Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual

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Chapter One
Why Are Financial Institutions Special?
Learning Objectives
LO1: Discuss the special functions that financial institutions provide.
LO2: Illustrate how financial institutions act as brokers and asset transformers.
LO3: Explain the types of regulations that are applied to financial institutions as a result of their
specialness.
LO4: Discuss the impact of the financial crisis on financial institutions.
LO5: Discuss the actions taken by governments to support the financial system during the
financial crisis.
Chapter Outline
Introduction
Financial Institutions’ Specialness
• FIs Function as Brokers
• FIs Function as Asset Transformers
• Information Costs
• Liquidity and Price Risk
• Other Special Services
Other Aspects of Specialness
• The Transmission of Monetary Policy
• Credit Allocation
• Intergenerational Wealth Transfers or Time Intermediation
• Payment Services
• Denomination Intermediation
Specialness and Regulation
• Safety and Soundness Regulation
• Monetary Policy Regulation
• Credit Allocation Regulation
• Consumer Protection Regulation
• Investor Protection Regulation
• Entry Regulation
The Changing Dynamics of Specialness
• Trends in Canada
• Risk Measurement and the Financial Crisis
• Global Issues
Appendix 1A The Financial Crisis: The Failure of Financial Services Institution Specialness

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Internet Exercise
Go to the website of the Office of the Superintendent of Financial Institutions (OSFI) at
http://www.osfi-bsif.gc.ca/ and compare the reports of the different types of FIs that OSFI
regulates. Click on “Financial Institutions” to see the drop-down menu. Under the heading,
“View Institutions”, click on “Financial Data”. Scroll down and click on “Banks.” Click on
“Submit” to download the latest Consolidated Balance Sheet. Repeat the process for the other
regulated FIs that are listed.
Solutions for End-of-Chapter Questions and Problems: Chapter One
1. What are five risks common to all FIs?
Default or credit risk of assets, interest rate risk caused by maturity mismatches between assets
and liabilities, liability withdrawal or liquidity risk, underwriting risk, and operating risks.
2. Explain how economic transactions between household savers of funds and corporate users
of funds would occur in a world without FIs.
In a world without FIs the users of corporate funds in the economy would have to directly
approach the household savers of funds in order to satisfy their borrowing needs. This process
would be extremely costly because of the up-front information costs faced by potential lenders.
Cost inefficiencies would arise with the identification of potential borrowers, the pooling of
small savings into loans of sufficient size to finance corporate activities, and the assessment of
risk and investment opportunities. Moreover, lenders would have to monitor the activities of
borrowers over each loan's life span. The net result would be an imperfect allocation of resources
in an economy.
3. Identify and explain three economic disincentives that probably would dampen the flow of
funds between household savers of funds and corporate users of funds in an economic
world without FIs.
Investors generally are averse to directly purchasing securities because of (a) monitoring costs,
(b) liquidity costs, and (c) price risk. Monitoring the activities of borrowers requires extensive
time, expense, and expertise. As a result, households would prefer to leave this activity to others,
and by definition, the resulting lack of monitoring would increase the riskiness of investing in
corporate debt and equity markets. The long-term nature of corporate equity and debt securities
would likely eliminate at least a portion of those households willing to lend money, as the
preference of many for near-cash liquidity would dominate the extra returns which may be
available. Finally, the price risk of transactions on the secondary markets would increase without
the information flows and services generated by high volume.
4. Identify and explain the two functions in which FIs may specialize that would enable the
smooth flow of funds from household savers to corporate users.

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FIs serve as conduits between users and savers of funds by providing a brokerage function and
by engaging in an asset transformation function. The brokerage function can benefit both savers
and users of funds and can vary according to the firm. FIs may provide only transaction services,
such as discount brokerages, or they also may offer advisory services which help reduce
information costs, such as full-line firms like BMO Financial Group. The asset transformation
function is accomplished by issuing their own securities, such as deposits and insurance policies
that are more attractive to household savers, and using the proceeds to purchase the primary
securities of corporations. Thus, FIs take on the costs associated with the purchase of securities.
5. In what sense are the financial claims of FIs considered secondary securities, while the
financial claims of commercial corporations are considered primary securities? How does
the transformation process, or intermediation, reduce the risk, or economic disincentives, to
the savers?
Funds raised by the financial claims issued by commercial corporations are used to invest in real
assets. These financial claims, which are considered primary securities, are purchased by FIs
whose financial claims therefore are considered secondary securities. Savers who invest in the
financial claims of FIs are indirectly investing in the primary securities of commercial
corporations. However, the information gathering and evaluation expenses, monitoring expenses,
liquidity costs, and price risk of placing the investments directly with the commercial corporation
are reduced because of the efficiencies of the FI.
6. Explain how FIs act as delegated monitors. What secondary benefits often accrue to the
entire financial system because of this monitoring process?
By putting excess funds into FIs, individual investors give to the FIs the responsibility of
deciding who should receive the money and of ensuring that the money is utilized properly by
the borrower. In this sense the depositors have delegated the FI to act as a monitor on their
behalf. Further, the FI can collect information more efficiently than individual investors. The FI
can utilize this information to create new products, such as business loans, that continually
update the information pool. This more frequent monitoring process sends important
informational signals to other participants in the market, a process that reduces information
imperfection and asymmetry between the ultimate sources and users of funds in the economy.
7. What are five general areas of FI specialness that are caused by providing various services
to sectors of the economy?
First, FIs collect and process information more efficiently than individual savers. Second, FIs
provide secondary claims to household savers which often have better liquidity characteristics
than primary securities such as equities and bonds. Third, by diversifying the asset base FIs
provide secondary securities with lower price-risk conditions than primary securities. Fourth, FIs
provide economies of scale in transaction costs because assets are purchased in larger amounts.
Finally, FIs provide maturity intermediation to the economy which allows the introduction of
additional types of investment contracts, such as mortgage loans, that are financed with short-
term deposits.

