20220910170523HCTAN008C3 Topic - 3 Comparative

Topic 3- Com parative Financial System s
Topic 3
Comparative Financial Systems
3 implications Outline &

(household, firms, FI) Exam Focus
Financial _______* Financial systems:

3 stages: _____________ vs Bank-based **
oCredit expansion (US, UK) (Germany, Japan)
oBubble burst
oDefault 4 causes of fin’l crises
Topic 3 • banking problem,
Example: Comparative • Increase in int rate
Dutch Tulip Mania Financial • Decline in stock mkt
Internet Bubble System • Increase in uncertainty
Financial Crises __________ mortgage crisis (2007)

in Emerging country Global Financial Crisis (GFC) (2008)
Example
Asia Financial crisis
2 key causes of GFC
Argentina financial crisis
a) Imbalance of macroeconomics growth
b) Securitization ****
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2
Outline of Topic 3
1. Financial systems can be
(a) bank-based (e.g. Germany, France, Japan)
(b) market-based systems (e.g. US, UK)
2. Evolution of Financial Systems:

– 1st phrase (millennium BC to first century AD)-Ancient practice
– 2nd phrase (1200 -1300s) - Italian Bankers
– 3rd phrase (early 1600s) - Dutch Finance
– 4thphrase (1719-1720)-Emergence of Market-based & bank-based
system
3. The financial systems in UK, US, Germany, France, Japan

3
Outline of Topic 3
4. The emergence of Market-based Vs Bank-based Financial Systems
4.1 Market based vs Bank-based financial system
4.2 Implications of the market-based & bank-based financial systems:
a) households’ asset allocation
b) firms’ financing
a) role of indirect intermediation
5. Causes of financial crises:

1) Banking problem (e.g. bank panic, bank runs)
2) Increase in interest rates
3) Decline in stock market
4) Increase in uncertainty
4
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Outline of Topic 3
6. Financial Crises In The USA
6.1 Great Depression (1929)
6.2 Subprime mortgage crisis 2007, Global Financial Crisis 2007–09
Key Causes of GFC 2007-2009
1) the growth of global macro-imbalances
2) financial market innovations (securitization, RMBS, CDO)
6.3 Timeline of Global Financial Crisis

• 2006–07: House prices fell (US)
• Late 2007- subprime mortgage crisis
• Sept 2008 -Lehman Brothers investment bank failed
5
Outline of Topic 3
7. Financial Crises In Emerging Market Countries
7.1 Financial crises in emerging market countries
7.2 Causes of financial crises in emerging countries:
a) Deterioration in banks’ balance sheets
b) Increase in interest rates abroad and internally
c) Stock market decline and increase in uncertainty
d) Fiscal problems of the government
e) Rise of interest rates abroad
8. Financial Bubbles
– Dutch Tulip Mania (1636–37)
– Internet Bubble(late 1990s)
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Learning Outcomes
• explain the importance of banks & financial markets around the world
• discuss how the historical evolution of financial systems helps
to explain the existence of bank-based & market-based financial systems
• outline the similarities & differences between the financial systems
of industrialised countries
• discuss the implications of the bank-based & market-based financial systems
(in terms of households’ asset allocation, role of indirect intermediation
and firms’ financing)
• explain the economic factors causing financial crises & its sequence
of events.
• discuss the historical financial crises and financial bubbles.
7
Part A:
Market-based vs Bank-based Financial System
Part B:
4 Causes of Financial Crises
2 key causes of Global Financial Crisis (GFC)
- imbalance of macroeconomic growth
- financial innovation –Securitization
Part C:
Financial Crises in emerging Countries
Features of Financial Bubble 8
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Topic 3-Comparative Financial System Key concept

Evolution of financial system:
1) Ancient practice
2) Italian banker (1st bank)
3) Dutch Finance (1st financial bubble)
4) Market-based vs Bank-based financial system*
(_____, UK) (__________, Germany, France, Italy)
No interstate banking firm & banks  close & long term relationship
No nationwide banking
50%- equity 50%- cash cash (36%,) bond(36%)
Recent trends [ ]
Implications*
Households Firms
Surplus unit shortage unit
Sources of funds
[allocation of assets] [Financing] ___________ source –retained earnings (1)
__________ source – Debt –loan [all firm]
- bond
-- Equity- shares
Introduction
• Financial systems (financial market & financial intermediaries)
can be divided into (i) bank-based d (ii) market-based systems.
(ii) bank-based systems

• banks are more important than markets (e.g. Japan & Germany)
• Bank claims on the private sector to GDP ratio for Germany was 127%
(i.e. 2.5 times of the USA, 48%)
(i) market-based financial system

• markets are more important than banks (e.g. UK & the USA)
• Equity market capitalisation to GDP ratio in 2009 for US was 107%
(i.e. 3 times of Germany, 39%)
Banks and market are equally important in France

other European countries (e.g. Italy, Spain) banks are important than markets
However, there are differences in the irrespective relevance 10
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11
International Comparison of Banks and Markets
11
Source: M. Buckle (2011) Principle of Banking and Finance, ch3
11
Introduction
• The importance of financial institution are different across countries
• Gross financial assets are held differently (e.g. by households,
by pension funds, by insurance companies, by mutual funds)
• Most assets are owned directly by households (except for the UK).
• Pension funds are important in USA & UK but
relatively unimportant in Germany & Japan
• Allocation of assets in the portfolio are different across countries.
• Equity (share) constitutes
high proportion of household portfolio assets in the UK (52%),USA (45%)
low proportion in Germany (13%) and Japan (12%)
• Bond, cash & cash equivalents (include bank accounts) constitute
high proportion of household portfolio assets in Japan (52%) & Germany
(36%)
low proportion in USA (19% cash, 28% bond) (Allen & Gale, 2001) 12 T3-pg6
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Introduction internal
Firms’ fund raising
• Retained earnings are the most important source of finance
in all countries (except Japan)
• External finance is simply not very important.
• Loans is the most important external sources of finance
• Loan is the 2nd source of finance in the USA, UK,
Germany, Japan, France & Italy (Mayer, 1990; Corbett and Jenkinson, 1997).
• USA & UK have the highest financial market capitalisation to GDP,
loans are important for corporate finance than are securities markets
(bonds & stocks).
• Germany & Japan have the lowest financial market capitalisation to GDP
loan is almost 10 times greater than that from securities markets.
13
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Summary for Introduction
• UK & USA are eg of market-based financial systems, where:

 Financial markets (i.e. organised markets for securities,
e.g. stocks/ bonds/ futures/ options) are more important than banks
 The proportion of gross financial assets owned by pension funds
is higher.
 The proportion of equity in the total portfolio allocation of assets
by householders is higher.
 Loans from financial intermediaries are more important for
corporate finance than marketable securities,
but at a lower extent than in other financial systems.
• Germany and Japan are examples of bank-based financial systems.
14
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Evolution of Financial Systems

• The historical development of financial systems
explain the existence of market-based and bank-based financial system.
1st phrase – Ancient practice (millennium BC to 1st century AD)

• From Mesopotanian financial system (3rd millennium BC) to
Roman empire (1st century AD)
2nd phrase (1200 -1300s) - Italian Bankers
• After the Romans, monetary systems did not develop in Europe until the next
period of progress, starting in 1200 until Renaissance in the 1300s
3rd phrase (early 1600s)- Dutch Finance
took place in Amsterdam in the early 1600s.
4th phrase (1719-1720) - Market-based & Bank-based Systems 15
15
1st phrase- Ancient Practices

• From the Mesopotanian financial system (3rd millennium BC)
to the Roman empire (1st century AD)
Characteristics
• Financial instruments were initially limited to precious metals or
metallic (gold & silver) coins.
• Then extended to loans and mortgages.
• Loans were made to individuals for consumption needs &
for agricultural financing (from landlords to tenants).
• Mortgages combine loan & insurance, and were used
for foreign trade financing to finance a voyager.
• When catastrophe, repayment was not required
(i.e. similar to equity instruments).
• Financial intermediaries were limited to banks & money changers
(as many different types of coins exists)
• Banks began to operate (accept deposits & make loans) in Athens 16
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• in the late 5th century BC.
16
2nd phrase- Italian Bankers

• After the Romans, monetary systems did not develop in Europe until 1200
• From North of Rome in Tuscany & further North to the Renaissance
in the 1300s.
Characteristics
• Financial instruments became more varied (e.g. trade credit and mortgages,
bills of exchange, government & corporate securities, insurance contracts)
• The innovation of bills of exchange has been very important and
opened up the way to banks in a modern sense.
• Bills of exchange were debt instruments drawn on the buyer of goods, which
promised the payment of a specified amount in the
buyer’s hometown at some date in the future.
• Due to the prohibition on usury imposed by the Roman Catholic Church,
bills of exchange could not be discounted. To overcome this prohibition,
the exchange rate specified in the transaction was such that there was a
de facto discount.
• Note: Refer to Allen and Gale (2001) – look out for the role of the pre-Reformation Church;
the aristocracy, nation states and taxation; the rise of Islam; trade routes between Asia
17 and
Europe (via the Silk Road).
17

Other new financial instruments appeared:
(i) Debt claims against amount borrowed by governments
(ii) Corporate claims (equity-like instruments) issued by partnerships
& companies.
(iii) Maritime insurance became important & life insurance was introduced.
• Financial intermediaries have early types of banks & insurance companies.
• After the Middle Ages Banks were first established in
Florence, Siena and Lucca, then spread to Venice and Genoa.
• In the 14th century Bardi and Peruzzi in Florence grew to a substantial size.
• In the 15th century, Medici banks in Florence achieved a sophistication
that remained unbeaten until the 19th century.
• The main activities of banks were:
18 ;
– transferring money for international trade & the Roman Catholic Church
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– establishing networks in Europe.
18

• Informal markets appeared.
• Government & corporate securities were transferable & traded.
• Jewish people were more important than the Italians in northern Europe.
• Jewish plays important financial roles in Spain and Poland.
• The Church’s rules against usury gave the Jewish bankers
their competitive advantage.
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3rd phrase- Dutch Finance (early 1600s)

• Took place in Amsterdam.
• The Netherlands independent from Spanish after a long, costly war.
• Trade & finance blossomed, Dutch called it’s as their ‘Golden Era’.
• The wealth that flowed down the River Rhine from
Germany, France & Switzerland led to new financial systems.
• Wealth increased - rise of Dutch painting, empire building & successful
wars against the English, culminating in a Dutch king of England in 1689.
• The Dutch gave the English a model for a ‘central bank’ and a new king.
20
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3rd phrase- Dutch Finance (early 1600s)

