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Role of Securitized Lending and Shadow Banking in the 2008 Financial Crisis

The role of securitized lending and shadow banking in the 2008 financial crisis
The financial crisis of 2008 started and engulfed the banking system of the United States and spread to many large European countries (Coffee, 2009) because of the financial institution’s fault was the excessive of borrowing, risky investments, a decrease in collapsing of mortgage lending standards and transparency (The Financial Crisis Inquiry Commission, 2011), but China only has a small impact on its economy and they were able to recover rapidly. This essay will discuss a summary about the financial crisis in the USA but it will mainly focus on the financial crisis in China and how the government has helped deal with the problem quickly in order to have a rapid recovery in the recession 2007-2008 and it will focus on shadow banking sector in China.
The USA economy was in recession in 2001, and the USA Federal Reserve — the banking system — cut the interest costs as a counter-patterned measure (Wirick and Mcintosh, 2015). Lower interest rate made it simpler for families to convey bigger measures of home loan obligation, thus the interest for US lodging expanded. The subsequent increment in costs animated private development action and the subsequent increment in work and yield in the lodging segment was a vital issue in the recuperation in the USA economy (Gordon, 2017).
A causal component behind the flood in lodging speculation was a gigantic inflow of remote venture into the USA, strikingly from China: by 2006, the USA current record shortage achieved 6 percent of GDP (Eastman and Ambler, 2013). A lot of this outside capital was thusly diverted into the US lodging division, offering bigger pools of funds for family units looking for home loan funding
The housing market is notable for its cycle of blasts and busts, and it ended up clear in the mid-2000s that US housing costs gave a significant number of the suggestions normal for a “bubble.” Asset-value bubbles happen when financial specialists make buys dependent on the desire for having the capacity to offer the benefit later at a higher cost, and not on the innate characteristics of the advantage itself (Hull, 2014). The purposes behind the production of the “rise” is the low interest and the relaxation of lending standards in the USA housing market (MacGee, 2009).
US housing costs at long last topped in mid-2006. Movement in the housing segment hindered, and the US economy started to embrace a change of speculation and work to different segments. This progress was not consistent, be that as it may, and the USA fell into downturn in the end of 2007.
One contributor was the deterioration in the mortgage guaranteeing standard: an expanding offer of advances was made to high-risk borrowers. The subprime contracts were effective from 2001-2006 by $2.5 trillion (Gorton, 2010). When lodging costs in the long run fell, these “sub-prime” contracts will probably go into default. Which has tightened the market to collapse.
One of the main causes which started in August of 2007 was securitization. Securitisation can be defined as a process that transforms illiquid assets (untradeable) into a security (tradable) this is according to (Gabbi, Kalbaska and Vercelli, 2014). The crisis contagion was helped from securitisation and spread almost all over the world. The expanded securitization of mortgages assets, and most strikingly the improvement (CDOs), enhanced the hidden risk. A CDO gave its proprietor a case on the stream of home loan instalments made by family units. CDOs that offered higher-need claims were viewed as sheltered resources and exchanged at a premium. The advancement of CDO and related instruments gave a further motivator to offer sub-prime credits: buyers of CDOs had a little method for confirming the nature of the hidden home loans whereupon the advantages were based.
When US housing costs fell, numerous property holders got themselves submerged: their loan debts obligations surpassed the estimation of their households and went into credit default swap. It before long ended up obvious to money related foundations and different speculators that a large number of them as far as anyone knows “safe” mortgage-based assets were worth substantially less than their book esteems. Financial market liquidity became scarce as establishments turned out to be less eager to make advances, out of dread that the counterparties may go bankrupt in the close term. These apprehensions reached a crucial stage with the fall of Lehman Brothers, the fourth-biggest US investment bank, in September 2008.
After the Lehman Brother bankruptcy helped this financial crisis to spread globally, which has caused a global downturn in the economies. Therefore it hits China economy very badly. China’s commercial banks have owned an MBS and CDOs in the USA, the losses was about $20 Billion, however in August of 2008 China was on about to fail when Fannie Mae and Freddie Mac were about to collapse, which the losses have been estimated $400 Billion but the USA has to place Fannie Mae and Freddie Mac into conservatorship which has saved the two companies and China from a big tragedy (Yu, 2010) (Figure 1).
