Deregulation, liquidity, and loan quality in banking crises since 1980

¶ … Liquidity and Loan Quality: the Impact it is having on Bank Health

Since the 1980's, there has been an emphasis on deregulation within the banking industry. Part of the reason for this, is because of shifts in the economy (thanks in part to globalization) as the markets and products have changed. This has forced many different governments around the world to reduce regulations to include: liquidity and loan quality standards. As a result, the underlying risks at many financial institutions have increased exponentially. In this research project, we will show how these reduced standards have contributed directly to: the financial crisis and stagnant economy. Once this takes place, it will provide the greatest insights as to how these two factors will determine the strengths of different of financial institutions. At which point, we can present specific ideas about how to effectively address these challenges in the future.

Introduction

: Background

Over the last several years, the issues of loan quality and liquidity have been increasingly brought to the forefront. Part of the reason for this, is because the total number of bank failures is currently sitting at 365 financial institutions. According to the FDIC, this amount is expected to increase, with the government taking over 40 banks so far in 2011. This accounts for over $660 billion in assets that the FDIC has seized since the beginning of the financial crisis in 2007. ("FDIC Failed Banks," 2011) This is significant, because it is illustrating how the overall amounts of liquidity and the quality of loans have threatened the economic viability of many institutions.

Further evidence of this can be seen with a study that was conducted by Thies (1993). He determined the total number of bank failures was directly tied to the quality of the loans that were underwritten. As it revealed that between 1921 and 1932, financial institutions began to take on large amounts of risk. This is because, the lack of regulation made it easy for them to create a number of different mortgage products. (Theis, 1993, pp. 109 -- 114) Over the course of time, this meant that the total amounts of loans increased exponentially. However, some of weaker banks began to also reduce their liquidity standards and offered even greater numbers of mortgages. Once the economy began to slow and unemployment was rising; these loans set off a wave of defaults that shook the financial industry. The hardest hit during this time was state banks. This is because they were the institutions that had: the least amounts of liquidity and the highest number of poor quality loans. By the 1932, these risks were having an adverse effect on these entities, setting off a wave of foreclosures. This caused a number of financial institutions to fail leading to: bank runs and a lack of confidence in the system. The only way to deal with the situation was through: the implementation of the New Deal and various financial regulations (such as the Glass Steagall Act along with the Banking Act). (Theis, 2008, pp. 3 -- 4) These different laws are important, because they would place strict regulations on: the kinds of activities banks could become involved in, the quality of loans that they were underwriting and their levels of liquidity.

However, improvements in technology have meant that the kinds of loans and liquidity standards have become less stringent. The reason why, is because many financial institutions are arguing that these Depression era laws are making it difficult for them to compete globally. As a result, these standards and the enforcement of the different regulations were severely reduced. This caused the total quality of mortgages and the levels of liquidity at a variety of financial institutions to decrease. Over the course of time, this would lead directly to the current financial crisis and economic implosion. This is significant, because it is illustrating how the overall amounts of liquidity and the quality of the loans can have a direct impact on the health of variety of financial institutions.

1:2: Hypothesis

The different challenges in the banking sector are indicative of a negative trend that has been occurring since deregulation began during the 1980's. This has lead to series of financial crisis that are based upon same problems most notably: the quality of loans and liquidity. These two factors have been the root causes of: the Savings and Loan Crisis during the 1980's and the recent financial crisis. As a result, they underlying amounts of deregulation have meant that the risks many banks are taking are rising exponentially. Once this begins to occur, it can cause the economy to go through extreme boom and bust cycles. This leads us to introduce the following hypothesis:

The quality of loans that are being underwritten will have a direct impact on liquidity level. The reason why is because, the two different standards will work in conjunction with one another. When you see a reduction in one or both of these policies, it means that the overall risks that banks are taking will increase dramatically. This causes the economy to become unstable, creating extreme boom and bust cycles. To increase stability, the government should introduce strict regulations that will improve loan quality and liquidity standards. This will limit the risks to: the financial sector and improve economic growth / stability over the long-term.

Once we have supported or refuted the hypothesis that has been presented, we will be able to see the impact that loan quality and liquidity are having a wide variety of banks. This will help us to determine if having regulations that will address these areas are effective over the long-term.

1.3: Aims and Objectives

The purpose of this study is to see the total impact that the overall quality of loans and liquidity will have on the viability of different financial institutions. This is significant, because there have been many individuals inside the industry and within the political establishment who are trying water down any kind of attempts to address these issues. The reason why, is they believe that the Federal government and the states are ineffective at tackling these challenges. As, they think that the markets will determine: what kind of standards should be set and the underlying amounts of risks banks are allowed to incur. A good example of this can be seen with comments from Niall Ferguson (an Economics professor at Harvard University) who wrote, "Let us not believe we can abolish both bailouts and depressions, other than by creating another layer of government regulation." ("Criticism of Obama's Financial Reform Plan," 2010) This is important, because it is showing how many of critics of big government will claim that this approach is ineffective.

While at the same time, many proponents of having increased standards for financial institutions believe that this will provide added stability to the financial system. As, these different laws will be able to: create a universal standard that will prevent banks from engaging in activities that will put their businesses at risk. Evidence of this can be seen with comments from President Obama who said, "Unless these reforms are enacted, our house will continue to sit on shifting sands, leaving our families, businesses and the global economy vulnerable to future crises." ("Criticism of Obama's Financial Reform Plan," 2010) This is significant, because it is illustrating how some kind of strict regulations are necessary to prevent the economy from being exposed to the banking sector.

To determine if increased amounts of regulation will address these issues requires looking carefully at: the quality of loans that are being underwritten and the liquidity standards of these institutions. Once this takes place, it will provide specific insights as to if these regulation will improve the stability. This will be accomplished addressing the following aims and objectives.

Aims

To see the impact that the quality of loans had on the banking sector over the last ten years.

To see how liquidity had an effect on the kinds of loans that were being underwritten.

Objectives

To examine the effect that past and current regulations are having on the quality of loans.

To see the long-term impact of different regulations on: liquidity standards.

