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Athens University of Economics and Business - Department of Economics

MSc. in Applied Economics & Finance for Executives

Master Thesis

The global financial crisis (2007- to date), the U.S policy


response and lessons for the European debt crisis.

3.000.000,00

2.500.000,00

Bank of America Corp


Total Assets in $ million
2.000.000,00
Citigroup Inc
JPMorgan Chase & Co
1.500.000,00

Wells Fargo & Co


1.000.000,00

Equity is defined
500.000,00 by bubble size

M&T Bank Corp


0,00
0,00 500.000,00 1.000.000,00 1.500.000,00 2.000.000,00 2.500.000,00
Deposits in $ million

Bank of America Corp JPMorgan Chase & Co Citigroup Inc


Wells Fargo & Co US Bancorp PNC Financial Services Group I
SunTrust Banks Inc BB&T Corp Regions Financial Corp
Fifth Third Bancorp KeyCorp M&T Bank Corp

When the music stops, in terms of liquidity, things will be complicated. But as long
as the music is playing, youve got to get up and dance. Were still dancing. Chuck
Prince

Supervisor: Dr. Nikolaos Topaloglou

Author: Elina Bantavani

Athens, October 2012


---The global financial crisis (2007- to date), the U.S policy response and lessons for the European debt crisis---

Table of contents
Introduction .......................................................................................................... 8
Chapter 1: US subprime crisis ...............................................................................10
1.1 Causes of the crisis and the role of leverage ....................................................10
1.2 Crisis Identification .........................................................................................13
1.3 The transformation of the U.S Banking system ...............................................20
1.4 The Securitization of the Mortgage Market ....................................................22
1.5 Housing-based Subprime Lending ...................................................................25
1.6 The slide into crisis .........................................................................................28
1.7 The Subprime Crisis ........................................................................................31
1.8 Liquidity issues ...............................................................................................32
Chapter 2: Addressing the financial crisis..............................................................34
2.1 Purchasing of Troubled Assets and Undercapitalization Problems ...................34
2.2 Background of the TARP .................................................................................43
2.3 The changing political environment and the costs of TARP participation .........49
2.4 Program Evaluation .......................................................................................50
2.5 TARP effects on the U.S economy....................................................................53
Chapter 3: Economic crisis in Europe.....................................................................57
3.1 Anatomy of the crisis ......................................................................................57
3.2 Economic consequences..................................................................................75
3.3 Governmental responses ................................................................................78
3.4 Policy challenges ............................................................................................87
3.5 Lessons to be learnt ........................................................................................90
3.6 Stress-tests for the EU banks ..........................................................................93
3.7 Reasons that justify supporting the EU banks and banks in general............... 104
3.8 Greeces Insolvency ...................................................................................... 106
Chapter 4:Conclusions ........................................................................................ 112
Bibliography Sources ....................................................................................... 114

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List of Figures
FIGURE 1: CRISIS IDENTIFICATION ................................................................................................... 19

FIGURE 2: CHANGES IN CRISIS COMPOSITION .................................................................................... 19

FIGURE 3: HOLDERS OF THE U.S MORTGAGE DEBT, 1979 2006(% OF THE TOTAL) ............................. 21

FIGURE 4: SECURITIZATION RATES FOR MORTGAGE CATEGORIES.......................................................... 23

FIGURE 5: GROWTH RATES OF REAL GDP AND MORTGAGE DEBT OUTSTANDING IN U.S 1971-2007....... 24

FIGURE 6: OUTSTANDING MORTGAGE TO GDP RATIOS ...................................................................... 25

FIGURE 7: SUBPRIME MORTGAGE ORIGINATIONS, ANNUAL VOLUME AND PERCENTAGE OF TOTAL ........... 25

FIGURE 8: MORTGAGE LOANS AS A PERCENTAGE OF THE TOTAL ........................................................... 26

FIGURE 9A: ALL LOANS PAST DUE AS A PERCENTAGE OF CATEGORY TOTAL OUTSTANDING ........................ 27

FIGURE 9B: FORECLOSURES STARTED DURING QUARTER AS PERCENT OF CATEGORY TOTAL OUTSTANDING. 27

FIGURE 9C: LOANS IN FORECLOSURES AS PERCENT OF CATEGORY TOTAL OUTSTANDING.......................... 27

FIGURE 10: THE CRISIS UNFOLDS .................................................................................................... 30

FIGURE 11: TRADITIONAL AND SHADOW BANKING SYSTEM .............................................................. 31

FIGURE 12: IMPACT OF COUNTERPRODUCTIVE INTERVENTIONS ON FSI IN UNITED STATES ....................... 38

FIGURE 13: GOVERNMENTAL GUARANTEED BONDS (GGB) AND NON-GUARANTEED INVESTMENT-GRADE


BANK BONDS .............................................................................................................................. 39

FIGURE 14: IMPACT OF LIABILITY GUARANTEES ON BOND ISSUANCE .................................................... 40

FIGURE 15: IMPACT OF FINANCIAL SECTOR STABILIZATION MEASURES ON CDS SPREADS......................... 41

FIGURE 16: SPREAD BETWEEN 3 MONTH $US LIBOR AND 3 MONTH TREASURY ..................................... 50

FIGURE 17: TARP IN BANKING SECTOR ............................................................................................ 51

FIGURE 18: RISK-RATING BY TARP AND NON-TARP BANKS................................................................ 55

FIGURE 19: FINANCIAL MARKET SPREADS ......................................................................................... 58

FIGURE 21: CPI (DIFFERENTIAL OVER GERMANY CPI, IN%), 1990-2010.............................................. 60

FIGURE 22: CONFIDENCE INDICATORS ............................................................................................. 60

FIGURE 23: FIRMS COMPRESSION DUE TO CRISIS .............................................................................. 61

FIGURE 24: WORLD TRADE AND EURO AREA EXPORTS ........................................................................ 62

FIGURE 25: GOVERNMENT BOND YIELDS.......................................................................................... 63

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FIGURE 26: HOUSE PRICES AND ECONOMIC CYCLES ............................................................................ 64

FIGURE 27: HOUSING PRICES IN THE EURO AREA ............................................................................... 64

FIGURE 28: HOUSING INVESTMENT AS A SHARE OF GDP .................................................................... 65

FIGURE 29: STOCK PRICES ............................................................................................................. 65

FIGURE 30 : INTEREST RATES FOR EURO COUNTRIES........................................................................... 66

FIGURE 31: COMPARISON BETWEEN US AND EURO AREA ON GDP, OUTPUT GAP AND INVESTMENT ......... 67

FIGURE 32: CURRENT ACCOUNTS BALANCE AS PERCENTAGE OF WORLD GDP ......................................... 68

FIGURE 33: EVOLUTION OF GLOBAL IMBALANCES .............................................................................. 69

FIGURE 34: CURRENT ACCOUNT DEVELOPMENTS IN EURO AREA .......................................................... 69

FIGURE 35: PUBLIC DEBT AS % OF GDP IN 1995-2010..................................................................... 70

FIGURE 36: PUBLIC DEBT AS % OF GDP IN 2007-2010..................................................................... 71

FIGURE 37: SECURITIZATION IN US AND EUROPE .............................................................................. 72

FIGURE 38: SOVEREIGN CREDIT DEFAULT SWAPS, DECEMBER 2007-JANUARY 2012 ............................. 72

FIGURE 39: SECURITIZATION IN US AND EUROPE .............................................................................. 73

FIGURE 40: BANK VS SOVEREIGN CDS SPREADS ................................................................................ 74

FIGURE 41: THE CONTAGION EFFECT FROM US TO EUROPE ................................................................ 75

FIGURE 42: KEY TRIGGER MECHANISMS OF THE CRISIS ........................................................................ 77

FIGURE 43: THE TRILEMMA OF CONFRONTING A FINANCIAL CRISIS........................................................ 81

FIGURE 44: ECB RATES ................................................................................................................. 82

FIGURE 45: EXPANSION IN BALANCE SHEETS AFTER ECB CONTRIBUTION .............................................. 83

FIGURE 46: FISCAL SUPPORT ACROSS THE EURO AREA ........................................................................ 84

FIGURE 47: MAGNITUDE AND COMPOSITION OF FISCAL SUPPORT PLANS ............................................... 84

FIGURE 48: THE EUROPEAN BANKING STABILITY FRAMEWORK ............................................................ 87

FIGURE 49: POLICY PROBLEMS IN EUROPE ....................................................................................... 88

FIGURE 50: THE RISING COSTS OF THE CRISIS: NON-PERFORMING LOANS AND UNEMPLOYMENT ................ 88

FIGURE 51: SPREADS BEFORE AND AFTER THE MONETARY UNION ........................................................ 90

FIGURE 51: COMPETITIVENESS ACROSS EUROPEAN COUNTRIES MEASURED BY UNIT LABOR COST ............... 91

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FIGURE 52: HOW A STRESS TEST WORKS .......................................................................................... 94

FIGURE 53: GOVERNMENT SUPPORT AS A PROPORTION OF CT1 END 2010 ........................................... 95

FIGURE 54: END 2010 NUMBER OF BANKS IN EACH BUCKET OF CT1 .................................................... 96

FIGURE 55: NUMBER OF BANKS IN EACH BUCKET OF CT1 RATIO WITHOUT CAPITAL RAISING ..................... 96

FIGURE 56: NUMBER OF BANKS IN EACH BUCKET OF CT1 RATIO .......................................................... 97

FIGURE 57: EVOLUTION CT1 RATIOS ............................................................................................... 98

FIGURE 58: EVOLUTION OF CT1 ..................................................................................................... 99

FIGURE 59: EVOLUTION OF DEFAULT RATES .................................................................................... 100

FIGURE 60: CONTRIBUTION OF EACH REGULATORY PORTFOLIO TO LOSS RATE ....................................... 101

FIGURE 61: EVOLUTION O NET-TRADING INCOME ............................................................................ 101

FIGURE 62: CAPITAL OUTCOMES WITH WITHOUT ADDITIONAL MEASURES IN 2011 ............................... 102

FIGURE 63: THE OPERATION OF BANKS .......................................................................................... 106

FIGURE 64: EXPOSURE BY COUNTRY TO GREEK SOVEREIGN DEBT........................................................ 107

FIGURE 65: REAL GDP AND GROWTH RATE, 1980-2013 ................................................................ 108

FIGURE 66: DEBT OF GREECE (% GDP) ,1980-2013 ...................................................................... 109

FIGURE 67: GREEK DEFICIT (%GDP), 1980-2013 .......................................................................... 110

FIGURE 68: DEBT AND DEFICIT OF GREECE (%GDP), 1980-2013 ..................................................... 110

List of Tables
Table 1: Historical review of crises .......................................................................................... 13

Table 2: Crisis definitions......................................................................................................... 18

Table 3: Thrift balance sheets before and after early-1980s competitive deregulation ........ 20

Table 4:Representative ABS CDO ............................................................................................ 23

Table 5: Total home sales attributable to Subprime loans ..................................................... 26

Table 6: Mortgage originators ................................................................................................. 28

Table 7: A slow moving crisis ................................................................................................... 29

Table 8: Asset Size Distribution of banks that borrowed from Fed ........................................ 35

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Table 9: Classification events .................................................................................................. 36

Table 10: Number of policy interventions ............................................................................... 36

Table 11: Effectiveness of Policy Interventions during the recent crisis ................................. 37

Table 12: Comparison regarding the reserves ........................................................................ 42

Table 13: Major Financial Events on September 2008 ............................................................ 43

Table 14: Allocation of funds under CPP ................................................................................. 45

Table 15: The legislative evolvement of TARP ........................................................................ 45

Table 16: Assets of Major U.S Financial Institutions as for September 2008.......................... 48

Table17: Risk-weighted assets and corresponding funds ....................................................... 48

Table 18: Program Evaluation ................................................................................................. 50

Table 19:Programs aim and cost ............................................................................................. 52

Table 20: CPP analysis ............................................................................................................. 53

Table 21: Features of Euro are mortgage market ................................................................... 76

Table 22: Bank exposures by country to the sovereign debt of six countries......................... 78

(in millions of euro and in per cent of Core Tier 1, as of December 2011) ............................. 78

Table 23: Alternative policies for solving the financial and sovereign debt crisis in Europe .. 80

Table 24: Debt ratios to GDP on government balances .......................................................... 85

Table 25: Measures undertaken by Euro countries to support the financial sector............... 86

Table 26: Various countries exposure to banking sector ........................................................ 92

Table 27a: Adverse scenario projections ................................................................................. 97

Table 28: Banks capital ratios with capital raising in 2011...................................................... 98

Table 29: Historical average net trading income distribution .............................................. 102

Table 27: Banks capital ratios without capital raising ........................................................... 103

Table 28: Selected bank capital positions ............................................................................. 104

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Dedicated to my parents for


everything they have done for me
till now.

Special thanks to my supervisor,


Nikolaos Topaloglou for his ethical
and crucial support throughout
this Thesis. His contribution was
determinant.

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Introduction

The issues that concern the economy are definitely diverse, multifaceted and draw
the interest of the society in different time points and as the economic science is a
social science, the academic communitys interest is driven by the social trends. On
the heart of the social changes in 2007 there was the outbreak of the greatest
financial crisis after the Great Depression in 1929 to observe which begun in USA.
The fact that USA is always ahead in terms of financial evolvement, convinced me to
begin my analysis with the exploration of the causes, the key triggers, the
malfunctions of the market and later the policy responses towards to this
unprecedented crisis and then examine the aftermath in Europe. The aim of this
Thesis is to offer an overview of the crisis by exploring in depth contractual aspects
of it in order to acquire an integrated view of the key triggers, the flaws and the
distortions of the market, the effectiveness of the policy responses and the
interlinkages between the variables that were omitted. The Thesis latter point is the
presentation of potential proposals which according to my point of view could
contribute towards a more sustainable and viable future as far as the recovery both
of the global and particularly of the European economy is concerned.
From the literature review some scientists tend to believe that the key driver of this
crisis was the extensive and irrational role of leverage, some others insist that the
constantly increasing macroeconomic imbalances between the countries inevitably
contributed to this direction, as the surplus of some countries was channeled in the
form of external debt in the weaker and currently advancing economies, definitely
causing fictional growth rates which due to the insufficient local planning and
infrastructure led to an explosion of the consumption without simultaneously
productive investments to be realized and others believe that the cause lies mainly
on the fact that the interest of the bank turned from supporting the real economy to
struggling for the absolute speculation. Of course this was facilitated by the
globalization and liberalization of the market and reinforced by the faith in the
neoclassical economic theories. According to my point of view of course all the
above mentioned and a multitude of other reasons that I will analyze in a while, have
played a major role, but above all, as the underline cause of this crisis and the one to
blame, is the structure of the economy in the western world which in the recent
decades gave great weight to the services and much less in the production process,
which for obvious reasons had migrated in low cost countries. In order for this model
to be continued with this monstrous growth rates, one should invent new citizens
in order for the demand to be increased! The global economy had risen in values
more than the real value of the product, causing tremendous impairments which
were hidden under the overall overabundance of the market. In this respect,
developing countries presented gigantic growth rates which were completely

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uncorrelated with the local economic momentum and as a result the foundations of
the local communities were significantly undermined on a financial, social and above
all ethical level. Debt and particular the external one, instead of being used in order
to strengthen an economy investing in productivity, was wasted in reckless
consumption which led to the absolute crunch of the system, as the benchmarks of it
were profoundly unsound.