The global crisis has effected china’s GDP to decrease from 13% in 2007 to 6.8% in 2008 (Yu, 2010) (Figure 2). This impact has reflected on the Chinese economic indicator performance such as the export and import (Whalley et al., 2009). The Chinese government has put the blame on worldwide economic slowdown because the world is less demanding on Chinese exports. Which means the production sector has decreased the doubled, when it’s compared to the previous year, this caused many other product sectors to drop to a negative percentage (Wearden and Stanway, 2008).
Furthermore, the decrease in GDP in 2008 was because of the sharp decrease in the export sector (Figure 3). Since the main export markets are effected for instance Hong Kong and Korea have all slipped into recession because of the worldwide financial crisis. However, China is a very dependent country on net export for an economic boost. In 2007, China net export was about 20% of GDP growth (Zhang, 2009).while, because of the effect of the global financial crisis, the export of China has been reduced dramatically due to the weakening of external demand. China as a labour-intensive industry. Exports are a huge number of unskilled employees from rural areas to other countries. The unexpected collapse of export market has made a lot of private companies to close down, which has resulted in a job loss which was about 20 million of job losses of unskilled employees (Zhang, 2009), which has increased in unemployment in China. The number of unemployment employees has increased from 12.5 million in 2008 to 21.7 million in 2009 (Whalley et al., 2009). Since most of the unskilled employees came from rural areas has a lack of education, they have faced the problem of poverty when being laid-off.
In 2008 the Chinese government has introduced a stimulus program to stabilize economic growth. In 2008 the government has implemented a stimulus program with a total cost of investment plan $586 billion in 2009 and 2010. The stimulus program has invested in key areas, for example, finance, tax cuts, housing, transportation, rural infrastructure, health and education (Msandgren, 2008) (Figure 4). The sources of financing of the stimulus program were divided into 4 parts. The government will pay one-quarter of the $586 Billion. Secondly, government bonds have been issued to cover the budget deficit. Thirdly the central government has created a bond on behalf of the local ones. Lastly bank loans to source a fund for the local governments. Although the Chinese government can print more money to spend it inside the economy which called “easy money”, but they wanted to keep inflation controlled and not fluctuating the currency. The China investment corporation (CIC) has invested $20 billion to China Development Bank, and 47 Billion to Agricultural Bank of China. The accompanying held $100 billion of bad loans and was the nation’s fourth-biggest state-possessed loan specialist to must be subsidized by the government. The rest of the fund has been allocated from the budget of provincial and local governments (Morrison, 2009) (Figure 4). It was one of biggest rescue plans. This strategy concerned on increasing the output expenditure and reducing tax. The budget mainly concentrated on the infrastructure of China and tax repayment for exports (Yu, 2010). While the China Central Bank (PBoC) was also releasing the monetary policy is to encourage the banks to lend more by cutting down the reserve ratio from 17.5% to 13.5%. Which means the interest rate for a loan has been reduced to increase consumer’s spending and borrowing (Zhang, 2009).
Moreover, the Chinese government has implemented expansionary financial policy. The government had to implement new strategy by using its own enterprises (SOEs) as a fiscal instrument (Raza, 2014). This critical decision from china using this fiscal stimulus programs that no other country has dared to adopt. Specially, the China’s government intelligently used its state-owned enterprises (SOEs) as a financial instrument to be actualized in their stimulus programs in 2009. Most of the companies are owned and controlled by the government, such as China Mobile. One of the largest mobile companies. The role they perform in Chinese economy seems to expand because of the financial crisis. As China fighting the recession with the stimulus program, while the banks increasing lending at the behest of the government (Kamrany, 2011). Which means the private sector is getting squeezed out. The loans have reached 61.7 Billion for private firms. It’s is not just financing that is flowing to SOEs.
The sector that has been affected the most is the Manufacturing industry, which was dominant by the private organisations, in 2008 most of the small and medium sized has been collapsed and the survivor is having more pressure, which leads to exports to decrease by 19.7% (Raza, 2014). SOEs revenues depend on government spending more than internal and external demand, in other words, the government state can create neglectful to the market demand but the private sector cannot do that. Which made the private sector to collapse, since they left standing. According to Li Rongrong, the chairman of State-Owned assets, the SOEs profits flowed 86% in March 2009, which means that government can increase its stimulus program spending (Ramzy, 2009).