To understand how loan quality and liquidity are changing.

Once these different aims and objectives have been addressed, we will be able to support or refute the ideas presented in the hypothesis.

1.4: Research Questions

To help effectively focus the research we will use various questions. They will concentrate on how the specific assets of loan quality and liquidity can have an impact on a variety of financial institutions. This leads us to the below research questions:

Is there a positive correlation between liquidity and loan quality?

If the answer is yes, what is the impact that this having on the financial health of banks?

Once these different questions have been answered, they will help to address the specific aims and objectives of the research project. This will support or refute the hypothesis that has been presented.

1.5: Definition of Key Terms

There are several different terms that will be referred to throughout the research project. Below is a list of the most common definitions of these different phrases.

The Glass Steagall Act -- an act of Congress that forbids banks, brokerage firms and insurance companies from becoming involved in each other's business activities.

FIDC -- this stands for the Federal Deposit Insurance Corporation. They have the responsibility for regulating different banks.

The Federal Reserve -- the central bank of the United States. They have the power to set monetary policies for the entire nation.

1.6: Methodology

The method that we will be using to address the different aim and objectives of the study will be empirical investigation. Simply put, this is when you are objectively analyzing the situation, based upon observations vs. any kind of economic or political theory. ("Empirical," 2010) The way that the research will be conducted, is we will examine a variety of different sources in a literature review. This will be accomplished using qualitative and comparative analysis. Qualitative analysis is when you are looking at: numerical, factors, outside information and specific facts about the subject. ("Qualitative Analysis," 2011) While comparative analysis, is when you are contrasting the findings from the research with one another. ("Comparative Analysis," 2011) The basic idea is to be able to: understand the underlying trends that are occurring and how they could be impacting a variety of financial institutions. Once this takes place, it will provide precise information that will support or refute the hypothesis that was presented.

1.7: Summary of the Chapters

The way that the research project will address: the aims / objectives, questions and support / refute the hypothesis is in the preceding chapters. They will discuss specific issues that are relevant to: the quality of the loans and the liquidity for a variety of financial institutions.

The literature review will look at primary and secondary sources about: the loan quality as well as liquidity standards at a number of entities. We will also focus on how the various regulations have been changing these standards. Once this takes place, we can be able to see how the transformation in these regulations is having an impact on these two factors.

The chapter on methodology will compare the different results with one another. This will be accomplished using: empirical investigation, qualitative and comparative analysis. Once this occurs, we can identify the different trends from the literature review. Any kind of anomalies that are discovered will be disregarded. The reason why is because, they are going against the overwhelming trends. Using logic and common sense, these facts are irrelevant, because they are not showing any kind of consistent support of different patterns that are emerging. In order to keep the study as accurate as possible requires ignoring these kinds of facts. Once this occurs, it will provide specific insights about the underlying trends.

The results chapter will discuss the findings of our research and it will analyze how the information that was examined is supporting or refuting the hypothesis. Once we have completed this analysis, we will be able to see the total impact that loan quality and liquidity are having on the financial services industry. This will allow us to make inferences about the effects of government regulations at addressing these issues.

The conclusion will address the findings from the previous chapters and it will provide specific recommendations. This will help with all future research projects by providing basic foundation that can be duplicated and built upon. Once this take place, it means that we can be able to: see how loan quality and liquidity are affecting the financial system. This will help us to determine if government regulation can address the challenges that are facing the financial system.

1.8: Statement of the Study

The purpose of this study is to examine the impact that loan quality and liquidity standards are having on: the health of various financial institutions. This will allow us to understand how this could be influencing, the kinds of decisions that executives are making. At the same time, it will provide insights as to if these standards need to be increased. Once this occurs, it will highlight how these two factors can have an effect on the financial system.

1.9: Limitations of the Study

The limitations of the study are: that we could be focusing on select aspects of banking. This is problematic, because the current state of the financial industry is allowing for new products to be quickly developed. Once this takes place, it means that bankers could begin concentrating on another area that is just as risky. However, no one is fully able to understand these overall risks until it is too late. This may not be reflected in liquidity levels or loan quality. As, these new transactions could be legally allowed to be accounted for in off the books transactions. This is point that the underlying risks to a financial institution can increase, with no one understanding these investments or how much of a company's assets are going into these areas. To avoid these kinds of situations requires having complete transparency. In this aspect, our study could overlook these elements, which can make some of our results not as accurate as they may appear to be.

1.10: Delimitations

The boundaries of our research project will be focused on examining all relevant pieces of literature on the subject and understanding the underlying trends that are occurring. This is designed to help identify what specific issues could be taking place and what can be done to address the problems. Once this occurs, it will provide insights about how this is influencing loan quality and liquidity standards.

US Trust

This information is significant, because it is illustrating how the repeal of the Glass Steagall Act, meant that the size of financial institutions grew dramatically. This is problematic, because it caused different approaches for managing risk to be combined together. Once this occurred, it was only a matter of time until the quality of loans and the liquidity positions at a variety of institutions began to decline. As a result, this helps to corroborate the different aims / objectives, the research questions and it supports the hypothesis that has been presented.

The piece of literature that was written by Lucas (2010), talks about how Fannie Mae and Freddie Mac encountered a number of problems in the mortgages markets. A few of the most notable include: increasing the amounts of risks taken in the portfolio, a lack over oversight and political pressure. What happened was that both of these entities have been working as a major player in the commercial mortgage industry going back to the early 1970's. Their basic function was to create stability in the market by providing a large selection of government backed mortgages. The basic idea was that with the federal government involved in the industry, private institutions were willing to take larger risks in lending money to home buyers. At the same time, the government could help to reduce interest rates and increase the number choices available to consumers. However, there were strict limitations on the kind of loans that both entities could underwrite. The main focus was to find homeowners who demonstrated credit worthiness. This is when a person has decent credit rating, yet they might not be able to save up to 20% of the purchase price of the home for a down payment. Under these programs, someone could qualify for the various mortgages with lower down payments of around 5 to 10%. Yet, anyone who received a mortgage had to show that they could be meet various income and credit requirements to qualify. Until the late 1990's, this basic model allowed these two entities to be able to remain solvent.

