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UNSW Business School/ Banking and Finance

FINS2622 Session 2, 2017

Week 7 Class
Global Financial Crisis 2007-2009
Global Financial Crisis (GFC)

In August 2007:
Collapse of several high profile banks, emergency bailouts
of others, fraud investigations
It brought down the global stock market which lost an
approximate $32 trillion in value from its peak
Destroyed confidence
Massive fiscal/monetary stimulus and institutional bailouts
What happened?

From mid 2006 dramatic rise in mortgage delinquencies in

the US. Prices fell while interest rate continued to rise.
Banks increased risk exposure (equity fell, leverage rose)
Liquidity dried up. Banks did not lend to each other
The US mortgage finance industry
Sub-prime model of mortgage lending
Meaning of sub-prime lending: financial institutions lend to
those who could ill afford.
Why? Banks perspective
Why? Borrowers perspective
Explanation of Figure 1: Homebuyer

MBS: mortgage backed securities

AAA: a top rating given to a corporation/country
Standard & Poor, Moodys, Fitch: top rating agencies
Investment bank:
a financial institution that assists individuals, corporations, and governments in
raising capital by underwriting and/or acting as the client's agent in the
issuance of securities. An investment bank may also assist companies
involved in mergers and acquisitions and provide ancillary services such
as trading of derivatives and equity securities etc
Securitization, CDO, CDS

Securitization: issuing securities to the public

CDO: collateralized debt obligations (backed by borrowers
CDS: credit default swap (insurance)
Figure 1
Figure 2 Lender Behaviour

ARM: adjustable rate mortgages

Why lenders (e.g. banks) were so relaxed?
They sold the mortgages to investment banks
which in turn sold them to other investors such
as hedge funds etc
Figure 2
Negative equity
Figure 3

As house prices fell, owners equity fell to the level where

it was below the mortgage incentive to default
more surplus of houses price fell further
Figure 3
Housing surplus
Figure 4

Excessive production
Low interest rate (note foreign currency surplus of countries
such as China were invested in US market)
Overvaluation of properties
Borrowers stretching themselves
Profit seeking financial institutions preyed on
unsophisticated/poor borrowers
Figure 4
Why this crisis requires close scrutiny?

Human misery
Negative behaviour of profit seeking mortgage lending
institutions at the expense of ill-informed poorly educated
Inappropriate relaxation of regulation: decades of de-
regulation since the days of Margaret Thatcher
Risk appetite of banks danger of bank failure and
consequences on system: a moral hazard issue
If banks mismanage and know they will be rescued
reinforces reckless behaviour
Executive behaviour?

Unduly high rewards for risk taking initiatives but face no

punitive consequences
Short term gains vs long term survival of corporations
GFC: Impacts on Asia

1. Slowdown in economic growth

All countries in the world showed large declines in
economic growth but growth slowdown in emerging Asia
much smaller.
5 Asian countries: Indonesia, Korea, Malaysia, the
Philippines, Thailand) experienced declines half as large
as those during the AFC.
Singapore had the largest decline whereas Indonesia,
India and China had the smallest declines.
Table 2 (continued)
OEM = other e
2. Contraction on foreign trade and current account
Decline in exports: - 47%
Decline in imports: larger than exports decline contributing
to a small rise in trade balance
In 2009 Asia had the largest current account surplus. This
situation persisted well after 2009. That is Asia has had
increasing current account surpluses. Good or bad?
Refer to this issue of current account deficits in 1997.
3. Fall in equity prices: - 17%. This is smaller than
emerging Europe but larger than emerging Latin
Within Asia largest falls: Singapore (-27%), Thailand (-
21%), the Philippines (-21%)
India had the best performance: almost no change.
4. Sovereign bond spread (difference between a soverign
bond yield and that of a bench mark, namely the US
Treasury bond of similar maturity). This is a neasure of
how risky a sovereign bond is. The higher the more risky
The higher the spread, the higher the cost of borrowing, the
higher the negative impact on investment/expansion
Asian bond spread during the GFC was smaller than
elsewhere. A good sign of the strength of Asian
economies in the eyes of international capital markets.
5. Declines in currencies against the USD: moderate and
less volatile compared to Central/Eastern Europe and
Latin America.
6. International reserves
Overall Asia showed the largest percentage increase (in
SDR, special drawing rights) compared to other regions.
Of Asian economies: large % increases in Thailand, China,
the Philippines and Hong Kong.
largest declines in reserves: Korea and Malaysia
Special drawing rights (SDR) refer to an international type of
monetary reserve currency created by the
International Monetary Fund (IMF) in 1969 that operates as a
supplement to the existing reserves of member countries. Created
in response to concerns about the limitations of gold and dollars as
the sole means of settling international accounts, SDRs augment
international liquidity by supplementing the standard reserve
An SDR is essentially an artificial currency used by the IMF and is
basket of national currencies. The IMF uses SDRs for internal
accounting purposes. SDRs are allocated by the IMF to its member
countries and are backed by the full faith and credit of the member
countries' governments.

7. Interest rates
Rise of interest rates were moderate. Refer to interest rates
raised sky high during the AFC and the consequential
Judgments on the GFCs impact on Asia: recovery

1. Resilience to external shocks depended on some

Size of the economy: China, India, Indonesia
avoided recessions due to sizeable domestic
Monetary and financial system largely resilient
No severe dislocations: interest rates and exchange
rates remained stable
These favourable outcomes were results of host of
reforms in economic and financial systems after
2. Stronger than expected rebound in Asia.
One quarter after the worst Asias GDP rebounded by 9.4%
on an annualized basis, significantly stronger than 4.93%
after the AFC.
This is due to timely roll out of appropriate fiscal and
monetary stimulus measures: governments injected
US$700 billion worth of stimulus measures. Interest
rates were cut swiftly
What now (Quo vadis)?

1. Asia has to accept a lower rate of growth

2. Asia has to rely more on domestic demand
3. Continue with reforms to increase productivity
4. Enhance investment rules and investors protection
5. Enhance quality of human capital and education
6. Enhance regional trade and financial integration
7. Facilitate cross border flows within the region such as
M&A, FDI, portfolio investments
8. Greater currency flexibility