Furthermore, the government starts to get concerns that the economy is over-reliance on their spending, so their economic goal is to boost the customers by spending more to make the economy more balanced, and less dependent upon customer’s requests from Europe and USA (Ramzy, 2009). They have boosted the rural incomes and spending levels to tighten the gap in living standards between urban and rural citizens (Morrison, 2009). If SOEs in a heavy sector, for instance, the steelmaking increase production at a time when the market is falling, this could waste their products cheaply internationally when the government will stop spending (figure 5).
In the other hands, when the credit crisis in China was promptly growing. Loans in the first quarter of 2008 are nearly equalling the total lending for the whole year, which leads to bad loans to increase, with small and medium size collapsing. The SOEs gave China banks margin of safety, which has the guarantee that the government will make a good loan (Kamrany, 2011).
Lastly, the government idea of implying SEOs on their stimulus program has a positive effect on the market, which indeed China was again on the track by having 11.9% increase in the GDP for the first three months in 2010 (Kamrany, 2011).
The shadow banking sector is a vital factor for the cause of the financial crisis 2007-2008. Shadow banking is described as activities that have been made by financial firms outside the former banking system, therefore, lacking a formal safety net such activities in credit intermediation is according to Global Financial Stability Report (2014). Shadow banking is totally different from traditional banking, this is because shadow banking cannot borrow in any situation from the central banks and they do not have any depositors, usually insurance company’s fund’s shadow banking (Kodres, 2013).
The 2007 – 2008 financial crisis was a framework wide bank run which happened in the securitized-managing an account framework and was driven by the withdrawals of a repurchase agreement (Claessens et al, 2012). The genuine issue was that these toxic assets were utilized by the banks to anchor financing in the repo market. As the value of was declining, the banks were ending up less liquid. Full-esteem for securitized securities was given by financial firms that got stressed that those securities may contain toxic subprime loans; accordingly, they reduced the measure of cash they would loan on the bonds. This reduction likewise called a “haircuts”. At the point when investors in light of the fact that worried about the value of these long haul, assets, they chose to pull back their funds at a time. Shadow banks should repay to these investors and, in this manner, needed to offer resources. Around then shadow delegates were profoundly utilized or had the very leverage of illiquid assets and were helpless against runs when investors pulled back vast amounts of assets at short notice (GFSR, 2014). It brought about “Fire sale” which for the most part diminished the estimation of these benefits. It constrained other shadow keeping money foundations and a few banks that had comparable advantages for lessening these benefits an incentive to mirror the lower market cost, making further vulnerability of their wellbeing (Kodres, 2013).
China has the third largest shadow banking system in the world (Jiang, 2014). In the past the traditional banks in China are almost owned by the state, they were strongly regulated and accounted for all lending happening in China. Nevertheless, at the present time, credit is accessible from a wide range of financers consisting of leasing and trusts. Which jointly called as shadow banking, but still traditional banking lending is much bigger than the shadow banking and is still growing, but the rate of the growth is stabilized. In contrast, shadow banking is increasing (figure 6), which made shadow banking to account a third of the rise in lending by expanding more than 50% in the process (Jiang, 2014).
Almost 90% of the shadow lenders in China are (SOEs). These firms were cash rich and cleverer than the private enterprise ones, in term of their ability to snitch around the regulation (Shen, 2013). The large-enterprise for example, China mobile has an excess cash to make directs loans to other companies by making a huge profit throughout shadow banking.
Shadow banking in China is getting an increase in attention not only due to its fast-growing but also for its new products and activities that have made a development in the financial system but at the same time increasing risk. Some of these new products have a positive effect on financial development such as trusts and credit guarantees. Which has proven that they are extremely risky, because of the rapid growth for the shadow banking and became hard to regulate and monitor all the aspects of the system.
Shadow banking in China involves of credit creation products and non-bank financial products, and these non-bank financial products consists of bank-trust corporation financial products, these products are issued only by financial leasing companies and trust companies, credit risk assets and Q-REITS (Li, Hsu and Qin, 2014). Credit creation are often issued to investment banks, small loans companies and many more. The shadow banking system in China is dominated by insurance companies, commercial banks (Off balance sheets transaction) and trust. Furthermore, this essay will explain more about trust.