Then, there were tremendous amounts of political pressure that was placed on executives and regulators. What was happening, is number of private banks began offering subprime mortgages to borrowers who did not qualify for a traditional mortgages. This could be based upon: them having a poor credit rating, they did not earn enough income or they could not afford the down payment. To address this demand many banks began offering subprime mortgages to these consumers. In most cases, they involved someone paying a higher amount interest, because of some kind of issue that was affecting them qualifying for a traditional mortgage. During the 1990s, low interest rates were encouraging these kinds of loans as way to market mortgages to a new demographic of consumers.

As these kinds of products were increasing in popularity, pressure was placed on both Freddie Mac and Fannie Mae to begin aggressively marketing these kinds of mortgages. At the heart these arguments, was that these programs were designed to address the needs of all consumers. However, many of the current restrictions made achieving this objective impossible. The reason why, is because they forbid both organizations from offering loan products that went beyond traditional lending standards. In the deregulatory environment many executives inside the company and within the government began calling for allowing both organizations to increase the amounts of risks that they were taking in their portfolios. This meant that their liquidity standards declined and the quality of the mortgages that they are underwriting decreased. At the same time, executives in both companies saw the ability to expand into subprime mortgages as a way to dramatically increase their overall profits and become more competitive.

Once the liquidity and loan quality standards were reduced, the two corporations quickly emerged as the largest players in the market. This was accomplished by marketing the various mortgages as receiving the support of the U.S. government. At the same time, they paid higher interest rates that could be adjusted upward with increases in the Federal Funds rate. These two factors made these mortgages attractive to a variety of investors as they were believed to: have lower risks and offered greater rewards.

The deregulation that had been occurring in the industry; meant that new products were being developed to market these securities (the tranche). This is when Wall Street investment bankers pooled all of the different mortgages together. They would then strip out the interest (commonly referred to as coupons) and market them as a basket of securities paying a higher rate. The basic idea with using this approach is that the risks were reduced, because you are spreading out the interest rates and maturities over a variety of different loans. In the event that there was some kind of default, the other mortgages that were a part of the tranche would protect investors against these kinds of risks. This significant, because it is showing how this basic model for marketing these securities caused everyone to: ignore the risks and lower their liquidity standards.

In the case of Fannie Mae and Freddie Mac, this became problematic, as both entities were the largest players in the subprime mortgage market. This increased their risks to: their liquidity positions and it reduced the quality of loans that they were underwriting. In this aspect, one could argue that these standards helped to lead directly to: the liquidity crisis that the two companies faced in 2008. The reason why is because the increased amounts of risks to the portfolio caused the quality of mortgages to decline and it reduced the levels of liquidity. The lack of oversight occurred, with these mortgages being sold in the secondary markets. Where, no one was questioning the fact that various tranches were being marketed as safe investments. When in reality, they had larger amounts of risks than anyone was accounting for. This allowed for these different products to be marketed around the globe to a variety of investors. Once this began to occur, it meant that it would only be a matter of time until interest rates began to consistently increase, with a number of these mortgages going into default. In this aspect, there were no regulations on how these entities were accounting for risks or the basic practices they were using to evaluate returns. The information from this source is useful, because it directly supports the hypothesis. At the same time, it is addressing the aims / objectives and the research question.

Moreover, Kolb (2010) discusses how liquidity is a necessary element in ensuring the continued strength of the financial markets and its institutions. Evidence of the can be seen with the authors observations where he wrote, "During tranquil periods, market illiquidity shocks are typically short lived as they create opportunities for traders to profit and, is doing so to provide liquidity and contribute to the price discovery process. During periods of crisis, however, several mechanisms may amplify liquidity shocks across the financial markets, creating systematic risks." (Kolb, 2010, pp. 502) This is important, because it is illustrating how liquidity is the life blood of all investments and institutions that are supporting them. During times, when liquidity standards are low this will have an adverse impact on the overall bottom line of a variety of banks.

Next, Kolb (2010) talks about how these standards can have an influence on the balance sheet of financial institutions to include: access to commercial paper markets and increased default fears. When liquidity standards are low during times of financial crisis, many companies will having trouble raising additional working capital to cover their short-term expenses. This means that many banks can have billions of dollars worth of mortgages, yet no way to sell them in the open market. Where, they are unable to raise money through a commercial paper offering and cannot turn to other financial institutions for help. Once this occurs, it means that many corporations will have trouble paying their basic expenses (such as: employees' salaries and their monthly bills). This is because of possible fears about the creditworthiness of the borrower. If the bank cannot find any kind cash infusion, they will be forced into liquidation. This is significant, because this information can be used to corroborate the findings from the previous research about liquidity levels. At the same time, it is supporting the hypothesis that was presented.

The piece of literature that was written by Koch (2009), talks about the impact that capital requirements can have on a variety of different banks. This is accomplished by looking at a number of different variables including: asset quality, liquidity, earnings, capital adequacy and market sensitivity to risk. According to Koch, these different elements will work together to have an impact upon the overall strength of the financial institution. As, he believes that the purpose of capital at any bank is to serve three main areas including:

To provide a cushion in the event that the financial institution begins to experience tremendous amount of loan defaults.

To ensure that they have ready access to: alternate sources of funding in the event of run.

To limit growth through: restricting the activities of mortgages trading.

These different elements are important, because if this basic approach can be utilized it will ensure that the financial institution will have enough liquidity to address the various challenges they are facing.

However, Koch (2009) finds that the underlying amounts of capital can have an impact upon growth and the earnings of the bank. What is happening is there is the constant struggle between: regulators and banking executives (who want to increase their earnings as much as possible). The most logical way that they can do this is to use some of their excess liquidity to make additional loans. The problem begins when financial institutions will become close to minimum federal levels for liquidity standards. As, their risks are increasing, because they are financing the activities of the bank based upon: their overall amounts of debt and reducing their working capital. This can have an impact on the quality of loans that are being underwritten. Over the course of time, this will increase the market risks that are facing the financial institution. This is because, they have risen to the point that they cannot adjust to changes due to: the low liquidity levels and high amounts of debt that they are incurring.

