How the 2008 Financial Crisis Affected the Banking Sector

Over the short term, the financial crisis of 2008 affected the banking sector by causing banks to lose money on mortgage defaults, interbank lending to freeze, and credit to consumers and businesses to dry up. For the much longer term, the financial crisis impacted banking by spawning new regulatory actions internationally through Basel III and in the United States through the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Key Takeaways

  • Measures taken after the financial crisis were designed to both protect banks and their members.
  • Some of the major effects on banks were centered on debt management, allowance, and available funds on hand.
  • The Dodd-Frank Act was passed in 2010 ensures that banks are held to a high standard of liquidity and available assets in order to mitigate risk.
  • Some financial experts believe the act to be too stringent, and have since attempted to repeal it.

Prior to the Crisis

Before the financial crisis hit in 2008, regulations passed in the U.S. had pressured the banking industry to allow more consumers to buy homes. Starting in 2004, Fannie Mae and Freddie Mac purchased huge numbers of mortgage assets including risky Alt-A mortgages. They charged large fees and received high margins from these subprime mortgages, also using the mortgages as collateral for obtaining private-label mortgage-based securities.

Many foreign banks bought collateralized U.S. debt as subprime mortgage loans were bundled into collateralized debt obligations and sold to financial institutions around the world.

When increasing numbers of U.S. consumers defaulted on their mortgage loans, U.S. banks lost money on the loans, and so did banks in other countries. Banks stopped lending to each other, and it became tougher for consumers and businesses to get credit.

After the 2008 Global Financial Crisis

With the U.S. falling into a recession, the demand for imported goods plummeted, helping to spur a global recession. Confidence in the economy took a nosedive and so did share prices on stock exchanges worldwide.

In hopes of averting another financial crisis, in December of 2009, the international Basel Committee introduced a set of proposals for new capital and liquidity standards for the global banking sector. The reforms, known as Basel III, were passed by the G-20 in November 2010, but the committee left it to member nations to implement the standards in their own countries.

The Dodd-Frank Act

In the U.S., the Dodd-Frank Act, passed in 2010, requires bank holding companies with more than $50 million in assets to abide by stringent capital and liquidity standards and it sets new restrictions on incentive compensation.

The legislation also created the Financial Stability Oversight Council, to include the Federal Reserve Bank and other agencies for the purpose of coordinating the regulation of larger, "systemically important" banks. The council can break up large banks that might present a risk because of their sizes. A new Orderly Liquidation Fund was established to provide financial assistance for the liquidation of big financial institutions that fall into trouble.

Some critics charge, however, that the act passed by U.S. Congress in 2010 is a greatly weakened version of the bill originally envisioned by President Barack Obama, watered down during its development through legislative and lobbyist maneuvering.

Meanwhile, the ultimate impact of the financial crisis keeps unfolding. For example, the Act also contains more than 90 provisions that require rulemaking by the U.S. Securities and Exchange Commission (SEC), along with dozens of other provisions where the SEC has been given discretionary rule-making authority. As of February 2019, the SEC has adopted final rules for 67 mandatory rule-making provisions of the Dodd-Frank Act.

Rules have been adopted to bring more transparency to the swap fund and hedge fund markets, to give investors say over executive compensation, such as setting up a whistle-blowers program for securities law violations.

Advisor Insight

Arie Korving, CFP®
Korving & Company LLC, Suffolk, VA

The financial crisis that began in 2008 decimated the banking sector. A number of banks went under, others had to be bailed out by governments and still others were forced into mergers with stronger partners. The common stocks of banks got crushed, their preferred stocks were also crushed, dividends were slashed and lots of investors lost part or all of their money.

The reasons for this were more complex than generally realized. The simple answer was that it came about because the housing bubble burst, but that’s the surface of the problem. Part of the problem was a liquidity issue due to “mark to market” accounting required by the government and part was the number of bad mortgage loans banks held on their books. The lesson for shareholders is to diversify. Unfortunately, many people had much of their investments in bank stocks because they were paying such high dividends.