7. The global financial crisis and the Eurozone sovereign debt crisis

‘The global financial crisis and the Eurozone sovereign debt crisis’ describes the chain of events in the US financial crisis that then triggered the Eurozone banking collapse. It outlines the problems in US mortgage-backed securities, the collapse of three of the ‘big five’ investment banks (Bear Stearns, Lehman Brothers, and Merrill Lynch), and the actions of the US Federal Reserve and the Treasury. Several major European banks also foundered at the height of the financial crisis as a consequence of the US crisis and, by the end of 2014, five Eurozone member countries—Ireland, Greece, Spain, Portugal, and Cyprus—had received bailout loans from the EU and International Monetary Fund, conditional on the implementation of tough austerity measures.

2. Financial intermediation

The term financial intermediation refers to the traditional banking business model, under which a bank accepts deposits from savers and lends funds to borrowers. The accumulation of bank deposits and the growth of bank lending are inextricably linked. ‘Financial intermediation’ explains the functions of maturity transformation, size transformation, and diversification. It goes on to outline adverse selection, moral hazard, leverage, and the magnification of return and risk. By acting as a financial intermediary, a bank takes on several types of risk, the two most fundamental types being credit risk and liquidity risk. Other sources of risk in financial intermediation include market risk, operational risk, settlement risk, currency risk, and sovereign risk.

8. Policy and regulatory responses to the global financial crisis

The 2007–09 global financial crisis brought a number of specific policy and regulatory challenges into sharp focus. From an historical perspective, the regulatory response follows a long-established pattern, whereby stricter regulation and supervision is enacted in response to a financial crisis, while pressure leading to financial deregulation tends to mount during times of prosperity. ‘Policy and regulatory responses to the global financial crisis’ describes the evolution of monetary policy and the adoption of quantitative easing. Important developments included the introduction of negative policy interest rates in several countries, setting new capital and liquidity standards, arguments for separating commercial and investment banking, or ring-fencing retail banking divisions from trading or investment banking operations.

6. Origins of the global financial crisis

The 2007–09 global financial crisis is widely considered to have been the most severe crisis since the 1930s Great Depression. During the two decades prior to the global financial crisis, localized banking or financial crises occurred in many different countries that contained warnings of the upheaval that was to come. ‘Origins of the global financial crisis’ describes some of these: the Japanese and Swedish banking crises beginning in 1990 and 1991 respectively, the US Savings and Loans crisis, and the Asian financial crisis. It then considers the causes of the 2007–09 crisis, including global macroeconomic imbalances and policy mistakes committed by the Federal Reserve and the central banks of other deficit countries.

4. The central bank and the conduct of monetary policy

In most countries, the central bank manages the country’s money supply and interest rates. Most central banks hold a monopoly over printing the national currency and have supervisory or regulatory responsibilities for overseeing the banking industry. The central bank typically performs a dual role, operating as the government’s banker, and as banker to the rest of the banking system. ‘The central bank and the conduct of monetary policy’ explains the central bank’s role and describes the central banks of the UK, EU, and US, as well as the International Monetary Fund. It also outlines the central bank’s responsibility for implementing monetary policy and explains the deposit expansion multiplier, interest rate targeting, and quantitative easing.

1. Origins and function of banking

A bank is an institution that accepts deposits from savers, extends loans to borrowers, and provides a range of other financial services to its customers. Banks are a central part of the modern financial system. ‘Origins and function of banking’ begins with a short history of banking before outlining the structure of a bank’s balance sheet and income statement. It goes on to describe the different types of bank and banking services provided by retail, corporate, and investment banks. It also explains the shadow banking institutions—such as hedge funds—which are not subject to the same supervisory and regulatory arrangements, and the payments system that has been transformed by the growth of computing technology.

5. Regulation and supervision of the banking industry

As financial intermediaries, commercial banks use liquid liabilities to finance illiquid assets. Banks hold only a small proportion of their assets in the form of reserves, and cannot cope if all depositors demand the return of their funds simultaneously. Together with leverage, this makes banks inherently fragile, and creates the potential for one distressed bank to cause a loss of confidence in others. ‘Regulation and supervision of the banking industry’ describes the causes of bank runs, the different regulatory authorities, banking licenses, and capital adequacy regulation, and the government safety net. Regulation and supervision of the banking industry aims to protect individual banks, and the financial system as a whole, from the possibility of collapse.

3. Securitized banking

Preceding the global financial crisis of 2007–09, an alternative business model of banking evolved. An important element in the development of the securitized banking model was a growing tendency for banks to rely less heavily on deposits as a source of short-term finance, and more heavily on other sources such as the repo market, commercial paper, and derivatives. ‘Securitized banking’ explains that having raised short-term funding through these means, the bank can deploy the funds to support loans to borrowers such as house purchasers. Often a bank will bundle a large number of loans together and sell the package to a Structured Investment Vehicle set up by the bank to administer the loans.