Evidence of this can be seen with Koch writing, "The FDIC ranks banks according to the Uniform Financial Institutions Rating System, which encompasses six general categories of performance labeled CAMELS: C = capital adequacy, A = asset quality, M = management quality, E = earnings, L = liquidity and S = sensitivity to market risk. The FIDC numerically ranks every bank on each factor, ranging from the highest quality (1) to the lowest quality (5). It also assigns a complete rating for the banks entire operation. A composite rating of 1 o 2 indicates a financially sound bank, while a ranking of 3, 4 or 5 signifies a problem bank with some near-term potential for failure." (Koch, 2009, pg. 508) This is important, because it is showing how the FDIC will use a rating system that will take into account all of these different factors (when assessing the financial soundness of the institution). Those banks that are coming close to these liquidity levels may be able to get around these requirements based upon their overall score. This can cause the overall quality of assets at the financial institution to decrease. Once this takes place, it means that the risks facing the bank have increased dramatically. As a result, if they can begin focusing on: their asset quality and the total amounts of liquidity. They will be able to reduce the possibility of runs taking place.

The information from this source is useful, because it is identifying specific factors that can have an impact upon the viability of a financial institution. As, the CAMELS system can be utilized to provide an overall assessment. Yet, beyond this ranking system it fails to identify problem areas that could be having an impact upon its liquidity position. Most notably: the overall quality of assets that they have on their balance sheet. This is significant, because it is illustrating how this can have an effect on their profit margins and the overall liquidity position. Once this occurs, it means the odds increase that the bank will be unable to deal with: possible runs and other financial challenges in the future. As a result, the information from this source is useful, because it is identifying specific factors that are contributing to the low levels of liquidity at a variety of financial institutions. This supports the hypothesis, while addressing the specific aims / objectives and research questions that were presented earlier.

The piece of literature that was written by Greer (2007), discusses the impact that CAMELS have been having on the financial industry. As, this has been continually utilized in the past to: address the various challenges that are facing most financial institutions (since the 1980's). The reason why this approach was selected is because it can provide a more balanced view of the underlying strengths of the financial institution. This is due to the fact that it takes into account a number of different elements including: the regulatory, political and economic realities in a particular region. During the 1990's this model was exported to many different developing nations. In this case, this approach was believed to be the most effective, as it was being utilized by a variety of financial institutions in the West. However, this model soon began to have a number of flaws most notably: it over looked specific issues that could be having an effect on the financial services sector. To include: liquidity standards and a reduction in asset quality. This contributed to a number of different financial crises that was seen during the mid to late 1990s. The reason why, is because the different standards ignored the most glaring risks facing the financial system (poor conforming assets and low liquidity levels). This fooled many executives and regulators into believing that the financial system was sound, when in reality it was facing a number of different problems. At which point, it only became a matter of time until a major economic calamity would take place.

Some good examples of this can be seen with this model being used in Latin America and Russia during the 1990s. What happened is that many of the leading Western banks began using these standards as a way of evaluating the financial system. The problems began when they encouraged these banks to take on larger amounts of risk by: offering loans and other forms of easy financing to borrowers. The problem was that many of the banks in these areas were functioning largely independent. At the same time, the various central banks in the different countries did not have the same kind of authority as the Federal Reserve. This made it difficult for analysts to understand the financial activities from one bank to the next. At the same time, they had difficulty comprehending how all of the bank's activities could have an impact on asset quality and liquidity standards. This is because, there was a lack of transparency and many of the various institutions were using complex strategies in the currency markets. Over the course of time, the CAMELS model was unable to understand the underlying risks facing the financial system, leading to a financial crisis in both regions of the world. This is significant because, it shows how the CAMELS system is taking a one size fits all approach when it comes to analyzing the financial soundness of an entity.

As a result, this increases the market risk that these institutions are facing and the changes that they are dealing with from liquidity challenges in the future. This helps to support the ideas presented from the previous source that was discussed. At the same time, it is helping to support the hypothesis by: showing how the loan quality and liquidity standards are an important part of determining risk for all financial institutions.

Moreover, De Brouwer (1999) discusses the impact that use of CAMELS is having on Asian countries. What he found, was that CAMELS were an effective tool in general. However, financial institutions need to have some kind of independent procedure for monitoring the overall quality of loans that are being underwritten. In the case of many Asian countries, they would learn this the hard way with: an overreliance on the CAMEL system. This contributed directly to the financial crisis that took place in 1997. At which point, it caused many different institutions to ignore obvious risks (asset quality and liquidity). Once their currencies begun to plunge in mid-1997, this would set the stage for the crisis and ensuing recession.

According to De Brouwer, there was one main cause that contributed to all of the issues financial institutions were facing most notably: a lack of internal controls. This is problematic, because it would limit any kind of effective communication about: the underlying risks and how they could impact a particular organization. There were several different ways that this could contribute directly to the issues facing an entity. Below are some of the most common that the author found, inside a variety of financial institutions,

A lack of oversight and accountability.

Problems with the reporting standards for different activities of the bank.

An absence of controls to prevent one department from overly influencing the others.

Ineffective communication between the various departments inside the bank.

A lack of leadership at many of these institutions, contributing to an attitude of complacency.

This is important, because it is showing how these different factors can contribute to the atmosphere of increased risk taking at these organizations. In this aspect, one could argue that it was a lack of internal control that would make the underlying amounts of careless worse at financial institutions. This is because it is helping to breed a culture of inefficiency and sloppiness.

Since these events, many financial institutions have begun to impose effective internal controls to: limit the overall amounts of speculation. As, they will rely on the use of the CAMELs model, where is augmented with their own internal controls. The idea behind this strategy is to use the two different procedures to: provide a greater understanding of the overall risks facing a particular institution.