Trusts is the third largest financial subsector and is considered as the riskiest subsector (Li, Hsu and Qin, 2014). These trusts are not subjectable to the same regulation that banks have, and it’s the primary reason for the encountered problems. Trusts are often involved in very risky activities, for instance, being invested in extremely risky investments. More often trusts offer returns as high as 10% and this particular way to increase money for the business and individual are discouraged on bank deposits due to the low cap and interest rates (Jiang, 2014). Usually, trusts lend firms that were unable to borrow from banks because of the fourth industries (steel market), where the regulators instructed banks to stop lending to them due to the overinvestment.
The total outstanding trust products assets in China has increased by 8% at the end of 2010 (Anderlini, 2014). The trust product worth of $400 Billion because of the borrowers is taking more loans and reinvest in them. After that many observers worried that investors lose faith in trusts can seriously damage parts of the financial system. Trust is the heart of the Chinese shadow banking sector, which has delivered more than $4.8 billion worth of loans to the county’s riskier enterprise since 2007 and created the largest credit boom (Anderlini, 2014). The rapid build-up of risk in Chinese shadow banking may cause similar damage last shadow banking bubble in the USA.
In addition, mostly of trust loans is secured with property and reliant on shadow finance, however china’s powerful housing market is cooling, precisely in smaller towns, so the fear cutting of the housing market bubble leads to a stress in shadow finance, which will shrink the access to credit, pushing the housing prices and economic growth decrease further.
Shadow banking in China is totally different from Europe and USA, they are still in an infant from without being integrated into a long intermediation chain (Shen, 2013), due to the disconnection of a wide range of securitization.
According to Li, Hsu and Qin (2014) the regulations gives attention to Chinese commercial banks, and not enough attention to other non-loan assets and the housing securities. As regards of trusts, both trust financing companies and issuing commercial banks are regulated, even some trust involved in the extreme risky investment. Regardless of the new laws and regulation that trying to keep the financial products and the development healthy, but the trust companies are involving in risky investments. Thus, the severity of shadow banking forces the government to increase lending and investment and issuing bonds.
In conclusion, this essay has discussed the impact of the financial crisis on China, and the fast response from the Chinese government by implementing the “stimulus program” and using SOEs in their program. As it discussed the Chinese shadow banking sector that recently became a primary concern to many investors, observers and other markets contributors around the globe. Being an important component of the global economy, the financial sector in China allows a number of questionable and risky banking activities that sets the world economy in danger of future recessions. Only well regulated, the aligned system in China and the rest of the globe nations can prevent the world from another financial crisis.

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Factors for Consideration for Government Interventions with Failing Banks

Based on your readings, and at least one example, discuss the key factors that governments take into consideration when dealing with a failing bank. Discuss how European financial stability policy has evolved in this area.

Support your answer with reference to how various types of creditors get repaid when a bank is put into liquidation, as well as the range of policy measures available to regulators in the formation of `bank resolution’ policy.
For as long as banks have existed there have been bank failures. They are a crucial part of the economy and failures are often left to up to individual governments to resolve. Failing banks are costly and careful consideration is needed for to the steps be taken to resolve the situation. Bank failure can quickly spread across the financial system and cause panic. Various methods are used by states to contain it including deposit guarantees and bailouts. Creditor repayments can have significant impact on the system and need to be managed. After the financial crisis of 2008, the EU has undertaken several steps to increase financial stability across the Eurozone, mainly in the form of setting up new funds to deal with future failures. Traditionally, creditors are repaid on a hierarchy with senior creditors pad first, followed by junior creditors, preferred shareholders, equity holders and finally depositors.
One of the first things for governments to consider when faced with a failing bank is the decision between corporate bankruptcy and keeping the bank afloat. While deliberately allowing a bank to go bust and the implications for the public may seem like poor government policy, there may be no other choice available. During the financial crisis, Iceland made the decision to allow their banks to more or less fail. The domestic portion of the banking system was bailed out with deposits given priority ahead of other unsecured claims. A debt moratorium was granted to the much larger international portion of the system and a resolution committee was selected to preserve the value of the assets (Hafliðason, Valgeirsson, and Marinósson 2009). Iceland suffered from ‘small country syndrome’ (Benediktsdottier, Danielsson, Zoega and Tile, 2011). In 2008, the Icelandic financial system was worth 900% of GDP. The government was simply be unable to finance a bailout for the entirety of the failing banks. A range of policy measures such as emergency resolution, capital controls, alleviation of balance of payments risks and preservation of financial stability were implemented in addition. In hindsight, the government’s response to the crisis seems to have worked well. (Benediksdottier, Eggertsson and Porarinsson, 2017).
