The financial crisis of 2008 had both short- and long-term effects on the banking sector. It affected the sector over the short term by causing banks to lose money on mortgage defaults, interbank lending to freeze, and credit to consumers and businesses to dry up. For the longer term, the financial crisis spawned new regulatory actions internationally through Basel III and in the United States through the Dodd-Frank Wall Street Reform and Consumer Protection Act. Let's take a look at how this all came about.
Key Takeaways
- Measures taken after the financial crisis were designed to both protect banks and their members.
- Some of the major effects on banks were centered on debt management, allowance, and available funds on hand.
- The Dodd-Frank Act was passed in 2010 ensures that banks are held to a high standard of liquidity and available assets in order to mitigate risk.
- Some financial experts believe the act to be too stringent, and have since attempted to repeal it.
Prior to the Crisis
U.S. regulations pressured the banking industry to allow more consumers to buy homes well before the financial crisis hit in 2008. In 2004, Fannie Mae and Freddie Mac purchased huge numbers of mortgage assets, including risky Alt-A mortgages. They charged exorbitant fees and received high margins from these subprime mortgages,, They also used these mortgages as collateral to get private-label mortgage-based securities (MBSs).
Many foreign banks bought collateralized U.S. debt as subprime mortgage loans were bundled into collateralized debt obligations (CDOs) and sold to financial institutions around the world.
When increasing numbers of U.S. consumers defaulted on their mortgage loans, U.S. banks lost money on the loans, and so did banks in other countries. Banks stopped lending to each other, and it became tougher for consumers and businesses to get credit.
After the Global Financial Crisis
With the U.S. falling into a recession, the demand for imported goods plummeted, helping to spur a global recession. Confidence in the economy took a nosedive and so did share prices on global stock exchanges.
Hoping to avert another financial crisis, the International Basel Committee introduced a set of proposals for new capital and liquidity standards for the global banking sector in December 2009. The reforms, known as Basel III, were passed by the G20 in November 2010. The committee left it up to member nations to implement the standards in their own countries.
A banking crisis is generally brought on when one or more banks fail or because of external shocks. The crisis is characterized by problems in liquidity or solvency with many banks at the same time.
The Dodd-Frank Act
The U.S. government passed the Dodd-Frank Act in 2010. Under the law, bank-holding companies with consolidated assets over a certain amount must abide by stringent capital and liquidity standards. Dodd-Frank also set new restrictions on incentive compensation.
Originally set at $50 billion, the threshold for consolidated assets required by banks was raised to $250 billion after the Economic Growth, Regulatory Relief, and Consumer Protection Act was passed in 2018. However, according to the Federal Reserve, banks "with $100 billion or more in total consolidated assets are subject to the Board's stress tests, with larger banks required to participate annually, and banks with $100 to $250 billion in total assets required to participate every other year."
The legislation also created the Financial Stability Oversight Council, to include the Federal Reserve Bank and other agencies for the purpose of coordinating the regulation of larger, "systemically important" banks. The council can break up large banks that might present a risk because of their size. A new Orderly Liquidation Fund was established to provide financial assistance for the liquidation of large financial institutions that fall into trouble.
Some critics charge that the 2010 law is a greatly weakened version of the bill originally envisioned by former President Barack Obama, watered down during its development through legislative and lobbyist maneuvering.
But the ultimate impact of the financial crisis continues to unfold. For example, there are more than 90 provisions in the Act that require rulemaking by the U.S. Securities and Exchange Commission (SEC), along with dozens of others where the SEC has the discretionary rule-making authority. The SEC has adopted final rules for 67 mandatory rule-making provisions of the Dodd-Frank Act.
Rules are also in place to bring more transparency to the swap fund and hedge fund markets, to give investors a say over executive compensation, and to set up a whistleblower program for securities law violations.
Advisor Insight
Arie Korving, CFP®
Korving & Company LLC, Suffolk, VA
The financial crisis that began in 2008 decimated the banking sector. A number of banks went under, others had to be bailed out by governments and still others were forced into mergers with stronger partners. The common stocks of banks got crushed, their preferred stocks were also crushed, dividends were slashed and lots of investors lost part or all of their money.
The reasons for this were more complex than generally realized. The simple answer was that it came about because the housing bubble burst, but that’s the surface of the problem. Part of the problem was a liquidity issue due to “mark to market” accounting required by the government and part was the number of bad mortgage loans banks held on their books. The lesson for shareholders is to diversify. Unfortunately, many people had much of their investments in bank stocks because they were paying such high dividends.
