BY: JOEL STITT

A View at the Financial Collapses in the United States and the Evolution of the Financial Services Industry

Introduction

Banking History

Financial Collapses Great Depression 2008 Housing Market Crash

Current Regulations

Consumer Banking

Can be defined as the cluster of products and services offered to consumers and small businesses by banks through a variety of physical and virtual channels

Modern consumer banking began in the early 20th century

Income sources prior to modern consumer banking Pawnbrokers Illegal small-loan lenders Family/acquaintances Retailers Mortgage brokers

Modern Consumer Banking

Consumers began to heavily rely on banks during the 1920s (Roaring 20s)

Modern consumer banking offers four major products/services areas: Payments Savings and Investing Credit Financial Advice/Other

Payments

Banks allow consumers to pay for goods and services

The majority of payments in America were paper-based up through the early 2000s By 2008, 57% of consumer payments were made

electronically, up from 29% in 1999Banks also heavily rely upon payment services

Banks in the U.S. attribute over 1/3 of revenues to payment services

Newer payment services: PayPal, Apple Pay, etc.

Savings and Investing

Banks help individuals save and invest their income 53% of families in 2013 claimed to have saved some portion of

their money Becoming more important as the future of social security is

unclear

Lower risk options Savings account U.S. Treasury Bills

Higher risk options Company stocks Certain bonds and securities

Credit / Borrowing

Two primary ways to borrow money through a bank: Credit cards

Typically short-term debt 40% of people have credit card debt in 1989 compared to 38% in

2013 Average amount of debt increased from $900 to $2600 during

that time period Installment loans

Typically long-term debt Over 60% of people have some form of installment loan from

1989 to 2013 Type of loan changed significantly (education loans increased to

20% in 2013 compared to less than 10% in 1989)

Financial Advice / Other

Financial institutions offer financial advice in a variety of areas Investment decisions (Consumer) Borrowing decisions (Consumer) Understanding financial doctrines

(Consumer/Commercial) Mergers/Acquisitions (Commercial) IPOs (Commercial)

Use of financial advisors is increasing Borrowing decisions: 32% - 41% from 1989 to 2013 Investing decisions: 33% - 38% from 1989 to 2013

Economic Crises & Financial Collapses

An economic crisis can be defined as an event, typically following a financial collapse, where the economy slides into a recession or a depression

Common Symptoms Poor economic performance Increased unemployment rates Stagnant global domestic product

“The seven year theory”Two of the most significant in recent U.S. history

Great Depression, 1929 Housing Market Crash, 2008

Great Depression

Largest economic crisis in U.S. history

The Economy Quantity of goods/services available lowered by 33% Over 25% of Americans unemployed An estimated 7000 banks closed 34 million Americans with zero income 20% malnourished Americans Many citizens lost their savings and trust in banking

Causes

Stock market crash of 1929 Roaring 20s and the Bull Market

By 1929, 1.5 million people had accounts covering 29 of America’s stock markets

One in four families had an active interest in the stock market

600,000 individuals trading on the margin

The Banking Industry during the Great Depression

Banking Failures Led to a significant decrease in value of securities and loans 1700 banking failures in 1931 and 1932 which increased to

over 4000 in 1933 “Contagion”

Deflation People were hesitant to spend their money or to deposit it

into banks Banks were holding larger cash reserves in order to combat

contagion As the stock of money supply decreases, the prices of goods

and services follow suit

Government Reaction

Roosevelt created banking holiday on March 6th, 1933 Four day closure of all banks, including the Federal

Reserve Announced the Emergency Banking Act Advertised deposit insurance on all reopened banks

FDR’s “The New Deal” Banking Act of 1933 (Glass-Steagall Act) Federal Deposit Insurance Corporation (FDIC)