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Chapter 1: US subprime crisis

1.1 Causes of the crisis and the role of leverage


The subprime crisis was a historic turning point in our economy and culture. It was
triggered by a bubble in the housing market that bursted out in US in 2006 and has
caused a domino-effect dragging along a multitude of other countries across the
globe, causing tremendous financial failures and leading to a global credit crunch.
The collateral damage that the subprime crisis has revealed has and will have a
significant economic impact with unpredictable results, which will eventually
transform the whole financial market. Simultaneously, this whole alteration in the
financial markets has set in motion fundamental changes that have to do with the
social structures .Those changes had affected greatly not only the quality of our life,
our consumer habits, our morals and our values but also set under serious
consideration whether the financial system is sustainable or not.

The gist of the subprime crisis problem was the epidemic irrational public
enthusiasm for housing investments1.Because of the boom in the late 1990s in the
home prices, placing an investment in a house seemed to be a good way that could
lead both to financial security and to wealth in some cases. Statistical data2 show
that the US homeownership rates increased between the years 1997-2005 from
65, 7% - 68.9% .The really impressive thing to be mentioned here is that the 11, 5%
increase in the number of home-owners were generated by loans that were given
mostly to people under the age of 35, with no significant income and to Hispanics
and blacks, namely to borrowers with weak credit histories paying no attention to
the underwriting standards, as it was till then the procedure. From the governments
point of view, they were found totally unprepared to deal effectively with this new
arising trend. Neither were they able to cope with it, nor had they the financial
institutions that could be used as a shield towards the on-coming crisis. The core of
the problem with those loans is that they were given unconditionally without any
prior screening in order to make sure that those people were at the position to pay
back the amount that they were borrowed.

The subprime crisis was triggered mainly by four factors:

Subprime mortgages
Collateralized Debt Obligations
Credit Default Swaps those all led to the blooming subprime
Frozen credit markets mortgage market.

1
Robert J.Schiller, The Subprime Solution How Today's Global Financial Crisis Happened, and What
to Do about It
2
Robert J.Schiller,The Subprime Solution How Today's Global Financial Crisis Happened, and What
to Do about It

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But the key factors that played a vital role and were the main causes of the crisis
were:

 The macroeconomic instability combined with very low interest rates for a
long period of time especially in USA, with global liquidity, with a severe
imbalance between the savings and investments which led to higher current
account deficits and with the fixed exchange rate policy.
 The globalization and the interdependence of the credit market. Through
that, the undersigned local crises are transmitted rapidly to the rest of the
world. For example the collapse of Lehman Brothers caused a huge liquidity
crisis on the international banking system.
 The excessive role of leverage
The role of leverage for the past 30 years in the US and in other developed
countries has been extremely high. Leverage has caused financial instability
and exposed the whole economy to severe systemic risk.
 The inadequacy of the regulatory authorities to follow the changes that took
place in the financial field and the lax of oversight. There should have been
better monitoring of the capital markets and reform of the regulatory
framework in order to meet the current needs.
 The systemic risks that emerged due to the abrupt expansion of the financial
sector were not taken into consideration. As a result there was an explosive
development of the securitizations, of the derivatives and of the leverage
which caused a more complicated genesis of endogenous risks.
 The asymmetric information and the principal-agent problem.
The asymmetry in information in all the collateralized obligations (e.g. CDOs,
CMOs, CDS, CBS) led to the undertaking of high risk. Simultaneously in the
environment of investment banks and hedge funds there was not
compatibility in the incentives between the managers and the shareholders,
the well-known principal-agent problem, which led to riskier decisions from
those who wouldnt incur the cost of their choices.
 The absence of accurate accounting depiction. IFRS turned to be inadequate
in the evaluation of the current price of the investments in the balance sheet.
 The displacement of the interest of the banks from financing the real
economy and the investments to pure speculation. Of course this was
facilitated by the globalization, the liberalization of the credit market and the
boom in the use of financial products. As a result, banks focused into
increasing their assets even by being financed from high risk sources such as
the interbank market.

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 The increasingly aggressive use of interest rate changes in an effort to fine


tune the economy and to reduce inflation problems3
 The inadequate and biased analysis from the rating agencies. It is worth
mentioning that agencies like Moodys, Fitch, Standard & Poors, etc. gave
AAA+ ratings, ratings of minimum risk, in a multitude of products. As a result
many investors placed their money in almost riskless investments which
turned to be toxic products. No agency took into consideration the significant
systemic risk. Moreover it is not surprising to underline that the issuers of the
securities were those who paid for the rating!
 The weakness of some economists and of governments to understand the
role of psychology in the formation of financial and investment decisions. For
instance the collapse of Lehman Brothers created a big phobia regarding the
survival of the financial sector.
 The huge imbalances among the countries which appeared with high current
account deficits in the USA and with surpluses in the Asian countries.
 The absolute faith in neoclassical theories such as the invisible hand of
Adam Smith, the agents rational expectations of Robert Lucas, the efficient
market hypothesis by Eugene Fama and similar theories.

Another factor that didnt cause, but inflated the crisis was the wrong perspective of
some economists regarding the extent and the duration of the crisis. They didnt
expect a domino effect but it seems that they waited for a decoupling in the
economy. According to my point of view, it is rather incomprehensible the fact that
well known economists didnt evaluate correctly or perhaps they did not want to
evaluate the high growth rates that were combined with low inflation for more than
10 years .Apart from that, although the house bubble is said to be a main factor, I
incline to believe that it was only part of the things that triggered the crisis.

To put it into short, the main characteristics of this crisis were the big leverage, the
credit expansion, the high inflation, the low reliability of the local monetary
authorities, the former economic bloom, and the bubbles both in the physical and in
the financial capital markets, which included high systemic risk.

In US the problem started to unfold in the housing market. Investors used to buy
from the US Federal Reserve Treasury Bills which was believed to be the safest
investment. But the Chairman of the Federal Reserve, Mr. Allan Greenspan in order
to keep the economy strong and competitive, lowered the interest rate to 1%. The
investors may not have found the 1% return appealing but the banks did. Now they
were at the position to borrow from the US Federal Reserve in such a low rate. As a
result, there was an overabundance of cheap credit which made borrowing much
3
L.Pandall Wray Financial Markets Meltdown, Public Policy Brief No.94 2008, Levy Economics
Institute of Bard College

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easier and the role of leverage determinant. Through leverage banks could use
money in more profitable investments. Because of the benefits of leverage, investors
and home-owners were connected through mortgages. Whoever needed to buy a
new house came in contact with a mortgage broker, who contacted a mortgage
lender in order to sell him the mortgage.

1.2 Crisis Identification

At Table 1 a series of historical crises is quoted in order for us to explore the


interaction of the crises and to present that the majority of them did not work as an
example for the aversion of further crisis.

Table 14: Historical review of crises


Year Crisis Episode

1637 Tulip mania damaged the futures market


and Dutch trade in general.

1720 French and British stocks of firms cashing


in on New World resources hit bottom.

1797 Reserves in the UK fell low, creating a


monetary crisis. BOE put a hold cash
payments creating widespread public
panic

1810 English credit crunch.

1819 Only 43 years old, the US experienced its


first major financial crisis.

1825 London stock market panic from over-


speculation in Latin American
investments.

1836 US real estate speculation caused stock


markets to crash in the UK, Europe, and
then the US.

4
Dr.Nantawan Noi Kwanjai, Anatomy of financial crisis, past, present and future

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1847 A credit crisis and bank panic ensued


when railroad stock prices crashed in
France and the UK.

1857 During the Civil War, a US credit crisis


crashed equity prices. All nations that
trade with the US were affected.

1866 Overend & Guerney went bankrupt (a


result of railroad speculation), resulting
in "Black Friday. A bank panic started,
which led to lack of credit. Walter
Bagehot advocated a new role of a
central bank as lender of last resort to
provide liquidity during crisis.

1873 Vienna stock exchange collapsed, causing


the great stagnation on a global scale
that lasted until 1896.

1882 In France, Union Generale went


bankrupt, causing banking crisis and
market crash.

1890 The first Barings crisis: the UK's oldest


bank, Barings, nearly collapsed from its
exposure to Argentine debt. A century
later, Barings went technically bankrupt
after the second Barings crisis in 1995.

1907 The Panic of 1907: US bank panic


following US stock market collapse, when
it fell close to 50% from its peak the
previous year. This soon spread to France
and Italy

1921 Commodity prices crash.

1923 Hyperinflation in Germany started


monetary crisis.

1929 "The Great Depression" the largest and


most important economic depression in
modern history. It originated in the

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United States with the Wall Street crash


on Oct. 29, 1929, known as Black
Tuesday, and had devastating effects on
many countries around the globe for
more than one decade.

1931 Financial crises experienced by the UK,


Japan, Germany, and Austria.

1933 Gold standard given up by the US,


starting panic in the banking system.

1966 US credit crisis created deflation and


huge economic slump.

1973 World financial crisis began after OPEC


quadrupled the price of oil. This resulted
in a long stagflation period.

1980s-1990s The savings and loan crisis of the 1980s


and 1990s was the failure of 747 savings
and loan associations (S&Ls) in the US.
The ultimate cost of the crisis was
estimated to have totaled around 160.1
billion dollars. The slowdown in the
finance industry and the real estate
market may have been a contributing
cause of the 19901991 economic
recession.

1982 The Latin American debt crisis: global


credit crunch prevented many
developing countries, particularly those
in the Latin American countries, from
paying their debt.

1987 Bond and equity market crashed.

1987 The Japanese bubble: the Japanese


asset price bubble was an economic
bubble in Japan from 1987 to 1990, in
which real estate and stock prices greatly
inflated. The bubble's collapse lasted for
more than a decade with stock prices

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bottoming in 2003. The time after the


bubble's collapse is known as the "lost
decade or end of the century" in Japan.

1987 The Black Monday crash: US stock


market fell 22% in one day, soon
spreading to European & Japanese
markets. The crash was associated with
programmed trading, leading to the so-
called circuit-breakers regulation.

1989 Junk bond crisis.

1992 The EU Maastricht Treaty sparked crisis


in European Monetary System.

1995 The second Barings crisis.

1995 Mexican financial crisis caused by the


peso's peg to the dollar during excessive
inflation.

1997 The Asian financial crisis: a period of


financial crisis that gripped much of Asia
beginning in July 1997. The crisis started
in Thailand with the financial collapse of
the Thai baht caused by the decision of
the Thai government to float the baht,
cutting its peg to the U.S. dollar. As the
crisis spread, most of Southeast Asia and
Japan saw slumping currencies, devalued
stock markets and other asset prices, and
a sharp rise in private debt. Indonesia,
South Korea and Thailand were the
countries most affected by the crisis.

1998 Russia defaults on payment obligations


during major financial crisis

1998 Collapse of the Long-Term Capital


Management Fund (LTCM) in the US,
leading to scrutiny of the hedge fund
industry.

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2000 Dotcom bubble busted, creating a


massive fall in equity markets from over-
speculation in technology stocks.

2001 Another junk bond crisis.

2001 911 attack created risk by hindering


various critical communication hubs
necessary for payment on the financial
markets.

2001 Financial crisis in Argentina, resulting in


the government defaulting on payment
obligations.

2001 The Enron Scandal created systemic


effects on creditors, banks and other
energy trading companies.

2002 Bond market crisis in Brazil.

2007 US real estate crisis caused the collapse


of massive international banks and
financial institutions. Equity markets
took a dive. This led to today's financial
crisis punctuated by credit crunch and a
frozen interbank market.

2010 The EU crisis: the European Union


faced its greatest crisis episode since the
introduction of the single currency the
euro, starting with Iceland and spreading
to Greek, and Ireland, threatening
several EU countries including Spain,
Portugal, and Italy AND put a severe
strain on the European Integration
efforts, particularly threatening the
credibility and sustainability of the euro.

As depicted on Table 2 a crisis can have different types, resulting in different market
distortions and needing different treatment.

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Table 25: Crisis definitions

On Figure 1 below, a chart is shown in order for us to understand the typology of


a crisis. A crisis could be identified till now based on specific indicators that took
into consideration the values of certain variables in the beginning of the crisis so
as to capture evidence that would help them predict the degree of the crisis, the
extent and the depth and the duration of it. A financial crisis can be characterized
by boom and boost phases of the economic cycle, as the first can be traced by an
excess in leverage, increase in credit expansion and the evolvement of financial
innovation. The situation can get a lot more complex as a multitude of factors
can play a vital role to the evolution of some variables and the crisis
identification to be prevented.

5
Yoichiro Ishihara, Quantitative analysis of crisis: Crisis Identification and causality

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FIGURE 16: CRISIS IDENTIFICATION

On Figure 2 we can see the crisis composition from the early 1980s till the early
2000s. After 2000 the financial system has presented a substantial alteration of
its structures and principles and as a result the composition of the late crisis
presents diversifications with the ones presented on the below Figure.

FIGURE 27: CHANGES IN CRISIS COMPOSITION

6
Yoichiro Ishihara, Quantitative analysis of crisis: Crisis Identification and causality
7
Yoichiro Ishihara, Quantitative analysis of crisis: Crisis Identification and causality

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1.3 The transformation of the U.S Banking system

The banking system in the US before 1980s was structured in a certain way that set
a lot of geographic and product-line restrictions, which limited significantly their
ability to respond to the credit demand that had an increasing rate. This regulatory
inflexibility caused a range of problems, particularly for the large banks. In order to
overcome this obstacle and to be in the position to absorb the credit demand, the
banks adopted a liability management method8 instead of borrowing from the
Federal Funds market and from other short-term borrowing sources. Problems of
stagflation and huge interest rates that have arisen gave a clear signal of what would
happen in the future. Parallel in 1980s a law has been voted in order to modernize
the banking system. This law led to the deregulation of the federal and state
regulators. The deregulation not only did not give the expected results but proved to
be a true catastrophe, because of a multitude of speculative attacks that took place
and drove the whole system to illiquidity and later to insolvency .As shown in the
Table 3, before deregulation there was not a significant liquidity problem. The really
impressive thing to be mentioned here is that in the pre-deregulation era the
mortgage loans were rated as default-risk free.

