EVALUATION OF REGULATORY RESPONSE

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Introduction

The Global Financial Crisis (GFC) of 2007-2008, a period of severe stress in global

financial markets, is considered by economists as the worst financial crisis since the 1930s’ Great

Depression. There is still ongoing debate on what are the exact causes of the GFC although the

market features and conditions leading to the crisis were immediately known, prompting

authorities around the world to draft and implement regulations to prevent a repeat. This paper

investigates the primary causes of the GCF, the market conditions and features characterizing

GFC, the response of policymakers and regulators, descriptions of a consequent regulation and

the myriad ramifications of such policies.

GFC Timeline of Key Events

A financial crisis became apparent after a series of events in early 2007. The following

are the series of events during the GFC based on timelines by Guillen (2009) and Giles (2011).

It started in the United States of America where there was a deepening housing crisis. As

foreclosure rates rose, banks and hedge funds are faced with useless assets after investing heavily

in subprime mortgages. It started in February 2007 when Freddie Mac, a big player in the

mortgage sector, announced it will stop buying subprime loans considered most risky. The

financial world was shaking with a series of troubles at New Century Financial in April, French

bank BNP Paribas in August and UK’s Northern Rock in September. By 2008, the US economy

was experiencing recession. In January, the US Federal Reserve stepped in to prop up the

mortgage-securities market. Bear Stearns was bought by JP Morgan in March. In September

2008, Fannie Mae and Freddie Mac were taken over by the government while several other

banks in the US and the UK went down before US Treasury Secretary Hank Paulson used the
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$700bn Troubled Asset Relief Program to purchase bad assets in the US. UK also bailed out

several banks in October. Recession followed in Ireland, the US and the UK (Guillen 2009, Giles

2011).

Market Features and Conditions of a Financial Crisis

During a financial crisis, some common occurrences lead to a rapidly worsening

condition in the market. These include (1) a contagion across assets, (2) increase in counterparty

risk, (3) credit rationing, and (4) deleveraging through capital outflow (Blanchard 2009).

Contagion across Assets. During a financial crisis, there is a steady growth in volatility

across assets. High volatility in the price of the asset results from a sudden decrease in the price

of the asset relative to its past average value. High volatility is a signal of growing financial

doubt and associated with policy uncertainty leading to reduced investment, production and

investment. It also delays investment since high volatility increases the value to invest in real

options (Blanchard 2009, Danielsson et al. 2018).

Increase in Counterparty Risk. Counterparty risk between banks refers to a rise in the

perceived odds that a bank’s loan from another bank may not be repaid. This is indicated by an

increase in the average rate banks charge each other for loans and the rate at which government

can borrow. During a brewing financial crisis, banks tend to attempt to keep sufficient cash on

hand and limit their reliance on loans from other banks. Thus, along with the increased

counterparty risk perception, there is also a reduction in the maturity of loans that banks are

eager to offer to each other (Blanchard 2009).

Credit Rationing. A worsening financial crisis is also affected by credit rationing or the

constriction of lending standards by banks. This is due to deleveraging by banks, another feature
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of financial crises discussed below. In other words, credit rationing is a condition wherein

lenders are reluctant to forward extra funds to borrowers at the ongoing market interest rate.

Credit rationing is an extreme case of a common problem of misallocation of capital market. In

the case of the GFC, credit rationing for firms and households occurred somewhere around mid-

2008 (Blanchard 2009).

Deleveraging. Deleveraging, or the simultaneous reduction of debt levels in numerous

sectors, via large capital outflows can cause a steep rise in indebtedness. Discrepancy in

exchange rate then exacerbates the condition, further burdening all types of debtors such as

household, companies and financial institutions (Blanchard 2009, Reinhart 2012).

Primary Causes of the GFC

The abovementioned market features and conditions during a financial crisis were also

present during the GFC. Causes that originate from excessive investments in subprime assets and

subsequent volatility led to these market features and conditions as described below.

Low to High Asset Volatility. Low volatility increases the likelihood of a financial crisis.

Since volatility is a factor in risk management practices, a period of low volatility encourages

financial institutions to bet on riskier positions, increasing their balance sheet leverage.

Therefore, during low volatility periods, financial agents who aim for higher gains tend to lend

more or place from safer to riskier assets. In other words, extended periods of low-volatility is

considered to cultivate optimism and excessive lending, thus, increasing the probability of a

financial crisis (Danielsson et al. 2018). Before the GFC, low volatility in the subprime

mortgages led to a sustained credit boom - the primary cause of the GFC - behind excessive
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lending and move towards riskier assets. In the end, the large boom episode resulted in the high

volatility and severe financial crisis (Claessens et al. 2010).

Shrinking Assets and Counterparty Risk. During the GFC, banks were reluctant to lend

each other - because of the risks and uncertainties associated with the volatility in the marked -

which was observed from the middle of 2007 onwards, especially in the US and the UK. A spike

in 3-month Libor and the three-month Tbill rates was noted when the US government let the

large, systemic bank Lehman Brothers fail and file for bankruptcy in September 2008, an

unexpected event in the financial markets (Blanchard 2009).