• Financial markets became more formalised.
• The 1st formal stock exchange was established in 1608 as a market
for commodities & for securities (although these were less important).
• The market soon developed sophisticated trading practices.
• Tulip Mania (1636–37), the first financial bubble,
helped the development of the Amsterdam Bourse.
• Price of tulips rose quickly to very high levels then collapsed dramatically.
Caused many speculators bankcrupt.
• Options & futures contracts were traded on the Amsterdam Bourse;
• Government involved in the financial system through central banks
• The Bank of Amsterdam (established in 1609) became a model for public
banks set up by governments. Its main purpose was to facilitate payments.
• Commercial banks took deposits & made exchanges,
but in general did not provide credit.
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4th Phrase- The Emergence Of

Market-based & Bank-based Systems (1719-20)
• South Sea Bubble occurred in England & the Mississippi Bubble in France.
• 2 distinctly different types of financial systems developed:
(i) stock market oriented US/UK model &
(ii) bank-oriented continental European model.
• UK repealed the heavy regulation of the stock market (called Bubble Act,
reacted to the South Sea Bubble) at the beginning of the 19th century.
• France only ease restriction on the stock market in 1980s.
• The French experience has substantially affected the development of
financial systems in continental Europe (especially the German system)
22
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Topic 3-Cmparative Financial System Key concept

Evolution of financial system:
1) Ancient practice
2) Italian banker (1st bank)
3) Dutch Finance (1st financial bubble)
4) Market-based vs Bank-based financial system*
(US, UK) (Japan, Germany, France, Italy)
No interstate banking firm & banks  close & long term relationship
No nationwide banking
50%- equity 50%- cash cash (36%,) bond(36%)
Recent trends [ ]
Implications*
Households Firms
Surplus unit shortage unit
Sources of funds
[allocation of assets] [Financing] Internal source –retained earnings (1)
External source – Debt –loan [all firm]
- bond
-- Equity- shares
23
[2006, 2007,2010, 2017] Key concept

Market-based financial system vs Bank-based Financial system
[US, UK] [Japan, Germany]
__________ ______________, specialized [Japan]
Firm & bank: close + LT relationship
Low integration of: _____________ integrated:
a) Bank & firm i) nationwide banking
b) Bank & non-bank service ii) ______________banks
[=commercial bank+ investment bank]
Germany Japan
Bank: bank:
No gov interfere gov interfer
3 implications * universal[private sector] [public sector]
1) Household -Asset allocation Hausbank system *credit allocation system
US UK 1)Household: low risk
Can take risk can take risk 36%cash 50% cash
52% stock 45% stock 36% bond
2) Firm- Financing 2) Firm Financing
Retained earnings -
Retained earnings (1st choice)
Loan Loans
Loan 3) FI-role
3) FI- role Insurance co,pension fund  not important
Insurance co, pension fund Investors held share indirectly via FI T3-pg12
 important
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USA
• The National Bank Acts (1863 & 1864) set up a national banking system to
react to the chaos of the US Civil War.
• Fears of excessive centralisation led to the banks in each state being granted
limited powers: each bank was confined to a single state; and banks were
prohibited from holding equity or paying interest on demand deposits.
• After a series of panics in the system (1873, 1884, 1893, 1907),
the Federal Reserve System was established with a regional structure in 1913.
• In 1933 another major banking panic led to the closing of banks for an
extended period.
• This led to the Glass-Steagall Act of 1933, which introduced
deposit insurance & required the separation of commercial & investment
banking operations
• Prohibited universal banking & prevented banks from underwriting securities.
• So, throughout the 19th century, the US banking system was highly
fragmented, without a nationwide system with extensive branch networks.
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US [Market-based financial system] Extra info

1873-1907 bank panic
1913 Federal Reserves [= US central bank]
1930 Great Depression [stock mkt crash]
1933 FDIC [= Federal Deposit Insurance Corporation
*Glass-Steagall Act [many restriction] [_______________________]
 no universal bank [separated commercial bank & investment bank]
 no underwriting
 no interbank banking & branching
[50 years of restriction]
1980 _________________________________________ [removed regulations]

1999 Financial Services Modernization Act [FSM]
2000-2006 Bank expanded very first, too much freedom
2007 _______________________________Crisis
2008 ______________________________ Crisis [banking crisis]
Post-2008 _______________________________ [Basel 3, see Topic 5] T3-pg13
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USA
Capital markets are more important than banks in the USA because:
1) The Civil War helped to develop New York’s financial market and the
First World War helped the New York market to supplant London markets
(as New York’s markets were financing all parties).
2) The prohibition on banks’ holding equity & the fragmentation of the
banking system (particularly to provide services to the corporate sector).
3) After the Great Crash 1929, Securities & Exchange Commission (SEC)
was created. SEC is the financial regulator to ensure the
integrity of the markets & the regulation of financial markets in US.
4) Financial innovation, introduced new financial instruments such as
derivatives (swap & options). At the same time, new exchanges for
options & financial appeared and become major markets.
27
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USA –Regulation Relaxation

Relaxed 3 restrictions on the banking system
1) Erode the Glass-Steagall Act prohibitions
In 1987 the Fed allowed affiliates of approved commercial banks to engage
in underwriting activities. As long as the revenue did not exceed a
specified amount (10% initially but was raised to 25%) of the affiliates’ total
revenues.
• In 1988 the Fed allowed 3 commercial banks (Bankers’ Trust, Citicorp & J.P.
Morgan) to underwrite corporate debt securities & to underwrite stocks.
2 competitive reasons determined this legislative change:
 Brokerage firms began to engage in the traditional banking business
of issuing deposits.
 Foreign banks’ activities in the USA eroded the position of national US
banks.
28
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USA –Regulation Relaxation

2) Eliminate the Glass-Steagall Act
The Gramm-Leach-Bliley Financial Services Modernization Act of 1999
allows securities firms & insurance companies to purchase banks &
allows banks to underwrite insurance and securities and
engage in real estate activities.
3) Relax the restriction on banks crossing state boundaries

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
stated that after 1997 banks would be essentially unrestricted to
interstate banking, except in states that opted out or imposed other
restrictions. Nationwide banks beginning to emerge.
29
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UK – Bubble Act (1720)

• South Sea Company was established in 1711, to fund the government debt
in exchange for a payment to the company.
• Speculation on South Sea Company stock caused a dramatic rise in its price.
This led to a large number of other stock issues by promoters who hoped to
profit from price appreciation.
• The Bubble Act (1720) was passed to prevent stocks from diverting
resources away from the South Sea Company. However, the Bubble Act did
not prevent a dramatic fall in the price of the South Sea Company, and many
speculators went bankrupt (note similar to the Tulip Mania in Amsterdam
Bourse).
• The Bubble Act was repealed in 1824 to create barriers to company formation.
Required a royal charter to form a joint stock company. As a result, the
London capital market did not become a source of funds for companies.
• However, London capital market did become important for government
financing in 19th century. 31
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UK – London Stock Exchange (LSE)
• The London Stock Exchange (LSE) was established in 1802.

• LSE become more important as a source of funds for firms because of:
a. the repeal of the Bubble Act in 1824
b. the freedom to form companies without specific parliamentary approval,
introduced in 1856
c. the development of railways in Britain and abroad,
which resulted in a large demand for capital.
• New York replaced London as the world’s major financial centre after 1918.
To this day the UK remains a stock market-based financial system.
32
32
UK – Development of Banking System

The UK banking system developed strongly in the 19th century because:
1) Establishment of the Bank of England (1694)
• Bank of England was established as a private institution
to help government market debt to finance the 9 Years’ War with France.
• 1742 Bank of England was granted a monopoly over note issues
in England except for private banks.
• [Note that the growth of central banking activities in England laid the
foundation for the development of central banks in other countries]
2) Banks consolidated into nationwide networks

• Country banks needed to have London branches because of the Bank of
England’s role.
• London banks needed to have branches outside London. 33
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33

3) Concentration of commercial banking
• Commercial banking was traditionally dominated by 4 clearing banks
( Barclays, National Westminster, Midland & Lloyds)
(now Barclays, Royal Bank of Scotland, HSBC & Lloyds).
• Although there is no equivalent to the Glass- Steagall Act &
universal banking is allowed, commercial & investment banking
(merchant banking or securities firms in UK terminology) were
traditionally separate because of restrictive practices.
• In 1986, the ‘Big Bang’ brought important structural changes in the LSE.
• All the securities firms became part of integrated financial institutions.
34
34

