Question

In 2008-2009, during the Great Recession, banks found themselves with too little capital and many became insolvent. Briefly explain why this occurred. Make sure you use proper terminology and support your answer by commenting on the changes in banks' assets, liabilities, and capital that occurred during that time.

Note: if you choose Option 1, make sure that a thorough explanation is provided regarding changes in the banks' liabilities and particularly assets and capital. The DQ will be graded according to the degree of detail, supportive statements provided, and usage of course material to tackle the DQ.

Answer 1

The 2008 financial crisis affected the banking sector by causing banks to lose money on mortgage defaults ,freezing of interbank lending,and drying up of credit to customers and businesses.A decline in lending activity by finacial institutions due to shortage of funds led to credit crunch.A credit crunch does not allow companies to borrow as lenders are apprehensive about defaults and this results in higher rates.The financial crisis greatly increased the size of central bank balance sheet in the world.The most important change on the liability side of the central banks balance sheet was big building up of reserves in the banking system.During the crisis the central banks provided loans to banks with the need of lending financial stability.This increased the liquidity of banks by increasing the amount of reserves. This increase in reserves became so large that it exceeded the demand of the banks .So measures were taken by central bank to limit the increase in reserves.Later quantitative easing was taken by central banks to boost the economy.Large scale asset purchase program increased. This increased reserves substantially. Asset purchases can stimulate the economy by reducing credit , liquidity risk premiums and lowering exchange rate.The majority of assets purchased were government bonds .So the dominant change in central bank balance sheet during the crisis was increased lending to banks,but asset purchases led to changes in asset holdings .These changes increased central bank's balance sheet ,and increased the stock of capital , which is a  component of money supply.