Banking Sector Fragility Causes

3382 words (14 pages) Essay in Banking

31/07/18

Disclaimer: This work has been submitted by a student. This is not an example of the work
produced by our Essay Writing Service. You can view samples of our professional work
here.

Any opinions, findings, conclusions or recommendations expressed in this material are

those of the authors and do not necessarily reflect the views of UK Essays.

Discuss factors which have decisively contributed to the fragility of the contemporary
banking sectors, as revealed in the form of the recent global financial crisis.

Prepared by:

 Ivan Gnatiuk 37193

 Artem Zaiets 36981
 Mark Pohodin 37141

Introduction
Firstly, crisis was originally started in US where it was a result of provided social policy. In
particular, government allowed, even insisted, on distribution of house mortgages not only
among wealthy part of society but also among poor one(so called NINJAs No Income, No
Job, no Assets). Second part of this policy was an allowance on sell of ‘sets’ or securitized
bundles of mortgages among banks. Market at that time was at the expansion at that time
i.e. expectations were positive and market accepted securitized sets of mortgage loans they
spread not only among US but also around the whole world. In detail, banks became
holders of risky assets in a large quantity that give good return during the expansion but
become sources of risk during recession. Second important factor was an asymmetry in
information i.e. banks who sold this bundles known all about their debtors and buyer of ‘
securitized’ bundle has no idea about quality or ability to pay of debtors in this bundle.
Thus, mortgage bundles were spread around the world with no information about ability of
money return just before market fall i.e. with a change in liquidity to very low as a result of
negative expectations and following mistrust of banks with respect to each other. As a
result, bundles lost their value because of that fact that opportunity of repayment thus value
was very low thus collected debt obligations become a worthless and cold be just deleted
form asset list of bank they currently situated. Therefore, many not only American but also
European banks, pension founds and even insurance companies suffered of recent financial
crisis. Moreover, interdependence in euro area only strengthened an effect.
Firstly, securitization is a methodology where mortgages and loans with a different
maturity collected into large sets for further sell on the market. The problem of such a way
operation provision is an asymmetry in information i.e. only seller know what percent of
credits are trustful and have a large opportunity of repayment in the future. In contrast,
now, Federal Reserve has a regulation that require keeping a fraction of loans i.e. not to sell
all loans given on the financial market that intense banks to be more careful with their
debtors.

Main reason of fall was an unpredicted unification of two factors. These factors were fall of
housing market not only in one particular city or area but it spreading among the whole
country with further fall of financial markets. This effect was accelerated by
interdependence of banking system. For example, complicated structure of interbank loans
such as credit-default swaps where in case third party default seller agreed to compensate
buyer.

Fall of such a large bank as Lechman Brothers created not only panic among creditors but
also mistrust among banks. It was one of the most hitting factors. Banks started to keep a
large amount of cash. In such situation banking system become ineffective and only
damage economy; collecting cash and decreasing overall liquidity i.e. banks become a cash
collectors and only reduce money multiplier.

Get help with your essay today, from our professional essay writers!

Qualified writers in the subject of banking are ready and waiting to help you with your
studies.

 Get help with your essay

 View professionally written samples

When money demand is inelastic, increase in money supply does not have an effect on
liquidity i.e. monetary policy become ineffective i.e. at some point holding of cash become
more profitable than any other investment. Thus, central bank loose quantitative instrument
of market control. Banks start to buy ‘safe’ government bounds with aim of protection of
their capital and limit their credit distribution to reduce risk of not repayment of credits
given.

The volatility of banks

In particular, banks play a very important role in determining the crisis. Problems
encountered banks were due to great mistrust by customers. That is, the customer
confidence in banks declined and that had a great influence on bank returns and stock
prices. Stocks are more risky, which in term increase banks stock volatility.

In finance, volatility refers to the standard deviation of continuously compounded by the

return of a financial instrument for a certain period of time horizon. Thus, the return
fluctuates over time and, therefore, an important determinant for the price of the shares.
This is because the volatility shows the standard deviation of stock returns and depends on
the risk of these stocks to hold. As a result, an increase in volatility leads to lower stock
prices and vice versa.