Started operations in 1934 Insures deposits in banks

Banking Trends Following the Great Depression

Newer Products / Services

Increased Demand / Access

Consumer-based decisions

Newer Products / Services

Rising popularity of credit cards Became popular beginning in the 50s

Automated Clearing House Payments (ACH) Introduced in the 70s

Automated Teller Machines (ATM) Introduced in the 70s

Point of Sale Technology Introduced in the 80s

Electronic payments surpassed check payments by 2003

Increased Demand / Access

Consumers have more income Annual median income per family rose from $7,550 in

1962 to $47,300 in 2013Some modern businesses require electronic

payment or payment by check Planet Fitness, Cards Against Humanity

Increase in popularity of shopping online Leads to an increase in electronic payments online

Convenience

Consumer-based Decisions

The internet has allowed consumers to more easily access information regarding financial decisions The number of consumers using the internet surpassed the

number using financial associates for borrowing decisions between 2007-2010

The number of consumers using the internet for investing decisions expected to surpass financial associates by 2016

Over 72% of families use the internet for financial purposes in 2013, over 20 times greater than in 1995

Deregulation of Banking in the 1970s

Reinterpretations of the Glass-Steagall Act 1986 – 5% of revenues allowed to derive from

investment activities 1996 – Up to 25%

Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 Banks were allowed to merge over state lines,

eliminating many inter-state restrictions Banks consolidated rapidly

27% less banks by 1998

Housing Market Crash of 2008

Considered the largest financial collapse since the Great Depression

Tens of millions of lost jobs, savings, and houses

Thirty million unemployed globallyDoubled the debt of the United States

Causes

Sub-prime Mortgage Loans

The “New” Financial System

Belief in the Housing Market

Subprime Mortgage loans

Sub-prime mortgage loan – a mortgage loan that is issued to an individual with poor credit Have ten times the default rate of prime loans Increased four times to 20% of all mortgage loans

between 1994 and 2006 Consumers were able to borrow up to 99.3% of the

house’s worth (very little money down) Many adjustable rate loans https://www.youtube.com/watch?v=xy8a0GKO_Ek

The “New” Financial System

Mortgage-backed Securities, Collateralized Debt Obligations (CDOs), and Credit Default Swaps

Belief in the Housing Market

“I cannot foresee any decrease in the price of the housing market, Freddie Mac’s analysis shows that there was not a single year in fifty years where the average housing price decreased” - Frank Nothaft, Chief Economist of Freddie Mac, 2005

Housing prices increased 132% between 1997 – 2006, as compared to 8.3% between 1990 – 1997.

What would have happened if housing prices continued to rise? Consumers could have renegotiated rates or sold their loans instead of

foreclosing Banks would have had low default rates on risky mortgage loans Credit rating agencies would have been accurate with their AAA ratings Insurance companies would have held little liability on credit default swaps The government wouldn’t have received blame for holding little regulation

over CDOs and credit default swaps Housing prices took their first fall in late 2006 Foreclosure rates increased by 75% in 2007

The Beginning of the Crash: Lehman Brothers

Filed for bankruptcy on September 15, 2008Largest bankruptcy in history at the time

639 billion in assets 25,000 worldwide employees 4th largest investment bank at the time

Was the largest lender of mortgage-backed securities in 2007

Completed “Repo-105” transactions to dilute transparency

Guilty Parties

Financial Institutions

Consumers

The U.S. Government

Financial Institutions

Not completing proper due diligence in the loan lending process

Predatory Lending Citigroup paid $215 million in fines in 2002 to end

dispute over abusive loan practicesGreed: short-term profits and bonuses > long-

term sustainability Wall Street Execs received bonuses equal to $23.9 billion

in 2006 alone Goldman Sachs had $16.5 billion of income allocated

towards salaries in 2006, which averages to roughly $622,000 per employee

Consumers

Poor consumer financial decisions Unaffordable loans

Median household price was roughly 2.9 to 3.1 times the median household income from 1980-2000

Ratio grew to 4.6 times from 2001-2006

In 2006, 39 million households spent 30% or more income on housing and 18 million spent over 50% Common recommendations are to keep household

under 30% of incomeConsumers were living outside their means

Government

Failed to regulate properly and deregulated banks throughout the late 20th century Did not regulate the trillion dollar industry of credit default swaps

Promoted poor lending decisions through government sponsored agencies (GSEs)

