European banks and the global banking glut


My latest post at Pieria considers the sizeable role of the Eurodollar market in the unsustainable growth of credit that led to the 2007-8 financial crisis. 
In a lecture presented at the 2011 IMF Annual Research Conference, Hyun Song Shin of Princeton University argued that the driver of the 2007-8 financial crisis was not a global saving glut so much as a global banking glut. He highlighted the role of the European banks in inflating the credit bubble that abruptly burst at the height of the crisis, causing a string of failures of banks and other financial institutions, and economic distress around the globe. European banks borrowed large amounts of US dollars through the money markets and invested them in US asset-backed securities via the US's shadow banking system. In effect, they acted as if they were US banks, but in Europe and therefore beyond the reach of US bank regulation......
What was it that drove the expansion of the Eurodollar market and encouraged European banks to leverage up with US mortgage-backed securities?

Read the post here.


Comments

  1. Hi Frances, long-time reader, first-time commenter. I simply wanted to applaud you for the stunningly pithy insight in your article:

    "The story of the financial crisis is a story of the failure of safe assets."

    The underlying concepts have been discussed for years now but I don't think anyone has expressed the nub of the crisis so eloquently, in so few words. Brava!

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  2. Frances, this is one of the best things I've ever read about the crisis. There might not be much new, but the way to handle and integrate different aspects of the same story is amazing. Honestly.
    Pablo Bortz.

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  3. Can we continue our capital requirement discussion here?

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  4. Some good points here.

    The extensive securitisation of dollar assets is certainly a key factor. Having loan assets transformed into tradeable securities has two major implications for the European banks. First, it made the assets more useful as collateral for things like repo and ABCP. This gave the banks the ability to access much greater volumes of dollar funding, than if they had been relying on the unsecured market.

    Secondly (and most importantly, IMO), it made it possible for positions to be run through the trading book, enabling the banks to derive a much lower capital charge. The vast majority of bank losses in the crisis arose on some form of traded credit, or on positions originally on the trading book but transferred to the banking book as a result of liquidity seizing up.

    Of course, when these securities started to become unacceptable as collateral, these benefits dissappeared. European banks found it harder to access dollar funding and took capital hits as traded positions became illiquid.

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    Replies
    1. What if these tradable securities remained liquid but just fell in value?

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    2. Falling value implies falling liquidity. When the price of a security is going into freefall, as happened to RMBS and their derivatives, it is because no-one wants them. Everyone is selling while they still can. Eventually, it becomes virtually impossible to sell them at all.

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    3. I'll add a few comments to what Frances has said there.

      A fall in value, without any loss of liquidity, would have some implications. These assets are generally carried at market value, so a loss in value translates into a loss in capital. This can impact on the capacity to advance new loans. But in the absence of the liquidity implications, this effect would be small.

      The relationship between the value of these assets and their liquidity depends to some extent on holdings by parties with two key features. First, they rely heavily on secured funding, especially repo, to finance their asset holdings. Secondly, they account for a significant part of the regular trading in those assets.

      If the asset prices fall, this may reduce the funding capacity of these parties, forcing them to reduce their holdings. This fire sale puts further downwards pressure on the price. However, because these parties also account for much of the trading, it also reduces the daily turnover which reduces the liquidity. If this reaches the stage where there is no longer a reliable market price for the assets, they cease to be useable as collateral.

      Not only does the declining liquidity exacerbate the fall in value but the combination of the two creates a triple whammy for the banks. They have loss of capital; they have higher capital requirements (because of having to pull assets out of low capital structures) and their funding has become more difficult because they can't access the secured market.

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    4. "Falling value implies falling liquidity."

      I don't get this part. I'm looking at this from a stock trader's point of view For example, look at IBM today in the USA.

      It was down by $13 to $14 most of the day. Here is a quote I saw.

      IBM bid: $168.38

      IBM ask: $168.41

      From that bid-ask spread, I would say IBM is still liquid.

      "If the asset prices fall, this may reduce the funding capacity of these parties, forcing them to reduce their holdings."

      If I buy a security from "money" I have saved and don't use "leverage", how can I be forced into selling?

      "A fall in value, without any loss of liquidity, would have some implications. These assets are generally carried at market value, so a loss in value translates into a loss in capital. This can impact on the capacity to advance new loans. But in the absence of the liquidity implications, this effect would be small."

      I thought Lehman was levered 33 to 1. That means a 5% fall in the asset values makes it insolvent. What if the capacity to make new loans is affected and the asset values are dependent on new loans? I'm thinking housing market here.

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    5. Some parties are leveraged; some are not. This effect depends, amongst other things, on how the market is made up between the different types.

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  5. As an ex-banker Frances can't quite bring herself to say it but I will. In a nutshell "regulatory capture" allowed the creation of toxic securities and "regulatory differentiation" allowed the widespread dispersal of those securities.

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    Replies
    1. "As an ex-banker Frances can't quite being herself to say it"......

      What an ill-informed and fatuous remark. I have said exactly that many times previously. And I am an ex-plumber, not an ex-banker. I've never in my life made a loan or bought a security on behalf of a bank.

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  6. I agree with you that the relationship between the value of these assets and their liquidity depends to some extent on holdings by parties with two key features.

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