4) Large Foreign Presence
• The foreign & domestic sectors banks are roughly equal in size.
• This large foreign presence may in part explain the high ratio of bank claims
on the private sector to GDP.
• However foreign banks are not involved with the domestic sector
(with a few exceptions)
• Traditionally, banks did not engage in long-term lending to industry.
• This explains why firms rely greatly on internal finance and markets for
raising funds.
35
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35
Germany
• Banks play a far more important role and markets are less relevant
• Prior to 1850, German financial markets were undeveloped
relative to those in the UK, joint stock companies were rare.
• The markets (Frankfurt & Berlin) were mostly for
government debt & loans to princes, towns and foreign estate.
• Banks provided the initial finance for industrialisation &
managed the issue of shares & bonds to repay the loans.
• Links between banks &industry grew substantially during this period.
Banks were represented on the boards of companies, and
industrialists held seats on the boards of banks.
• Formed the Hausbank system where
firms have a long-term relationship with bank and
use it for most of their financing needs. 36
36
Germany
• This qualifies as a universal banking system.
• Universal banks offer a full range of services to commercial customers &
are formally linked to their commercial customers through equity holdings.
• 3 major universal banks (Deutsche, Dresdner & Commerzbank)
dominate the allocation of resources in the corporate sector.
• This explains why the most important sources of funds for firms
were bank financing and internal finance.
37
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37
Germany
Financial markets in Germany is relatively undeveloped because:
1) Rely on bank finance & the close relationship between banks & firms.
So bank loans are very important, although retained profit
is the most important source of finance.
2) Few households participate directly in the speculative financial market.
No prohibition for insider trading.
3) Limited availability of mutual funds.
German investors have a limited range of equity instruments to invest in.
The allocation across assets is mostly in cash & cash equivalents (36%) &
bonds (36%), while equity is fairly unimportant (13%).
38
38
Germany
• Recent developments – to create a single market in banking in the
European Union (EU) countries. This is to remove trade barriers across
European banking systems, by harmonising regulation in the EU countries.
• The Second Banking directive (1993) created the EU passport. It allows a
bank in 1 member country to provide core banking services throughout the EU.
• Complementary directives (Basel Capital Requirements Directives) aim to
harmonize solvency regulation across the EU.
• Basel 1 (1988) helped to strengthen the soundness & stability of the
international banking system by requiring higher capital ratios.
• Basel 2 (2006) revised Basel I by making the framework
more risk sensitive & representative of modern banks’ risk management
practices.
• Note: Basel Committee on Banking Supervision
39
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Exam Focus
PYQ-QA3 – Comparative Financial Systems
2 Compare and contrast the relative importance of banks in 2010-2b-ZA
Germany and the USA. (12 marks)
3 Compare and contrast a market-based financial system with a bank-based2006-1a-ZA
financial system. (15 marks)
4. Explain the main implications of the presence of market-based versus bank-20075b-ZAB
based financial systems. (12 marks)
5 Explain the differences between market-based and bank-based financial2017-3b-ZA
systems. (12 marks)
40
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2010-2b-ZA
2(b) Compare and contrast the relative
importance of banks in Germany and the USA. (12 marks)
• refer to pp.40–49 of the subject guide, and to Chapters 1, 2 and 3 of Allen and Gale
Comparing financial systems.
• The Examiners would expect answers to identify the key features of the banking systems
of Germany and the US and then to compare and contrast these features.
• Banks in Germany are universal banks offering a full range of banking products to
customers. Banks in the US tend to be split into commercial & investment banks although
this distinction had to some extent been eroded due to the ending of some of the Glass-
Steagall Act provisions.
• A very good answer would discuss the proposed reforms to the US banking sector
where the separation between commercial & investment banking may be re-established
in the reforms coming in following the financial crisis. The link between banks and firms
(through the Hausbank system) is strong in Germany. It is not as strong in the US.
• Good answers would discuss the implications of this for adverse selection and moral
hazard in the two countries with Germany likely to have a lower incidence of each, Finally,
good answers would discuss the differences in the provision of long-term capital to
businesses in the two countries, with banks being very important providers of long term
capital in Germany. This is less the case in the US where capital markets play a larger role. T3-pg20
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Japan
• Bank-based financial system is Japan (similar to German)
• Japan the government was active in the development of the banking system
(whereas the Germany Hausbank system developed in the private not public
sector)
• The Ministry of Finance & the Bank of Japan (BOJ) supervise extensively
over areas (e.g. opening of new branches, opening hours, credit volumes,
interest rates & accounting rules)
42
42
Japan
• In 19th century, feudalism and the Meiji Restoration were abolished.
• Japanese authorities played a leading role in the growth of the modern
industrial economy & the establishment of a financial system.
• During wartime (1937 to 1941), Japanese government introduced central
control of financial resources system (namely credit allocation system).
It determined a close relationship between banks & companies in the keiretsu
(i.e. a group of industrial firms with a core group of banks)
Characteristics of Japanese banking system:
1. Long-term relationships between a bank & firm.
2. Bank hold both debt & equity of non-financial firms.
3. Bank intervene actively in firm with financial problems.
Japan loans (not retained profit) are the most important source of financing.
43
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Japan
• Japanese banks are highly segmented & specialized along functional lines.
• Financial Reform (1992) reduced the amount of segmentation
(i.e. different types of financial firms are allowed to enter new financial
activities through separate subsidiaries).
• Japan experienced a major banking system crisis in 1997 & 1998,
7 large financial institutions went bankrupt.
Private financial institutions still have not fully recovered from this crisis:
in July 2007 only 1 Japanese bank (Mitsubishi UFJ Financial Group)
still maintains a global presence & occupies the 7th position in
The Banker’s ranking of the top 1,000 banks.
In 1994, six of the 10 top banks were occupied by Japanese banks.
44
44
Japan
• In the past 50 years, Japanese securities market has been weak.
• Japanese banking system experienced an abundance of funds due to
the large financial surplus of the personal sector caused by
– Japanese households are heavy savers
– limited investment opportunities in housing.
• Japanese households’ asset allocation is mainly cash & cash equivalents
(52% including bank accounts).
• The equity market is volatile & speculative as
companies reply on banks’ financing, thus high leverage ratios.
45
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45
Japan
• In recent years, financial markets have steadily become more important.
 The Japanese government relaxed several regulatory restrictions
(e.g. restriction on issuing bonds) to gain international recognition.
 Large firms are increasingly rely on financial markets to raise funds.
 Resulted in fairly sophisticated financial markets.
• The development of the Japanese financial market has determined
the relative unimportance of equity (13%) & bonds (12%) in
the asset allocation of Japanese households.
• Note that in the 1990s the fall in individual ownerships has mainly been
offset by an increase in the holdings of banks, insurance companies and
business corporations.
46
46
France
• The Mississippi Bubble profoundly affected the development of the stock
market and banks in France.
• Official Bourse was set up after the collapse.
• Markets for company securities did not develop significantly during the 19th
and 20th centuries.
• The Mississippi Bubble retarded the development of banks for many years.
2 main institutions (1938–62) aim to provide long-term loans for the industry.
But they ended up providing short-term commercial loans & speculating in
foreign bonds.
(This suggests that the system of banks lending to industry developed in a
deeper way only in Germany).
47
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47
France
• bank-based financial and markets are less relevant.
• In the 1980s, French government reformed the financial system and the
financial markets developed greatly because:
1) Two main reforms.
(i) the creation of a single national market, so that stocks from any of the 7
exchanges could be traded at any exchange.
(ii) the completion of a computerised trading system (i.e. Cotation Assistée
et Continu(CAC).
2) The immediate success of derivatives markets (e.g.MATIF) in mid-1980s.
3) The substantial presence of collective investment scheme (e.g. mutual funds),
holding 19% of financial assets (much higher than other country).
• Note, a high proportion of assets (62%) are held directly by households, and
hold mainly cash and cash equivalents (38%) & bonds (33%).
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48
Market-based Vs Bank-based Financial Systems

• market-based & bank-based financial systems are different due to the
national banking structure:
1) Integration of banking and commerce
can operate either by
(i) banks’ ownership of commercial firms or
(ii) commercial firms’ ownership of banks.
– USA & UK - no integration of banking & commerce.
– Germany & Japan - close relationship between banks & firms, with
higher amount of information available to banks.
Reduce moral hazard problem through monitoring firms.
Moral hazard is one of the problems intermediaries face in lending.
It represents the risk (hazard) that the borrower engages in
undesirable activities (immoral) after lending. 49
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49

2) Integration of the provision of bank & non-bank financial services
• Bank financial services: deposit-based lending
Non-bank financial services: investment, underwriting, insurance,
trust & property services.
• UK & USA - low integration bank services (Note: now, more integration are
now possible after financial reform)
• Germany - high integration of bank services (characterizes universal banks).
• France & Italy - limited universal banking.
50
50

Some peculiarities
• USA (unlike UK & EC) – no nationwide banking system with few banks.
• Germany & France – Equity markets only develop in recent years.
Banks are the primary source funds to firms.
Germany – strong links between banks & firms
France - banking relationship is less successful developed
• Japan - government is important in the development of the banking system,
Germany (Hausbank system) - no government intervention in the
development of banking system
51
T3-pg25
51
Qns: What is the economic reason for the existence of market-based & bank-
based system?
Ans: different reactions to the instability of financial markets.
• South Sea Bubble (UK) & Mississippi Bubble (France)
resulted the existence of market-based and bank-based financial system.
• UK repealed the heavy stock market regulation (Bubble Act) in the 19th century
France relaxed the stock market restriction only in 1980s. 1720
• Many financial crises & speculative bubbles (Tulip Mania, Great Crash,1929)
affected the development of financial systems.
• Financial systems are fragile and crises are endemic.
52
52
• Financial markets did not develop spontaneously.

• Various kinds of financial institutions were responsible for the first financial
transactions in loans & transfers. 1st stock exchange
• Amsterdam Bourse was established in 17th century
• Market imperfections (e.g. transaction costs & asymmetric information)
cause the financial systems have been much closer to the extreme
where no financial markets exist.
• Financial intermediaries are needed to overcome market imperfections,
and allows firms & investors to exploit the market effectively.
53
T3-pg26
53
Implications of Market-based & Bank-based Financial Systems

The implications of the market-based & bank-based financial systems:
i) firms’ financing
ii) households’ asset allocation
ii) role of indirect intermediation (pension funds, insurance companies, mutual funds)
Households’ asset allocation [see Figure 3.2]
• UK & USA equity is a much more important component of household assets
than in Japan, France and Germany.
• Equity holding in asset portfolio:
UK (52%), US (45%), Japan (12%), Germany (13%)
• Cash & cash equivalents (include bank accounts):
Japan (52%), Germany (36%), USA (19%)
Bond holding
Japan (13%), Germany (36%), USA (28%)
• Bonds are fairly unimportant in the UK & Japan.
• USA & UK households bear significant risk 54
Germany, France & Japan households bear relatively little risk.
54
Implications of Market-based & Bank-based Financial Systems

The implications of the market-based & bank-based financial systems:
a) households’ asset allocation
c) role of indirect intermediation (pension funds, insurance companies, mutual funds)
(a) Households’ asset allocation [see Figure 3.2]

• In the UK & USA equity is a more important component of household
assets than in Japan, France and Germany.
• Bonds are fairly unimportant in the UK & Japan.
• USA & UK households bear significant risk
Germany, France & Japan households bear relatively little risk.
Households’ Asset Allocation US UK Germany Japan
Equity 45% 52% 13% 12%
Cash & cash equivalent (+bank a/c) 19% 36% 52%
Bond 28% 36% 13%55
T3-pg27
55
56
56

• distinction between market-based & bank-based systems is not clear.
• Differences in firms’ external financing.
• Germany & Japan (bank based system) –firms’ financing from financial
intermediaries is 10 times greater than that from securities markets,
due to low financial market capitalization to GDP
• In market-based systems- financial markets are also unimportant source of
finance.
.
57
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57

c) Role of FI
• Gross financial assets are held directly by households, by pension funds,
Most assets are owned directly by households (except for the UK) see Fig3.3
• Germany, France & Japan – individuals invest indirectly through
intermediaries (e.g. pension funds & mutual funds)
• USA - individual direct participation in the stock market is high (but falling).
Different individual, different investment decisions.
• Individuals are becoming less involved in making transactions
directly in financial markets, whereas the market share of
pension funds & mutual funds are increasing.
• Pension funds & insurance: UK & USA (important);
Germany & Japan (unimportant)
58
58
59
T3-pg29
59
Current Trend: Towards Market-based Financial Systems

