LLAW6093B Chap.10 The Financial Crisis, Capital and Resolution
The Financial Crisis, Capital and Resolution
Innovation, stability and failure in one chapter
The third part of the syllabus runs from regulating financial innovation, with securitisation and tokenisation as the case, through prudential regulation and capital to regulating for financial stability, with bank resolution and systemically important institutions as the case.
The background reading on the crisis of 2007 to 2009 connects them, tracing a path from mortgage lending to a global recession and the reforms that followed in the United States.
How the crisis built up
The reading describes low real interest rates and a hunt for returns, lenders who earned fees on loans they then sold into securities, and investors who held those securities with borrowed money.
When house prices turned, securities backed by weak mortgages lost value, holders tried to sell together, and funding markets stopped rolling over short-term debt.
The central difficulty for the authorities was telling firms that were short of cash from firms that had lost their capital.
From emergency lending to rescue
The central bank widened access to its lending, created new facilities and arranged the sale of one investment bank to a larger rival.
Another investment bank had no buyer and too little collateral, and no agency had power to absorb its losses, so it failed and markets froze.
Congress then authorised the Treasury to buy troubled assets and inject capital into banks, a programme the reading reports eventually returned more than it cost.
What the reforms tried to change
The reform statute created a council to watch for systemic risk and bring large firms, including designated non-banks, under central bank supervision.
It set capital floors and asked for capital that rises in booms, capped exposures to single counterparties, and barred banks from proprietary trading and from owning hedge and private equity funds, subject to exceptions. Large firms must also file plans showing how they could fail in an orderly way.
The questions that remain open are the ones the course asks you to argue: whether these tools answer the failures that caused the crisis, and at what cost to other goals.
What this chapter covers
- 01
Securitisation and the originate-to-distribute model
- 02
Liquidity crisis and fire sales
- 03
Emergency facilities and the lender of last resort
- 04
Why one bank was sold and another failed
- 05
Fiscal rescue and the troubled asset programme
- 06
Systemic oversight and designation of non-banks
- 07
Capital floors, countercyclical capital and exposure limits
- 08
Proprietary trading and living wills
Worked example · free
Judge a resolution plan
- 2Identify what a resolution plan must show.
- 4Test the plan's key assumptions.
- 2State the consequence if it is not credible.
Key terms
- Securitisation
- The pooling of loans such as mortgages and the sale of securities whose payments come from that pool.
- Originate-to-Distribute
- A lending model in which the lender earns fees by making loans and then sells them on rather than holding them.
- Fire Sale
- Forced selling that pushes prices below fundamental value, spreading losses to every holder of similar assets.
- Proprietary Trading
- Trading by a bank as principal for its own short-term profit rather than to serve clients.
- Living Will
- A resolution plan in which a large financial firm shows how it could be wound down in an orderly way in bankruptcy.
- Countercyclical Capital
- Capital requirements designed to rise in expansions and fall in contractions, reversing the pattern of earlier risk-sensitive rules.
The Financial Crisis, Capital and Resolution FAQ
Why did the authorities rescue one investment bank but let another fail?
In the first case a private buyer was willing to proceed with central bank lending behind it. In the second there was no buyer, the firm lacked collateral the central bank could lend against, and no public body had power to absorb its losses. The failure then froze markets, which later reforms tried to prevent.
What does the ban on proprietary trading prohibit?
It bars banking entities from trading as principal for their own short-term account and from owning or sponsoring hedge funds and private equity funds, subject to exceptions for activities such as underwriting, market making and hedging. The hardest question is telling genuine market making from trading for the bank's own profit.
What happens if a large firm's resolution plan is not credible?
It must revise and resubmit the plan. If it still falls short, it can face stricter capital, liquidity or operational requirements, and if no acceptable plan is produced within two years it can be ordered to divest assets or operations.
Exam move
Draw a timeline of the crisis from the reading on one page and mark, for each event, which regulatory strategy was used and which failure it addressed. Then add the reforms at the end and draw a line from each reform back to the event that prompted it.
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