Table 39: Thrift balance sheets before and after early-1980s competitive
deregulation

At the same time, at Figure 3, we can observe that at the beginning of the 1980s the
holders of the mortgage debt were mainly the saving institutions. As the years had
gone by, the transformation of the US banking system took place and at the end of

Gary A. Dymski, From Financial Exploitation to Global Banking Instability:


Two Overlooked Roots of the Subprime Crisis
9
Gary A. Dymski, From Financial Exploitation to Global Banking Instability:
Two Overlooked Roots of the Subprime Crisis

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2007 the Federal Agencies were the dominant holders of the mortgage debt in the
market. After the deregulation many mergers and acquisitions took place in the bank
sector, in order for this market to be strengthened and the liquidity stocks to be
increased. So as the banks to attract the consumers, they made the bank products
more appealing by decreasing the interest rates .The fictitious boom of the credit
cards and the mortgage loans market had begun.

FIGURE 310: HOLDERS OF THE U.S MORTGAGE DEBT, 1979 2006(% OF THE TOTAL)

10
Gary A. Dymski, From Financial Exploitation to Global Banking Instability:
Two Overlooked Roots of the Subprime Crisis

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1.4 The Securitization of the Mortgage Market

The securitization of the mortgage market began in the U.S in 1980s with the launch
of private market MBS(mortgages that are securitized creating bonds), having a
significant default risk because there was no provision of government guarantees. It
seemed to be a very nice tool because it allowed issuers to diversify their funding
base, enabled the evolvement of the synthetic market and facilitated an interest
shift from the real economy into the speculative one. The payments for the
underlying assets, in our case for the mortgages, were made upon a certain logic.
First of all they were directed to the most senior tranche,then to the following,
ending to the equity tranche, which was regarded as the riskiest one. Because of the
risk that this tranche was pressumed to have, it was granted with the highest
return.The top tray of course received a lower return, but still an attractive one. All
the tranches together formed the so-called Collaterilized Debt Obligation(CDO).In
order banks to make the senior tranche more appealing, they insured it by paying a
small fee, which is called Credit Default Swap(CDS). In the whole procedure the
subprime risk passed into a sequence from the broker, to the lender, to the
securitizers and final to the investor portfolio.In order to meet each investors
personal criteria by targeting to the exact risk profile of each one, investment
bankers offered to the risk averse ones the senior tranche, to the risk neutral the
mezzanine and to the risk lovers like hedge funds, the equity tranche. Throughout
the transactions, as one party sold it to another, there was no further exposure to
the performance-risk of the loan. The profit increase through those new financial
instruments triggered the incentive from the brokers part to generate as much
volume of loans as possible without paying any attention in the credit risk that those
loans may had. They didnt interpret correctly that the excess spreads that those
products had, was because of the high risk that they included. At the same time
many managers showed a significant interest in buying BBB+ or BBB- tranches from
various securitizations forming a portfolio of mezzanine tranches bearing not in mind
that those products may have a high correlation ratio. In contrast they formed a CDO
using this subprime bonds, rated as an AAA bond by more than one rating agencies,
as shown in Table 4. In the end many investors that bought an AAA CDO didnt
comprehend the high credit risk that it included , because of their ability to buy
insurance against default propability, because for some was just an opportunity for
arbitrage and they didnt care about the loan quality or because the shelter of an
AAA rating was more than adequate for them.

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Table 411:Representative ABS CDO

In Figure 4 the securitization rates on subprime mortgages have evolved gradually


from 45% , reaching almost 100% in 2007, where all the other types of mortgages
ranged more or less at the same levels.In the securitization procedure of the
mortgage market , a really impressive thing is that after 2005 the securitization was
no longer applied only to loans that met the criteria and were believed to have good
performance.Apart from that it is rather intriguing to think that yield-hungry
investors never bothered to to analyze that excess speads were receiving better
return than the 1% of the treasury bills and other types of investments, gave those
return based on the excess risk that they were bearing.They were reassured by the
impessive well credit ratings!

FIGURE 412: SECURITIZATION RATES FOR MORTGAGE CATEGORIES

As it clearly depicted on Figure 5, we can observe a parallel evolvement between


real GDP and the outstanding mortgage debt. In 1996 those two figures developed
with the same rate,while from then on we notice that there is no longer a covariance

11
Karen Weaver, Deutsche Bank The subprime mortgage crisis: a synopsis
12
Securities Industry and Financial Market Association

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between those two figures, with the GDP growth rate, being around 4%, while the
outstanding mortgage debt increasing at 9%. It is worth underlining that in 2001,
where GDP shows a declining trend , the outstanding mortgage is jumping at more
than 10%, and begins to fall rapidly in 2007.Bearing that into consideration and by
having a closer look at Figure 6 we must point that although Switcherland seems to
hold the first position and United States to above the average, the crisis hit US.But
why then the subprime crisis bursted in U.S and not for example in Switcherland or
Denmark?The reasons lie mainly on the operation and the exposure of the US
banking system, which was more prone to significant systemic risks.

FIGURE 513: GROWTH RATES OF REAL GDP AND MORTGAGE DEBT OUTSTANDING IN U.S 1971-2007

13
Gary A. Dymski, From Financial Exploitation to Global Banking Instability:
Two Overlooked Roots of the Subprime Crisis

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FIGURE 614: OUTSTANDING MORTGAGE TO GDP RATIOS

1.5 Housing-based Subprime Lending

As shown on Figure 7 below, the mortgage market in the US started from a very low
level in 1994, it expanded gradually till 2002 and from then on the increase was
rapid, reaching the absolute peak in 2005 and decreasing dramatically in 2007 when
the crisis begun.

FIGURE 715: SUBPRIME MORTGAGE ORIGINATIONS, ANNUAL VOLUME AND PERCENTAGE OF TOTAL

The great boom in the mortgage market which occurred in 2005 presented an
annual loan volume of 600 billion dollars. As it depicted on Figure 8, mortgage loans
have reached the 20% of the total loan originations.

14
Dwight M.Jafee The U.S Subprime Mortgage crisis: Issues Raised and Lessons Learnt, Commission
on Growth and development, working paper no.28
15
Inside Mortgage Finance, www.insidemortgagefinance.com

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FIGURE 816: MORTGAGE LOANS AS A PERCENTAGE OF THE TOTAL

The only benefit that the mortgage lending had was that the vast majority of US
population succeeded in buying a house. Table 5 shows the total number of the
subprime loans, the loans for home purchase as a percentage, the number of homes
purchased and the adjusted number of homes purchased.

Table 517: Total home sales attributable to Subprime loans

As shown on the table the percent of the subprime originations rose over the years
reaching the 20% .Leverage as we already have mentioned played a determinant
role for that.

16
http://www.wikinvest.com/image/Subprimeshare.png
17
Dwight M.Jafee The U.S Subprime Mortgage crisis: Issues Raised and Lessons Learnt, Commission
on Growth and development, working paper no.28

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FIGURE 9A18: ALL LOANS PAST DUE AS A PERCENTAGE OF CATEGORY TOTAL OUTSTANDING

FIGURE 9B: FORECLOSURES STARTED DURING QUARTER AS PERCENT OF CATEGORY TOTAL OUTSTANDING

FIGURE 9C: LOANS IN FORECLOSURES AS PERCENT OF CATEGORY TOTAL OUTSTANDING

Figures 9a, 9b, 9c present obviously, that a major number of low-quality credits
were part of the subprime loans.19

18
Mortgage Bankers Association
19
Dwight M.Jafee The U.S Subprime Mortgage crisis: Issues Raised and Lessons Learnt, Commission
on Growth and development, working paper no.28

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1.6 The slide into crisis

The slide into crisis was inevitable. The transformation of the whole banking system
and the fact that credit standards were loosened irrationally led to the ambiguous
results of the profit-seeking financial innovations.

Table 6: Mortgage originators

As it is shown in Table 6, the craving for speculation led to the offering of loans in
unreliable borrowers even at the time at which the housing market has already
reached its peak! As a result many of those borrowers were not in the condition to
pay back the money needed for the loan, because they had no refinancing ability and
because the sudden decline in home prices made it meaningless to sell the property
so as to repay the mortgage.

One thing that played a vital role for the crisis is that all market participants failed to
understand that through their actions they pushed the market to explode through
the house bubble that it was revealed with steadily increasing prices. From the side
of the investors there was a profound underestimation of the risk that subprime
portfolios had and that is the reason why they kept leveraging the portfolios creating
mismatches in the maturity horizon by borrowing short-term and lending long-term.
As history repeats itself the crisis was ante portas.

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Table 7: A slow moving crisis

Although the subprime mortgages are said to have been a small percent of the total
mortgage market, the significant thing to underline is that the subprime20 borrowers
were the marginal buyers of housing and the prices were very much driven by them.
Together with Alt-A borrowers the made up almost up to 40 percent of the home
buyers in 2006. It is worth taking a look at the table, which shows indications of the
evolvement of the crisis in the US market.

As the crisis hit the market the risk spreads increased sharply, the risk premiums of
the emerging countries were dramatically higher and the net exports showed a
rough decline, as shown on Figure 10.

20
Karen Weaver, Deutsche Bank The subprime mortgage crisis: a synopsis

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FIGURE 1021: THE CRISIS UNFOLDS

21
Erik Bergloef,Yevgeniya Korniyenko,Alexander Plekhanov and Jeromin Zettelmeyer ,Understanding
the crisis in emerging Europe, European Bank

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FIGURE 1122: TRADITIONAL AND SHADOW BANKING SYSTEM

Because of the securitization of the market the funding for the mortgages sprang
from non-bank institutions. Institutions like insurance companies, hedge funds,
pension funds, SIVs and other generated the shadow banking system which was
very difficult to be supervised by regulatory authorities. A large number of many
subprime loans could be attributed to the shadow banking system (Figure 11) which
in the mid 2007 provided $6 trillion in credit, reaching almost the same level of
credit that was provided by the traditional banks.23

1.7 The Subprime Crisis

The contagion effect of the crisis revealed that economists and government
members hadnt taken into serious consideration the correlation that a crisis in the
US would have with the rest of the world. The subprime crisis in the US triggered a
multitude of unexpected negative results affecting seriously and in different ways a
majority of other countries creating tremendous solvency problems, threatening the
stability of the global financial market and leading inevitable to recession. Financial
institutions could have used the securitization of the credit market as a lever to
achieve further benefits because the securitization enables risks to be allocated
across the diversified portfolios, it broadens the sources of funds especially for home
mortgages and it helps to the liquidity of the mortgages . In contrast, securitization
was used for irrational speculation by transforming healthy transaction methods into

22
Gregory A.Krohn, William R.Gruver , Department of Economics, Bucknell University, Lewisburg
The complexities of the financial Turmoil 2007 and 2008
23
Zandi Mark Financial Shock, NJ : FT Press 2008

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deceptive lending practices, leading to a financial market catastrophe. Apparently,


the subprime crisis was the result of a fundamentally flawed model called market
fundamentalism, resulting in the huge systemic failure that was revealed with the
credit crunch and is yet more obvious than ever.24All those alterations that made to
transform the banking system we would expect to have resulted in a healthier and
more robust financial system but instead they made the system more prone to crises
in general. As many economists support, long-term stability is in the end always
destabilizing.

Speaking for this crisis, its severity is demonstrated by the duration of it and by the
tremendous negative impact that it had and still has in the supply of the credit which
is directly reflected in the economic activity affecting the vast majority of the
countries across the globe. Stock markets around the world have decreased
dramatically and the financial system became extremely volatile. The subprime
mortgage meltdown led to financial collapse and now is the crisis more
unprecedentedly intensified than ever, with uncertain extend and duration, unless
measures are taken in order to steer the economy out of recession.
The failure of Bear Sterns in March 2008 devastated deeply the financial system as it
sent shock waves. Lehman Brothers bankruptcy afterwards on September 15 was
another shock with even more profound consequences.

1.8 Liquidity issues

The huge crisis revealed huge liquidity and simultaneously solvency issues. Because
of the very low liquidity and the decrease in traded volumes, market prices fell far
below their fundamental value25.The widespread disruptions in the worldwide
financial market were caused by the complex nature of the structured financial
instruments leading to a severe liquidity crisis.

What should be underlined so as the features of liquidity crisis to be explained is the


interaction that exists between liquidity and asset prices. There is a vicious circle
between them because when asset prices fell erratically, this resulted automatically
in funding illiquidity because highly leveraged institutions that borrowed money in
order to acquire assets were no longer in the position to do so. Simultaneously,
borrowers had the incentive to sell some assets in order to have adequate capital so
as to meet the requirements imposed by creditors and regulators. As a result, asset
24
L.Pandall Wray Financial Markets Meltdown, Public Policy Brief No.94 2008, Levy Economics
Institute of Bard College
25
Dwight M.Jafee The U.S Subprime Mortgage crisis: Issues Raised and Lessons Learnt, Commission
on Growth and development, working paper no.28

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prices showed a more rapid decline and this led to market illiquidity. Again this
caused asset prices to fall even more. As an aftermath this vicious circle resulted in
the financial institutions insolvency, as this downward spiral of liquidity and asset
prices expanded into the global financial market. In addition what happened in this
financial turmoil was that when investors started interpreting a little bit the
uncertainty of the environment that they were activating in, they sold large
quantities of risky assets in order to buy those which were considered from their
point of view safer. This caused a malfunction in the market because it increased the
yield spread between risky and safe assets26. Obviously after the expansion of the
crisis in 2007, investors who held risky financial instruments started asking for
increasingly higher premiums and this resulted in the total absence of funding
liquidity.

Apart from that, a vital role to the liquidity crisis and to the credit strains played the
CDS and the synthetic CDOs. CDS embed considerable counterparty risk because the
base of the transactions was bilateral and not through an exchange which could
secure the reliability of the clearing and at the same time they included severe
intrinsic credit risk. As with the beginning of the crisis, the value of the MBS fell, the
counterparty risk that the CDS included began to increase.