Affordable housing act 1992 quota – 32% 2000 quota – 50% 2007 quota – 55%

To meet demand, Freddie Mac and Fannie Mae Offered zero down payment mortgage loans by 2000 Purchased a trillion poor or subprime loans by 2002

By 2008, 27 million subprime mortgage loans were in the market (50% of all loans) GSE’s were holding or guaranteeing 70% of them

Current Regulation

The Dodd Frank Act of 2010

CCAR

Volcker Rule

Basel III Framework

Dodd Frank

Most significant law in response to the financial crisis of 2008

SEC has adopted 61 final rules as of March 2016Key Risk Areas

Private Funds -Asset-backed securities Security-based swaps -Credit Rating agencies Clearing agencies -Specialized Disclosures Municipal securities advisors Executive compensation

Dodd Frank

The Dodd Frank Act also formed the following government organizations: Office of the Whistleblower Office of Credit Ratings Office of Investor Advocate Office of Women and Minority Inclusion Office of Municipal Securities Consumer Financial Protection Bureau (CFPB) Financial Stability Oversight Board (FSOB)

Comprehensive Capital Analysis and Review (CCAR)

Administered by the Federal Reserve Board (FRB)

Requires Global Systematically Important Banks (GSIB) to complete annual or semi-annual “stress tests”

Accounts for 28 different economic variables2016 stress test

Unemployment rises to 10% Treasury bonds decrease in value

Objective is to ensure that banks can still function in economic downturns

Volcker Rule

Created with Dodd Frank in 2010 Finally implemented in July 2015

Restricts proprietary trading within major banks

Help to prevent banks from making risky, speculative bets with customer deposits

Still unclear exactly how it will be interpreted and enforced

Basel III Framework

Voluntary international standard for banking regulation Countries can choose whether or not to adopt it

U.S. announced to implement the majority of the framework in 2014

Banks will progressively meet the standards by 2019-2021

Basel III Framework

Three Pillars Pillar one

Capital, risk coverage, containing leverage Pillar two

Risk management and supervision Pillar three

Market discipline

Banks will adhere to varying degrees of compliance standards based on their size

Working Towards a Safer Financial System

Governance and Risk Management

Better Banking Cultures

Recovery and Resolution Planning

Consumer Protection

Consumer Fiscal Responsibility

Governance and Risk Management

Banks primarily have three main lines of defense Front-line units Independent risk management Internal Audit

Front-line units need to become more accountable to regulatory requirements Core of the business More intimate knowledge of operations

Building Better Banking Cultures

Poor reputations – greedy and corrupt Lehman Brothers

Use a top-down approach

Consider new incentive systems

What it will lead to: Banks with strong values worrying more than just if

transactions within the law Better brand images, brand values, and reputations for banks

Recovery and Resolution Planning

Banks are now required to file annual reports to the FRB and FDIC Demonstrates that banks can remain resolved under a

bankruptcy and not cause severe affects on the U.S. economy

All banks are expected to be operationally ready to be resolved by 2017

Banks without acceptable reports are likely to receive higher liquidity and capital requirements

Consumer Protection

The Dodd Frank Act created the Consumer Financial Protection Bureau (CFPB)

Consumer Financial Protection Bureau Actively uses consumer and market data to track consumer

complaints and uses its authority to adopt new laws and increase consequences for certain activities to protect consumers Mortgage lending and credit card lending

New disclosure requirements Created fee limits

CFPB’s current short term goals Enforce actions on pricing discrimination for auto financing

and student loans

Consumer Fiscal Responsibility

Consumers must become more accountable for their role in causing financial crises Become educated on the risks of using newer

technologies and the exposure to risk

Understand debt obligations and budget properly to ensure debts are affordable

If you cannot understand terms of a loan, use the assistance of a lawyer, accountant, or third party financial associate

Conclusion

Banking has evolved significantly over the past century

Newer technologies and innovations lead to newer risks

Financial crises will occur again

Consumers, financial institutions, and the government need to work together to minimize risk and exposure to future financial collapses

References

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