The article that was written by Barth (2002), talks about the impact that of numerous forms of regulations are having on a variety of countries. What happened was they examined the relationship that this model would have: in conjunction with the levels of supervision by central banks. They found, that when there is one strong single entity that is regulating the financial sector, the total of non-conforming loans increases. While, those financial systems that are taking a multi-jurisdictional approach are more effective at ensuring that everyone has high liquidity ratios. This is significant, because it is highlighting how some kind of regulatory structure must be in place that will increase the overall amounts of monitoring.

The information from this source is useful, because it is illustrating how regulators must have dual responsibilities. This will help to ensure that liquidity standards and the quality of loans are improving. As a result, this information helps to support some of the aims and objective by: showing how effective regulations in a dual structure can address the underlying problems facing many institutions.

The piece of literature that was written by Herring (2009), discusses how the total amount of subprime mortgages began to increase between: 2000 and 2008. This is because, the lower amounts of deregulation made it easier to offer a variety of adjustable rate mortgages (ARMs) to homeowners. At the same time, the origination and appraisals were shifted away from the traditional model that was used in the past. In this case, these activities were outsourced to various mortgage brokers. While, those appraisers that had more liberal standards for: valuing investments were often utilized. This allowed many financial institutions to offer these ARMs to a wide variety of investors based upon: the low introductory rate or teaser offer. The motivations of many brokers were to qualify as many people as possible for a mortgage. The easiest way that this could be accomplished was by: using the introductory rate and easy terms to sign up a wide variety of consumers. At the same time, different real estate appraisers, who could offer larger valuations of the property, were most often utilized. This meant that many consumers were lured into purchasing homes with ARMs (that were at the highest appraisal values on the market). Once interest rates began to rise, this meant that many people would not be able to afford the increase in their monthly payments (which helped contribute to a rise in the number of foreclosures).

At the same time, many of these ARMs were marketed to existing homeowners. The basic idea was to have these individuals refinance the equity in their home using an adjustable rate mortgage. This helped to give them a low down payment and they were able to receive a large upfront sum (for utilizing the increased values in their property). For many consumers this made sense, as they could use these funds to make big ticket item purchases or they could invest this amount for retirement. The problem began when interest rates began to rise and many of these homeowners saw their house payments increase exponentially. This lead to: an additional round of foreclosures, which caused the total number of delinquent loans at many banks to increase. Once this began to occur, it meant that the total number of loans that were in default skyrocketed. This resulted in a number of banks seeing their liquidity positions dramatically reduced, due to the total amount of bad loans they had on their balance sheet.

Evidence of this can be seen by looking no further than the total number of ARMs that were on the average bank's balance sheet between 2001 and 2006. As, this number would rise from: 60.5% of their underwriting activity (in 2001) to 70% (in 2006). This is significant, because it is showing how the focus on ARMs would cause many financial institutions to increase their overall risks dramatically. Over the course of time, this would reduce their liquidity position and it would cause the number poor quality loans to increase. Once interest rates were consistently resetting themselves higher, is when many of these organizations would begin to face a variety of financial challenges.

The information from this source is useful, because it is providing specific insights about: the how liquidity and quality of the assets they have on their balance sheet will determine the strength of a financial institution. As a result, this helps to support the finding from the other sources that were discussed earlier. At the same time, it is providing specific insights that are supporting the hypothesis.

Moreover, Mosquera (2010) discusses the effect that repeal of the Glass Steagall Act had on the sector. He found that this was a part of increasing political pressure that the federal government was feeling from lobbyists inside the banking industry. They felt that various laws (such as Glass Steagall) were inhibiting the ability of financial institutions, from creating products that can address the needs of all consumers. At the heart of this philosophy, was extending easy credit to anyone who was willing to seek out a loan. As, many of the different lenders were: offering consumers increased amounts of credit cards and they were using mortgages to lure them into conducting business with a particular financial institution. This was part of an effort to mass market a variety of loans to the general public.

A good example of this can be seen with advertisements that were common during the real estate bubble; promising someone that they could finance 125% of the price of their home. This is troubling, because it is showing how someone can receive more money on the loan than the actual value of the property. Once this began to occur, most consumers assumed that this was a common practice in the industry. This is significant, because it shows the overall extent that many financial institutions were willing to go to market various loans.

At the same time, many banks felt that these kinds of practices were normal. The reason why, is because both Fannie Mae and Freddie Mac were facing increased amounts of pressure to lower their lending standards from the Clinton Administration. This was in response to pressure that they were feeling from the industry about reducing various government regulations. There were also arguments that by: having both Fannie Mae and Freddie Mac embracing such conservative lending standards; that millions of Americans were priced out of the housing market. This lead to calls of: discrimination against minorities and those individuals who are from lower income demographics (based upon these lending standards). As a result, Congress agreed to allow both companies to become actively involved in the underwriting of subprime mortgages.

This is problematic, because it meant that there were increased amounts of risks that were being taken (from: marketing to these borrowers), as these kinds of loans would be seen as normal. Over the course of time, subprime mortgages became very common because of: the low introductory rate and the fact that they offered more money to homeowners. These two factors would help to fuel the increase in demand for these kinds of loans. At the same time, many mortgage brokers and companies inside the industry could increase their earnings dramatically. These factors meant that the total quality assets on the balance sheet began to decline. While, the reduction in various regulations (such as: the Glass Steagall Act) allowed many banks to begin cross marketing these products with very easy terms.

Based upon greed and the desire to receiving as much money as possible, the total number of subprime loans became a major part of all banking activity. Evidence of this can be seen by looking no further than the total number of subprime mortgages that Citigroup was underwriting in 2007. Before the repeal of the Glass Steagall Act, this accounted for 5% of all loans that were being underwritten by the bank. Once these different standards were eliminated, the total amount of subprime loans increased to 30% of all lending activity. This is significant, because it is showing how the lack of regulation would cause the overall amounts of risks that financial institutions were taking to increase dramatically.