According to Choi et al. (1992)xi the interest rate variable is important for the valuation of
common stocks of financial institutions because the returns and costs of financial
institutions are directly dependent on interest rates. Moreover they mention a model which
states that three different shocks affect bank’s profit during a given period namely; interest
rate, exchange rate and default shocks. Since these three factors have a great influence on
the profits of banks, it has also a great influence on its volatility of stocks. The interest rate
directly has a great influence on the volatility. Profits of banks are determined by the
interest rate. As mentioned, the revenues banks obtain are the interest payments of
customers. The costs are the payments made to the customers. So an increase in the interest
rate the banks gain will increase the banks’ profits and thus make those banks’ stocks more
attractive. Investors can get more dividends on investment but also can earn money by
buying low and selling high. So when a bank is doing well, stocks prices will increase and
that results in a saver investment. This causes a decrease in the volatility of those stocks. So
an increase in the interest rate, at which banks lend, leads to a decline in the stock volatility
and on the contrary. The interest rate at which banks ‘borrow’ has another influence on its
stocks. A growth in that interest rate will rise banks costs, and thus decrease the banks’
profits. That 13 make the stocks less attractive and causes a decline in its prices. So the
growth of that interest rate causes an increase in banks stock volatility and vice versa.
Grammatikos et al. (1986)xii investigated the portfolio returns and risk associated with the
aggregate foreign currency position of U.S. banks. They found that banks have imperfectly
hedged their overall assert position in individual foreign currencies and exposed themselves
to exchange rate risk. This fact suggests that exchange rate risk may importantly affect
bank stock returns. Thus, it also affects the volatility. To make business internationally you
always need to convert your money. That is why it is especially for banks an important
factor. Companies dо business with other corporations internationally via banks. Banks
hold the foreign currency which investors and companies have to buy in order to invest or
do business internationally. Moreover the exchange rate defines also in which country it is
attractive to do investments. For example, when the exchange rate is low for Europeans so
that the euro/dollar is low, it is attractive for Europeans to make investments in America. It
is advantage for European banks because European investors are now buying dollars from
the bank. Since investors have to pay fees for that and banks have more money to lend out,
the profits are growing which means that the volatility is decline. So an increase in the
exchange rate decreases the volatility. Default shocks are according to Choi et al. the last
determinant of the banks profit and thus banks stock volatility. Default occurs when a
debtor has not met his or her legal obligations according to the debt contract. This can be
that he has not made a scheduled payment, or has violated a loan condition of the debt
contract. A default is the failure to pay back a loan. Default may appear if the debtor is
either unwilling or unable to pay their debt. This can appear with all debt obligations
including bonds, mortgages, loans, and promissory notes. So it is an important factor in the
banking industry. When huge amount of customers default, the banks have a high bad debt
expense. This leads to an increase in the volatility. Furthermore if the risk of default rises,
the interest rate rises as well because banks want to be compensated for this risk. As we
have seen, an increase in the interest rate means a decline in volatility. So shocks in default
mean shocks in volatility. This can be either up or down. When we take a closer look at the
determinants of the volatility of banks stocks, we can see that it all depends on the state of
the economy. When the economy is healthy, there are a lot of 14 actions in the markets as
well as in the banking market. Corporations are investing a lot and thus are borrowing from
banks; the housing market is doing well which means a lot of mortgage loan for banks.
Overall there is a huge amount of business for banks which means that banks are doing well
and thus stock prices are increasing, which indicates low volatility. On the contrary, during
economic crises it is the other way around which we will see in the next part.

Get help with your essay today, from our professional essay writers!

Qualified writers in the subject of banking are ready and waiting to help you with your
studies.

