Crisis Background

In order to understand the credit crisis it is important to understand certain fundamental banking principles. A bank is basically a trading company. The only difference is that it trades in money. It buys money from those that have too much (customer savings, money market) and lends it to those that have to little (companies, consumer loans). The price which a bank pays is interest (for instance the interest on your savings account). The price which a bank receives is also interest (which you pay if you lend money). A bank cannot loan somebody any money which they did not first lend themselves (or money is available as equity, but ignore this for now). In other words a bank cannot sell what it has not bought.

If people are talking about funding they are talking about the need for banks to buy money, before they can sell it again. Consider the following example. A bank has two customers (customer A and B) with a deposit holding €100,- each. There is one customer (customer C) lending €200,- from the bank. In this example customers A and B with the deposits provide the bank with funding, which the bank than uses to loan to customer C. If a new customer (D) requests a loan of €200,- from the bank, a problem arises. The bank will have to attract additional funding. In other words it will have to find somebody prepared to lend €200,- to the bank. This could for instance be additional savings accounts from customers. From a banking perspective the funding is a liability (right side of a balance sheet) because it is a debt which it will have to repay. The €200,- loan to customer C is an asset because the customer will have to repay the bank. On a balance sheet this looks as follows:

Assets	Liabilities
Customer C €200,-	Customer A €100,- Customer B €100,-
Total Assets: €200,-	Total Liabilities: €200,-

By buying and selling money, banks fulfill an important role in society. They are an intermediate between those people who have more than they need and those that want to expand their business. But banks also have a more subtle role in society with which they also earn their money (or some of it anyway). Banks provide liquidity. Let me first give the formal definition of liquidity: The ability to fulfill short term obligations.

In other words the ability to pay those people who you have to pay, in the short term (say the coming year). A company has a good liquidity if its liquid assets are worth more than its short term liabilities. This means that a company is able to generate more money (by selling liquid assets in the short run) than it needs (for paying its short term liabilities). This also means that some of the liquid assets need to be paid with long term loans. The balance sheet shown below gives a representation of a company with a good liquidity.

As the figure shows, the liquidity can be improved by attracting more long term capital (equity or long term loans) to finance short term assets. This gives a company a larger buffer for paying its short term obligations.

Banks provide liquidity to normal companies (non banks) by purposely destroying their own. Let us return to our example. Assume customer C has lend the €200,- for ten years (the maturity is ten years). This means that the bank will not receive the money back for ten years. In general, banks will make sure that their funding has a shorter maturity. Let us assume that customer A and B both have put their money in a deposit with a five year maturity. In other words the bank will need to repay customer A and B in five years. To recap, a bank will have to repay customer A and B in five years and will receive money in ten years. In liquidity terms this is horrible. This bank will not be able to pay their short term obligations (to customer A and B) because it has no cash flow (from customer C) when they have to be paid. For customers who lend money from a bank this is fine. They are able to lend long term money and thus increase their own liquidity (by using the long term money to invest in short term assets).

Banks do not undertake these activities out of the goodness of their harts. It is an important (if not the most important) source of income. In general the interest rate on a short term loan is lower than the interest rates on long term loans. In our example the cost (interest rate) of the deposits (the funding) from customer A and B will be lower than the return on the loan to customer C, thus generating profit. In return for this profit, banks accept a risk. After five years the bank needs to repay customer A and B but has no money to do so. This means that a bank will need to refinance those loans. This means it has to find other customers (or convince the same ones) to put money in a deposit. If nobody is willing to do this, a bank will go broke.

The Credit Crisis

Many people are talking about the “Credit crisis”, the “Liquidity crisis” or the “Financial crisis”. However what is actually happening.

As discussed in the previous chapter, banks create liquidity. They do this by borrowing money in the short run and lending it for the long run. By doing this they absorb a certain risk. They run the risk that they cannot repay their short term obligations if they cannot find someone willing to refinance them. This risk increases as the funding gets shorter and the loans get longer. If a bank funds a ten year loan with ten year funding there is no (very little) risk for a bank. The bank knows that the ten year funding can be repaid after ten years from de cash flow received from the customer (given the customer pays). If the funding of the loan has a maturity of one year, the risk becomes rather large because the bank will need to refinance the loan ten times. Each of these ten times a bank might fail to raise funding. The risk of failing to raise capital and repay its creditors is the liquidity risk.

