations.(Research Article)(Report). PLoS ONE, 14(3), e0213730.

Retrieved from https://doi.org/10.1371/journal.pone.0213730

Open Learn (n.d.). Understanding and managing risk. Retrieved from

https://www.open.edu/openlearn/money-business/understanding-and-managing-

risk/content-section-2.2.4

Pedersen, L. 2008. Liquidity risk and the current crisis. Retrieved from

http://voxeu.org/article/understanding-liquidity-risk-and-its-role-crisis

Pisani, B. (2018). How the financial crisis changed stock trading on Wall Street. Retrieved from

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wall-street.html

Richardson, M. (2012). Regulating Wall Street: The Dodd-Frank Act. Economic Perspectives,

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Twight, C. (2015). Dodd--Frank. Independent Review, 20(2), 197. Retrieved from

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