The liquidity crisis was revealed in the US partly with the closing of the Bear Stern
hedge fund because it had an immediate effect in the psychology of the investors, a
factor that I consider to be of high importance. This was the beginning of mistrust of
how highly rated CDOs defaulted and it created suspicion regarding the outcome
that holders of subprime MBS would presumed to face and of course mistrust
towards institutions that were known to have large holdings of subprime MBS.

What in the beginning seemed to be pure credit risk was transformed in significant
liquidity risk, leaving the financial system in the US more fragile than ever.

26
Elul Ronel, Liquidity Crises, Business Review Federal Bank of Philadelphia Q2 2008

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Chapter 2: Addressing the financial crisis

2.1 Purchasing of Troubled Assets and


Undercapitalization Problems

Troubled Assets created a multitude of problems in the banking system, causing fear
and uncertainty about the future viability of the global financial market. Due to the
existence of toxic assets, which value could not be clearly defined, banks werent at
the position to find ways which would ensure additional capital and simultaneously
their vital role was inevitably neglected. Troubled assets consisted of mortgage-
backed securities, mortgage related instruments and debt related products, which
value has fallen dramatically and banks were unwilling to sell them in low prices.
Banks showed great aversion in selling the assets at very low prices and that has
contributed in a gigantic troubled-asset market. In the end those troubled assets
were bought at a premium over their current deflated value partly because of the
reduction of the house prices and of other asset classes. The inability those assets to
be sold resulted in the frozen markets.

Impressive to point is that according to various data from different sources, US banks
appeared to be adequately capitalized on the threshold of the crisis! In the
maelstrom of the financial meltdown in a severely indebted economy the restore of
the capitalization was of paramount importance.
Banks tried very hard to put the toxic assets out of their balance sheets. They were
found facing severe undercapitalization, having assets of poor quality and as a
result they sold assets as a way to de-leverage their portfolios. The consumers
negative psychology that was depicted greatly in their risk-aversion made things
worse for the banks as they were forced to held more capital, while at the same
time the write-downs ruined the capital. As a policy response, government tried to
inject amounts of public funds in banks (Table 8).27

According to Federal Deposit Insurance Corporation (FDIC) banks are classified


according to their risk-based capital ratio into five categories:

27
The role of banks in the subprime financial crisis, Michele Fratianni, Indianna University Kelley
Business School and Franchesco Marchionne ,Mofir Working Paper no 23

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Well capitalized: >= 10%


Adequately capitalized : >= 8%
Undercapitalized: < 8%
Significantly undercapitalized: < 6%
Critically undercapitalized: <2%

Table 828: Asset Size Distribution of banks that borrowed from Fed

Note: Asset size measured on September 30, 2007

In order the prolonged slowdown in the aggregate economy to be hindered central


bank and the US government took action as it was inevitable otherwise to alter the
deteriorating financial institutions and to unfreeze the markets. In this respect, in
order to restore the confidence in the severely damaged market central banks
intervention was presented through interest rate changes and liquidity provision,
whereas the governmental action had to do with refinancing, liability guarantees and
asset protection, as it is depicted on Table 9.

28
Federal Reserve Lending to Troubled banks during the financial crisis 2007-2010, Working Paper
2012-006A, March 2012

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Table 929: Classification events

Table 10 shows the number of interventions that took place based on the stage of
the crisis for the Euro Area Japan, Sweden, Switcherland, UK and US, helping us to
make a comparison between the growth of the countries, the former stability of the
financial institutions as well as the successful or not response of them to the
measures taken in order to restrain the crisis.

Table 1030: Number of policy interventions

29
IMF
30
IMF, http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/chap3.pdf

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It is of paramount importance to analyze the effectiveness of those interventions as


they are presented on Table 11.

Table 1131: Effectiveness of Policy Interventions during the recent crisis

As it was anticipated, the lowering of the interest rates by the central bank gave a
slight boost in the economy, as it made funding easier due to the lower cost,
resulting in the attraction of liquidity. Simultaneously, in the three phases of the
crisis market participants reacted in different way in the need of liquidity. For
instance, as the crisis became more severe the announcement of further liquidity
measures did not have the same impact on all the market participants as it was more
than expected that central banks would again play their role and safeguard the
financial market from the absolute meltdown.

On Table 11, the effectiveness of the measures announcements is presented, using


the FSI index. The results show that the capital infusions do not seem to have a
significant impact on the FSI, possibly because this index is not sensitive enough

31
IMF, http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/chap3.pdf

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regarding the CDS spreads. The question that is posed here is how each one assesses
the effectiveness of the policy measures in terms of short-term market efficiency or
long-term sustainability.

FIGURE 1232: IMPACT OF COUNTERPRODUCTIVE INTERVENTIONS ON FSI IN UNITED STATES

The above Figure 12 is a result of a study that examined the procyclical and the
countercyclical policy actions that were taken. Regarding US the results clearly depict
that if those measures were not taken the economic downturn would have been
even worse contributing to a significant fall in the aggregate output.

The financial turmoil in the US brought an unexpected decline in the bonds issuance
as it is presented at Figure 13, which showed a slight increase in 2008 only due to
the governmental intervention.

32
IMF

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FIGURE 1333: GOVERNMENTAL GUARANTEED BONDS (GGB) AND NON-GUARANTEED INVESTMENT-GRADE


BANK BONDS

As it is shown on Figure 14 in all the regions in 2009 there is an upturn basically due
to the issuance of government-guaranteed bonds, except from Japan, but this will
not be analyzed because it is out of the scope of this Thesis.

33
IMF

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FIGURE 1434: IMPACT OF LIABILITY GUARANTEES ON BOND ISSUANCE

34
IMF

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FIGURE 1535: IMPACT OF FINANCIAL SECTOR STABILIZATION MEASURES ON CDS SPREADS

In the end as it is shown at the Figure 15 above policy makers succeeded in reducing
in some extent the credit risk and contributed in limiting the credit risk-premia for
the banks, of course not precisely the same effectively and efficiently for all the
countries.

As the crisis bursted, reserve balanced began to be used by the central banks not for
the conduct of monetary policy, as they set the required amount of reserves needed
so as the overnight interest rate to be in absolute accordance with the desired rate,
but for the provision of liquidity to financial institutions that had serious solvency
problems and due to this incapability to fund themselves they were unable
otherwise to access the interbank market.

The malfunction in the market that appeared due to the crisis shifted downwards
the overnight interest rates. At the same time central banks were assigned with the

35
IMF

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role to purchase MBS, a fact that put additional systemic risk on their balance sheets
In the end the net effect of the policy directives is still ambiguous because on the
one hand, capital infusions increased the amount of reserves, that means central
banks received more interest and they had more profit but simultaneously they had
low returns on the assets that they had in their possession. What is to be pointed
through this procedure is the excessive risk that central banks have gone into putting
in danger their reserves (Table 12).

Table 1236: Comparison regarding the reserves

To sum up during the recent crisis, policy makers used multiple ways of financing so
as to induce a shift in the lending pattern and the economy to exit the stagnation,
the most important of which are the following:

Common stock capital infusion


Governmental liquidity provision
Preferred stock recapitalization
Loan guarantees
Governmental purchase of equity stakes
Toxic Assets purchase

36
IMF

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2.2 Background of the TARP

As the financial crisis unfolded, global credit markets reached the ultimate drop in
September 2008 as huge institution such as Lehman Brothers and the America
International Group defaulted, making the need imperative for immediate measures
from side of the government. Bearing also in mind the severe destabilizing effects
depicted in Table 13 that that occurred in the fall of 2008 extraordinary government
support was one-way, as a more systemic approach was needed to amplify stability
prevent further market imbalance and avoid financial meltdown .

Table 1337: Major Financial Events on September 2008

As a response to all this turmoil, the Troubled Asset Relief Program (TARP) was
designed by the Emergency Economic Stabilization Act of 2008 and was
administrated by the Office of Financial Stability at the US Treasury. Initially it was
created so as to buy the toxic MBS in order to provide the severely destabilized
market with lending stability and liquidity as an immediate equity injection method.
Before TARP was put into effect, attempts had been made from the side of
government to address the financial crisis but they turned to be insufficient to
defuse the financial deterioration. Simultaneously there were heavy objections and
severe political cost that the government should undertake because of the imposing
of significant tax burden, all efforts failed.

37
Emergency Capital Injections provided to support the viability of Bank of America, other major
banks and the U.S financial system, October 2009, Office of the Special Inspector General for the TARP

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On the 3rd October 2008 the Treasury was provided the authority to spend up to
$700 billion in purchasing such assets. This capital injection plan took place in three
distinctive steps .At the beginning $250 billion were given for capital infusion to
banks by the purchase of their shares as an attempt to withhold the intensity of the
crisis, then the President should give permission for additional $100 billion more and
the rest $350 billion were up to Congress consent. On October 14, 2008 the Capital
Purchase Program (CPP) was announced through which the allocation of the $250
billion was directed in the purchase of preferred stock of US financial institutions.
Under CPP non-voting preferred stock were purchased by the Treasury giving banks
the possibility to apply for this program in amounts between 1-3% of their risky
assets. CPP infusions in order to be attractive for banks took the form of preferred
stock.38Simultaneously with those capital injections, there were set limits on
executive compensation which were revised on February 4, 2009 and further
modified on February 19, 2009 under ARRA. As depicted in Table 14, CPP was
provided in 707 institutions, 646 of which were Commercial banks, 350 were Public
and 296 were private accounting at 192.8, 188.2 and 4.6 billion respectively. As it is
shown on the Table most of the banks applied for the maximum amount that they
could. On February 10, 2009 the Financial Stability Plan was introduced which was
funded by the remaining $350 billion .Financial Stability Plan consisted of four
elements, one was the CAP, the other one was a consumer lending initiative and the
other two were a public-private investment fund for illiquid assets and a home
mortgage modification initiative.39 Under CAP 19 banks that had total assets with
value that exceeded the $100 billion were subject to SCAP.

38
Assessing TARP, Dinara Bayazitova Anil Shivdasanari, University of North Carolina
39
Assessing TARP, Dinara Bayazitova Anil Shivdasanari, University of North Carolina

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Table 1440: Allocation of funds under CPP

At the same time the legislative evolvement of TARP is depicted in Table 15.

Table 1541: The legislative evolvement of TARP

40
Assessing TARP, Dinara Bayazitova Anil Shivdasanari, University of North Carolina
41
SIGTARP

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Between October 28, 2008 and June 30, 2009 over 600 banks and bank holding
companies accepted the capital infusions. The first wave of TARP was provided to
nine major US banks and institutions which were the Bank of America, Citigroup,
JPMorgan Chase, Wells Fargo, Goldman Sachs, Morgan Stanley, Merrill Lynch,
State Street and the bank of New York Mellon in order to improve the safety of the
banking system though greater capitalization. These were chosen based on their
market activities, their size, the interdependence that they had, their importance to
the broader financial system, and some smaller as a part of the Capital Purchase
Program (CPP) whose responsibility was to support banks that didnt face liquidity
problems. Those nine banks possessed more than $11 trillion in banking assets, as it
is shown on Table 16, and received in the end $125 billion which are around 61% of
the total CPP fund and 75% of all assets held by US-owned banks. By September
2009, over 670 banks have received a total of $204.55. Meanwhile $20 billion were
given to Bank of America as a part of Targeted Investment Program (TIP).TIP was
used in order to inhibit severe collapses of important financial institutions if there
was such presumption. At the same time through Asset Guarantee Program(AGP),
the Bank of America became almost the largest recipient of TARP funds .The amount
of money that each bank received was based on how risky were the assets that it
possessed(Table 17).42As it shown on Table 17 the majority of them received the
maximum amount of money that could under the requirements of the program .For
the rest three, Bank of America, Merrill Lynch and Wells Fargo, things were more
complicated due to pending merger plans. However we must stress that although
both Wells Fargo and the Bank of America were under merger discussions they did

42
Emergency Capital Injections provided to support the viability of Bank of America, other major
banks and the U.S financial system, October 2009, Office of the Special Inspector General for the TARP

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not receive the same treatment. The reason here lies according to my point of view
to the belief of some crucial officials that this merger could severely undermine the
sustainability of the Bank of America something that could prove to be destructive
on a global level.

Also worth to mention is the fact that some banks exited TARP. The reasons for that
may lie upon the fact that banks that had higher returns on assets, had raised
common or preferred stock, had stronger capital ratios, healthier asset profile and
had high CEO pay, had entered the program after ARRA had more possibilities to exit
TARP43.Apart from those factors there are some that cannot be quantified easily
such as the way that banks interpreted the stigma that this government help would
leave them. After all what is to highlight is that banks that entered TARP had weaker
capital ratios, a significant exposure to funding risk and a portfolio with many toxic
assets from certain troubled asset classes and banks which was believed that they
could contribute to new lending opportunities. It is important to stress that to which
bank were chosen, political connections that banks had surely played a vital role.

43
Escaping TARP, Linus Wilson, University of Luisiana and Lafayette and Yan Wendy Wu, Wilfrid
Laurier University

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Table 1644: Assets of Major U.S Financial Institutions as for September 2008

Table1745: Risk-weighted assets and corresponding funds

44
Federal Reserve
45
Federal Reserve, Securities and Exchange Commission and Treasury

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2.3 The changing political environment and the costs of


TARP participation

TARP brought social turmoil and a great opinion divergence as it was a controversial
economic policy. Its two most credible critics were John Taylor and Joseph Stiglitz
who strongly believed that without TARP the economy would have gone better.
Stiglitz insists on the fact that TARP process was not transparent enough, there was
not an objective reasoning of the banks for receiving TARP funds, banks that were
lent didnt used those money so as to lend and it aggravated the already significant
moral hazard that lured in the financial sector. 46On the other hand their critics
insisted on supporting the counterfactual that TARP brought even more recession
and financial collapse. They support their opinion by underlying that the equity
purchases through CPP were at transparent prices and had injected the nine big
financial institutions with immediate liquidity. The tremendous changes that took
place in the US economy have altered in a great extend the political environment
there, mainly because of the fact that it affected the incentives and the expectations
of the investors that in case of future financial distresses the government in order to
avert a financial meltdown would again bail-out banks. Having this in mind investors
had little incentive to be involved in less risky decisions. Apart from the fact that it
imposed a heavy tax burden on the public, which was believed to be distributionally
unfair, created a negative political atmosphere. Adding to that the opinion that most
people consider the political-economic interventions to firms that are on the verge
of collapsing as unethical and financially harmful, we can understand why TARP were
presumed to be ineffective. I incline to believe that without TARP intervention,
although I have to underline the failure of the political manipulation through the use
of politicians own leverage in respect of their own benefit, US economy would suffer
under worse macroeconomic instability and the economic effects of deflation and
unemployment would be more intensive. As the public opinion is guided, their belief
of the TARP failure was formed based on the deficient information that they
gathered their educational level, their social culture and the interests that they
wanted to support. As depicted in Figure 1647below, interbank spreads that reveal
the existence or absence of financial stability, reveal that after TARP the financial
stability was restored in a great extent.