Current trend is towards market-based systems
Several government policies support this argument.
• European Union (EU) countries- towards a single financial market
through harmonising regulation throughout EU countries.
• France - financial markets are getting more important since mid-1980s.
• Japan – financial system reforms (i.e. ‘Big Bang’) in 1998-1999
2 reason for the growing importance of market-based systems:

i) Discredited government intervention.
ii) Effectiveness of financial markets in allocating resources
as emphasised by economic theory
Note: Market imperfections (e.g. transaction costs & asymmetric information)

limits the grow of financial markets. 60
60
Concept Check Activity:

Market-based vs Bank-based Financial Systems
___________-based financial system _______-based financial system
UK & USA Germany and Japan
F______________ are more important ________ are more important
financial assets owned by pension funds is higher.
S________ are the most important in

households’ portfolio
L______ are more important than securities
for corporate financing
(but still lower than those in Japan)
61
T3-pg30
61

Implications of Market-based Vs Bank-based Financial Systems
a) firms’ f_____________ b) households’ a a_________________
c) role of in_______inter________ (pension funds, insurance companies, mutual funds)
Asset allocation (Equity) Bond Cash & Risk

(in households’ portfolio) Share cashequivalent tolerance
U______ High (45%) Low (28%) Low (19%) High
UK High (52%) unimportant High
Germany Low (13%) High (36%) High (36%) Low
France High (33%) High (38%) Low
J________ Low (12% ) low (13%) High (52%) low
62
62
Exam Focus
2 Compare and contrast the relative importance of banks in 2010-2b-ZA
Germany and the USA. (12 marks)
3 Compare and contrast a market-based financial system with a bank-based2006-1a-ZA
financial system. (15 marks)
4. Explain the main implications of the presence of market-based versus bank-20075b-ZAB
based financial systems. (12 marks)
5 Explain the differences between market-based and bank-based financial2017-3b-ZA
systems. (12 marks)
63
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63
5 (b) Explain the main implications of the presence of

market-based versus bank based financial systems. (12 marks) 2007-5b-ZAB
• A good answer would explain that essentially in

market-based systems (US and UK) – (1 mark for examples) in contrast to
bank-based financial systems (Germany and Japan) (1 mark for examples) – the
financial markets play a greater role in providing finance to firms (1 mark), the
relationship between banks & firms is not close (1 mark) and there is a
lower level of integration between bank & non-bank financial services (1 mark).
A better answer to this question would mention the following:
• The proportion of gross financial assets owned by pension funds is higher (2 marks).
• Equity is a more important component of households’ asset portfolios in
market-based systems (2 marks).
• Moral hazard should be lower in bank-based financial systems (1 mark).
• Trend is towards market-based systems suggesting their superiority in terms of
capital allocation (2 marks).
64
Market-based Financial System vs Bank-based Financial System

1. Introduction – eg. market-based systems (US and UK) in contrast to
bank-based financial systems (Germany and Japan) the financial markets
2/3/4- Body of discussion= Compare and contrast the differences
in the context of:
- bank and firm (/ gov) relationship
- level of integration (e.g fragmented vs segmented)
- bank and non-bank financial services (full services vs non-full services)
- without vs with Universal bank
-implications for:
-asset allocation of household
- firm financing
- role of intermediaries
- others (e.g. moral hazard, regulations)
- future trends
- discuss the above with relevant examples (e.g. UK, US, Japan, German situations)
5. Conclusion
T3-pg32
65
Part A:
Part B:
- financial innovation -Securitization
Part C: 66
Features of Financial Bubble

66
Topic 3b- Financial Crises Sequence of events

Loan, investment, economy –all drop
[common] causes of financial crises * Bank panic [failure bank more,
1) Bank problems
more, more]
Int rate [higher, higher, higher]
More problem loans [=asset value drop] Economy [worse, worse, worse]
Banks balance sheet [asset] value drop
Firm Net worth drop, P drop
Firm’s indebtness [higher, higher]
Bank run [withdraw $ in ST]
Bank panic [many bank runs]
Contagion effect [domino effect]

Great Depression (1929/30)
Systemic banking crisis [nationwide] 1928: stock mkt boom [P up x2]
2) Int rate up [loan] 1929: stock mkt crash
1930: ½ US bank collapsed
Only risky borrower willing to pay high int [unemployment rate 25%]
Loan drop [bank unwilling to offer to loan]
Investment drop, economy drop
3) Stock mkt down
4) Uncertainty ?
T3-pg33
failure of FI, Recession, stock mkt crash
67
Financial Crises
Definition of financial crises
~ major disruptions in financial markets that are characterised by sharp falls in
asset prices and the failure of many financial institutions (including banks).
• A financial crisis cause sharp decline in the economic activities.
• Financial crises have been common in Europe & USA and
its impacts on the development of financial systems are deep.
• Many emerging countries have had several banking problems in 1980-1996.

3/4 of IMF members suffered some form of financial crises
(Lindgren, Garcia, Saal, 1996).
• The causes & consequences of the various financial crises are important.
68
68
Financial Crises – Asymmetric Information

• Financial crises occur where there is a large increase in asymmetric information
in financial markets.
• Asymmetric information occurs when one party to a transaction has
less information than the other party, unable to make an accurate decision.
• Market become less efficient is information asymmetries increase.
• Channel for moving funds from savers to investors (market-based system)
becomes less attractive relative to the banking system.
69
T3-pg34
69
Causes of Financial Crises

Causes of financial crises:
1) Banking problem (e.g. bank panic, bank runs)
2) Increase in interest rates
3) Decline in stock market
4) Increase in uncertainty
70
70
1. With reference to examples (including the recent 2007/8 crisis) discuss the
main causes & characteristics of financial crises in the US. (25 marks)
• See subject, guide pp.54–57. 2012-1a
Financial crises in the US are generally the result of:
i. problems in the banking sector – this could be caused by a
financial bubble in the stock or property markets that bursts
ii. an increase in interest rates
iii. stock market decline
iv. an increase in uncertainty.
• Better answers would use at least 2 examples to illustrate some of the

similarities between US financial crises (e.g. dot-com bubble & 2007/8 crisis)
both resulting from financial bubbles.
T3-pg35
71

(1) Bank Problem (bank panic, bank run)
• Banks play a major role in the financing investments as they are informative.
• Banks are vulnerable to liquidity shocks if they mismatch the
maturities of liquid liabilities and illiquid assets
• Deterioration in the banks’ balance sheets implies fewer resources for lending.
This causes a decline in investment spending which slows economic activities.
• In the case of a severe crisis, the banks might fail.
• Fear can spread from one bank to another.
• One bank panic can spread very quickly to other banks
(as depositors rush to withdraw their deposits simultaneously).
Bank run  bank panic  systemic banking crisis

(Depositors withdraw $) (many bank runs) (almost all of the banking capital in a
72
country is wiped out)
72

• Without deposit insurance and ignorant of the loan quality,
depositors withdraw their funds from both good & bad banks simultaneously.
• Banks will have insufficient funds to meet all these requests.
• Depositors have a strong incentive to run on the bank first because banks
operate on a sequential service constraint (i.e. first come, first served ).
73
T3-pg36
73

• Uncertainty about the health of the banking system can lead to bank runs
on both good & bad banks
• The failure of one bank can provoke the failure of others banks
(i.e. contagion effect or systemic risk).
• These multiple bank failures are known as bank panics.
Consequences of a bank panic:

(i) a loss of information in financial markets and a loss of financial intermediation
by the banking sector.
(ii) a decrease in the supply of funds to borrowers (because of the absence of
lending), which leads to higher interest rates.
74
74

(2) An increase in interest rates
• A sharp increase in interest rates (due to decrease in the money supply or

an increase in the demand) means that individuals & firms with the
riskiest investment projects are the only ones willing to pay the higher interest.
• Customer with bad credit risks are the only ones still willing to borrow
when interest rates are high.
• They are those who are likely to have weak, risky uses for the money.
• The consequence is that lenders no longer want to make loans.
• This decrease in lending leads to a decline in investment &
aggregate economic activity.
75
T3-pg37
75

(3) Stock Market Decline
• Stock market decline implies a lower value of the firm’s net worth &
lower collateral value
(which is property promised to the lender if the borrower defaults).
• Banks are less willing to lend as they are less protected by the
declining value of collateral.
Resulted a reduction in investments & aggregate economic activities.
• Decline in net worth induces firms to take on more risky investments,
as they lose less if they have to default.
76
76

(4) An increase in uncertainty
Financial markets are more uncertain when:
i) failure of prominent financial institutions
ii) recession
iii) stock market crash
• Lenders become unable to screen good and bad credit risks

(due to the adverse selection problem).
• Decrease in lending causes decrease decline in investments &
aggregate economic activity.
77
T3-pg38
77
Financial Crises In The USA

Sequence of events characterises many US financial crises:
a. 4 factors causing financial crises (mentioned earlier) lead to
an increase in adverse selection and moral hazard problems.
b. Decline in lending, investment spending & aggregate economic activity.
c. Bank panic happened as depositors to withdraw their funds from banks due
to economic slowdown and uncertainty about the banking system caused
d. Interest rates increase further and financial intermediation by banks
decreases as number of banks reduced
e. Adverse selection & moral hazard problems worsen.
f. Economic contracted further.
g. Debt deflation (i.e. prices declined sharply, firms’ net worth deteriorated
because of the increased burden of indebtedness borne by firms) happened.
The recovery process is short circuited. 78
78
Great Depression (1929)

