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The Central Bank’s point of view over the sub-prime causes

Written by A Forex View From Afar on Thursday, June 19, 2008

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The following text is taken from the Swiss National Bank Financial Stability Report. It comprehends the actual causes that led to the sub-prime crisis from a Central Bank point of view. Practically, this report opens a door for every retail trader and investor on how a crisis is seen from the top. This article includes only the causes that led to the sub-prime. Soon, an article regarding the possible solutions will appear. Stay tuned.

The current financial turmoil is probably the most severe of the past few decades. Lessons need to be drawn from this crisis, in order to enhance the resilience of the Swiss banking sector as a whole. This also applies to the Swiss National Bank (SNB), since it has a legal mandate to contribute to the stability of the financial system. In this text, the SNB first summarises the causes and catalysts of the current crisis, and then describes the most important lessons from its perspective.

The causes: high risk appetite and misjudgments

The crisis was rooted in an increasingly high risk appetite on the part of market participants. The current financial turmoil was preceded by a long period of stable macroeconomic conditions and high liquidity. Against such a favorable background, many investors took on ever greater risks, as evidenced by the low level of risk premia observed in many markets. Another indication of the greater appetite for risk was the unusually high rates of growth in trading and lending activities. With hindsight, certain risks were clearly underestimated. This led to developments in individual markets which have now been revealed as excesses– inter alia on the US real estate market.

Three catalysts of the crisis

The disruptions on the US real estate market that led to such severe international market turbulence were a result of three key factors.

First, the high leverage of large international banks proved to be a source of vulnerability. As a rule, these banks hold relatively low levels of capital compared to their total assets. This applies in particular to the Swiss big banks: over the last few years, they have steadily expanded their business activities without making a concomitant increase in their capital. Thus in this crisis, for some large international banks, losses that were small in comparison to their balance sheets depleted a significant portion of their capital. As a consequence, they had to resort to recapitalisation measures. 

Second, the limitations of risk management have become clear. In particular, in the current crisis, it has become evident that banks have failed to give sufficient consideration to the risks of extreme events. In the area of market risk, events occurred which, in the models being used, should not have been possible (or at least would have been considered extremely unlikely). Likewise, with regard to liquidity risk, many market participants have not taken a sufficiently conservative approach when setting the size
of their liquidity cushions. 

Third, the lack of transparency turned out to be a handicap. For outsiders, the business conducted by large international banks represents, in many ways, a black box. Generally speaking, banks do not disclose enough information about their risk positions and have difficulty providing comprehensible assessments of their risks. Consequently, market participants had problems gauging the creditworthiness of their counterparties quickly and with sufficient accuracy during the turmoil. The lack of transparency combined with the high leverage proved to be a dangerous mix.
It was a cocktail that, from the market’s perspective, cast doubt on the solvency of a number of banks. It resulted in a sustained crisis of confidence on the interbank market such as had never been experienced before.

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