46
The political economy of TARP:A Public Opinion Approach, Michael E.S Hoffman, Center for
Economics, U.S Government Accountability Office
47
The political economy of TARP:A Public Opinion Approach, Michael E.S Hoffman, Center for
Economics, U.S Government Accountability Office

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FIGURE 16: SPREAD BETWEEN 3 MONTH $US LIBOR AND 3 MONTH TREASURY

2.4 Program Evaluation

The executive summary below on Table 18 summarizes the evaluation of the


program taking into consideration different sectors. As the Treasury data reveal,
through TARP, more than three-fourths of the funds disbursed were actually
recovered.

Table 1848: Program Evaluation

48
TARP: Three year Anniversary Report, A Supplement to the TARP Two Year Retrospective, Treasury-
Office of Financial Stability

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The financial performance of the program has not yet been assessed in absolute
numbers, as it relies on a multitude of factors. For example the stock market
volatility in US during the summer in 2011 has become an obstacle for some TARP
investments as it has significantly depreciated their value.

In the banking sector the provision of liquidity was of paramount importance. Many
of the banks supported are small-medium community banks or CDFIs which had a
severe problem to access capital markets. Because of their order of magnitude those
banks present a difficulty in repaying the received funds to the Treasury.

FIGURE 1749: TARP IN BANKING SECTOR

In the Automobile Industry approximately $80 billion were injected in order to


prevent a total devastation of the US market which would have for sure a
tremendous inestimable impact on the global financial chain. As the data reveal
there incurs a loss on this investment but is still less regarding the one primarily
expected.

In AIG, Treasury infused almost $180 billion. It is expected that AIG will repay almost
in total the funds that it received.

Regarding the Credit Market Programs that were initiated under TARP, that is the
Term-Asset Backed Securities Loan Facility (TALF), the Public-Private Investment
Program (PPIP) and the SBA 7(a) Securities Purchase Program I quote the following
Table 19:

49
TARP: Three year Anniversary Report, A Supplement to the TARP Two Year Retrospective, Treasury-
Office of Financial Stability

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Table 19:Programs aim and cost

Program Aim Cost


credit availability and
liquidity in the securitization
market with low interest rate
TALF spreads no burden on taxpayers

support credit market


functions and provide credit
PPIP to consumers' and businesses $29.4

credit infusion for small


SBA businesses not calculated yet

Data received from TARP: Three year Anniversary Report, A Supplement to the TARP Two
Year Retrospective, Treasury- Office of Financial Stability

In respect to the housing programs the Treasury in order to avoid foreclosures


introduced the Making Home Affordable Program (MHA), the HAMP and the
Hardest Hit Fund (HHF). MHA is said to have improved the social welfare as it had
contributed to this direction in multiple ways, having assisted more than 800.000
home-owners to receive mortgage modifications in order to save their property.

Regarding a principal component of TARP, the CCP, Treasury data reveal on Table 20
that in the end $204.9 billion were invested in 48 stated with the largest investment
amounting at $25 billion and the smallest at the $301.000, 00. It is believed that CPP
along with TARP investments on the banking sector will have a long-term positive
return on taxpayers which will exceed the $ 20 billion.

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Table 2050: CPP analysis

2.5 TARP effects on the U.S economy

The risks for the global financial instability were presumed to be great to justify
absence of any action. With the implementation of TARP there were hopes for
expanding the flow of credit while reinforcing at the same time the economic
growth. But things didnt turn exactly as US governors wished to have been. The
lending in the interbank market didnt work effectively and the cost of borrowing
increased sharply causing tremendous malfunctions.
Capital infusions was considered to be costly by some banks and that combined with
the interference of the government in the executive compensation and in lower
extend the adverse signaling was why those banks opted out of participating in the
program or rejected to go into it .Banks that were more viable and had healthier
assets didnt accept those infusions. Important to consider is the fact that CPP
injections didnt help banks which had distressed portfolios. Apart from that, one
point to consider is that although government owned banks may have been less
reluctant to finance some projects that private banks would be unwilling to support
and according to Stiglitz theory government-owned banks address market failures
and improve social welfare, it is significant to examine the negative effects of the
government protection that changed the financial market in US and which had a
global impact. The controversial nature of TARP was the cornerstone of the problem.
From the one hand TARP tried through the capital injections of the banks to stabilize
the market and from the other hand it was also expected of it to provide macro-
50
TARP: Three year Anniversary Report, A Supplement to the TARP Two Year Retrospective, Treasury-
Office of Financial Stability

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stabilization through investing this new cash in even riskier loans51. According to
many economists TARP did affect greatly the lending of banks and risk-shifting.
Wilson and Wu believe that behind this government purchase there is a moral
hazard problem because of the ICC (incentive compatibility constraint) between the
government and the way that the shareholders value is generated. Simultaneously
there is not a guarantee that those recapitalization efforts will generate better loans.
Hence, if the banks shift the risk into the creditors, the size of the capital injection
and the lack of leverage-increasing prohibitions may have caused the inefficiency of
TARP.52 Empirical evidence has revealed that banks that received TARP showed a
tendency to approve riskier loans; maybe because of the safety that they felt that
again the government would bail them out no matter what. I tend to believe that
TARP reinforced the incentives of the risk lover ones to be involved in even riskier
investments, something that had significant negative cumulative effects both for the
US economy and the rest of the world. In Figure 18 we can see a comparison in the
risk profile between the TARP and non-TARP banks. As we can see risk ratings
fluctuate between 1 to 5, with the 1 being the safest and banks are categorized
based upon their size to large (total assets > 10 billion $), medium (total assets
>=10>1 billion$) and finally small (total assets<1 billion $) .It is to be highlighted that
both TARP and non-TARP receivers have become more risky overall, with the first of
them to have a significant higher rating risk rating in comparison with the non-
receiver banks. Having a closer look in the Figure below we observe that both large
and medium sized banks have become more risk-taking after the capital infusions.
On the other hand the opposite is to be noticed regarding the small sized banks.

51
The Effect of TARP on Bank Risk-Taking, Lamont Black and Lieu Hazelwood, Board of Governors of
the Federal Reserve System IFDP 1043 March 2012
52
The Effect of TARP on Bank Risk-Taking, Lamont Black and Lieu Hazelwood, Board of Governors of
the Federal Reserve System IFDP 1043 March 2012

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FIGURE 1853: RISK-RATING BY TARP AND NON-TARP BANKS

Actually there is a possibility that capital injection reduced the risk-taking incentives.
Another thing to consider from a macroeconomic point of view is whether this
attempt to increase bank capitalization was welfare-improving. A benefit-cost
analysis was not made by the regulators prior to the imposing of TARP probably due
to the tight time limits. As a result the consequences of TARP are kind of ambiguous.
According to my point of view the lack of planning was not the only problem of how
TARP was introduced and in what it resulted in the end. I tend to believe that the
regulators didnt seriously examine the complexity of the banking sector and
especially the optimal capital structure that banks wanted upon their specific
criteria. To make things clear, a bank with less capital than the one perceived by her
as the optimal one, would like to acquire more in order to increase its capital ratios
whereas another bank which is less-capitalized but doesnt have an incentive for
further expansion will be in the position through capital infusions to enrich its

53
The Effect of TARP on Bank Risk-Taking, Lamont Black and Lieu Hazelwood, Board of Governors of
the Federal Reserve System IFDP 1043 March 2012

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balance sheet and write down more loans. In the end banks instead of being the
vehicle of reallocating liquidity, because of their nature to diversify well across every
specific liquidity need that raises in the market, the turned to be a part of a complex
game with unpredictable results even today. And yet the risk is wider allocated but
still more risks are undertaken in comparison to the past. Simultaneously another
impact has emerged through the great interdependence and linkage of the financial
markets, because through this planning the system can withstand small shocks but at
the same time greater systemic risks are profoundly unavoidable. As a result the
results in the US economy could be characterized countercyclical instead of
procyclical as it should have been so as to manage the crisis. The absence of planning
created some more distortions which impact we can hardly presume.

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Chapter 3: Economic crisis in Europe

3.1 Anatomy of the crisis

Whereas the crisis in the US was mainly a solvency based banking crisis which was
followed by a growth crisis, the crisis in Europe was triggered by a debt crisis which
was followed by a severe fiscal currency and growth crisis. For many economists it is
also a competitiveness crisis, stemming from political erratic demands among the EU
members governments, as countries had contradictory interests a priori. The crisis in
the European Union is a multi-dimensional crisis which has affected greatly not only
the Euro zone, causing a multitude of malfunctions which yet have not been
recovered, but also had a global impact. The improvident fiscal policies that were
induced by the dominant countries of the Euro zone such as Germany faced the
moral hazard of the single currency. As well as this the tendency for immediate
integration of all European countries and the interdependence of the financial
market led to the well-known contagion effect. The financial crisis of 2007 is well
known as the Great Moderation because it has been characterized by high
inflation, high growth, increased worldwide saving, lenient monetary policy and
intensified global integration.54 The crisis was driven by financial elements like
asymmetric demand shocks and of course non-financial drivers such as confidence
and uncertainty shocks and of course the interlinkage of some factors. It was
reflected mainly in money market spreads, in interbank rate spreads and in the
increase in the financing costs as depicted in Figure 19.One of the main causes and a
major driver of the crisis was the underpricing of the risk which had two branches:
the excessive leverage and high risk products.

54
Laurence Boone, Barclays European integration and financial crisis: causes, implications and policy
directions

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FIGURE 1955: FINANCIAL MARKET SPREADS

Because of the strong performance of the European economy in 2006 and in the
beginning of 2007, no one expected a crisis and especially with that extend. But no-
one took into serious consideration that such growth rates should have been
prevented in order for the economy to cool down, as such long-term growth rates
depict a turn in the consumption and not in the investment, creating deficits. The
boom in the residential house purchase was a result of low interest rates and capital
inflows, which gave to the EMU members the potentiality to increase the nominal
wages as a consequence of the high growth rates with a parallel rise in the labor cost
per unit as depicted on Figure 20.Simultaneously the weaker countries in the Euro
area were hit hardly facing a sharp rise of the inflation and especially Ireland, as
shown on Figure 21.

55
Geoff Kenny, Julian Morgan, Some lessons from the financial crisis for the economic analysis,
Occasional Paper series no 130, October 2011 ECB

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FIGURE 2056: AVERAGE ANNUAL WAGES (IN 2009 US $, CONSTANT PRICES, 1990-2010)

Unit Labor Costs (OECD index base year 2005=100), 1990-2010

56
Ulrich Volz, Asian Development Bank Institute, Lessons from the European Crisis for Regional
Monetary and Financial Integration in East Asia

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FIGURE 2157: CPI (DIFFERENTIAL OVER GERMANY CPI, IN%), 1990-2010

But with the first signs of the financial turmoil the European Commissions
confidence indicators dropped vertically as it is shown in Figure 22 and
simultaneously the confidence in the market was disrupted.

FIGURE 2258: CONFIDENCE INDICATORS

57
Ulrich Volz, Asian Development Bank Institute, Lessons from the European Crisis for Regional
Monetary and Financial Integration in East Asia
58
Watt Andrew, European Trade Union Institute, The economic and financial crisis in Europe:
addressing the causes and the repercussions

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At the same time there is to observe the exports decrease on average in Europe, and
the funding problems that the firms faced as they have difficulty in accessing
financing. The demand has fallen unprecedently sharply. The financial compression
that the enterprises have faced is quoted on Figure 23.At Figure 24 we can observe
the dramatic fall of the global trade, especially after the fall of Lehman Brothers. The
paradox is that the same linkages that have given a boost to the development of
the global supply chains have been the culprit of the downward decline of the
performance of the world trade. Stock Markets have shown a parallel fluctuation
both in Europe and in US. Financial listed companies lost more than 60% of their
book value and as anticipated, all the efforts to raise their capital have crashed.59

FIGURE 2360: FIRMS COMPRESSION DUE TO CRISIS

59
Watt Andrew, European Trade Union Institute, The economic and financial crisis in Europe:
addressing the causes and the repercussions
60
OEDD Economic Outlook,84, November 2008

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FIGURE 2461: WORLD TRADE AND EURO AREA EXPORTS

Banks restricted their lending to firms mainly in order to safeguard themselves of


bankruptcy and because of collateral lack .As we observe on Figure 23 through the
spread between the interest rate on corporate bonds and on government securities,
we see that a higher premium is demanded on new bond issuance by firms that have
credit problems, based on credit rating agencies data, even when the rate of the
government securities declined because of the global recession.
In between apart from banks lending to firms, banks had themselves difficulty in
lending each other and that was depicted by the high inter-bank rate spreads.

61
Geoff Kenny, Julian Morgan, Some lessons from the financial crisis for the economic analysis,
Occasional Paper series no 130, October 2011 ECB

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The causes of the European crisis are both structural because of the deficient design
of the economic fundamentals that govern the Euro zone and systemic. According to
my point of view the US crisis was the trigger of the European but not the cause. The
causes are many and there is a causal linkage between them. One of them and
rather significant to me is the one which lies on the way that the markets operated
under the shelter of capitalism and of the auto-regulation prophesies which have
left the markets without robust regulatory framework. Most economists believe that
the current account imbalances on a global basis were the initial problem. Some
countries for example China, Japan and Germany have current account surpluses
and on the contrary countries like Portugal, Spain and Greece have significant
deficits. Many of them also take into serious consideration the negative aggregate
demand shocks that Europe faced in early 2008.

The government bond yields in many countries fell under historical levels as depicted
on Figure 25 while the housing demand expanded rapidly as depicted on Figure 26
Specifically in Europe the existence of low interest rates, the market deregulation in
some countries and the deterioration in the asset market helped the increase of the
demand in the housing sector and their prices exploded as depicted on Figure 27
and Figure 28. All this outbreak of turbulence was depicted in sharp declines in the
prices of the stocks as it is shown on Figure 29.