• the worst ever experienced by the USA.
• 1928-1929: Stock market boomed which stock prices doubled.
The Fed pursued a tight monetary policy by increasing interest rates.
• 1929: Stock market crashed
• Middle-1930: >50% of the stock market decline had been reversed.
• After mid-1930: stock market continued to decline & the adverse shocks
extended to the agricultural industry. Uncertainty increased & economic
contracted, adverse selection & moral hazard worsen in credit markets.
• Oct 1930 to March 1933, a sequence of banks collapsed (over 1/3 of the
US banks went out of business).
– Decline in the amount of financial intermediation and the ability of financial
markets to channel funds to firms.
– Price fell by 25%. This triggered a debt deflation (i.e. net worth fell because
of the increased burden of indebtedness borne by firms).
– The decline in net worth and the resulting increase in adverse selection &
moral hazard problems in the credit market prolonged economic contraction 79
and unemployment rate rose to 25%. T3-pg39
79
Concept Check:
4 General Causes of Financial Crises
1) Banking Banks face liquidity shocks when mismatch the maturities of liquid liabilities
problem & illiquid assets. Banks’ balance sheets ddeterioration
(bank p___, Caused less lending less investment & aggregate economic activity
bank r___) Bank run as depositors withdraw their deposits from both good & bad
banks due to uncertainty about the banking system & economics downturn.
Bank psnic as the c______ effect or systemic risk cause 1 bank fails after
another bank. Banks operate on a first come (to withdraw), first served
basis. Banks have insufficient bank funds to meet all the withdrawal..
2) _______rates (due to decrease in the money supply or an higher demand) i.e. only riskier
rise individuals & firms (=bad creditworthiness) willing to pay higher interest
 Caused less lending less investment & aggregate economic activity.
3) _____market Implies the firm’s net worth & collateral value decline.
drop  Caused less lending less investment & aggregate economic activity
4) more When (a) financial institutions fail (b)recession (c)stock market crash
uncertainty Adverse selection caused lenders unable to screen good & bad credit risks.
80
 Caused less lending less investment & aggregate economic activity.
80
Part A:
Part B:
- Financial Innovation and Securitization
Part C:
Financial Crises in Emerging Countries
T3-pg40
81
2 key causes of 2006 Key concept

Global Financial Crisis, GFC Int rate up, up, up
[2007-2009) Property Price down, down, down
1) ______________________________
goods 2007
Europe <---------- Asia Northern Rock Bank (UK] bankrupted
-------- Due to liquidity problem
Gov bond
2008 GFC
(US, UK, EC) (China, India)
Freddie Mac, Fannie Mae
Trade deficit trade surplus
Low price ___________________________Investment Bank
Low interest (1%) [Sept 2008]
Property P up [2000-2006] AIG
Subprime prime mortgage 2007 ….
[NINJA]
Low creditworthiness Global recession
High credit default risk
FI, seek high return [yield]
2) Financial ________________________
 ________________________* [graph]
82
Global Financial Crisis 2007–09

2 key Causes of GFC 2007-2009
2) financial market innovations

• Large current account deficits for the counterparties (e.g. US, UK, Europe)
• Large current account surpluses in Asian (e.g. China & Japan, oil exporting
countries).
• The surpluses had been used to buy large amounts of government debt in
the US & Europe and drove down interest rates in US & Europe.
• Low interest rates in the US & Europe resulted low inflation as low cost
imports coming from fast growing developing nations such as China.
• Low inflation has allowed central banks to keep interest rates low.
83
T3-pg41
83
• Low interest rates caused massive expansion of debt (esp. mortgage debt).
• A rapid expansion of mortgage lending by banks fuelled a
property price bubble as house prices grew at very fast rates.
• This in turn led lenders to relax credit standards leading to a
rapid expansion of sub-prime mortgage lending in the US (& EC).
Sub-prime borrowers:
~ borrowers who do not qualify for prime interest rates because they have
weakened credit histories, low credit scores,
high debt-burden ratios or high loan-to-value ratios.
• Investors desire to obtain higher yields to
offset the lower interest rates available in credit markets.
84
84

2) Financial market innovation
• This desire for higher yields was satisfied by financial innovation,
in particular the process of securitization (i.e. debt is

packaged then transferred off the balance sheets of banks and new
securities issued).
• See Figure 3.4 for the securitization process.
• Securitisation allows banks to diversify risk by transferring risk off their
balance sheet and transfer the debt to other parts of the financial system.
• Majority of investors in the securitised debt were other banks that held the
securities in their trading books.
• The ratings agencies also assigned high credit ratings to much of the
securitised debt products, thus creating the perception that the default risk on
these securities was very low.
85
T3-pg42
85
Extra notes
86
86
Securitization process Extra notes

=create new Financial Securities
NINJA borrower
Mortgage broker No Income, No Job, No Assets
Sell the loans Investment Bank (Lehman Brothers IB)

(Assets) Earn high int income but high credit risk
Mortgage lender Repackage the loans
(banks) offer loans to new securities
[face credit risk] to swap the credit default risk
 credit default swap
new securities have Credit rating agency
Credit Insurance (AIG)  “AAA” products
Mortgage Backed
3% Safe
Security (MBS)
5% Moderate
Worldwide investors:
7% unrated Financial Institutions
Individual investor T3-pg43
[Pass through the risk
87
Securitization Process Extra

Adjustable Rate Mortgage notes
[ARM]
= process to create new securities
Securitized product
Borrower [NINJA] MBS, CDO, CDS
Mortgage Broker = risk mgt tool
= derivative
Mortgage lender = servicer
= off-balance sheet products
[commercial bank] FI issue [sell] – to mgt risk
Freddie Mac and Fannice Mae invest [buy] – to earn high return
Investment Bank [e.g. Lehman] originator
Special Purpose Vehicle/Entity [SPV, SPE] Credit rating agency
Credit default swap [CDS]
Pool of loans =issuer
= credit insurance [AIG]
Mortgage Backed Securities

A1 [prime loan] Collaterised Debt Obligation
B1 [Alt-A loan] MBS1
C1 [subprime loan]
[CDO]
A2 = multiple MBS
B2
MBS2 Low risk [3%] Investor
C2 Medium risk [5%] Individual
A3 High risk [7%] FI
B3
MBS3
C3
88
89
• The bank transfers the pool of mortgages
to a separate entity called a special purpose vehicle (SPV).
SPV should be independent of the bank and is normally set up as a trust.
89
T3-pg44
89

Residential Mortgage Backed Securities (RMBS)
= securities created from packages of residential mortgages
Collateralised debt obligations (CDOs)

• additional securities
• combine multiple RMBSs (or parts of RMBSs) and then
selling portions of the income streams derived from the
mortgage pool or RMBSs to investors with different appetites for risk.
90
90

Global Financial Crisis (2007–09)- 2 key Causes
Causes of GFC:(1)global macro-___________ g______ & (2) financial in__________

=big current a/c deficit in US, UK, Europe & big current a/c surplus in Asian
(China & Japan, oil exporting countries). _______buy US & Europe government debt.
resulted (high/low) interest rates in the US & Europe
resulted (high/ low) inflation as low cost imports coming from fast growing developing nations
(e.g. China)
 low interest rates caused massive debt (esp. mortgage debt).
 resulted financial bubble (as house prices grew rapidly)
 lenders relaxed credit standards
 suprime mortgage lending expanded rapidly in the US (& EC).
S_______ borrowers=borrowers who do not qualify for prime interest rates because
they have bad credit history, low credit scores, high debt-burden ratios or 91 T3-pg45
high loan-to-value ratios.
91

Global Financial Crisis (2007–09)- 2 key Causes
2) Financial innovation
• Financial innovation provide higher y_______ through s__________________ (i.e.
debt is packaged then transferred off banks’ balance sheets & issue new securities).
• Securitisation allows banks to default risk by transferring risk off their balance
sheet & transfer the debt to other parts of the financial system.
• The bank transfers the pool of mortgages to __________________ (SPV). SPV is
a separate entity, independent of the bank, set up as a trust.
• Other banks invested the securitised debt (held the securities in their trading books)
• C_________r________ agencies assigned high credit ratings to the securitised debt
products, created low default risk perception on these new securities.
92
92
Exam Focus
6 Explain the process of securitization carried out by banks and2014-1a-ZAB
discuss the reasons why banks may wish to engage in such a process. (12m)
7 Explain the process of securitisation and identify the advantages to a2017-1a-ZAB
financial institution in securitising its assets.(10m
8 Discuss the role of securitization in causing the 2007/8 global financial crisis.2014-1b-ZA
9 Discuss the contribution of securitisation to the global financial crisis of2012-2b-ZA
2007/8. (15 marks)
93
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93
2(b) Discuss the contribution of securitisation

to the global financial crisis of 2007/8. (15 marks)
• See subject guide, pp.56–57. ZA-2012-2b

• A number of causes have been suggested to explain the
global financial crisis of 2007/8. These include the
1. capital flows resulting from global imbalances,
2. inadequate regulation and
3. innovations such as securitisation.
• Answers need to explain how securitisation works &

its role in the financial crisis. Better answers will discuss the
relative contribution of securitisation to the crisis
alongside the other suggested factors.
94
1(a) Explain the process of securitisation and identify the advantages to a

financial institution in securitising its assets. (10 marks) 2017-1a-ZAB
• See subject guide, Chapter 3, pages 56{7.
• This question part requires two things: an explanation of the process of securitisation and the
identification of reasons why a financial institution such as a bank securitises its assets. Many
answers simply focused on an explanation of the process and did not cover advantages.
• Securitisation is the process of transforming illiquid financial assets (such as loans and
mortgages) into marketable securities. Typically, this involves packaging illiquid loans into
bundles and then passing these on to a third party (special purpose vehicle (SPV)). The
SPV then manages the securitisation by issuing new (loan backed) securities to investors.
• The original loans continue to earn interest which is typically passed through to the SPV to
pay the interest/capital on the issued securities. The SPV will pass the proceeds from the
sale of the securities back to the bank as cash.
• In engaging in this process, the bank has therefore transformed illiquid loans into cash.
This allows it to manage liquidity risk over the medium/long term. It can also be used to
remove assets that have a high-risk weighting into assets with a lower risk weighting to help
manage its capital requirement.
• Better answers would also identify the risks with securitisation.
T3-pg47
95

2006–07: House prices fell (US)
• Many borrowers found that they owed more on their house than it was worth.
Many borrowers chose to default (particularly subprime borrowers who were
more sensitive to the fall in house prices).
• Rising loan defaults caused many RMBSs and CDOs (backed by residential
mortgages) experienced substantial losses.
Late 2007
• Banks (e.g. Northern Rock, UK) that depended heavily on securitisation to
fund expansion of its business, found that this source of funding dried up as
investors began to shun new issues of securitised mortgages.
• Banks holding securitised debt in their trading books began to experience
severe mark-to market losses.
• Liquidity problem arise as banks reduced lending to each other through the
inter-bank market as fears of insolvency increased.
96
Video: MBS, CDO
96