The information from this source is useful, because it is providing specific insights about: how reducing the lending standards and regulations would lead to large amounts of speculation. At the same time, it is showing how targeting those social economic groups that did not qualify were a touchy situation (politically speaking). Where, you are discriminating against these them based on the fact that they do not qualify for a mortgage under traditional lending standards. Yet, both Fannie Mae and Freddie Mac were designed to support the interests of all Americans. This lead directly to a shift in: the kinds of loans that they were offering. This caused the overall amount of risks that they were taking in their portfolio to increase exponentially. Once this began to occur, it meant that most mortgage players would see these different activities as normal. At which point, there was less of an emphasis on loan quality standards and liquidity levels. This is significant, because this helps to: support the hypothesis that has been presented and it is also corroborating these fact that were presented earlier.

When you examine all of the information that was studied in this chapter, it is clear that the liquidity and quality of loans that are being underwritten will have a direct impact upon the long-term health of financial institutions. The evidence is overwhelmingly indicating that these standards have been the causes of numerous financial crises that have occurred in the past. In previous decades there were increased efforts to address these challenges by having different laws in place (such as: the Glass Steagall Act). However, various efforts to deregulate the industry and increased amounts of globalization have meant that a variety of financial products have been introduced most notably: the subprime loan. This was marketed as a product that will provide consumers with the financing they need to purchase a home. This allowed many low income families and minorities to be able to purchase various properties vs. renting.

However, these changes also meant that investors were marketed these securities based on: the fact that Fannie Mae or Freddie Mac was the underwriters and they paid higher rates of interest. Once the Federal Reserve began raising interest rates, is when this would become a major issue. As the majority of these homeowners, could no longer afford to stay in their properties. This is when a wave a foreclosures would hit the market and the number of defaults rose exponentially.

Based upon our findings, the majority of financial institutions that were involved with these kinds of transactions were large money center banks. The small / regional banks had: higher liquidity standards and better quality loans due to the lack of access to the financial markets. At the same time, the CAMELS model ignored key issues that could be affecting these financial institutions. When you put these different elements together, they are highlighting that new kinds of underlying trends have emerged after the repeal of the Glass Steagall Act. This caused the amounts of risks facing the financial system to increase exponentially in less than ten years.

Chapter 3: Methodology

Like what was stated previously, the main focus of our study will be through empirical investigation. This is when; we are looking at a variety of different sources and are determining the underlying trends that have been taking place in the industry. Based upon our findings, we have identified a number of different patterns that are emerging. The most notable include: that risks are increasing with large money center banks, the CAMELS model is ineffective at evaluating solvency, the reduction in regulations have allowed for more speculative products to be sold to investors and there is a lack of internal controls at many financial institutions. These different elements are important, because they are showing how: the quality of assets on the balance sheet and liquidity standards will have an impact on the strength of the organization.

The Risks are increasing at Large Money Center Banks

One of the most unusual trends was: the overall risks have been increasing exponentially. Part of the reason for this, is because of the reduction in regulations (i.e. The Glass Steagall Act) has allowed many companies to merge. The basic idea is they want to cross market a variety of products to customers, creating the one stop financial solution. The below table illustrates how the overall amounts of risk facing these organizations have increased in: comparison with small and medium sized entities.

The Types of Loans that was underwritten between 1997 and 2010

All Banks

Large Banks

Med. Banks

Small Banks

Dep. - Assets

.749

.679

.762

.548

Cap. - Assets

.095

.091

.096

.097

Del. Loans

.021

.023

.020

.020

Loan Loss

1.324

1.400

1.270

1.335

Appr. Loans .448

.687

.389

.235

% Return

.274

.257

.274

.298

# of Banks

97

Total Assets

(in millions)

31,392.30

95,956.80

3,605.40

(Kwan, 2010)

This information is significant, because it is showing how the reduced liquidity levels and quality of loans have caused their returns to increase less than smaller banks. While at the same time, they (smaller institutions) have greater quality of assets on their balance sheets. This is significant, because it shows how the reduced regulations have not improved the overall bottom line of large money center banks. Instead, they only thing that has happened is their risks have increased.

The CAMELS Model is Ineffective at Evaluating Solvency

The CAMELS model has been shown to be ineffective at evaluating the various risks facing a financial institution. This is because it is focused, on a number of other factors outside of liquidity and the asset quality. The most notable include: the regulatory, political and economic realities in a particular region. However, these different factors have been shown to ignore, if the underlying risks are increasing. This is problematic, because it allows regulators to assume that a particular bank is stable. Yet, it could be on the verge of a financial meltdown. This is significant, because it is illustrating how the wide spread use of this model has been shown to contribute to a number of financial crises in the past.

The Reduction in Regulations have Allowed for more Speculative Products to be Sold to Investors

The reduction in regulations has allowed more speculative products to be sold to investors to include: subprime mortgages. This is important, because these kinds of loans were marketed to homeowners as an easy way for them to receive the largest amounts of financing. At the same time, investors were sold these securities as a safer investment with higher rates of return. These two factors were naturally appealing to most individuals, which enticed them to accept these kinds of mortgages over all of the others.

While, Freddie Mac and Fannie Mae were feeling increasing amounts of pressure to begin underwriting these different mortgages. Once this took place, it meant that these activities appeared to be normal. Yet, in reality all of the different financial institutions were increasing their overall amounts of risk dramatically. In this aspect, the reduce amounts of regulations allowed homeowners and financial institutions to increase their levels of speculation dramatically. This is significant, because it is showing how changes in the underlying trends would have a dramatic impact upon the kinds of loans that were being underwritten and the liquidity standards at a variety of institutions. This is the point, that the entire system would be exposed to incremental changes in the Federal Funds rate.

There is a Lack of Internal Controls at Many Financial Institutions

The lack of internal controls at many of the different financial institutions meant that they would face increased amounts risk. This is because the various regulations that were eliminated reduced the amounts of segregation that occurred inside the different departments of large financial institutions. Over the course of time, this would prevent various divisions from exercising undue amounts of influence. However, once these laws were eliminated this allowed banks to coordinate on various offerings. This is the point that certain departments would have more influence over others within the bank (such as: Marketing having more of a voice in comparison with Compliance). Once this began to occur, it meant that there would be a lack of internal controls inside various financial institutions. Over the course of time, the reduced the underlying amounts of liquidity and increased their exposure to various changes in the industry. This is significant, because it is illustrating how this trend would contribute directly to financial crisis and subsequent bailout.