 Get help with your essay

 View professionally written samples

Banks volatility in crisis

During economic crises, we have seen that the economy in general is depreciating, during
these years banks carry a lot of risk that customers are going to default. That is, the risk of
having a lot of bad debt expanses rises. That risk causes fluctuation in the volatility of
banks. During the last financial crisis, the housing market collapsed which caused a lot of
default on mortgage loan. Because of the rise of default the interest rate is increasing and
the currency is becoming cheaper. The three factors that affecting the volatility of banks
according to Choi et al. were all affected during the last financial crisis, which caused
increase in the volatility of banks. Moreover during banking panics, the volatility also
increases. A banking panic means a bank run that appears when a huge number of
customers withdraw their deposits because they think that the bank is, or might become,
bankrupt. As amount of people who withdraw their deposits increases, the likelihood of
default increases, and this leads to further withdrawals. This can destabilize the bank and
finally lead to bankruptcy. So the bank carriesuncountable amounts of risk at that time.
Because of that risk, investors are not willing to buy stocks of that bank and investors
holding the stock already, want to sell their stocks. As a result the price of its stocks will
decline and eventually be very low. Therefore the volatility will be very high. To sum it up,
we have seen that the major determinants of the banks stock volatility are the interest rate,
the exchange rate and the default shocks. More importantly, these three factors are all
indicators of the state of the economy. When the economy is doing well, the factors
influence the volatility negatively. However during financial crises and banking panics, the
volatility will rise. So the volatility of banks’ stocks is affected by the health of the
economy, which is indicated by the three factors mentioned.

Globalization, as important crisis factor

In this part we would like to reference such sector of banking as regional instability. Since
the beginning of 21st century, the fragility of singular unit of the banking system was
determined as a factor that affects only this particular institute. With increased globalization
and technological progress, we have faced the new problem, which is a result of our own
actions.

Everyone loves traveling, but no-one likes to have big amounts of cash, casually lying in
their pockets. This is the reason why we use plastic cards. Little do we think that they are a
result of hard work and complicated connections between thousands of institutions. Such
companies as Visa and MasterCard are offering us freedom of movement, in some way, and
since the 90-th they grant us wide range of possibilities which we would never have in
other way. We should state that both Visa and MasterCard, went public just recently before
financial crisis, in October and may of 2006. This simply means that they became big
enough, that there were a need of external financing, so the companies can expand even
faster and bring their services to broader audience.

The process of globalization brings us to the point of time, when there will be no more
ways of globalizing without bringing any harm to economy of the world or even humans.
Willing to expand, “systems” will fight over for the customer. Thus is when we meet the
term that was implemented just recently – “reverse globalization”

In the face of great economic risks, a lot of countries have started to implement the policy
of protectionism. For example, in 2013, more than 2000 trade restrictions had been
implemented by different governments, including United States and China. Another
problem is that most companies which have their manufacturing powers abroad, mainly in
china, report that their departments there are getting even more profitable. So we see the
creation of the link between such countries. If one of them will be affected by the stroke,
other one is going to feel the result as well. Banks are also taking part in such policy, or at
least they used to. Since 1995 we can observe the steady trend to an increase in number of
the foreign banks, from 780 to more then 1300, in 2007. The amount of new foreign banks,
entering the market in OECD countries, peaked in 2007 at 132 in a year.

The financial crisis dramatically reduced the number banks, up to the point when for the
first time, since 1995, net exit of banks appeared to be bigger than net entrance. With the
peak number being 1350, in 2009, it has been reduced to 1272 in 2013. Though this impact
was intense, we can see even more radical change in the number of domestic banks. Here
the number of facilities fell from 2704 to 2384, in 2007 and 2013 respectively, increasing
market share of foreign banks up to 35%, from around 33% previously.

The most interesting effect crisis had on banks of emerging and developing countries.
Firstly, the amount of banks there didn`t decrease, but rose by 30. Also significant amount
of banks that have been opened in European countries, had an actual headquarters in
developing country. So, in regards to regional economy, European banks had the greatest
reduction, as 29 foreign banks left the market. Nevertheless, we had an increase of such in
Sub-Saharah Africa, where it peaked on the mark of additional 31 bank. The trend of
developed countries being in lead, by an annual net entry, had been changed, when
emerging and developing countries took this spot, even though developed countries are still
shoving positive rates in all years after, except 2013.
Get help with your essay today, from our professional essay writers!