2008
• Large institutions (e.g. Fannie Mae & Freddie Mac) became reliant on
government support in the US.
Sept 2008 -Lehman Brothers investment bank failed
• A large drop in confidence occurred in Sept 2008
when Lehman Brothers investment bank failed,
so signalling that major institutions were not too big to fail.
• The collapse in confidence in the banking sector in the world
led central banks & governments to intervene
to provide exceptional liquidity support,
then recapitalisation of major banks, to prevent further failures.
• The severely impaired state of the banking system
led to a large reduction in credit extension by banks thus resulting in
97
T3-pg48
a severe world economic recession.
97
Exam Focus
10 With reference to examples (including the recent 2007/8 crisis) 2012-1a-ZB
discuss the main causes and characteristics of financial crises in the US.(25m)
11 Critically examine the main causes of the 2007/8 global financial crisis (25m) 2013-1-ZB
12 Discuss the lessons of the 2007/8 global financial crisis for bank regulators.(25m) 2013-1-ZA
13 Discuss the causes of the 2007/8 global financial crisis and consider whether the 2015-1-ZAB
regulations put in place since 2008 will prevent a further crisis on this scale. (25m
14 Discuss the main causes of the global financial crisis of 20082021-Q1-ZA
and discuss the consequences of the crisis for banks and regulators. (25 marks) online
15 In the 2008 global financial crisis many banks faced both a liquidity shock and a 2021-Q1-ZB
solvency shock. Discuss the main causes of each of these shocks and explain online
how regulators and governments responded to the illiquidity/insolvency faced by
banks. (25m)
17 Discuss the causes and consequences of asset price bubbles in relation to US 2014-1b-ZB
internet-based company stocks in the late 1990s &
the 2007/8 global financial crisis. (13m)
18 Explain the main characteristics of the recent crisis of the2009-1b-ZA
sub-prime mortgage lending. (12 marks)
19 Explain the main characteristics of the 2007/8 sub-prime mortgage crisis.2017-1b-ZA
(15m
20 Explain how and why a stock market decline is a factor that causes financial crises. (5m 20082c-ZAB
98
98
2013-1-ZB
1. Critically examine the main causes of the 2007/8 global financial crisis(25m
• See the subject guide Chapter 3, section headed `The global financial crisis 2007-09'.
Approaching the question
• The global nancial crisis of 2007/8 exposed many weaknesses in the structure of banks
and the effectiveness of the system of bank regulation. As the crisis broke, banks were
found to be short of liquidity and short of capital.
• Liquidity shortages emerged because banks had come to rely upon securitisation and
liability management to manage their liquidity. As a consequence, banks had run down
their stocks of liquidity on the balance sheet over time. In addition, banks had exposed
themselves to excessive amounts of risk; both market and credit. The capital allocated to
cover this risk, determined by the Basel capital accord, was inadequate. The new Basel 3
accord addresses the issues of liquidity with more monitoring and greater holdings of stocks
of liquidity required | and capital | with more capital of better quality required.
• As Basel 3 is the main development post-crisis this needs to be discussed in some detail.
Other lessons learnt include:
• The need to focus more on systemic risk. Prior to the crisis the emphasis in bank
regulation had been to ensure the safety of individual banks and hence the system.
• Post-crisis, the emphasis has moved to macro-prudential regulation where factors that
might impact on systemic risk are monitored and managed. Banks had become too big99to T3-pg49
fail , need to address such problems.
99
1. Discuss the lessons of the 2007/8 global financial crisis 2013-1-ZA

for bank regulators.(25 marks)
• See the subject guide Chapter 3, section headed `The global financial crisis 2007-09'.
Approaching the question
• The global nancial crisis of 2007/8 exposed many weaknesses in the structure of banks
and the effectiveness of the system of bank regulation. As the crisis broke, banks were
found to be short of liquidity and short of capital.
• Liquidity shortages emerged because banks had come to rely upon securitisation and
liability management to manage their liquidity. As a consequence, banks had run down
their stocks of liquidity on the balance sheet over time. In addition, banks had exposed
themselves to excessive amounts of risk; both market and credit. The capital allocated to
cover this risk, determined by the Basel capital accord, was inadequate. The new Basel 3
accord addresses the issues of liquidity with more monitoring and greater holdings of stocks
of liquidity required | and capital | with more capital of better quality required.
• As Basel 3 is the main development post-crisis this needs to be discussed in some detail.
Other lessons learnt include:
• The need to focus more on systemic risk. Prior to the crisis the emphasis in bank
regulation had been to ensure the safety of individual banks and hence the system.
• Post-crisis, the emphasis has moved to macro-prudential regulation where factors 100 that
might impact on systemic risk are monitored and managed. Banks had become too big to
fail , need to address such problems.
100
Part A:
Part B:
- financial innovation –Securitization
Part C:
Financial crises in Emerging Market
T3-pg50
101
Financial Crises In Emerging Market Countries

• Many emerging market countries have experienced financial crises in recent
years.
• Financial crises are different between the emerging market countries & USA
mainly due to the differences in the institutional features of debt markets
in emerging market countries.
• The sequence of events characterising these financial crises is different from
what occurred in the USA (19th & early 20th centuries) mainly due to
differences in the institutional features of debt markets in emerging market
countries. Mexico Dec 1994
Venezuela 1994
Thailand, Indonesia South Korea July 1997
Ecuador 1998
Turkey 2000
Argentina Dec 2001 102
102

Causes of financial crises in emerging countries:
1) Deterioration in banks’ balance sheets
due to the increase in loan losses caused by
(i) weak supervision by bank regulators &
(ii) lack of expertise in screening/monitoring borrowers at banks.
– This factor affected Mexican & East Asian crises and determined an
erosion of banks’ capital.
– Note: Argentina with well supervised banking system & no lending boom
occurred before the crisis;
in 1998 Argentina entered a recession that led to some loan losses.
2) Increase in interest rates abroad and internally
amplified adverse selection
(i.e. the parties willing to take on the most risk would seek loans).
103
Consistent with the US, affected Mexican & Argentine but not East Asian crises. T3-pg51
103

3) Stock market decline and increase in uncertainty
• consistent with the US experience,
affected Mexico, Thailand, South Korea & Argentina.
4) Fiscal problems of the government

• As government budget deficits could not be financed by foreign borrowing,
the government forced banks to absorb large amounts of government debt.
• Investors lost confidence in the ability of the government to repay its debt.
The price of government debt decreased
• Big losses in banks’ balance sheets.
• This factor was typical of the Argentine crisis,
but not of the US, Mexican & East Asian crises.
104
104

5) Rise of interest rates abroad
• The US Fed began to increase the government rate
to head off inflationary pressures.
• Although this monetary policy was successful in the USA,
it put upward pressures in foreign countries (esp in Mexico & Argentina).
105
T3-pg52
105

Sequence of financial crises 20082d-ZB
a. These factors worsened adverse selection & moral hazard problems.
b. Financial intermediaries experienced more
difficulties in screening out good & bad borrowers.
c. Decline in capital caused a decrease in the value of firms’ collateral &
an increase in firms’ incentives to make risky investments
(because of less equity to lose if the investments were unsuccessful).
d. speculative attacks developed in the foreign exchange markets,
plunging the economies into a full-scale crisis.
e. The interaction of the institutional structure of debt markets with the
currency devaluations played an important role.
Large proportions of firms’ debts were denominated in foreign currencies,
the depreciation of domestic currencies implied an increase in indebtedness.
106
106

• Currencies collapse caused a rise in actual & expected inflation & interest rates.
• The increased interest payments caused 20082d
reductions in the cash flows of households & firms.
• The very short duration of debt contracts (of emerging market countries)
provoked a substantial effect on cash flows.
• The sharp decline in lending led to an economic activity decline and to a
deterioration in balance sheets, thus worsening banking crisis.
• Banks experienced substantial losses
because many firms & households were unable to pay off their debts.
• The deterioration of banks’ balance sheet worsen because of the large amount
of short-term liabilities denominated in foreign currencies,
which experienced a sharp increase in their value after the devaluation.
• The banking system would have collapsed in the
absence of a government safety net (e.g. the assistance of the IMF). 107 T3-pg53
107
2(d) Explain the main features of the financial crises in emerging market
countries: Mexico (1994-1995) and East Asia (1997-1998). (10 marks)
20082d-ZB
• refer to p.396 of Mishkin and Eakins.

• discuss real cases of financial crises in emerging marker countries.
• The Mexican crises started in December 1994 and
• the East Asian crises started in July 1997;
• Mexico began to recover in 1996, East Asian countries in 1999.
• because of the different institutional features of emerging-market countries’
debt markets, the sequence of events in the Mexican and East Asian
crisis is different to what occurred in the US in the 19th & early 20th centuries
• the sequence of events in the Mexican and East Asian financial crises.
108
108
• Several factors led up to both financial crises: 20082d
(1) Deterioration in banks’ balance sheets because of the increasing loan

losses due to weak supervision by bank regulators and a lack of expertise
in screening and monitoring borrowers at banks. This caused an erosion of
banks’ net worth (capital).
(2) Increase in interest rates abroad and internally (factor participating to the
Mexican but not East Asian crises, consistent with the US experience). The
rise in interest rates added to increased adverse selection in Mexican
financial markets because it made it more likely that the parties willing to
take on the most risk would seek loans.
(3) Stock market decline and increase in uncertainty (consistent with the US
experience).
The above factors worsened adverse selection and moral hazard problems. On
the one hand, it became harder to screen out good and bad borrowers. On
the other hand, the decline in capital decreased the value of firms’ collateral
and increased their incentives to make risky investments because there
was less equity to lose if the investments were unsuccessful. 109
T3-pg54
109
• At this point speculative attacks developed in the foreign exchange markets,

plunging these countries into a full-scale crisis. This in turn worsened adverse
selection and moral hazard problems.
• The institutional structure of debt markets in Mexico and East Asia now
interacted with the currency devaluations to push the economies into full-
fledged financial crises. This happened because so many firms in these
countries had debt denominated in foreign currencies, and the depreciation of
their currencies resulted in increases in their indebtedness in domestic
currency terms, even though the value of their assets remained unchanged.
110
110
• The collapse of currencies also led to a rise in actual and expected inflation
rates in these countries, and in market interest rates. The increase in interest
payments caused reductions in households’ and firms’ cash flow, which led to
further deterioration in their balance sheet. Given that debt contracts have
very short duration in these countries (typically less than one month), the
effect on cash flows was substantial. 20082d
• The resulting economic activity decline and the deterioration in balance
sheets led to a worsening banking crisis. The problems of firms and
households meant that many of them were no longer able to pay off their
debts, resulting in substantial losses for banks. Even more problematic for
banks was that they had many short-term liabilities denominated in foreign
currencies, and the sharp increase in the value of these liabilities after the
devaluation led to a further deterioration in the banks’ balance sheet. Under
these circumstances, the banking system would have collapsed in the
absence of a government safety net. With the assistance of the International
Monetary Fund these countries were in some cases able to protect
depositors and avoid bank panic.
111
T3-pg55
111
Financial Bubbles
• Financial crises often arise after asset prices bubbles.
• A bubble occurs when an asset or commodity becomes overinflated in value.
3 distinct phases of bubbles:
1) Credit expansion due to financial liberalisation, & increase in asset prices
(e.g. real estates & shares). They rise as the bubble inflates.
2) bubble bursts & asset prices collapse (within a short period of time).
3) Default of many firms & other agents that have borrowed to buy assets at
inflated prices. A banking crisis may follow,
causing problems in real sectors of the economy such as industry.
112
112
Financial Bubbles
Examples of Financial Bubbles
Dutch Tulip Mania (1636–37) Mexico (1994–95)
South Sea Bubble in England East Asia (1997– 98)
Mississippi Bubble in France Housing market bubbles (US, UK, Spain)
Bubbles in Japan (late 1980s) Internet bubble (late 1990s)
113
T3-pg56
113
1(b) Explain the main characteristics of the 2007/8 sub-prime mortgage

