a) The financial crisis of 2007-2010; should accounts of its causes focus on the world of finance alone? (50 marks).

b) With reference to your discussion in part a); why did Lehman Brothers collapse? (50 marks). THESIS (a): Impossible to separate world of finance from the rest of the world. Finance had an effect on most outside factors regulation (through lobbying and recruitment of regulators after their term), macro fundamentals (again, lobbying for decreased interest rates, increasing the levels of HH debt by underpricing and then offloading risk, fuelling GDP growth through massive investments in real estate etc.),
a) World of finance has had a big role. Financial innovation Capital requirements both during boom (for triple AAA rated securities etc.) and during bust (need to sell off assets at low prices) Mortgages Excess liquidity from where? Compensation structure (?) this benefits bankers during booms but they incur no immediate losses during bust. Skewed incentives towards risk-taking, etc. Leveraged returns this is a consequence of cheap liquidity also consequence of stable environment, search for yield, very low long-term interest rates you can see how these are part of the Liquidity/maturity mismatches. Shadow banking. Falling profits from traditional banking push into trading etc. SPVs Risk undervaluation in the financial system as a whole. Frequent tail risks. Cognitive regulatory capture by Wall st. Spike in perceived counterparty risk due to the failure to bail-out bear stearns. This is both due to judgement from banks they would be bailed out and to the Fed for being extremely random.

But there are quite a few factors external to the world of finance that need to be taken into account. Accounting techniques and bad regulatory oversight repo 101 Low interest rates Perfect storm of micro and macro pathologies (Butler fin crisis)

Cheap liquidity is in part due to the entry of high-saving countries like China and the transfer of wealth to commodity exporters with a high propensity to save ( Rating agency business model, skewed incentives Incoherent regulation Distorting moral hazard due to bail-outs bankers believed they would be saved by the gvt if they fuck up too much. They had a perceived put on the bank, encouraging excess risk taking. deregulation

b)

c) General questions - Macro vs micro? can macro be considered outside the world of finance? Finance affected the macro situation cheap liquidity fuelled growth, the enormous inflow of capital into mortgages led to growth. Increasing private sector debt, d) What you need to do: - Find definition of the world of finance. Then argue that finance is not a world outside everything else. In fact, due to its high revenue etc, it influences everything it comes in contact with, from households, to corporations, to regulators, to global macro fundamentals. Therefore, it is erroneous to talk about the world of finance vs. everything else. It is indeed more important to view each of the main contributors to the fin. crisis as a combination of the world of finance and outside forces, that morph influence and form each other to create the perfect storm that was the Global financial crisis. Each issue should be considered in light of the above. How finance has influenced macro fundamentals, how macro fundamentals influenced finance. How search for yield leads to more leverage. How rating agencies, through flawed business model, and through the incentive of BASEL II cap requirements for AAA securities, led to undepricing of risk. How securitisation comes as a logical answer to the search for yield. How both increasing leverage, opaque securities with high ratings and low regulatory oversight do not exist in a vacuum academic community asleep, narrative of innovation led growth, rather than leveraged inorganic growth. How all of these combine in one fueling of cheap mortgages, offloading of risk, little interest in counterparty risk, perception of risk reduction. How, through search of yield and market pressures systematically important institutions feel the need to enter into the inorganic growth market of MBS and other securities. The lack of regulatory oversight and lapses in accounting rules lead to repo 101 and other techniques to manage balance sheets. Paint a big picture of interconnectedness, complexity, and mutual influence. - Use definit

GENERAL PLAN: 1. Introduction a. Focus of report will be on systematically important institutions vs regular investors (hedge funds, pension funds). Even though most things discussed below are true for both systematically important institutions and regular investors, their influence on systematic institutions led to the increased fragility of the system and the financial crisis. 2. Situation before the crisis a. Entry of China and other net savers into the financial system leads to lots of cheap liquidity. b. Low interest rates as a response to previous financial crisis in 2001-2, dot com bust. c. Macro stability. d. Deregulation. 3. Search for yield (could be split into search for yield and financial innovation. Search for yield would then discuss the initial need to find revenue growth outside traditional banking; innovation would discuss the role of securitisation in both providing a key component in the new business models and as a source of higher yields.) a. Stems from situation before crisis, low interest rates, low returns on traditional banking b. Search for yield leads to invention of new business models originate and distribute. This will be discussed in detail here. c. The role of financial innovation both as a driver of the new business model and as a source of fee-driven revenue growth. d. Leverage as a central player in amplifying returns. Again, leverage depends on cheap liquidity which stems from 2.

e. Compensation structure can be mentioned as bonuses are tied to share performance. This leads to short-termism. f. Liquidity and maturity mismatches as drivers of inorganic growth.

4. Risk (Mispricing of risk by the market and incentives for increased risk are very distinct. Discuss each one separately.) a. Compensation structure b. Rating agencies c. BASEL II accords and AAA securities d. Narrative of innovation-driven system-wide reduction of risk e. Again leverage should be mentioned as it has amplified all above risks. f. Derivatives, already discussed in 3., are considered here as carriers of unperceived tail risks. Banks believe their own narrative of safe securities and more and more of those derivatives are held directly by systematically important institutions. This results in a build-up of risk in the system. g. Shadow banking. This is linked to poor regulatory frameworks and oversight. 5. Regulatory oversight and response a. Cognitive regulatory and academic capture by the industry the narrative of innovation driven growth dominates thinking. Fed response to Bear Stearns, Lehman and AIG important. b. In addition, direct regulatory capture revolving door. c. Moral hazard created by the Fed during the crisis via bail-outs. d. Failure to bail-out Lehman leads to liquidity dry up as counterparty risk is unclear. e. Inadequate initial response failure to provide liquidity, leading to knock-on effects. How was this failure affected by the industry? Was the overwhelming narrative such that it suggested to regulators to act this way? f. Lack of understanding of derivatives.

6. Lehman 7. Conclusion