How did the financial crisis affect the banking sector?
Over the short term, the financial crisis 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.
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-backed securities.
Many foreign banks bought collateralized U.S. debt as subprime mortgage loans were rebundled 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.
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.
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 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.
When President Donald Trump took office he ordered a review of the Dodd-Frank Act, with the aim of eliminating many of its rules. In March of 2018 the Economic Growth, Regulatory Relief, and Consumer Protection Act (S.2115), also known as the Crapo Bill, passed the Senate. The bill is named after Mike Crapo, a United States Senator (R-ID) and chairman of the Senate Banking Committee, who sponsored it. It is designed to roll back parts of Dodd–Frank.
If passed into law, one of the main provisions of the Crapo Bill would increase the asset threshold that banks must pass to $250 billion, up from $50 billion under Dodd-Frank. The Crapo Bill must be reconciled with the Financial CHOICE Act in order to pass into law.
Rules that have been adopted so far include bringing more transparency to the swap fund and hedge fund markets, giving investors say over executive compensation and setting up a whistle-blowers program for securities law violations, for instance.
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.
Very good question. It is loaded!
Let's consider the effects on individual investors different from those on institutional investors.
1) Capital always seeks its highest return. If you believe in this notion, then the financial crisis decimated confidence. Confidence is what drives economic commerce. However, individual and institutional investors were driven to purchase risk-free assets (e.g. cash and bonds) to preserve capital as all asset prices were driven down. Ultimately, policy changes were put in place to save the banking sector (in order to restore confidence) which was predominantly the recapitalization of banks which had bad assets like home mortgages on their balance sheets. The problem is that this was done with the consequence of lowering interest rates in order to encourage the borrowing of money and “grease” the economic engine. (I suggest viewing a video by Ray Dalio about “How the Economic Machine Works” that I have on my website that gives a good overview of the economy.)
2) Putting lipstick on a pig—“this was not a long term solution.” Whenever you can borrow money cheaply bad things happen. Institutional investors found this as an opportunity to use low interest rates to borrow and buy stocks (e.g. the carry trade). Companies used the low interest rates to buy back stocks and pay dividends (e.g. P/E expansion), while most individual investors remained scared with no place to earn return (e.g. head in the sand). The consequence of all these actions was a flood of "new" capital buying risky assets to boost their rate of return on their money at whatever cost.
3) Where we are now. Banks have moderately done better...for now. Banks received the recapitalization and now look better on their balance sheets. However, the long-term implication of zero or low interest rate policy on their income statements is a story that is still unfolding. Most banks thrive on a revenue model that is “spread” based. Meaning their profit is the difference between where they borrow [capital] and how much they loan it out for. That “spread” has been incredibly small since the crisis. Domestic, regional banks have fared much better than the money-center big banks because they usually have a more diverse revenue model. What will be interesting is the effect all this will have on international banks and insurance companies with negative interest rate policies, as it will be incredibly hard to remain profitable without using their float to buy stocks and boost returns.
This all means that most conservative financial institutions that were reasonably profitable for decades by lending at reasonable interest rates, have been forced to take unnecessary risks in order to just stay in business. Very interesting times indeed.
Hope this helps!
Unfortunately the big banks got bigger. The top 4 banks represent approximately 45% of all deposits nationally. Since they got bigger, the banking system is more at risk for too big to fail. On the flip side, the non bank sector BDC (business development companies) is a great arena to invest since they are not plagued with all of the same government compliance.