crisis. (15 marks) 2017-1b-ZA
• See subject guide, Chapter 3, pages 56{7).
• One way to begin answering this question part is to explain that over the period prior to 2007
structured credit markets experienced a rapid growth under benign conditions. Investors
showed a high-risk appetite that stimulated further development by financial institutions of
techniques for unbundling and distributing risks through financial markets.
• This led to a marked expansion of the so-called sub-prime mortgage market.
• In 2005 and 2006, the competition among the sub-prime originators intensified. To maintain
volumes and/or increase market share, originators introduced product innovations such as
teaser rates. At the same time, there was an apparent weakening of lending standards.
• Loans were made with increasingly high loan-to-value ratios and often without full
documentation. Most originators sold the loans to larger banks, who in turn securitised them
and sold them to end-investors. As interest rates increased and house prices fell rapidly in
the U.S. in 2006 there was an increase in mortgage defaults, particularly among sub-prime
borrowers (especially for those who moved o teaser interest rates to higher rates). These
mortgage defaults led to a decline in the quality of securitised debt leading to a fall in value of
this debt leading to spread of the problem outside of sub-prime originating banks.
• Better answers would tell a coherent `story' of the causes of the crisis relating the different
elements together. Weaker answers will simply list the characteristics of the crisis.
114

Financial Bubbles
• Financial crises often arise after asset prices b_______ which occurs
when an asset or commodity becomes o____________ in value.
3 distinct phases of bubbles:

1) C________ expansion due to financial liberalisation, &
asset (e.g. real estates & shares) prices increase as the bubble inflates.
2) b________ bursts & asset prices collapse (within a short period of time).
3) Default of firms & other agents that have borrowed to buy assets at
inflated prices. A banking crisis may follow, causing industry or
economy problems.
115
T3-pg57
115
Exam Focus
21 Explain the main features of financial bubbles. (10 marks) 2006-1b-ZA
22 Discuss the characteristics of the financial crisis in in 1994 to 1996. 2010-2a-ZA
23 Explain the characteristics of a financial bubble. (10 marks) 2012-2a-ZA
24 With reference to examples, discuss the characteristics and consequences 20111a-ZA
of financial bubbles. (15 marks)
25 With reference to examples, discuss the characteristics and 2017-1b-ZB
consequences of financial bubbles in markets. (15 marks)
26 With reference to examples, discuss the characteristics and 2020-3a-ZA
consequences of financial bubbles. (12 marks)
27 Explain the main features of the financial crises 20082d-ZB
in emerging market countries: Mexico (1994-1995) & East Asia (1997-
1998)(10m
28 Explain the main features of the financial crises 2008-2d-ZA
in emerging market countries: (1994-1995) and (1997-1998). (10 marks)
29 Discuss whether the occurrence of financial bubbles is consistent with 2011-1b-ZA
informational efficiency of financial markets. (10 marks)
116
116
20111a-ZA
1. (a) With reference to examples, discuss the
characteristics & consequences of financial bubbles. (15 marks)
• See pp.59–60 of the subject guide.
• A starting point in answering this question would be to define a financial bubble.
Financial bubbles are where prices of financial or real assets increase
well above fair value (fundamental) levels.
• Then identify the main characteristics & consequences.
There are typically 3 phases to a financial bubble:
1. Rapid expansion of credit either from financial liberalisation or
expansionary monetary policy.
Assets bought on credit – excess demand pushes up asset prices rapidly.
2. Asset prices collapse.
3. Increase in loan defaults. Banking crisis often follows.
• The question asks you to refer to examples of bubbles to illustrate your answer.
Examples can be drawn from Tulip mania, the internet bubble of the late 1990s or
the global banking crisis of 2007/8 which had at its heart a bubble in housing
markets in US, UK, Ireland, Spain, etc. driven by relaxed monetary policy T3-pg58
causing an increase in credit expansion that fuelled house prices
117
Dutch Tulip Mania (1636–37)

• The first serious financial bubble.
• Tulip bulbs prices rose quickly to very high levels,
before collapsing dramatically & causing many speculator bankrupt.
Sequence of events characterised the Dutch Tulip Mania

• The tulip experienced a strong growth in popularity in the Netherlands,
boosted by competition for possession of the rarest tulips.
• The competition escalated until prices reached very high levels.
• The flower rapidly became a luxury item and a status symbol.
• In 1623, a single bulb of a famous tulip variety could cost as much as a
thousand florins (vs. the average yearly income of 150 florins).
• Tulips were also exchanged for land & houses.
• By 1636, tulips were traded on the stock exchanges of numerous Dutch
towns and cities. 118
118
Dutch Tulip Mania

• People started to trade their other possessions in order to
speculate in the tulip market.
• Some traders sold tulip bulbs that had only just been planted or those they
intended to plant (i.e. tulip future contracts, a type of derivative instrument).
• Dutch government started to introduce regulation to control the tulip mania.
• A few informed speculators started liquidating their tulip bulbs & contracts.
• Supply of tulip bulbs increased as people harvesting new tulip bulbs.
• Suddenly tulip bulbs were not quite as rare as before.
• People began to suspect that the demand for tulips could not last.
• The tulip market began a slight downward trend.
119
T3-pg59
119
Dutch Tulip Mania
• In February 1637 the market experienced a widespread panic: everyone

realised that tulips were not worth the prices people were paying for them,
and began to sell.
• The bubble burst: in less than 6 weeks, tulip prices crashed by over 90%.
• Attempts were made to resolve the situation, but these were unsuccessful.
• Individuals were stuck with the bulbs they held at the end of the crash.
• Note:
Lesser versions of the tulip mania also occurred in other parts of Europe
(e.g. UK), but never reached the state they had in the Netherlands.
120
120
Internet Bubble (late 1990s)

• Remarkable market values assigned to internet & related high-tech companies
seemed inconsistent with rational valuation.
• Equity valuations were based on uncertain future forecasts.
• Even if all market participants rationally priced common stocks as the present
value of all future cash flows expected, it was still possible for
inflated prices to develop.
2 main causes for the internet bubble

1) Outlandish & unsupportable claims were being made regarding the growth of
the internet (& the related telecommunications structure needed to support it);
2) Unsustainable projections for the rates & duration of growth of these
‘new economy’ companies.
121
T3-pg60
121

Example:
• Amazon.com stock was trading for $130 a share, a prominent analyst issued
a buy stock recommendation, even though official projections led him to a
valuation of only $30.
• Admitting that he could justify any valuation between $1 and $200, the
analyst stated his recommendation was based on the company,
its opportunities & its management.
• During those years, professional investors argued that
the valuations of high-tech companies were proper, and
professional pension fund and mutual fund managers overweighted
their portfolios with high-tech stocks.
• Although it is now clear in retrospect that these professionals were wrong,
there were certainly no obvious arbitrage opportunities available.
122
122

• While there were no profitable and predictable arbitrage opportunities
available during the internet bubble, and although stock prices eventually
did adjust to levels that more reasonably reflected the likely present value of
their cash flows, an argument can be maintained that
asset prices did remain ‘incorrect’ for a period of time.
• In the USA, the market index of the internet stock industry went
above 1,000 in February 2000, and fell to 200 in October 2000.
• Internet firms represented 6% of the public equity market during Feb2000,
the pure internet sector represented 19% of the daily volume.
• The above stylised facts about returns and volumes provide evidence of the
irrationality of financial markets.
• The result was that too much new capital was allocated to internet and
related telecommunications companies.
• The stock market may well have temporarily failed in its role of 123
T3-pg61
efficiently allocating equity capital.
123
Revision Exercise
Topic 3-Comparative Financial Systems
1. Explain the differences between market-based and bank-based
financial systems. (12,12,12, 15 marks)
2. Discuss the causes of the 2007/8 global financial crisis and
lessons learnt/ consider whether the regulations put in place since
2008 will prevent a further crisis on this scale. (25,25,25,25,13
marks)
3. What is meant by securitisation? Explain the process of
securitisation [+graph] and identify the advantages/ reasons to a
financial institution in securitising its assets.+ role of securitization,
contribution (5, 10,12,12,15marks), see also Topic 4
4. Explain the main features/characteristics of financial bubbles.
+Consequences, +Give examples (10,10,10,10,15,12,15,15
124
,15marks)
124
Summary for Topic 3

• Differences reactions to the instability of financial markets explain the
existence of market-based financial systems (where financial markets are
more important than banks) and bank-based financial systems.
• A clear distinction between marketbased (USA & UK) & bank-based
systems (Germany, Japan & France), although the current trend is towards
market-based systems.
125
T3-pg62
125
The two types of financial systems have different implications for:

 Households’ asset allocation: in the market-based systems, equity (in the
sense of stocks and shares) is a much more important component of
household assets than in the bank-based systems; the reverse is true for
cash, cash equivalents (which include bank accounts) and bonds.
 The role of indirect intermediation (pension funds, insurance companies,
mutual funds): individuals’ indirect investments through intermediaries are
dominant in the bank-based systems, whereas individuals’ direct participation
to the stock market is high in the market-based systems, especially the USA
(although even there it is in decline).
 Firms’ financing: in the market-based systems, loans from financial
intermediaries are more important for corporate finance than marketable
securities, but at a lesser extent than in the bank-based financial systems.
• financial crises, a major disruptions caused by a marked increase in the
asymmetric information problem in financial markets. The four types of
factors that lead to financial crises are bank panics, increase in interest rates,
stock market decline and increase in uncertainty. 126
126
Sample Examination Questions
Q1. Analyse the historical evolution of financial systems in order to explain the
reasons for the existence of market-based and bank-based systems.
Q2. a. Compare and contrast the German and Japanese banking systems.
b. Explain the main implications of the presence of market-based versus
bank-based financial systems.
Q3. a. How did competitive forces lead to the repeal of the Glass-Steagall Act’s
separation of the banking and securities industries? What are the recent
changes in US regulation on the separation of the banking and securities
industries?
b. In the light of the global financial crisis of 2007–09 discuss the case
127for a
T3-pg63
new Glass-Steagall Act.
127
Sample Examination Questions
Q4. a. How can a stock market crash provoke a financial crisis?