FIGURE 2562: GOVERNMENT BOND YIELDS

62
Ecowin

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FIGURE 2663: HOUSE PRICES AND ECONOMIC CYCLES

FIGURE 2764: HOUSING PRICES IN THE EURO AREA

63
OECD, J.Elmeskov, The general background of the crisis, May 2009
64
OECD, J.Elmeskov, The general background of the crisis, May 2009

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FIGURE 2865: HOUSING INVESTMENT AS A SHARE OF GDP

FIGURE 2966: STOCK PRICES

Parallel the maintenance of low interest rates affected greatly the Euro area as
shown on Figure 30.

65
OECD, J.Elmeskov, The general background of the crisis, May 2009
66
Geoff Kenny, Julian Morgan, Some lessons from the financial crisis for the economic analysis,
Occasional Paper series no 130, October 2011 ECB

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FIGURE 30 67: INTEREST RATES FOR EURO COUNTRIES

The confidence in the market created a multitude of problems in the euro area both
for the consumers and the firms as in contributed to the abort of all the investments.
The total consumption and investment in both US and in Europe have been above
domestic output creating a gap which could be covered only through borrowing.
The solution was given by the surplus countries which strengthened their economies
following a rapid industrialization model e.g. China or by establishing new business
entities decreasing successfully their unemployment rate such as Germany.
As depicted at the following Figure 31, the recession in US was on 2009 at - 0.5%
approximately and as it seems measures were taken immediately and they
prevented the economy from declining further, whereas in Europe on 2009 the GDP
was at -4% approximately and as we examine the following years the measures were
not sufficient effective and the recession led to further stagnation. The output gap
between 2008 and 2009 revealed also another reason for the downturn spiral in the
field of exports and that is the accumulation of inventory and its adjustment
volatility.

67
Bruegel, A.Ahearne,J.Dlgado, J von Weizsaecker, A tail of two countries Policy Brief April 2008

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FIGURE 31: COMPARISON BETWEEN US AND EURO AREA ON GDP, OUTPUT GAP AND INVESTMENT

us

4,00 25.000,00

2,00
20.000,00

0,00
2007 2008 2009 2010 2011 2012 15.000,00

-2,00

10.000,00
-4,00

5.000,00
-6,00

-8,00 0,00

Gross domestic product, constant prices Output gap in percent of potential GDP
Total investment

eu

4,00 23.000,00

3,00
22.000,00
2,00

1,00 21.000,00

0,00
2007 2008 2009 2010 2011 2012 20.000,00
-1,00

-2,00 19.000,00

-3,00
18.000,00
-4,00

-5,00 17.000,00

Gross domestic product, constant prices Output gap in percent of potential GDP
Total investment

Source: based on IMF data

There were significant asymmetric information incidents which created the ideal
conditions for imprudent speculation. Due to the moral hazard, over-lending was the
rule, not the exception resulting in credibility problems. The self-fulfing prophesies
have driven the expectations in the market and have caused severe meltdown. If a
country was expected to have a high possibility to abrogate the guarantees that it
had given, automatically the market interpreted it with higher interest rates,
downturn of the GDP and in the end capital flight. This had a negative impact on a
countrys firms because it decreased their ability to borrow. The infrastructure of the
financial market has shown that it has not the necessary safety valves in order to
confront this highly debatable crisis. The global imbalances that were induced by the

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globalization and are depicted on Figure 32 and Figure 33 and the current account
developments in Euro area that are shown on Figure 34, have made the situation
even more intriguing. There is not a formulaic solution. The need for complete
review of the structure and rules of the Euro zone is mandatory.
For me the crisis in Euro zone was an inevitable penalty as a response to the careless
regulatory planning.

FIGURE 32: CURRENT ACCOUNTS BALANCE AS PERCENTAGE OF WORLD GDP

Current accounts balance as % of GDP

60%

turkey
40%
u.s
italy
20% canada
australia
uk
0%
france
2009 2010 2011 2012
eu
-20% japan
china

-40% russia
germany

-60%
year

Source: based on IMF data

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FIGURE 3368: EVOLUTION OF GLOBAL IMBALANCES

FIGURE 3469: CURRENT ACCOUNT DEVELOPMENTS IN EURO AREA

Furthermore, the globalization and financialization of the economy contributed


in the contagion effect and played a vital role in the European crisis as it was not
accompanied with strong supervisory and regulatory institutional framework.
The greater economic openness, the increased international competition and the
cheaper financing triggered global growth. The global institutions have not
shown signs of true integration as policies and activities reflect the needs of a
specific group of countries. The lack of effective governance simultaneously with
the internationalization and delocalization worsened the already vague
environment.

68
Dr.Nantawan Noi Kwanjai, Anatomy of financial crisis, past, present and future
69
OECD, J.Elmeskov, The general background of the crisis, May 2009

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Apart from that, the state ownership in the majority of the European countries
was reduced with an obvious parallel weakening of the institutions and
strengthening of the privatization forces and as a result the financial services
sector was profoundly deregulated.
If we add to all this the technological burst, we come to observe substantial shifts
in the way that income is distributed, and with a severe gap between the very
rich and the very poor if we examine it from a social and anthropocentric point of
view. This malfunction has let the very rich ones be in the position to use their
abundance of money as a speculation vehicle. Simultaneously as the market was
money driven, the poor ones suffered as the only way to maintain survival was
through extensive borrowing of resources.
The remarkable gap between the investment rate which was poor in the vast
majority of the European countries and the high levels of consumption was
covered only through constant borrowing. As quoted on Figure 35 and Figure 36,
between 2007 and 2010 the increase of public debt was unprecedentedly high,
increasing from 66,3% to 85.4%70, whereas from 1995 to 2006 it has shown for
the majority of the countries an almost parallel fluctuation.

FIGURE 35: PUBLIC DEBT AS % OF GDP IN 1995-2010

Source: Eurostat

70
Ulrich Volz, Lessons of the European Crisis for Regional Monetary and Financial Integration in East
Asia, Asian Development Bank Institute

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FIGURE 36: PUBLIC DEBT AS % OF GDP IN 2007-2010

Source: Eurostat

Of course the securitization of the market and its complexity and opacity plus the
diffusion of the risk exposure played a significant role coupled with the lenient
macroeconomic backdrop. The proliferation of those complex products was the
trap for many investors, as there was great misalignment of incentives. The
result was the extensive and irrational use of leverage. As shown on Figure 37
Figure 38 and Figure 39 the securitization in Europe was significantly high with
regard to the one in US, bearing always in mind the differences that the financial
markets present.

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FIGURE 37: SECURITIZATION IN US AND EUROPE

Source: OECD

FIGURE 3871: SOVEREIGN CREDIT DEFAULT SWAPS, DECEMBER 2007-JANUARY 2012

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Ulrich Volz, Lessons of the European Crisis for Regional Monetary and Financial Intergration in East
Asia, Asian Development Bank Institute

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FIGURE 3972: SECURITIZATION IN US AND EUROPE

What is also to be pointed is the close interconnection and interaction that bank CDS
and sovereign CDS spreads had during the crisis. At Figure 40 we can observe a
correlation between them which begins from Jan 2008 till 2011, revealing the
interaction of those two markets, having a break on 2011 and ongoing mainly due to
policy restrictions.

72
IMF

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FIGURE 4073: BANK VS SOVEREIGN CDS SPREADS

Moreover the sharp rise in the commodities price and especially the one of the
oil which almost tripled between 2007 and 2008 created exogenous shocks and
raised tremendously the variable costs of the firms, decreased the nominal
wages, increased the inflation, and reduced the aggregate demand.
The fact that the euro was appreciated between the end of 2006 and 2008,
caused malfunction in the firms ,as it decreased their profit margin due to the
depression of the net exports., having immediate impact in the current account
balance which was presented with deficits.
The overabundance of credit, the so called credit-boom and the low interest
rates that leave open space for yield and which was accompanied with poor
performance of the average European economy, was not possible to be
accompanied with something less than a crisis, measures should have been taken
in order to cool down the economy and to avert the contagion effect depicted on
Figure 41. Especially in countries like Greece, Spain, Ireland and Portugal the very
low interest rates gave a fictitious boost in the economy which produced high
growth rates without having a robust fiscal policy to constrain demand and
reduce the inflationary pressure. In contrast, in those countries fiscal policy was
profligate. In retrospect it is more than crystal clear that there were many of
contradictory interacting forces to blame for this crisis and not a single one
culprit.

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FIGURE 4174: THE CONTAGION EFFECT FROM US TO EUROPE

3.2 Economic consequences

The consequences in Europe were inevitably multidimensional as the crisis unfolded


differently depending on the specific characteristics of each country and it hit both
the firms and the households in a different way, creating the so-called Knightian
uncertainty. The severe debt crisis raised doubts on the viability of the Euro zone
and the single currency, as the unrestricted financial integration revealed to be the
Achilles heel of the crisis.

For instance Spain, Portugal, Greece, Italy and Ireland were hit most by the financial
crisis as they are countries which have large current account deficits, as they import
the majority of the tradable goods and their expansion was rested mainly on credit.
The other countries experienced most indirectly the crisis as they had less internal
imbalances .Due to national regulation of the European financial institutions, various
countries were affected at a different extend. As well as this the geographical

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addressing the causes and the repercussions

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position of a country within Europe and its neighbors plays a role on which extend it
had been exposed to the financial shock.

Enterprises in order to cut down the cost cut down also the nominal wages, they
dismissed a lot of the employees, and there was no investment incentive, they faced
liquidity problems, they reduced their import demand, the faced depressed demand
of their products as a result of the downturn in the consumption. Due to the
financial instability and the uncertainty of the market firms also immigrated in more
stable, tax favorable environments mainly out of Europe.
On the other hand households faced the decreased value of their assets, suffered
income losses and due to the inflation or even the stagflation in some countries they
were unable to have a certain living standard. In order for them to survive in some
cases their savings vanished totally.

From a monetary point of view the crisis affected Europe in a different way than the
one affected the US as money market funds in early 2007 closed fiercely for Europe.
For many economists, Europe should have got out of the crisis easier than US
because the subprime market in US is wider, but toxic assets were not the only
problem for Europe. The mortgage market features of Europe are presented in Table
21.

Table 2175: Features of Euro are mortgage market

In total I quote the following Figure 42 in order to have a comprehensive idea of the
factors that triggered the crisis. As it is depicted the financial sector and the
malfunctions within it, was the basic driver. Policy interventions had propitious
effects on general but they didnt get to the core of the problem as fiscal imbalances
did not improve but in some cases sharpened and the sovereign risk increased. As
shown in the figure below, the complex interdependence of the sectors and the
policy agents made the crisis even more stagnate. The rapid macroeconomic

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developments that occurred between 2008 and 2010 led the market to a profound
instability which resulted in volatility and caused panic in the market.

FIGURE 4276: KEY TRIGGER MECHANISMS OF THE CRISIS

The exposure of the banking sector differed across the European country. Especially
the deficit ones as Table 22 represents. What is to underline here, that countries
such as Greece and Cyprus presented a very low performance, having in total 53 bn
euro exposure. In the second place regarding the exposure of the banking sector is
Italy, following Spain Portugal and then Ireland.

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Geoff Kenny, Julian Morgan, Some lessons from the financial crisis for the economic analysis,
Occasional Paper series no 130, October 2011 ECB

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Table 2277: Bank exposures by country to the sovereign debt of six countries

(in millions of euro and in per cent of Core Tier 1, as of December 2011)

3.3 Governmental responses

The policymakers tried to mitigate the contagion and restore the confidence in the
financial system through monetary policy actions, fiscal policy guidelines and by
supporting the financial sector .Credible governance was a demand, but inevitable
the result was sorely inadequate, as it seems till now, as European policymakers
faced a challenge of restructuring the whole mechanism in the midst of the crisis,
with the measures taken facing substantial ramifications for the viability of the

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European Financial Mechanism. The crisis has been compounded by an inadequate


governmental response which worsened the systemic fragility of the market.

A multitude of policies were discussed in order for the crisis to be prevailed, as


depicted on Table 23, but there were not put into force as the costs clearly
outweighed the benefits. The plan for the implementation of new fiscal rules which
would be accompanied with radical structural reforms did not present coherence.

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Table 2378: Alternative policies for solving the financial and sovereign debt
crisis in Europe

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FIGURE 4379: THE TRILEMMA OF CONFRONTING A FINANCIAL CRISIS

The intricacies of the financial system made the monetary authorities to accelerate
their actions and to implement various measures from the summer of 2007 aiming
to inject liquidity through central banks by easing the requirements on collateral for
refinancing. At first instead of lowering the interest rates, central banks raised them
as a response to inflation, but shortly the need for cutting them down was
inevitable. Through monetary policy low nominal interest rates were maintained in
the end, which resulted in low real interest rates .Apart from that ECB extended the
type of the collaterals it could receive in refinancing operations. Through a covered
bond program it made credit easier in order for the damaged financial system to be
restored. In urgent cases, when a country have drought from liquidity and it wanted
an immediate help, ECB co-coordinated the supply of money to cross-border
European banks and provided also FX swap lines. The crisis management was not as
effective as in US partially because each country tried to preserve its own financial
sector from devastating and there was not a coordinated action. ECB has succeeded
in lowering the interest rates as depicted on Figure 44 so as the functionality of the
Euro area to be restored and it has expanded significantly its balance sheet as
depicted on Figure 45, where we can observe that ECBs balance sheet almost
doubled, not as much as Fed in US of course, mainly because in US, TARP was a
cornerstone which help Fed to almost triple its balance sheet.

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FIGURE 44: ECB RATES

Source: ECB

ECB succeeded in lowering Euribor significantly

Source: ECB

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FIGURE 4580: EXPANSION IN BALANCE SHEETS AFTER ECB CONTRIBUTION

The fact that the European legislation allows some countries to benefit from low
interest rates, while others borrow money at significantly higher rates constitutes a
market distortion, something that is absent in the US market. At the same time,
some European countries clearly had the incentive to free ride on fiscal policy
measures applied and as a result all the actions failed.

At November 2008 the Commission announced a European Economic Recovery Plan


in order for the aggregate demand to improve with a provision of 200 billion Euro.
Apart from that other measures were designed to be taken but the implementation
of them presented great difficulty.

From a fiscal policy point of view, due to the massive demand shock that occurred in
the last semester of 2008, the fiscal support amounted on average at 2.5% of GDP
between 2008 and 2010 with a diversification across the countries, as depicted on
Figure 46 and Figure 47.