Credit Spread and Credit Rationing. Due to the subprime volatility, there was a large

decrease in the values of the financial institution’s asset holdings during the GFC. As a result, a

drastic intensification of agency troubles in these financial institutions as well as, to a lesser

extent, nonfinancial firms. Consequently, there was widening of credit spreads and proliferation

of credit rationing. Huge cutbacks on all types of investments, thus, occurred (Hall 2010).

Domestic and Sovereign Deleveraging. Over the course of the GFC, deleveraging not

only occurred in domestic credit but also in sovereign credit which made the financial crisis of

2007-2008 a global crisis. In the said process, first-world country banks dramatically reduced

their exposure to emerging markets through closing of credit lines and repatriation of funds.

Selling exploded across the board resulting in the steep rise in the premium especially for

counties with extensive current account deficits (Blanchard 2009), considered one of the deeper

causes of financial crises.

Policy and Regulatory Responses to the GFC

In response to the GFC, policymakers and regulators have attempted to repair the damage

done to financial systems and economies through the implementation of a range of reforms at the
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international and domestic levels. Key reforms that have been completed through the Financial

Stability Board (FSB) include the following policies and regulations:

1. Basel III Capital Requirements (discussed in detail below) as well as adoption of a capital

buffer and a surcharge for G-SIFIs or globally systemically important institutions

2. Liquidity standards such as the LCR or the Liquidity Coverage Ratio.

3. Reduction of too-big-to-fail firms through the identification of international and domestic

systemically important institutions.

4. Securitization model improvement.

5. Sound compensation practices adoption.

6. Adoption of practices like US GAAP or Generally Accepted Accounting Principles and

IFRS or International Financial Reporting Standards.

7. Harmonization of collection of data on major systemic banks (Claessens et al. 2010,

Claessens & Kodres 2014).

Basel III Capital Requirements. The Basel framework is comprised of three pillars; these

are Pillar 1 which establishes the computations of regulatory capital requirements for risk

involving credit, market and operation, Pillar 2 which establishes how a bank should assess its

capital adequacy and pursue actions based on assessments, and Pillar 3 which establishes the

bank disclosure requirements to foster market discipline (Achterberg & Heintz 2012). In 2010,

the main features of the Basel III included stipulations to increase capital level and quality,

improve risk capture, restrict bank leverage, enhance bank liquidity and restrain procyclicality. In

2017, revisions to risk capture feature to include standard approaches to computing risks and

bank leverage feature to include higher leverage ratio requirements for G-SIFIs were made

(BCBS 2018).
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The above provisions of Basel III follow the general theme and rationale of financial

regulation by dealing with several failures in the existing pre-crisis regulatory structure and at the

same time introducing groundwork for a robust banking system that will ensure that build-up of

systemic vulnerabilities is avoided (BCBS 2018).

One of the downsides to the Basel III is a disruption to the credit supply to the economy

due to the implementation of the new regulations. Furthermore, long-term growth of the

economy will be adversely affected if small businesses do not have access to finance due to

reduced available loans and elevated credit risk premiums (Chan et al. 2012). Basel III is also

seen to negatively affect the liquidity management practices by banks thus restricting banks’

ability to freely control balance sheets soon and possibly dampening fund movement into new

creative and productive investments (Konig & Pothier 2016).

Despite these unintended effects, there could be benefits in the long term since Basel III’s

aim is to ensure a stable economy. A stable economy could ease access to bank lending. An

economic environment with less fluctuation results in a reduced volatility in credit supply to

small businesses. Therefore, innovative entrepreneurship and economic growth could be

promoted by Basel III in the long term, after all.

Policy and Regulatory Responses: Intended Effects, Features Needing Regulation and

Downsides of Implementation

As mentioned above, policies and regulations such as the Basel III were intended to build

a stable economy and prevent a repeat of the GFC. According to Blanchard (2009), generally, the

reforms are aimed at lowering the fragility of the financial system without severely hampering its

efficiency. The liquidity provisions and government interventions are put in place to dampen the
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amplification mechanisms of a financial crisis. Securitization, meanwhile, is aimed at making

derivative securities more complex to ensure a better allocation of risk. Another objective is to

decrease leverage. Since leverage before the GFC was too high, regulation is therefore needed to

enforce lower leverage.

According to above assumptions, liquidity, derivative securities and leverage are features

of the financial market that need regulation. One other important feature is asset price and credit

booms, both are known to be controlled by proper, active monetary policy (Blanchard 2009).

A couple of downsides have already been described above regarding the Basel III. Other

unintended effects of financial regulations and policies include possible lessening of competition

leading to inefficiency, discouraging innovation in financial intermediation, and distortions such

as avoidance by firms of markets they would have entered without policies and regulations

(Garrona 2015).

Summary and Conclusion

Financial crisis is preceded by periods of low volatility in asset values and subsequent

underestimation of risks. In this scenario, asset bubbles and credit booms typically followed by

asset volatility and contagion, increased counterparty risk, credit rationing and deleveraging that

constitute a financial crisis. The GFC is not exempt in these indicators and market features. Thus,

policies and regulations such as the Basel III were put in place to prevent a repeat and foster a

stable economy. However, downsides and unintended effects are probable in the implementation

of reforms such as disruption of credit supply and long-term economic growth. Nonetheless, ease

of access could result from a stable economy brought about by policies and regulations.
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Therefore, disruptions and slow economic growth in the short term are sacrifices that the

financial world should endure to reap the long-term benefits of the highly-needed reforms.

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