b. Analyse the main events of financial bubbles. Refer to the internet bubble
of the late 1990s as a case study.
Q5. a. Analyse the causes of the global financial crisis of 2007–09.

b. What lessons can regulators learn from this crisis?
128
128
References
• M. Burkle (2011) Principle of Banking and Finance, chapter 3
Essential reading
• Allen, F. and D. Gale Comparing Financial Systems. (Cambridge, Mass.:
MIT Press, 2001) Chapters 1, 2 and 3.
• Mishkin, F. and S. Eakins Financial Markets and Institutions.
(Boston, London: Addison Wesley, 2009) Chapter 18.
Further reading
• Heffernan, S. Modern Banking. (Chichester: John Wiley and Sons,2005)
Chapter 2. 129
T3-pg64
129
Appendix 1-Financial Crises

a)Dutch Tulip Mania
b)South Sea Bubble
c)dotcom bubble
d)Housing Bubble
131
Dutch Tulip Bulb Market Bubble'

• The tulip was brought to Europe in the middle of the sixteenth century from
the Ottoman Empire. Holland's upper classes soon competed for the rarest
bulbs as tulips became a status symbol.
By 1636, tulip bulbs were traded on the stock exchanges of numerous

Dutch towns and cities, encouraging all members of society to speculate in
the markets. Many people traded or sold possessions to participate in the
tulip market mania. Like any bubble, it all came to an end in 1637, when
prices dropped and panic selling began. Bulbs were soon trading at a
fraction of what they once had, leaving many people in financial ruin.
• One of the most famous market bubbles of all time, which occurred in
Holland during the early 1600s when speculation drove the value of tulip
bulbs to extremes. At the height of the market, the rarest tulip bulbs traded for
as much as 6 times the average person's annual salary.
T3-pg65
132
(b) South Sea Bubble'

• The scam occurred in 1720, when South Sea's stock soared in the wake of
speculation and greed surrounding the monopoly the South Sea Company
was perceived to have in the shipping and trade industries,
particularly in Mexico and parts of South America.
With nothing to prevent it from doing otherwise, South Sea Company's
management continued to issue shares in response to seemingly
insatiable demand. As a result, the stock's price soared, defying all
fundamental sense. Eventually, the truth was exposed: the company was
making virtually no profit, and the share price plummeted when
investors fled. In the post-Enron investing world, some have dubbed this
scam the "Enron of England".
• It was one of the largest stock scams of all time. The U.K.-based South
Sea Company's shares saw a huge appreciation based on rumor,
speculation and false claims before plummeting and eventually becoming
worthless. Thousands of people lost their life savings.
133
(c) dotcom bubble

• The dotcom bubble grew out of a combination of the presence of
speculative or fad-based investing, the abundance of venture capital
funding for startups and the failure of dotcoms to turn a profit. Investors
poured money into internet startups during the 1990s in the hope
that those companies would one day become profitable, and many
investors and venture capitalists abandoned a cautious approach for fear of
not being able to cash in on the growing use of the internet.
• There was an rapid rise in equity markets fueled by investments in internet-
based companies. During the dotcom bubble of the late 1990s, the value of
equity markets grew exponentially, with the technology-dominated Nasdaq
index rising from under 1,000 to 5,000 between 1995 and 2000.
T3-pg66
134
(d) Housing Bubble'

• Traditionally, housing markets are not as prone to bubbles as other financial
markets due to large transaction and carrying costs associated with owning a
house. However, a combination of very low interest rates and a
loosening of credit underwriting standards can bring borrowers into the
market, fueling demand. A rise in interest rates and a tightening of credit
standards can lessen demand, causing a housing bubble to burst. Other
general economic and demographic trends can also fuel and burst a housing
bubble.
• A run-up in housing prices fueled by demand, speculation and the belief that
recent history is an infallible forecast of the future. Housing bubbles usually
start with an increase in demand (a shift to the right in the demand curve), in
the face of limited supply which takes a relatively long period of time to
replenish and increase. Speculators enter the market, believing that
profits can be made through short-term buying and selling. This further
drives demand. At some point, demand decreases (a shift to the left in the
demand curve), or stagnates at the same time supply increases, resulting in a
sharp drop in prices - and the bubble bursts.
135
Appendix 2---Securitization
T3-pg67
136
9-137
Securitizing Loans
• Securitization of loans and other assets is a simple idea for raising new funds
– Requires a lending institution to set aside a group of income-earning, relatively
illiquid assets, such as home mortgages or credit card loans, and to sell relatively
liquid securities (financial claims) against those assets in the open market
• In effect, loans are transformed into publicly traded securities
• The lender whose loans are securitized is called the originator
• These loans are passed on to an issuer, who is usually designated a special-
purpose entity (SPE)
– The SPE is separated from the originator to help ensure that, if the originating
lender goes bankrupt, this event will not affect the credit status of the pooled
loans, supposedly making the pool and its cash flow “bankruptcy remote”
• Securitization process:
137
9-138
Securitization
• A credit rating agency rates securities to be sold so that investors have a
better idea what the new financial instruments are worth
– Possible moral hazard problem
• The issuer then sells securities in the money and capital markets, often
with the aid of a security underwriter (investment banker)
• A trustee is appointed to ensure the issuer fulfills all the requirements of
the transfer of loans to the pool and provides all the services promised
investors
• A servicer (who is often the loan originator) collects payments on the
securitized loans and passes those payments along to the trustee, who
ultimately makes sure investors who hold loan-backed securities receive
the proper payments on time
• Investors in the securities normally receive added assurance they will be
repaid in the form of guarantees against default
– Credit enhancer
– Liquidity enhancer T3-pg68
138
9-139
Securitization Process: Cash Flows and Supporting Services That
Make the Process Work and Generate Fee Income
Source: Rose (2013) Bank Management and Financial Services, ch9
139
9-140
Securitization
• The concept of securitization began in the residential mortgage
market of the United States
• Three government-sponsored enterprises (GSEs) worked to
improve the salability of residential mortgage loans
– The Government National Mortgage Association (GNMA, or
Ginnie Mae)
– The Federal National Mortgage Association (FNMA, or Fannie
Mae)
– The Federal Home Loan Mortgage Corporation (FHLMC, or
Freddie Mac)
• Unfortunately for Fannie Mae and Freddie Mac the long-range
outlook for their growth and survival is questionable due to recent
record defaults on many of the home loans they traded
T3-pg69
140
Examples of Types of Securitized Assets

9-141
– Residential Mortgages – the beginnings of securitization

▫ The role of GSEs (GNMA, FNMA, FHLMC)
– Riskier CMOs
– Home Equity Loans
– Automobile Loans
– Commercial Mortgages
– Small Business Administration Loans
– Mobile Home Loans
– Credit Card Receivables
– Truck Leases
– Computer Leases
141
Advantages of Securitization 9-142
– Diversifies a bank’s credit risk exposure

– Creates liquid assets out of illiquid assets
– Transforms these assets into new sources of capital
– Allows the bank to hold a more geographically diversified loan portfolio
– Allows the bank to better manage interest rate risk
– Allows the bank to generate fee income
T3-pg70
142

20220910170523HCTAN008C3 Topic - 3 Comparative

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20220910170523HCTAN008C3 Topic - 3 Comparative

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Topic 3- Com parative Financial System s

3 implications Outline &

Financial _______* Financial systems:

Financial Crises __________ mortgage crisis (2007)

2. Evolution of Financial Systems:

3. The financial systems in UK, US, Germany, France, Japan

5. Causes of financial crises:

6.3 Timeline of Global Financial Crisis

Topic 3-Comparative Financial System Key concept

(ii) bank-based systems

(i) market-based financial system

Banks and market are equally important in France

Summary for Introduction

• UK & USA are eg of market-based financial systems, where:

Evolution of Financial Systems

1st phrase – Ancient practice (millennium BC to 1st century AD)

1st phrase- Ancient Practices

2nd phrase- Italian Bankers

2nd phrase- Italian Bankers

2nd phrase- Italian Bankers

3rd phrase- Dutch Finance (early 1600s)

3rd phrase- Dutch Finance (early 1600s)

4th Phrase- The Emergence Of

Topic 3-Cmparative Financial System Key concept

[2006, 2007,2010, 2017] Key concept

US [Market-based financial system] Extra info

1980 _________________________________________ [removed regulations]

2000-2006 Bank expanded very first, too much freedom

2008 ______________________________ Crisis [banking crisis]

Post-2008 _______________________________ [Basel 3, see Topic 5] T3-pg13

USA –Regulation Relaxation

USA –Regulation Relaxation

3) Relax the restriction on banks crossing state boundaries

UK – Bubble Act (1720)

UK – London Stock Exchange (LSE)

• The London Stock Exchange (LSE) was established in 1802.

UK – Development of Banking System

2) Banks consolidated into nationwide networks

UK – Development of Banking System

UK – Development of Banking System

Market-based Vs Bank-based Financial Systems

Market-based Vs Bank-based Financial Systems

Market-based Vs Bank-based Financial Systems

Market-based Vs Bank-based Financial Systems

Market-based Vs Bank-based Financial Systems

• Financial markets did not develop spontaneously.

Implications of Market-based & Bank-based Financial Systems

Implications of Market-based & Bank-based Financial Systems

(a) Households’ asset allocation [see Figure 3.2]

Market-based Vs Bank-based Financial Systems

Market-based Vs Bank-based Financial Systems

Current Trend: Towards Market-based Financial Systems

2 reason for the growing importance of market-based systems:

Note: Market imperfections (e.g. transaction costs & asymmetric information)

Concept Check Activity:

S________ are the most important in

Concept Check Activity:

Asset allocation (Equity) Bond Cash & Risk

5 (b) Explain the main implications of the presence of

• A good answer would explain that essentially in

Market-based Financial System vs Bank-based Financial System

Features of Financial Bubble

Topic 3b- Financial Crises Sequence of events