When you step back and look at these different trends, it is clear that they are showing how the reductions in: liquidity standards and the quality of loans are having a dramatic effect on the strength of financial institutions. This is problematic, because it means that until these kinds of issues are addressed, the underlying trends will continue and the sector will face a number of challenges. In many ways, one could argue that this is a similar situation that occurred prior to the implementation of the New Deal. Therefore, until some kind of effective action is taken to address these issues, the various patterns will continue for the foreseeable future.

Chapter 4: Results

When you examine the different results of research, it is clear that the evidence is supporting the hypothesis. At the same time, it has answered all of the different aims / objectives and research questions. This is important, because it is illustrating how the total amounts of loan quality standards and liquidity will have a dramatic impact upon all financial institutions.

The reason why, is due to the fact that globalization and technology have improved the ability to offer products all over the world. This means that there will be increasing amounts of pressure for all financial institutions to become increasingly competitive. The basic idea is to create a one stop shop for a variety of financial services. During the process of creating these kinds of institutions, this has meant that different regulations have been repealed (the most notable include: the Glass Steagall Act).

This Depression era law provided stability to the financial services industry by: preventing the banks, brokerage firms and insurance companies from becoming involved in each other's businesses. Over the course of 65 years, this would provide stability to the sector by: limiting the amounts of speculation that banks were allowed to engage in. At the same time, it set high limits for liquidity ratios within numerous entities. These two factors meant that the economy and financial system would avoid any kind of major meltdown.

However, once the Glass Steagall Act was repealed, this would set the stage for a period of unprecedented consolidation. In this case, the various financial institutions were interested in creating large money center banks. Their objectives were to offer a variety of different products to large demographics of consumers. At the heart of their basic philosophy was to create different financial solutions for each individual. Once a customer is doing business with a particular company, they can be able to address all of their needs by selling them a variety of products to include: investments, loans and insurance.

However, the problem with using this model is that it did not address the needs of the customer. Instead, this was designed to maximize the underlying profit margins of these large banks as much as possible. This meant that a culture of increasing the overall bottom line at all costs quickly developed. Once this occurred, a variety of financial institutions were overlooking some of the most basic fundamentals when selling customers their riskiest products (loans). To include: no verification of income, they did not discuss the risks of different loans and they offered more than the value of the property. These different factors would set the stage for greed run amok. As bank executives wanted to increase their overall bottom line at all cost. This meant that they dramatically reduced their lending standards and liquidity ratios. Once this took place their earnings and risks increased exponentially.

Two of the main causes for this, is that the repeal of the Glass Steagall Act allowed for a lack of internal controls to exist inside a number of institutions. Over the course of time, this gave certain departments (within a financial institution) greater amounts of influence over the others. Once this occurs, it means that various standards in accounting for risks are often ignored, as part of an effort to increase the profit margins of the company. This is significant, because this lack of internal controls allows banks to be able to reduce their asset quality and liquidity levels.

At the same time, the CAMELS standard was believed to be an effective tool for understanding the challenges facing a financial institution. This is because many economists think that this model; looked at a number of different variables that could have an impact upon a bank. To include: the regulatory, political and economic realities in a particular region. These different factors are important, because they are illustrating how a change took place in the views of regulators and executives. As, everyone believed that this system was: letting them know the overall amounts of risk facing an entity. Yet, beneath the surface this failed to accurately account for: the decreasing liquidity standards and asset quality. This is the point that the financial system was exposed to sudden shocks. Once this occurs, it means that the troubles of one major financial institution will have a dramatic impact upon the entire system. This is exactly what happened in September 2008, when Lehman Brothers filed for bankruptcy and it appeared as if a variety of companies were on the verge of following suit including: AIG, Citigroup, Wachovia, Countrywide, Merrill Lynch, Goldman Sachs and Morgan Stanley. (Mosquera, 2010)

It is also important to note, that with Fannie Mae and Freddie Mac aggressively selling subprime mortgages. They set lower standards for asset quality and liquidity. This is because, many executives believed that if these levels were not a problem for the government backed mortgage providers, then they were fairly conservative levels. Over the course of time, this would help to build upon the belief that these lower standards were helping to protect a host of different banks. When in reality, they are increasing the overall amounts of risks that they were facing.

At the same time, many of these subprime mortgages were marketed to investors as one way to: reduce their risks and increase their returns. This is because, the government backed subprime loans, were providing some kind of guarantee. While, the adjustable interest rates meant, that they would be able realize higher returns. This caused many individuals and institutional investors to assume that the underlying amounts of risks were reduced. When in reality, they were increased exponentially.

As a result, the various findings are indicating that there is a clear link between: the strength of a financial organization, its liquidity standards and asset quality. These different factors will determine the overall amounts of risks that are being taken and if they are able to withstand various events. In the case of the banking sector, the reduction in regulations has meant that the amounts of speculation increased dramatically. This is important, because it is showing how this contributed to increased profits and the total number of loans that were on the balance sheet. The CAMELS model increased the amounts of confusion, because it did not tackle the issues of liquidity and loan standards head on. Instead, it looked at other factors that could have an effect on their balance sheet. This reduced the importance of these variables. Once this occurred, it meant that no one was aware of the systemic risk that was facing the industry in 2007. This is significant, because the information that was examined is supporting the hypothesis that was presented. Therefore, regulators need to create new standards to address these challenges in the future.

Chapter 5: Conclusion

Clearly, there is direct link between: the quality of loans and liquidity standards to the underlying strengths of financial institutions. As, these two factors will work in conjunction with each other to determine how well a bank can be able to withstand the various challenges that they are facing. This is important, because it shows how this must be a focus for any kind of models that are examining the fiscal soundness of different organizations.