This risk was generally considered negligible. In history there were always people or companies ready to refinance a bank. However now this situation has changed. People are still willing to finance banks, but under an extra condition. Banks can currently only attract money for a very short period (up to 3 months). This means that the liquidity risk which banks are forced to run is very high right know. Banks have a lot of short term obligations (repayments in three months) but only long term assets (loans to customers for ten years). In other words, there is a lack of liquidity for banks. Furthermore banks are unable to increase their liquidity, because they cannot lend money for a longer time period. Thus the cure to the liquidity crisis will be long term lending to banks, but who will do this? Banks will not. They cannot afford to lend money to other banks for long periods because this will dramatically increase their own liquidity risk. Government guarantees will not change this. The credit risk is not relevant in this decision anymore (for banks). Even if a bank has a surplus of cash it cannot be lend to other banks for ten years, because the surplus can evaporate in three months.

The Cause

The match that lighted the current crisis can be found in the sub prime mortgage market. A wonderful euphemism for mortgages sold to people who can not (or just barely) afford them. These mortgages where sold, based on the assumption that the raise in the value of the realty could finance the payments on the loan and not so much the income of the buyer.

Several circumstances led to a strong increase in the sub prime market. Or put differently, decreased the credit standards set by banks.
First: The economy had been stable and/or growing for a long time.
Second: The prices of realty had been growing consistently for a long time.
Third: Margins on loans had been decreasing.
Fourth: There was a lot of liquidity in the market (many investors where willing to commit money).
Fifth: New financial innovation (debt securitisation) obscured the view of the risks.
The stable economy and rising real estate prices led to a general underestimation of the risks in mortgages by banks. The small margins caused banks to actively seek the edges of acceptable risks. The underestimation of the risk and misunderstood financial structures caused them to unwittingly cross that line. The ample liquidity made it all possible.
To put it a bit less formal and a bit more crude. Banks got greedy and like love, greed is blind.

The above mentioned circumstances led to a general decrease in the credit quality (especially for the sub prime mortgages), without the banks and/or investors noticing it. This powder keg slowly grew until it was ignited by an interest rate raise. The raise had two effects. First: many of the sub prime mortgage loaners were not able to pay the higher rates and defaulted. Second: the real estate prices stopped growing. This caused a sudden realization among banks of the predicament they were in. More and more home owners were defaulting and the banks backup (the collateral e.g. the homes) was melting away.

The question remains why this had such an impact on the financial markets? The total expected los from the sub prime market should be easily absorbed by the banks. The effect is because of insecurity among banks and investors. Many of the mortgages where packaged and sold on the market. This means that the loans were placed in a separate company (structured investment vehicle or SIV) and subsequently investors would finance that company using bonds. By using separate companies these mortgages did not show in the banks balance sheet and no solvency needed to be held for them. This seemed reasonable as the perception was that the investors who bought the bonds carried the risks.

However this turned out to be a wrong perception. Because investors saw the sub prime mortgage deteriorate they lost interest in buying the bonds. As mentioned before, banks tend to loan for shorter terms themselves then the loans they sell. In other words the bond to investors had to be repaid before the mortgages from customers were repaid. As bonds from investors became due and no new investors were available to sell the bonds to, banks were confronted with two choices:
1. Do nothing and let the SIV go bankrupt (for not repaying the investors).
2. Pay the investors out of their own pocket and take the mortgages back on their balance sheet.

Many banks chose option 2. Either because they where contractually obliged to, or to save their reputation. This led to insecurity as to which bank or investor actually bared the risk of the mortgages and who would have to take the losses. This insecurity led investors to stop investing money in general. The bank with which you would do business with, could be in bigger problems than it could handle. There was just no way of knowing. Thus the crisis which started with the sub prime market spread out towards the entire financial market and the liquidity crisis was born.

This insecurity is also visible in the media. It is the reason for the many speculations of the total loss that will have to be taken due to the sub prime crisis. It is also the reason why any additional provisions or write offs by a bank is headline news.

Crisis and BIS II

There are some lessons to be learned from this crisis and the role of BIS II in it. Several improvements have been formulated. Most of these are focussed on preventing this particular crisis from happening again. However chances are slim, that the next crisis will equal this one. In this section the strengths and weaknesses are discussed on a somewhat more abstract level. Focussed more on how BIS II is used.