How Resilient Is the U.S. Banking Sector?
The U.S. banking sector is strong and safe, according to a report from the American Bankers Association. Even with the economic uncertainty surrounding high inflation, the COVID-19 pandemic, and Russia's invasion of Ukraine, capital levels are high and liquidity levels remain positive.
How Big Is the U.S. Banking System?
The U.S. banking system is one of the largest in the world. As a whole, the finance and insurance industry made up 8.3% of total U.S. GDP in 2020. That's a total of $1.7trillion,
Which Country Has the Largest Banking System?
China has the largest banking system in the world. This is followed by the United States and Japan. Four of the world's largest banks are based in China. These are the Industrial and Commercial Bank of China, the China Construction Bank, the Agricultural Bank of China, and the Bank of China. The fifth- and sixth-largest are based in the United States (JPMorgan Chase and Bank of America). Japan's Mitsubishi UFJ Financial Group takes the seventh spot.
The Bottom Line
The U.S. banking industry is one of the largest and most important in the world. But it wasn't immune to the financial crisis that brought on the Great Recession. Lax regulations and lending standards led to the collapse of several institutions while others lost billions in value, causing a ripple effect throughout the national economy as well as global markets. When the dust settled, the world learned a valuable lesson. New laws, standards, and regulations are safeguarding the financial sector.
Correction—Aug. 29, 2023: A previous version of this article misstated the minimum threshold set by the Dodd-Frank Act as $50 million in assets. The article was corrected to show the correct amount of $50 billion.
I'm a seasoned financial expert with a deep understanding of the intricate details of the banking sector, particularly in the context of the 2008 financial crisis. My expertise extends to the regulatory landscape that emerged post-crisis, including Basel III and the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Now, let's delve into the concepts covered in the provided article:
Short-Term Effects of the 2008 Financial Crisis:
- Mortgage Defaults: The crisis led to significant losses for banks as a result of widespread mortgage defaults.
- Interbank Lending Freeze: Banks stopped lending to each other, causing a freeze in interbank lending.
- Credit Drying Up: Consumers and businesses faced difficulties in obtaining credit as a consequence of the crisis.
Long-Term Regulatory Actions:
- Basel III: Introduced internationally by the International Basel Committee, Basel III set new capital and liquidity standards for the global banking sector. G20 passed these reforms in November 2010.
- Dodd-Frank Act: Enacted in the United States in 2010, this act imposed stringent capital and liquidity standards on banks, aiming to mitigate risks. It also introduced new restrictions on incentive compensation.
Dodd-Frank Act Details:
- Capital and Liquidity Standards: Banks with consolidated assets above a certain threshold must adhere to strict capital and liquidity standards.
- Incentive Compensation Restrictions: The Dodd-Frank Act placed restrictions on incentive compensation within the banking industry.
- Financial Stability Oversight Council: Created to coordinate the regulation of larger, "systemically important" banks and the authority to break up such banks.
- Orderly Liquidation Fund: Established to provide financial assistance for the liquidation of large financial institutions facing trouble.
Criticisms and Impact:
- Criticism of Dodd-Frank: Some financial experts find the Dodd-Frank Act too stringent, and there have been attempts to repeal it.
- Evolution of the Act: The article highlights that the 2010 law may have undergone changes, leading to a weakened version from its original conception.
- Ongoing Impact: More than 90 provisions in the Dodd-Frank Act require rulemaking by the U.S. Securities and Exchange Commission (SEC), showcasing its ongoing impact.
Expert Commentary:
Arie Korving, a Certified Financial Planner, provides valuable insight into the depth of the financial crisis's impact on the banking sector. He emphasizes the complexity of the issue, attributing the crisis to factors beyond the bursting housing bubble and advising shareholders to diversify.
Current Status of the U.S. Banking Sector:
The U.S. banking sector is reported to be strong and safe, with high capital and liquidity levels, even amidst economic uncertainties like inflation, the COVID-19 pandemic, and geopolitical events.
Additional Banking Sector Information:
- U.S. Banking System Size: The U.S. banking system is one of the largest globally, constituting 8.3% of the total U.S. GDP in 2020, totaling $1.7 trillion.
- Global Banking Systems: China has the world's largest banking system, followed by the United States and Japan.
In conclusion, the 2008 financial crisis left a lasting impact on the banking sector, prompting significant regulatory changes globally and in the U.S. through Basel III and the Dodd-Frank Act, respectively. The article provides a comprehensive overview of the crisis, regulatory responses, and ongoing effects on the banking industry.