However, there has been a shift away from these various policies. The reason why is because, globalization has been having a dramatic impact upon the way these institutions are competing with one another. This means that a shift has taken place in the kinds of products that are sold and the focus of banking executives. At which point, various regulations addressing these issues have been reduced and a number of financial institutions are allowed to merge together. Over the last ten years, this has created a situation where many of these banks have become too big to fail. As, they have tremendous amounts assets on: their books and are vital for ensuring that all economic activity will continue. This is troubling, because it means that there is lack of internal controls and no focus on reducing risks. Instead, there is an emphasis on: increasing the overall profits and diversifying the kinds of products they are offering. This has caused the liquidity standards and quality of assets to decline dramatically. At the same time, the active involvement of Fannie Mae and Freddie Mac in these areas made everything seem normal. As, these entities were backed by: the U.S. government and they were following the same basic standards. This meant that any kinds of focus on possible risks to financial system were quickly discounted. Once this began to occur, it meant that it was only a matter of time until a major financial implosion would take place.

As none of the tools, were effectively evaluating risks that were facing investors and regulators. Evidence of this can be seen by looking no further than the CAMELS model that was utilized to: determine the financial strength of banks. On the surface this would appear to be a general tool. However, when you look beneath the system some kind of change needs to take place in the tools that are being used. The reason why, is because they are missing critical early warning factors about possible dangers. This is problematic, because it makes regulators ineffective at: responding to various threats and it increases the risks to the financial system.

When you put these different tools together, they are illustrating the overall challenges facing the financial system and the importance of liquidity as well as loan quality standards. Until these issues can be addressed in the future, the system will go from one bad situation to the next. As, there will be: extreme periods of boom and bust cycles that will develop in the economy. Once this occurs, it means that many of various regulations will be reactionary to the changes that have taken place. Recent evidence of this can be seen by looking no further than, the Savings and Loan Crisis of the 1980's along with the recent financial crisis that was triggered by these events. The only difference is that the overall scope of the problem is more severe with: these issues. Therefore, it is imperative that the government impose conservative lending standards and loan practices that will support the long-term health of the sector.

Recommendations

The most obvious change that needs to take place is that there needs to be some kind of regulations that will address the liquidity standards and asset quality of these institutions. This means that some kind of new financial regulations must be implemented that will limit their size and scrutinize these different activities. There has been an attempt by the U.S. government to deal with these challenges. The most notable example of this can be seen with the passage of the Dodd -- Frank Wall Street Reform and Consumer Protection Act. This created a new consumer agency that had the authority to oversee these large money center banks. As, they have a number of different powers including: the ability to reduce the size of financial institutions, limit the kinds of transactions they can become involved in and increase amounts of disclosures that they have to make. ("The Dodd Frank Act," 2011)

While this is a good first start, the reality is that the different rules and regulations are being enacted; could be watered down to benefit the industry. If this happens, then it means the overall effectiveness of the law will be dramatically reduced. On the other hand, if they are able to increase the kinds of liquidity standards and the types of assets these banks are allowed to own this will reduce the risks to the system. The key going forward will depend upon: the kind of rules that are being proposed and how they are enacted by the new consumer protection agency.

At the same time, some kind of effective internal controls must be established at all banks. This could occur with the FDIC raising the limits on: liquidity standards and they can restrict the amounts of risky assets to a certain percentage of the balance sheet. This would quietly impose new regulations behind the scenes on these different institutions. Once this occurs, it could work in conjunction with the Dodd -- Frank Wall Street Reform and Consumer Protection Act.

If this kind of an approach was taken, it will ensure that the overall risks facing the financial system are dramatically reduced. This is point that many of these banks can begin functioning at a level that will safely provide them with increasing profits. At the same time, it will not have any kind of adverse effect on: their liquidity or the assets they own. In the event that there is some kind crisis, this will protect the bank against sudden financial crunches and possible runs. This is when they will be able to adapt to the various challenges that they are facing.

As a result, these recommendations are illustrating how important liquidity and the quality of assets are in protecting the fiscal foundation for all banks. The real challenge going forward will be: how quickly these kinds of shifts can be implemented and the overall scope them. If this can occur, it will protect the financial sector from future credit crunches. However, if these kinds of regulations are watered down, then the overall impact that they have will be limited.

Therefore, the only time will tell if these kinds of changes can be effective. This is because there have been improvements to the law. Yet, many lobbyists will try to reduce the impact that these regulations are having on banks as much as possible. In many ways, one could argue that this will determine the risks to the financial system in the future and how they will be looked at.

Appendix

The Types of Loans that was underwritten between 1997 and 2010

All Banks

Large Banks

Med. Banks

Small Banks

Dep. - Assets

.749

.679

.762

.548

Cap. - Assets

.095

.091

.096

.097

Del. Loans

.021

.023

.020

.020

Loan Loss

1.324

1.400

1.270

1.335

Appr. Loans .448

.687

.389

.235

% Return

.274

.257

.274

.298

# of Banks

97

Total Assets

(in millions)

31,392.30

95,956.80

3,605.40

(Kwan, 2010)

Mergers and Acquisitions that occurred after the Repeal of the Glass Steagall Act

Year Merger Closed

Purchasing Company

Acquired Bank

1998

Citicorp

Traveler Group

1999

Fleet

Bank of Boston

1999

Duetsch Bank

Bankers Trust

1999

HSBC

Republic Bank Corp.

1999

AmSouth

First American National

2000

Chase

JP Morgan

2000

Washington Mutual

Bank United

2000

UBS

Paine Webber

2001

Firstar

US Bank

2001

First Union

Wachovia

2001

Fleet Boston

Summit Bank Corp

2002

HSBC

Household International

2004

Bank America

Fleet Boston

2004

JP Morgan

Bank One

2004

Sun Trust

National Commerce

2004

Wachovia

Sun Trust

2005

PNC Bank

Riggs Bank

2005

Bank of America

MBNA Financial

2006

Capital One

Northfork Bank

2006

Wachovia

Golden West Financial

2007

Bank America

LaSalle Bank

2007

Bank of New York

Mellon Financial

2007

Bank America

US Trust

(Russell, 2008)