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The current hotly debated issue is the financial turmoil in large banks around the world
that sparked the global financial crisis. The respective governments, to protect their
economies and financial systems, utilize taxpayers' money in the name of reconstruction to bail out
the problematic banks. The banking crisis had caused major job loss and its ancillary
problems associated with the poor performance of individual national economies. The policy of
non-intervention, market-driven economy, self-regulatory process and lack of transparency
pushed the financial system of almost all countries to the brink of collapse. The economic
problems are not severe for over-regulated and strict economies' financial systems; however, the
strong under-regulated economies were badly affected. The problem emanated primarily from
two sources—the subprime lending and the reckless creation and unregulated trading
of Collateralized Debt Obligations (CDOs). In subprime lending, the credit quality and
repaying capacity of the borrower took a back seat, without proper assessment, where the bankers
lent loans believing in the future appreciation of property price. In the event of borrowers'
default, the banks were confident of selling the collateral at a decent price; thus, the loan was
always deemed safe. The above premise is true when a few individual borrowers fail to repay the
loan. However, if several borrowers simultaneously fail to repay, the credit risk increases
several fold due to the existence of correlation risk. The correlation risk is the main cause of
the crisis that banks and financial institutions around the globe face today.
The second cause of crisis is the regulatory measures proposed by Basel II. The Basel II
mandates all banks to keep adequate Tier I capital to meet any credit risk arising from financial
assets created by them. To avoid Tier I capital and to minimize credit risk from lending,
the commercial banks issued structured financial products through a specially created
Special Purpose Vehicle (SPV). Table 1 provides operational details of banks that sell
asset-backed securities through their own SPVs to transfer risk and to get liquidity. In fact, the banks
buy protection against portfolio of its financial assets (loans and bonds). The banks pay
regular premium to the investors (protection sellers), quarterly or semi-annually. Investors
receive premium from SPVs and bear losses when credit event occurs. The investors are none
other than the institutional investors and banks of different countries. |