The Icelandic banks were operating under EU passporting rules in order to carry out banking services across member states. Under this arrangement, non-EU credit institutions can establish an EU-based entity which is licensed to operate regulated services under EU law across the 28 countries provided home regulators are exercising adequate controls on the institutions. However, the failure of Icelandic banks left depositors across the Eurozone in danger of losing their deposits. They were under the belief that deposit insurance was in place for their deposits and the Icelandic institutions were in line with EU rules which was not the case. Iceland had undercut the supervisory standards of the other member states due to their own lax controls, which in turn weakened the entire system. The fragmented supervision left the entire financial system vulnerable due to too much faith being placed in national supervisors. The passport system had grown too fast and regulation was too slow to adapt. In 2016, this scheme was updated to increase the coordination between member states and reduce some of the weaknesses that existed with the intention of reducing instability.
If a government does take the decision to attempt to save the failing banks, it can have many non-monetary implications. Resolving a bank failure using public funds could reinforce future expectations of public support for distressed financial institutions. This could lead in the future to undermining market discipline and excessive risk-taking throughout the market and even possibly build the foundation for the next financial crisis. Moral hazard risks can be limited under the threat of temporary public ownership.
The area of controversy with financial support relates to who foots the bill. In New Zealand, all banks, even foreign owned, are structured in such a way that taxpayers do not have to pay for the failure of a bank. No deposit insurance exists in New Zealand, instead depositors are treated as junior creditors whose claims are written down in proportion along with others of the same class. All deposits are divided into a continuing portion that can be continued to be used in normal transactions and a frozen portion.
Many governments have no choice but to use taxpayer’s funds to finance a failing institution. The Irish government committed to a bank bailout after the property crash in 2008. Irish banks faced an imminent threat of collapse due to insolvency and were unable to bear the cost of such a bailout themselves. Taxpayers were left having to pay the price of the risky behaviour undertaken by the banking sector. Under the terms of the bank guarantee the government paid out €64 billion in bank bailouts. There is a fixed hierarchy setting out which creditors get repaid, based on seniority of their claim. Interestingly, the State was a junior creditor of the bank. The government had the decision to impose losses of €9 billion on senior debt holders. Financing should be arranged where possible so that taxpayers are beneficiaries from resolution measures that restore failing banks successfully. It is inappropriate for bank-owners to profit from such activities as it would be returns to resolved banks and those who caused the failing in the first place at the expense and risk of taxpayers. The ownership of the bank after government help is important. Will taxpayers ultimately own the bank, such as in the case of the nationalisation of Fannie Mae and Freddie Mac at a cost of $187 billion to taxpayers. Another option is a private entity taking control over the failing bank, similar to the case of Bear Stearns. JP Morgan acquired a loan from the Federal Reserve of $29 billion to finance the transaction.
One fund which attempts to place the cost of government aid for the financial system is the Single Resolution Fund (SRF) was set up by the EU in 2016. It collects contributions from credit institution and investment firms across 19 participating member states. Between 2016 and 2023, the fund will be gradually built up to reach the target level of at least 1% of total deposits of all credit institutions within the banking union. The aim of the fund is to provide a way for the financial industry to contribute to the stabilisation of the financial system. The SRF will be used only when necessary to ensure the effective application of resolution tools such as to make loans to or purchases on assets of the firm under resolution and to make contributions to a bridge institution. Funds will only be awarded on two condition – the SRF contribution does not exceed 5% of total liabilities and losses no less than 8% have been absorbed by creditors of the firm. The European Stability Mechanism (ESM) is a fund financed by taxpayers which replaces the European Financial Stability Facility and European Financial Stabilisation Mechanism. The ESM was set up after the crash of 2008 to act as a safeguard to the Eurozone by providing instant access to financial assistance for member states in financial difficulty. In 2012, Cyprus was able to use this fund to recapitalize its banks.