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FIGURE 46: FISCAL SUPPORT ACROSS THE EURO AREA

Source:Eurostat

FIGURE 4781: MAGNITUDE AND COMPOSITION OF FISCAL SUPPORT PLANS

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Among all countries Greece and Ireland have tightened their fiscal policy. In Europe
fiscal policy was not as efficient as the monetary one and certainly smaller and not as
careful planned as than the one in U.S. For many countries fiscal policy measures
was even counterproductive, e.g. Greece because it has reached the fiscal limit and
the revenues showed a downward trend. On Table 24, we can see a market
recrudescence as the debt to GDP ratio is around 82% of GDP on average and for
some countries like Greece, Belgium and Italy even higher. When the crisis unfolded
with a substantial downward spiral, policy makers responded with countercyclical
fiscal measures which inevitably increased they already high fiscal deficits.

Table 24: Debt ratios to GDP on government balances

Source: European Commission

In supporting the financial sector, measures were undertaken depending on the


characteristics of each country, as presented at Table 25. The aim was the guarantee
of the deposits so as for capital flight and bank run to be avoided .Capital infusions
were made in order for the liquidity of the banking sector to be supported mainly
through guaranteeing bank issuances, always differentiating across countries in the
Euro zone.

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Table 2582: Measures undertaken by Euro countries to support the financial


sector

Due to the complicated financial regulation framework across the EU, as it is shown
at Figure 48, measures failed to serve their cause. The common currency led to a
thirst for financial integration as there would be total absence of exchange rate risks
but the total absence of financial regulation, because it was limited between the
national boundaries of each country, played a catalytic role in the expansion of the
crisis.

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FIGURE 48: THE EUROPEAN BANKING STABILITY FRAMEWORK

Source: IMF

3.4 Policy challenges

Comparing the financial crises in the US and in Europe we need to stress that in the
US the meltdown caused a prolonged stagnation which was rather inevitable,
whereas in the European Union, the economy could be shifted out of the chaos if
substantial policy actions and structural reforms took place. The policy problem in
Europe could be summed up with the help of Figure 49. The main cause of the
malfunction in Europe is the different structure that each country has which receives
a different impact when a real shock occurs as some countries are vertical and
others are horizontal integrated. As well as this the non-performance of the majority
of the loans and the increase on average on the unemployment rate as depicted on
Figure 50 due to the inflexibility of the exchange rates causes social turmoil, as
governments failed in creating an optimal environment but instead left the fiscal
imbalances stagnate uncontrolled leading to a proliferation of the already high risk
of an overdue recession. Parallel the structure of the market and its inability to be
recapitalized quickly led to a liquidity crisis.

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FIGURE 4983: POLICY PROBLEMS IN EUROPE

FIGURE 5084: THE RISING COSTS OF THE CRISIS: NON-PERFORMING LOANS AND UNEMPLOYMENT

The European Union needs to reform the guidelines of the financial system in order
the market to be more transparent, robuster, to enhance credit lines, to infuse
credibility and confidence, to be in the position to increase equity capital inflows
compared to debt inflows.

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Erik Bergloef, Yevgeniya Korniyenko, Alexander Plekhanov and Jeromin Zettelmeyer
,Understanding the crisis in emerging Europe, European Bank

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We cant have simultaneously fiscal interdependence and fiscal solidarity. Some


rules must be set for all the European countries and be obeyed. Financial integration
is very important for the conduct of the monetary policy but factors like the systemic
risk that arises from this shall be carefully reviewed.

There should be definitely central fiscal surveillance, in order for the macro
aggregates to be reinforced, but at the same time each nation should be left to make
its own allocation of resources within the predefined macro limits.

Every country shall place an amount of money to a central fund which will use those
resources in order to bail-out any country facing bankruptcy threat.

Gaps in the regulatory and supervisory framework must be filled through efficient
institutions that will somehow respect the mentality of each country but will serve
simultaneously the multinational standards.

National sovereignty is given up to an extent, one should admit it. This is the only
path to real convergence. Darwin theories must vanish in order for a stable financial
and political environment to be achieved.

Policy makers shall understand that debt deflation dynamics can prove to be
destructive when the market asks for different measures in order to stabilize.

Coordination between monetary and budgetary policy is mandatory in order for


the spreads to be cooled down as the approximation to the pre-Euro period before
the Monetary Union reflects the uncertainty in the market and the differential credit
risk which drove the market expectations towards the collapse of the euro currency,
as depicted on Figure 51.

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FIGURE 5185: SPREADS BEFORE AND AFTER THE MONETARY UNION

Better evaluation of the candidates and stronger surveillance of them prior to their
entry, is a way to prevent the disturbance of the Union.

The challenges that appear nowadays partly reflect the non-linear historical
construction of Euro, which was interrupted by crises and is the result of
compromise between appetite for more integration and resistance of national
sovereignty.86

3.5 Lessons to be learnt

One unique monetary policy could apply in Europe but it should have the flexibility
so as to accept the divergence across the Euro countries and it must proceed
gradually in order to pursue successfully. Simultaneously the financial integration
must be reviewed as it does not guarantee an ex ante efficient allocation of the
capital. To serve this purpose, national regulators must cooperate closely.

The Euro crisis has revealed that a fixed-exchange rate policy is prone to be affected
from crisis if the gap between the deficit and the surplus countries does not mitigate
and if the internal economy of each country fails to follow the necessary

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restructuring reforms. Macroeconomic imbalances in such exchange rate policy are


inevitable and they will definitely exacerbate the already significant structural
divergence.

Macroeconomic and fiscal coordination is the demand for macro prudential success.

Cost and benefit analysis of potential measures is necessary so as for the potential
impact to be ex ante calculated.

The structural divergence that I have already mentioned has led to severe
imbalances across the Euro zone .Policymakers must make all the efforts needed to
improve the competitiveness (Figure 51) is presented in order to have a sight of the
competitiveness across EU) and give countries like Greece or Spain which are
traditionally importing countries, the incentives to exploit their strong points and
become more exporting so as their current account balance to come to an
equilibrium. The reduction of fiscal profligacy is demanded in order for the
convergence to come to reality.

FIGURE 51: COMPETITIVENESS ACROSS EUROPEAN COUNTRIES MEASURED BY UNIT LABOR COST

Before a country enters the EMU, careful planning must exist in order for the new
entrant to adjust at first structural and then to be fuelled with credit packages and
increased leverage of the national economy. The geographical diversity among with
the structural can justify the cyclical divergence across European countries as it is
presented at Table 2687.

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Table 26: Various countries exposure to banking sector

Structural and financial surveillance should be reinforced as they are mandatory


for the financial integration and for the conduct of stability-oriented monetary
policy. The monitoring of the regional markets must be empowered as crises spread
quickly creating the already known contagion effect.

Economic tools and models are not panacea. They provide forecasting tools but
economies shall not exclusively lie on them because it is noteworthy mentioning that
no model succeeded in seizing the signals that a major crisis was on the threshold.
Indicators as far as the recent crisis is concerned, has shown a poor predictive
performance. In that direction, the should be given an impetus to the extension of
the existing tools and the development of new ones which will capture the linkage
between the linear and non-linear dynamics is mandatory in order for the
macroeconomic projections to deliver reliable information. This will contribute
considerably to the meticulous analysis of financial shocks and their impact on the
demand and supply, something which will be used as a feedback for preventing the
extent of further economic crises. Also the oversimplification of the assumptions
regarding the exogeneity of some variables shall be re-discussed.

The development of better risk analysis methods and the in general better pricing
of the risk exposure, which will be in the position to monitor the imbalances in the
euro area might help the policy makers to correct the disequilibria and better predict
the timing and the extend of further crises having a competitive advantage of ex
ante assessment, as the underpricing of the sovereign risk revealed structural gaps.
Also the management of the systemic risk from the policy makers must be seriously
considered, as risk must be better quantified and controlled.

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Complex financial instruments such as CDS must be used under surveillance and in
a more transparent and prudent way, leaving no margin for speculation attacks.

The prevalence of non-linear dynamics should have been more carefully


considered as well as the signaling effect of confidence indicators and the
behavioral aspect of the finance, as the psychology of the mass has a proven to have
an impact on expectations which shape market trends. For me the way that
psychology interacts with the market forces, leaves no doubt that it shall not be
again disregarded. Instead it shall be considered as a major-driver of the economic
developments. Apart from that the admission of the absolute linearity in model
creates considerable frictions and it cannot identify the time that a regime
changes. Model shall be adjusted to non-linear environments, because the real
economy does not reflect linearity especially in periods of economic turmoil and as a
result those models are not only useless but they also create distortions.

Unprecedented effects shall be used as a lesson to avert further economic downturn


and recession on a global level, while simultaneously the international linkages in
both financial and non-financial level must be highlighted as there is a tendency for
integration.

Importance of financial frictions and non-financial elements. In the analysis more


weight should be given to financial variables and their meaning. A new indicator, the
Area-wide Leading Indicator (ALI) has been developed recently which tries to explore
which is the leading financial indicator in a financial time series.

Regulators must establish mechanisms and tools which will be used as a shield
towards upcoming crises. Resolution mechanisms must be carefully thought prior to
the next backfire of a crisis.

The extensive recapitalization of banks across the Europe is obligatory for banks to
strengthen their capital base and not face undercapitalization problems, with a
leverage ratio on the un-weightened assets of at least 5%, as OECD proposes. On the
contrary stress tests were conducted in Europe in 2010 didnt maintain to restore
the confidence in the market as it happened in the U.S. A proper cleaning up of the
European bank balance sheets is mandatory.

3.6 Stress-tests for the EU banks

A stress test is a technique used at a certain point of time based always on a


benchmark variable or ratio, in order to determine if an entitys portfolio of assets

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and liabilities is robust enough towards different financial conditions. Stress tests
were used extensively during the last financial crisis in order to foresee which banks
would survive against the adverse market conditions. In Europe the results of the
stress tests have shed light to the malfunctions of the European banking system .In
the stress tests multiple indexes and macroeconomic variables such as GDP,
unemployment rate, etc. and their decline from baseline , are used in order to assess
a bank. A stress test is a hypothetical analysis which provides a projection, as it does
not capture all the potential outcome scenarios, but mainly its objective is the
provision of knowledge to the market participants through transparency. The way
that a stress test works is presented in Figure 52

FIGURE 5288: HOW A STRESS TEST WORKS

An EU-wide stress test is conducted by the European Banking Authority since 2009.
In the last aggregate report of it, the stress tests were conducted for the period
between 2010-2012. At first as it is mentioned in the report, banks had strong capital
positions with the Core Tier 1 capital ratio being at 8, 9% (EUR 1 trillion, the vast
majority of which was common stock). The projection for the end of year 2010 was
that 20 banks would fall below 5% CT1 with total losses amounting at EUR 26.8 bn. In
the first quarter of 2011 the European Banking Authority helped banks to raise their
capital ratios and banks gave a try to strengthen their capital positions prior to the
conduction of the stress test, as they showed a preemptive behavior, a fact that

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affects the data and does not present the crystal-clear information but instead we
observe a better performance without this to be the absolute truth. After this
procedure, the new simulation showed that only 8 banks were on the verge of falling
below 5% CTR1, having losses of EUR 2.5 bn. Simultaneously 16 banks were
struggling between 5-6% CTR1.

FIGURE 5389: GOVERNMENT SUPPORT AS A PROPORTION OF CT1 END 2010

As depicted on Figure 53 governments support was mainly in common equity


provision amounting at EUR 106 bn, whereas the rest EUR 57 bn consisted of other
capital instruments.

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FIGURE 5490: END 2010 NUMBER OF BANKS IN EACH BUCKET OF CT1

Despite the strong capital ratios, three European banks out of the 90 for which the
test was conducted in 21 countries, were under 5% CTR1(Figure 54)and if it was not
for the government provision of capital, banks would confront a serious decline in
CTR1 (Figure 55)

FIGURE 5591: NUMBER OF BANKS IN EACH BUCKET OF CT1 RATIO WITHOUT CAPITAL RAISING

At the below Table 27a bearing in mind the adverse scenario, we have to point that
there is a CT1R decline from 8,9% to 7,7% regarding some banks in countries like
Cyprus, Spain , Greece, Slovenia, Portugal and even Germany and Austria to fell
below 5% CT1R.

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Table 27a92: Adverse scenario projections

After the capital raising of the banks there is a significant alteration of the
performance of the EU banks to consider as it is depicted on Figure 56 and Table
28.Only few of them showed signs that they could fall below from the 5%
benchmark. This restored temporarily the confidence of analysts, investors and
other market participants for the viability of the European banking sector.

FIGURE 5693: NUMBER OF BANKS IN EACH BUCKET OF CT1 RATIO

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Table 2894: Banks capital ratios with capital raising in 2011

By looking now at Figure 57 we can see the evolvement of the aggregate CT1R both
for the baseline which is calculated towards the recovery direction of the European
economy and the adverse scenario. In this respect the first scenario estimates a 9,8%
decline whereas the second one estimates a 7,7%.

FIGURE 5795: EVOLUTION CT1 RATIOS

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The evolvement of the CT1 ratio between 2010 and 2012 bearing in mind the key
drivers that affect its performance are mainly the pre-impairment income which led
to 3.2% percentage points, net equity raising with 0, 4% percentage points, trading
losses with -0, 4% percentage points, risk-weighted assets with -1, 1% percentage
points and other factors with 0, 3% percentage points and impairments with the
highest impact on CT1 with 3, 6% percentage points. Whereas the factors that that
reduce the CT1R are at 5, 1% percentage points the other ones which increase it
are at 3, 90% .This clearly depicts that factors that have a negative impact on CT1R,
have evolved substantially between 2010-2012 and unfortunately there were not
offset by the ones that positively contribute to its raise (Figure 58)

FIGURE 5896: EVOLUTION OF CT1

Based on this stress test information, 8 banks will not succeed by the end of 2012
and the total deficit will reach EUR 2, 5 bn. As stress tests have played the role of a
catalyst, we can observe an improvement of the European banks capital positions
mainly due to regulatory and supervisory pressure which ended at increasing banks
reserves by EUR 50 million and simultaneously increasing CTR1 percentage points. Of
course there are some questions arising regarding the reliability of the tests, as not
all the information is comparable because it stems from different countries, but on
average vigorous stress tests tend to contribute to the strengthening of a banks

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capital position and of the orderly function of the financial markets, as it allows
market participants to have an insight in the credit risk.
The impact of the stress tests can be widely seen in the evolution of the default and
loss rates as it is presented on Figure 59.There is a decrease from 1,9% points for the
baseline in 2010 to approximately 1,8% in 2011 and 1,6% in 2012, whereas for the
adverse scenario there is a fluctuation regarding the evolvement of the default risks
with 2,1% in 2009 decreasing in 1,9% in 2010 and increasing to 2,3% in 2011,
reaching the 2,5% in 2012 mainly because of the macro economic variables that are
included to this scenario.

