It starts with a crisis
In 2007 and 2008 the global financial markets 1Financial markets are markets where institutions trade financial securities experienced an extinction level event (to borrow a phrase). Only this time the extinction did not wipe out the financial institutions related to these markets but, rather, it wiped out certain ideas or concepts we had developed and depended on in the financial markets.
These were ideas or concepts predominantly in the areas of risk management and financial instrument pricing. In other words, in some instances, we used long established ‘facts’ to price complex financial instruments and depended on other ‘everyone knows-isms’ to measure and manage some of the risks accompanying various financial instruments 2Financial instruments are money based contracts between different parties.
Upon closer inspection and, with the benefit of the historical rearview mirror, we have established that many of the fundamental assumptions from finance turned out to be flawed theories and, in some instances, ignored critical risks that caused significant losses.
The first market to buckle and then collapse under its own pressure was the subprime mortgage market in the United States 3The sub-prime market is a mortgage or home loan market between banks and borrowers with less than stellar credit scores. When the subprime market initially started to fracture, the media response was far from the peak it would achieve in the months to follow. The reason that this market collapse was not front page news, was because most experts and commentators believed that the subprime market was not large enough to spread to other financial markets and cause significant damage.
Unfortunately, this view by commentators and some experts proved wrong and the losses originating from the subprime market kept expanding and expanded into various markets. This expansion of a market collapse is often referred to as a contagion effect and the losses spread across markets and countries far out from where it started.
<Insert graphic or video here comparing losses from savings and loan and other market crashes.>
The most distressing fact surrounding the losses were that they soon reached numbers no one was expecting and the staggering size of the losses revealed that an enormous amount of leverage 4Financial leverage refers to the use of borrowed funds to increase investment in the hope of increasing returns was at play, when you are leveraged, profits are magnified but unfortunately the same applies to losses. The losses experienced were multiples of the size of the underlying market and the losses revealed another unpleasant fact: it wasn’t just a few bad actors that got their hand caught in the cookie jar. The over investment in the subprime market was so widespread that it became difficult to establish who didn’t have their hand in the cookie jar.
For a number of weeks the large fissures tore through financial centres around the world and at this global level the damage left by the collapse in certain securities had the attention of the entire world. It was as if the world had come to a standstill and started to realize that ‘Wall Street’5 Wall Street refers to both a physical street in New York City’s financial district and a symbolic representation of the U.S. financial markets had been drinking the Kool-Aid 6Drinking the Kool-Aid is an idiom that means to blindly accept and support an idea or belief, often without questioning its validity or potential consequences.
Most financial transactions or instruments involve two parties. A buyer and a seller. A word used to describe two-party trades is bilateral trades. In an interest rate swap for instance, one party may be receiving a fixed payment in exchange for making a payment linked to a floating interest rate.
On the other hand, many financial instruments serve a similar purpose to insurance contracts where one party pays a premium and is then protected from unfavourable market movements. In taking out such a contract, the buyer and payer of the premium will prevent losses, an action we refer to as hedging.
In all cases, these trades can be viewed as a bet by one participant in favour of a certain future outcome (normally linked to a market variable like the oil price or currency exchange rate) and the other market participant holds the exact opposite view. In all cases there will be a clear winner and a clear loser in these instrument trades and, using gambling terminology, it is understood that one participant is taking one side of a bet 7Bet: risk a sum of money against someone else’s on the basis of the outcome of an unpredictable event such as a race or sporting match and the other market participant taking the opposite side of the bet.
In order to survive, many financial institutions were required to settle their ‘bad bets’ and, it soon became apparent, many did not have sufficient cash (or other available liquid assets) to pay for these losses. This was when the fire spread and we witnessed the collapse of a number of large financial institutions.
These unexpected collapses and financial market chaos, instilled a level of fear that has not been experienced in the market before. For instance, the normally well functioning interbank market for cash borrowing and lending between banks froze and banks were not willing to lend to one another at any rate for fear that they would be providing a lifeboat to a bank, only to be left stranded without a lifeboat should they need a lifeboat in the near future.
This credit freeze worsened the crisis and led to another round of failures which effectively led the global economy on the brink of total collapse. The only way out was for governments to intervene and put up funds to ensure no more financial institutions went bankrupt. During this time it was especially important that large financial institutions have sufficient cash amounts injected because collapse of these large institutions could set a domino effect in motion that not even governments would be able to stop. At the time of the crisis, these institution were deemed ‘too big to fail’ and in years to come they were labelled as systemically important financial institution (SIFIs).
With governments entering the picture some semblance of normality resumed but the general populace expressed a fury and called for the heads of those responsible for the crisis to roll. It’s important to realise that governments have no cash of their own and all so-called public funds were raised via taxation. The action of bailing out the banks and other financial institutions, were done using the tax revenues paid by ordinary citizens. Another way of looking at it is saying that the financial system was in of a blood transfusion and the government used public blood.
When we looking back and zoom out to investigate the damage caused by the global financial crises and the levels of risk-taking that prevailed in the system, the government response and proposed solution resulted in a massive overhaul (called reform 8Reform: making changes to institutions or practices in order to improve it) and reams of new regulation to prevent a similar financial crises from ever occurring again.
To those on the outside, both learned scholars and the man in the street it appeared that many long-time professionals were caught on the wrong side of bets at a casino. The losses were so severe and the threat as well as ensuing global financial recessions forced everyone in the world to stop and look on helplessly at the unwinding of highly leveraged positions which, in the final reckoning, turned out to be castles made of sand.
The world was never going to be the same again. This particular financial crisis has had an enormous effect on the way modern markets operate and, in upcoming lessons, we’ll be looking at the way banks and financial institutions ran prior to the crisis and contrast that to how they operate today. A historical perspective will be crucial in piecing all of these moving parts together and also in taking a look at what the future has in store by investigating current trends.
The second component to understanding modern financial institutions and banks is the influence and adoption of technology. This is the topic of the next lesson.