Today, due to globalisation, banks are linked to one another. While some banks can be considered ‘too big to fail’, the links with other banks is the financial system is of more concern. Governments must consider how ‘contagious’ a failing bank is. If a failing institution is in a network of banks who rely heavily on each other, failure could be contagious within the web. The larger and more complex this system, the greater the implications for the financial system as a whole. The collapse of Lehman Brothers turned a global financial distress into an international emergency due to the exposure of international firms. As the majority of banks are entwined in this network, liquidity for depositors is greatly reduced and a bank run can quickly occur. However, while early intervention can lower the cost of remedying bank failure, it may also prematurely interfere with the ownership, property, and rights of bank shareholders. There is a need to balance the advantages both to other bank creditors and to society as a whole, against the rights of bank owners.
In the Forgotten Panic of 1929, the intervention of the Federal Reserve highlights how banking runs can be limited and protect failing banks to allow them to continue operations. In 1929, revenues from fruit sales amounted to 51% of Florida’s revenue from crops. The discovery of fruit fly infestations resulted in the destruction of the majority of fruit crops in the state. With farmers taking a massive financial hit, there were worries about their ability to repay their loans. Panic spread quickly resulting in a run on the bank and subsequent bank failures across the state. In July of that year, 8% of the state’s banks closed their doors over the 48 hours following the failure of Citizen’s Bank which served as the financial centre for these citrus-growing areas (Carlson, Mitchener and Richardson, 2011). The response of a central bank to a bank’s failure demonstrates the larger role illiquidity plays (Summer, 2000). Worsening concerns over solvency increase the probability of a bank run, which was seen here. The Federal Reserve Bank of Atlanta took action to halt the panic by rushing currency to banks and publicly announced the guarantee of depositor’s currency. They provided targeted liquidity support helping to prevent a wave of further bank failures. Banks survived and creditors were repaid as operations returned to normal.
As economies become more globalised, banks become more interdependent and interconnected and requires cooperation between countries. This is especially true in the case of the European banking system. Many of the countries joining the EU have fundamental structural differences and the euro was introduced to help create the conditions necessary for further economic unity among the member states. One of the ways this was to be secured was through creating financial linkages across countries thus, making the economies more similar and subject to more common shocks over time (Frankel and Rose, 1998). Ultimately, this lead to country-specific shocks developing into systemic shocks. The financial crisis exposed important failures in the financial supervision of individual institutions, which proved unable to prevent, manage and resolve the crisis which evolved and revealed shortcomings in cooperation, coordination, consistency and trust that existed between national supervisors. In March 2009, the European Commission which set out to ensure the “long-term financial stability”. The Bank Recovery and Resolution Directive (BRRD) is a framework implemented in 2015 which set guidelines for the 28 member states on how to deal with failing banks at a national level and encourage cooperation agreements to tackle cross-county banking failures. It sets out guidelines as to how and when member states should intervene, encompassing precautionary, early intervention and measures designed to prevent bank failures. To promote financial stability, the aim is to shift the cost of failing banks to the shareholders and creditors of the bank and not taxpayers to avoid fiscal strain on governments. It is vital to have cooperation and coordination between all 28 countries to avoid moral hazard which hinders the process of restoring and maintaining confidence. Banks are no longer treated as purely national institutions, now risks are considered in the context of the negative repercussions for all euro area banks.
When faced with bank failures, governments must first consider if supplying federal funds is economically feasible before taking into account the complexity and implications of the resolution. Many funds have been set up by the EU in the wake of the financial crisis to finance these issues. Governments must decide the best policy to suit the institution, whether it’s by guaranteeing bank deposits or nationalising banks, and must evaluate how creditors will be repaid.
(Frankel and Rose, 1998), Frankel J.A. and Rose A.K.: The Endogeneity of the Optimum Currency Area Criteria, NBER Working Paper, 1998.
Carlson, Mark, et al. “Arresting Banking Panics: Federal Reserve Liquidity Provision and the Forgotten Panic of 1929.” Journal of Political Economy, vol. 119, no. 5, 2011, pp. 889–924. JSTOR, JSTOR,
(Hafliðason, Valgeirsson, and Marinósson 2009)