FIGURE 5997: EVOLUTION OF DEFAULT RATES

To the decline of the CT1R ratio different regulatory portfolios have played their role
as it is presented in Figure 60.

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FIGURE 6098: CONTRIBUTION OF EACH REGULATORY PORTFOLIO TO LOSS RATE

The ongoing crisis and the demand shocks have a large impact on the net-trading
income which declines significantly from the baseline one, showing a 50% fall in the
income (Figure 61) especially if one considers its evolvement from 2006 till 2010 as
shown on Table 29.

FIGURE 6199: EVOLUTION ON NET-TRADING INCOME

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Table 29100: Historical average net trading income distribution

The results that according to my point of view justify the reasoning of the additional
measures taken to restore the European economy are presented on Figure 62.Based
on their asset portfolios, the 30 largest banks are depicted below prior and after the
measures taken. As well as this below the 30 larger we can observe 60 banks with
smaller assets size which according to the graph, were affected on a greater extend
in a positive way through the capital raising.

FIGURE 62101: CAPITAL OUTCOMES WITH WITHOUT ADDITIONAL MEASURES IN 2011

The below quoted Tables 27 and 28 present the capital ratios prior to the capital
raising for Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Spain

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European banking authority 2011 EU-wide stress test aggregate report
101
European banking authority 2011 EU-wide stress test aggregate report

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and the capital positions of the most representative banks inside the European
Community supporting the already mentioned results of the recent stress tests

Table 27102: Banks capital ratios without capital raising

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Laurence Boone, Barclays European integration and financial crisis: causes, implications and policy
directions

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Table 28103: Selected bank capital positions

Stress tests are supervisory tools and after their publication the results must be
taken into serious consideration as Europe is under severe strain and measures shall
be taken immediately both on European but also on a global basis as the interlinkage
of the financial system affect greatly the rest of the globe, in order for the stability
and reliability to be restored and the market uncertainty to be reduced. Local
authorities together with the European Commission should be alert when a Core Tier
ratio falls below the benchmark one of 5% and help those banks that have significant
sovereign exposure to strengthen their positions through carefully planned
measures such as deleveraging, issuance of new capital, etc.

3.7 Reasons that justify supporting the EU banks and


banks in general

According to OECD, the financial sector is the set of institutions, instruments, and
the regulatory framework that permit transactions to be made by incurring and
settling debts; that is, by extending credit. The financial system makes possible the

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Financial market trends ,Issue 2, Volume 2011

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separation of the ownership of wealth from the control of physical capital. As an


economy develops, the financial sector deepens, strengthens and widens.

The banking sector is a sequence of institutes that provide financial services in a


country. Its basic operation is to receive deposits and to leverage them, through the
pursuit of investments. This money is used in order for the bank to issue loans, buy
securities and provide a variety of financial services. Consumers and firms use the
banks in order to acquire loans the first one for consumption purposes and the other
in order to supporting the expansion of their business activities. Through this cyclical
procedure the money that a bank earns are deposited again or reinvested. Apart
from that banks have a rather psychological activity and that is the one of the safety
provision, as they keep the investors money secure sealed. As well as this they
operate as agents between nations so as to amplify the global economic activity.

The banking sector is the reflection of the real economy. As this is the case, a
collapse of the banking system will automatically cause an erratic catastrophe in the
real economy. Supporting the financial sector must be an undeniable and
unquestionable objective, as it is the cornerstone that can support the growth of the
economy, through which deposits are guaranteed, bank runs are avoided and the
stability and continuity of the system is ensured. People should be convinced to
believe in the system and their faith and confidence must be restored, because
otherwise there is no system and without the presence of it anarchy and
impoverishment prevail.

The fundamental idea behind the role of banks in the real economy is the sequential
lending of money. For example one deposits $ 100 in bank A. Bank A lends $90 to
Bank B and keeps $10 in order to have a safeguarded cash limit. Those $90 act as an
investment as Bank A will receive a greater return from Bank B in regard to the one
that she would receive if only it deposited the money. Based on the same model
Bank B holds 10% of the money borrowed and invests the 90%. As a result the
banking system operates based on the economic multiplier which plays a
fundamental role as it partially reflects aspects of the economy:

Economic Multiplier= 1/1- MPC

On the below quoted Figure 63 is the graphic depiction of the banking operation
model.

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FIGURE 63: THE OPERATION OF BANKS

3.8 Greeces Insolvency

Greek debt was already high before even the crisis outbreak, as in 2007 the external
debt amounted at 107% of GDP, reaching the 145% of GDP in 2010. The high public
debt was accumulated in Greece mainly during the 1980s when an overabundance
of credit gave an irrational boost to the consumption which was not accompanied
with productive investments .As Greece is a periphery European country with low
competitiveness, as it is not an export country but a mainly importing one, when the
crisis was at the threshold, Greece confronted great unemployment and inflation
problems. The extraordinary period of decoupling which was followed by
accelerated output growth, large capital inflows and cheap credit unabated and
even inflated the external indebtness. Greece first response was the alleviation of
the burden through loose fiscal policy, which turned to be a catastrophe as it
proliferated the already high risk of a steeper recession. The fiscal and social
predicament of Greece has taken inconceivable dimensions and has occupied a lot
the rest of the Euro members, as it set in vulnerability the whole Euro area.
Questions have arisen if Greece, Portugal, Spain and Italy should have entered the
Euro area, as their contribution to the stability of it is profoundly questionable.

Greece faced both internal and external challenges between 2009 and 2010, as
various credit rating agencies downgraded its credit ability and concurrently it
unveiled an austerity program, announcing public sector wage and pension cuts,
increases in the VAT and extraordinary imposition of income taxes. The measures

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taken didnt only affect the high- income tax earners but the vast majority of the
Greek people.

Nowadays the exposures of other European countries to the Greek sovereign debt is
presented on the below Figure 64.

FIGURE 64104: EXPOSURE BY COUNTRY TO GREEK SOVEREIGN DEBT

As quoted on Figure 65, the evolvement of GDP in Greece can be divided in three
phases: During the decade 1980-1990 we observe a rather stable evolvement of GDP
of 0.7% ten years average increase. The second phase we can claim that it is the
period between 1990-2000 and has been characterized by steeper increase in the
GDP ratio around 2.15% on average, something that lays mostly on the fact that the
country was preparing itself for EU zone entrance. The last phase can be divided into
two subphases, the first between the ages 2000-2006, presenting average GDP
change of 4.3% and the second from 2006 and onwards, with GDP declining to -1.6%
on average. The crucial cause behind the noteworthy increase on GDP was the
conduction of the Olympic Games in Athens in 2004 which gave a boost to the
economy, as productive investments took place, diminishing the unemployment
rate. Between 2004 and 2006 inertia is to be observed regarding the Greek economy
as the echo of the Games created a fictional stability. From 2006, the time point
when the recession started in the west economy, impacted on the Greek one,
shortly afterwards with GDP between 2007-2010 reducing at -2, 17% on average.

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FIGURE 65: REAL GDP AND GROWTH RATE, 1980-2013


Real GDP and growth rate

250 8

200
4

2
150
bn euro

%
0

100
-2

-4
50

-6

0 -8
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
13
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20
20
20
20
20
20
20
20
20
20
20
20
GDP in constant prices(euro) GDP(% change)

Source: based on IMF data

Simultaneously for the above mentioned years the evolution of the debt as quoted
on Figure 66, is separated also in three phases. From 1980-mid 1995 we can observe
an increase in the debt due to the overabundance of credit as I have already
mentioned. In the second phase from 1996-2007 we can see a relatively stable
evolvement of the debt whereas from 2007 when the crisis unfolded, the increase
on the interest rates and liquidity drought led the weaker economies such as Greece
need capital injections but with declining GDP and the interest rates increase this
forced GDP to reach incredible high levels.

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FIGURE 66: DEBT OF GREECE (% GDP) ,1980-2013

General government gross debt

200

180

160

140

120
General government gross
%

100
debt
80

60

40

20

0
80

83

86

89

92

95

98

01

04

07

10

13
19

19

19

19

19

19

19

20

20

20

20

20

Source: based on IMF data

At the same time the current account balance, as Greece is an importing country
presents deficits from 1980, but has a significant drop between 2006-2008 when the
crisis was about to reveal. The turnaround in the steep decline of the current
accounts balance begins with the fiscal adjustment imposed by the IMF and TROIKA
in 2009, as the current account balance in this year was reaching the -16% (in % GDP)
whereas in 2012 is approximately -2.4%(Figures 67,68)

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FIGURE 67: GREEK DEFICIT (%GDP), 1980-2013

Deficit of central government

80

82

84

86

88

90

92

94

96

98

00

02

04

06

08

10

12
19

19

19

19

19

19

19

19

19

19

20

20

20

20

20

20

20
0 0

-2
-10
-4
-20
-6
bn $

%
-30 -8

-10
-40
-12
-50
-14

-60 -16

Current account balance in US dollars Current account balance in % change

Source: based on IMF data

FIGURE 68: DEBT AND DEFICIT OF GREECE (%GDP), 1980-2013

Debt and deficit of central government % GDP,1980-2013

200 0

180
-2
160
-4
140

120 -6

100 -8
80 -10
60
-12
40
-14
20
0 -16
80

82

84

86

88

90

92

94

96

98

00

02

04

06

08

10

12
19

19

19

19

19

19

19

19

19

19

20

20

20

20

20

20

20

General government gross debt in % current account balance in %

Source: based on IMF data

Countries like Germany, which present significant current account surpluses, feared
that a costless bailout of Greece would signal to the rest of the countries and

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especially the deficit ones like Portugal, Spain and Italy that there would be no
problem if emulating Greeces paradigm as there is an easy way to overcome the
crisis, something that would sharpen the moral hazard problems within the Euro
area. They wanted through the obligatory measures that they posed to set Greece as
the counterfactual in the Euro zone. The resolution of the Greek problem was and
still is a highly debatable subject, which has bifurcated not only the EU members but
also the rest of the world, leaving Greece without proper structural and debt
restructuring measures by offering piecemeal ineffective solutions. Surplus
countries, individual incentive driven, showed a reluctance in endorsing proposals
such as Eurobonds and the very slow negotiations process worsened more the
already wrecked financial scenery. Nowadays Greece is facing a significant credit
contraction and a perilous hazard for an uncontrolled currency collapse, coupled
with social break down, which will not leave both the Euro area and the rest of the
globe unaffected. The high external debt accumulation, the multitude of non-
performing loans, the budgetary holes and the incapability of Greek governors
trigger new rounds of output declines. Due to the general malfunction in the Greek
economy, Greece was forced and still is, in painful and overdue measures that have
caused social turmoil.

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Chapter 4: Conclusions

The financial crisis that begun from the US and unfolded shortly afterwards in the
European market, was the culmination of a credit squeeze and basically a turning
point for the alteration of the whole financial system as it revealed a multitude of
multileveled failures. Certainly we must underline that it is still an ongoing process
and obviously, the parameters that affected the crisis and are analyzed in this Thesis
can be revised at any time.

According to my point of view, the financial crisis could not have been avoided but
indeed, it could have been foreseen. Certainly the response of the authorities could
have been different so as to limit as much as possible the negative impact of it.
Regulatory loopholes and supervisory gaps have unfolded the weakness and the
myopic behavior of the governors to create a robust system, less prone to systemic
risks. In-between banks were given the allowance to leverage largely their portfolios
without even elementary monitoring of their performance and caused the
procyclicality of leverage. This conceptual mistake amplified substantially the
systemic risk to which the market was exposed. Governments and authorities that
were in charge have not prepared in advance the necessary mechanisms to respond
quickly and with substantial measures to a crisis so as to avert a downward spiral
with unpredictable effects. At the same time, the excessive borrowing, the
underpricing of risk, the shadow MBS contributed considerably to the absolute lack
of transparency and break down of the system as the absence of rationality
dominated on the market and the systemic implications of those instruments could
not easily been examined. Over the counter derivatives have played a vital role as
they were the catalyst for the evolvement of speculative practices. The imbalances
between the savings and the borrowing led inevitably to a bubble which took
different shapes as the crisis unraveled. Moral hazard cannot be underestimated as
it presented a significant distortion of the individual incentives that market
participants had. Definitely local interests were served at an extent without been
taken into serious consideration that the linkages in the market are so tight that a
countrys deterioration or even bankruptcy will raise significant challenges in the
global area and will most probably cause a domino effect with unprecedented
outcome in the future. One should bear in mind that the attention should be shifted
away from local interests towards the consolidated one.

The need for a robuster system is more imperative than ever. Policy makers must be
actively implicated in correcting the market distortions that spring from gaps in the
regulatory framework. In this respect policy interventions must be rational so as to
contribute in the improvement of the economy and not to create chaos. At the same
time the distorted incentives of the market participants must be rectified. Negative

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externalities must be restricted and the role of leverage must be definitely


redefined, as it can prove to be a useful financial instrument when it is used under
rational prequisitions. Apart from that, the confidence of financial intermediaries
must be restored in order for a positive shift in the world economy to be realized.

This crisis depicts a moral collapse. The whole system was based on an unethical
ground, as every market participant had the incentive unilaterally to deviate from
the Nash equilibrium. The trigger strategies in the end were not set from the other
players of the market, but from the market itself. In this respect I consider of
paramount importance the existence of ethics in the financial market, although it
may be against capitalism nature.

Above all, the most challenging task nowadays, is the management of the greed
whether it stems from the regulators or the investors, whose aim is the permanent
growth in the economy and the permanent rise in the markets. In operating in such a
way, they removed the circularity of the economy and as a result, the economy was
overheated and forced to run a course that was externally imposed. Towards this
overheated direction of the economy, whether the banking system was persuaded
that this was the case and that it could be continued, overestimating the capacity of
the financial market, or as Chuck Prince has said as long as the music is playing,
youve got to get up and dance, banks have undertaken higher risks and became
extensively leveraged. A slight decline of their asset values led to the wipe out of
their equity, leading to their unreliability and insolvency. Towards this direction,
stress testing and risk calculation should be the imminent tool for the banking
system to fight against uncertain future. Further research is necessary in order to
drill down to specific and detailed reasoning with respect to the crisis, the previous
errors and the evaluation of the adopted policies.

Economy seems to be like chess, with the countries having the role of the pawns.
Different pawns have different strategies .A game can last indefinitely. In the end
whether the pawn has ex ante a dominant role like the one of the king or a less
important one like a horse, all end up in the same box.

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