Strengths
The first Basel accord had a very distinct drawback. It stimulated banks to finance risky counterparties. Let us reconsider our previous example:
1.A corporate loan of two million to a multinational AA corporation, fully collateralized by machinery.
2.A corporate unsecured loan of two million to an empty company (no actual assets or income production capacity) in a tax haven.

Now we add the impact of pricing to this example. The bank will be able to demand a higher interest rate from the second company, because of the higher risk. Let us assume that the margin (interest rate minus funding costs) for the first company is 1% and the interest rate for the second company is 3%. The solvency requirement for both companies is €160,000. Therefore the return on equity for the first company is 12,5% ((1%x2.000.000)/(8%x2.000.000)). The return on equity for the second company is 37,5% ((3%x2.000.000)/(8%x2.000.000)). This means that a bank will gain higher returns if it engages into riskier deals.

BIS II will eliminate this unwanted stimulation of banks towards risks. Furthermore it encourages banks to set up a risk management system with a certain level of professionalism. It does this not only by legislative force, but also by allowing the market to make its own decision about a banks quality. Thus banks are setting up better management information systems and policy is more directly linked to risk developments.

Weaknesses
The weakness of BIS II lays in the method in which it determines risks. It uses models to determine the risk of a certain bank. These models however can only extrapolate what has happened in the past. They cannot take into account a changed environment. Although BIS II mentions the fact that this should be taken into account but there is no method available to do so. Furthermore, those people considered expert in a particular market are usually also dependant upon this market. In other words, they do not want a market to be risky and therefore in their eyes it never will be.
This weakness renders BIS II useless in preventing the crisis described earlier.
This is best illustrated by a fictional example.
China has been growing rapidly due to large production and exports. Assume that in 2010 China decides to open up its borders and allow banks and investors to finance Chinese production directly. When this happens banks are confronted with an investment opportunity which has a good track record. China has been booming for several years now. The market is also new because banks are not directly involved at the moment. These are two of the characteristics often present with a collective over-valuation. As money continues to be invested in China and production keeps growing the idea of China being a safe investment is confirmed. This will cause more investors to make financing available to China.

As this happens BIS II will also confirm this image of China being a save investment. As long as the money supply keeps growing in China only a few companies will go broke due to mis-management. But over-all the statistical view of low risk confirms the qualitative view of the market.

Now assume that towards 2015 the cost of labour has increased dramatically. The interaction with western culture due to the open borders has increased the desired living standards of employees. They demand their share of the profits which are being generated. This will decrease the profitability of investing in China. The rise in costs continues until China is no longer attractive for its low wages. In other words, the basis for the investments and growth in China has disappeared.

If this happens BIS II models will still say that china is relatively safe (as there have still been few defaults in the past). The market specialist at a bank will probably be the person responsible for the China branches. Therefore he does not want China to become more risky. He or she will generate other reasons why China is still solid. Either, that an internal market has developed (not dependant on export). Or that other investors are also still investing, thus the risk cannot have increased (else everybody would have to be wrong). Companies will not move their production because of possible tax reasons, etcetera. This is not deliberate misinformation. The expert will genuinely believe this, because he wants to believe it.

This means that while the reason for China’s growth has disappeared, banks will not react to it. Not with BIS II and (often) not out of their own accord. The growth of invested money will delay a correction. The newly invested money can be used to artificially increase (basically finance) consumption and refinance companies who cannot repay their loans from their cash flow. This obscures the fact that the financial basis for growth is gone. The growth becomes dependant on the money supply increase.

This can continue for several years until the amount of investments in China can no longer grow or it becomes too obvious that there is no basis for growth any more. At this points bank will massively withdraw their money from China. This will lead to a sudden and dramatic increase in defaults, causing large losses for banks.

This example shows how BIS II will not change anything in this cycle which leads to a crisis. This in itself is not a thread. The thread only develops when bank management assumes that BIS II will prevent a crisis and therefore stop using their own (qualitative) risk assessments. In short, BIS II and risk models are a good tool. But owning a good hammer will not make you a good carpenter.

A development which has been proposed as a solution to this problem is the use of scenario analysis. This means that the potential loss in a particular situation is calculated. The only weak point with this view lies in determining the scenarios. In our example a systematic failure of the Chinese economy would probably be seen as unrealistic and not used as a scenario.