Qualified writers in the subject of banking are ready and waiting to help you with your
studies.

 Get help with your essay

 View professionally written samples

Concluding this point, we can assume that increasing amount of banks is not useful for
overall health of world economy. Also such actions on the behalf of new banks can create
issues for regional economies, as they tend to accumulate resources from citizens and not
being effective as allocating institute.

Such point leads us to the point that banks, as institutes which are supposed to be an
effective tool for cash flows allocation, can be harmful for small regional economics. They
create risks of collapsing and creating systematical problems, through connections between
small banks and systems of such institutions. Finalizing all the information above, we
would like to mention that banks, as fiscal institutions, are a source of great possibilities,
but they may create bigger problems. Analyzing such data we see that market economy is
self-efficient in some respect. It naturally clears itself during each crisis peaks. The problem
is that banks link different economies, some of which are better and some are not that
healthy. That just means that some links must be destroyed and thus operations of such
banks are not necessary. In future risks of crisis fluctuations will be higher, as there will be
even more banks to create harder connections, and thus world economy will suffer from
those “small depressions” even harder with each next starting its action.

Conclusion
To sum it all up, from our research we have seen that crisis of 2007-2008 show us the
fragility’s of banking system and the factors, which have decisively contributed to the
fragility of banking sectors. We saw that some strengths of banking system in light of
global financial crisis become fragilities. Banks volatility increased over the time period of
a crisis especially during the last financial crisis. We can say that the volatility of banks
increased during the financial crisis of 2008 and that the main driver is the GDP growth rate
and that the less important drivers are the interest rate the exchange rate. In addition, we
can say that increasing amount of banks is not useful for overall health of world economy.
Also such actions on the behalf of new banks can create issues for regional economies.

Bibliography
1. Launch of 2013 Depth Index of Globalization: http://www.iese.edu/en/about-
iese/news-media/news/2013/november/launch-of-2013-depth-index-of-
globalization/
2. Why globalization is going into reverse, by Carol Matlack:
http://www.bloomberg.com/bw/articles/2013-11-25/why-globalization-is-going-
into-reverse
3. Rising Costs, Protectionism Hit U.S. Companies in China, Says Survey:
http://www.bloomberg.com/bw/articles/2013-10-10/rising-costs-protectionism-hit-
u-dot-s-dot-companies-in-china-says-survey
4. The Impact of the Global Financial Crisis on Banking Globalization; by Stijn
Claessens and Neeltje van Horen, October 2014:
http://www.imf.org/external/pubs/ft/wp/2014/wp14197.pdf
5. http://www.nber.org/papers/w4532
6. http://www.ft.com/cms/s/0/842a1f88-d41c-11e4-99bd-
00144feab7de.html#axzz3XyHF1cLC
7. http://www.bloomberg.com/news/articles/2015-01-15/good-volatility-eludes-banks-
trading-revenue-hits-3year-low
8. http://www.voxeu.org/article/high-volatility-breeds-high-correlation-new-analysis-
european-bank-stock-prices
9. Business Cycles, Financial Crises, and Stock Volatility, by G. William Schwert,
1989:http://www.nber.org/papers/w2957.pdf
10. http://geomar-
search.kobv.de/authorSearch.do;jsessionid=54AC3C46B1787F442C4032CE1265C
4A1?query=Kopecky%2C+K.+J.&plv=2
11. Stock volatility and the crash of ’87, byG.W. Schwert, 1990:
https://ideas.repec.org/p/nbr/nberwo/2954.html
12. The Financial and economic crisis of2008-2009 and developing countries Edited by
Sebastian Dullien Detlef J. Kotte Alejandro Márquez Jan
Priewe: http://unctad.org/en/Docs/gdsmdp20101_en.pdf