Adham Chehab, professor of finance, presented the findings of his research regarding U.S. banks and their role in the financial crisis of 2007 and 2008 at a faculty lecture on Tuesday in the Executive Dining Room.
In his lecture titled, “U.S. Banks Participation in Credit Derivatives and the Financial Crisis,” Chehab explained to an audience of 20 the type of U.S. bank that participated in the credit derivatives that played a role in the financial crisis 13 years ago.
“The attitude toward credit derivatives changed around the financial crisis. Before the financial crisis they were viewed as a good way for banks to transfer the risk, get rid of it, and just concentrate on creating assets,” Chehab said. “What happened is the appetite for risk kept increasing.”
When banks in the U.S. began considering credit risk management around 20 years ago, they wanted to lower their risk of default, or the probability of the loan going unpaid, Chehab said.
Because of this, banks began to invest in credit derivatives, something Chehab described as a form of insurance where banks could maintain their assets while also removing the risk of default from themselves.
“The risk of somebody not paying back the loan is still there, but with credit derivatives, which work like insurance, the risk is transferred to someone else,” Chehab said. “Banks know that they can keep the loan, keep the revenue and keep the assets but transfer the risk to someone else.”
Through research, Chehab and his colleagues looked at three factors: what type of bank participated in credit derivatives, what determined their level of involvement and what determined whether the bank was a guarantor or seeking guarantee.
They obtained data from every U.S. bank that reported $5 million in any quarter from 1997 to 2017, Chehab said.
What they found was that larger banks with more experience in holding other types of derivatives who habitually involved themselves in holding riskier assets were much more likely to participate in credit derivatives than smaller banks with lesser experience in risky assets and credit derivatives, Chehab said.
Banks holding less capital were also more likely to participate than those with more, he added.
“This would create an opportunity for banks to lend a lot more money… the more lending we have in the economy, the more debt we have in the economy and the faster the economy grows,” Chehab said. “Debt is like food for the economy, but the problem with that is that you need the type of lending that people can pay back otherwise you are not feeding the economy you’re hurting it.”
As banks came to realize they could create more new assets with little to no risk, they began to behave badly, Chehab said.
Banks began to make a larger number of high-risk loans which led to numerous defaults resulting in them making a claim for their assets, however, insurance companies who held the risk began going bankrupt, such as the largest insurance company at the time, ARG, he added.
“Banks were not able to continue lending money because every time they lose an asset an equivalent amount is removed from their capital and when their capital went below the minimum legal requirement, they had to seize operations,” Chehab said.
In 2007, many of the banks making insurance claims were not receiving them, thus triggering the financial crisis as many of the banks failed in response.
Following the lecture, guests were allowed to ask questions, such as senior political science major Jacob Rodriguez.
“In your opinion, would the banks still be able to maintain good behavior themselves without regulation?” Rodriguez asked.
Chehab went on to emphasize that it was not always bad behavior.
Comparing the U.S. with other countries, Chehab stated that in his opinion the U.S. would not have been able to achieve as much as the country has without the opportunity and freedom to experiment.
“We had a problem in 1929, 1987 and we had a problem in 2007,” Chehab said. “We had three problems but in return we’re leading the world in the financial market. It’s worth it in my view.”
Chehab also mentioned that without experimentation and innovation, New York would have never taken over as the biggest financial center in the world in the early 1900s.
“Because you said it was beneficial to have low regulations so the economy can expand, would it then be wise to add more safety nets so that it’ll help prevent or lessen the damage of a financial crisis like this?” Michael Sekera, sophomore physics major, asked.
Credit derivatives were the safety net, but there will always be unintended consequences, Chehab explained.
“It’s like taking a medicine to cure something but the medicine has a side effect that causes something else to go wrong,” Chehab said. “It’s difficult to predict what will happen and regulate against it until you see it happen.”
Jocelyn Arceo can be reached at email@example.com.