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8. What are agency costs? How do FIs solve the information and related agency costs when
household savers invest directly in securities issued by corporations?
Agency costs occur when owners or managers take actions that are not in the best interests of the
equity investor or lender. These costs typically result from the failure to adequately monitor the
activities of the borrower. If no other lender performs these tasks, the lender is subject to agency
costs as the firm may not satisfy the covenants in the lending agreement. Because the FI invests
the funds of many small savers, the FI has a greater incentive to collect information and monitor
the activities of the borrower.
9. How do large FIs solve the problem of high information collection costs for lenders,
borrowers, and financial markets?
One way financial institutions solve this problem is that they develop secondary securities that
allow for improvements in the monitoring process. An example is the bank loan that is renewed
more quickly than long-term bond debt. The renewal process for loans updates the financial and
operating information of the borrowing firm more frequently, thereby reducing the need for
restrictive bond covenants that may be difficult and costly to implement.
10. How do FIs alleviate the problem of liquidity risk faced by investors who wish to invest in
the securities of corporations?
Liquidity risk occurs when savers are not able to sell their securities on demand. Banks, for
example, offer deposits that can be withdrawn at any time. Yet, the banks make long-term loans
or invest in illiquid assets because they are able to diversify their portfolios and better monitor
the performance of firms that have borrowed or issued securities. Thus, individual investors are
able to realize the benefits of investing in primary assets without accepting the liquidity risk of
direct investment.
11. How do FIs help individual savers diversify their portfolio risks? Which type of FI is best
able to achieve this goal?
Money placed in any FI will result in a claim on a more diversified portfolio. Banks lend money
to many different types of business, consumer, and government customers. Insurance companies
have investments in many different types of assets. Investments in a mutual fund may generate
the greatest diversification benefit because of the fund’s investment in a wide array of stocks and
fixed income securities.
12. How can FIs invest in high-risk assets with funding provided by low-risk liabilities from
savers?
Diversification of risk occurs with investments in assets that are not perfectly positively
correlated. One result of extensive diversification is that the average risk of the asset base of an
FI will be less than the average risk of the individual assets in which it has invested. Thus,
individual investors realize some of the returns of high-risk assets without accepting the
corresponding risk characteristics.

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13. How can individual savers use FIs to reduce the transaction costs of investing in financial
assets?
By pooling the assets of many small investors, FIs can gain economies of scale in transaction
costs. This benefit occurs whether the FI is lending to a business or retail customer, or
purchasing assets in the money and capital markets. In either case, operating activities that are
designed to deal in large volumes typically are more efficient than those activities designed for
small volumes.
14. What is maturity intermediation? What are some of the ways in which the risks of maturity
intermediation are managed by FIs?
If net borrowers and net lenders have different optimal time horizons, FIs can service both
sectors by matching their asset and liability maturities through on- and off-balance sheet hedging
activities and flexible access to the financial markets. For example, the FI can offer the relatively
short-term liabilities desired by households and also satisfy the demand for long-term loans such
as home mortgages. By investing in a portfolio of long-and short-term assets that have variable-
and fixed-rate components, the FI can reduce maturity risk exposure by utilizing liabilities that
have similar variable- and fixed-rate characteristics, or by using futures, options, swaps, and
other derivative products.
15. What are five areas of institution-specific FI specialness, and which types of institutions are
most likely to be the service providers?
First, commercial banks and other deposit-taking institutions are key players for the transmission
of monetary policy from the central bank to the rest of the economy. Second, specific FIs often
are identified as the major source of finance for certain sectors of the economy. For example,
savings institutions (e.g. banks, credit unions, caisses populaires) traditionally serve the credit
needs of the residential real estate market. Third, life insurance and pension funds commonly are
encouraged to provide mechanisms to transfer wealth across generations. Fourth, deposit-taking
institutions efficiently provide payment services to benefit the economy. Finally, mutual funds
provide denomination intermediation by allowing small investors to purchase pieces of assets
with large minimum sizes such as t-bills, bonds, and other securities.
16. How do DTIs such as banks assist in the implementation and transmission of monetary
policy?
The Bank of Canada can directly involve banks in the implementation of monetary policy
through changes in the Target Overnight Rate. The open market sale and purchase of
Government of Canada securities by the Bank of Canada involves banks in the implementation
of monetary policy in a less direct manner.
17. What is meant by credit allocation regulation? What social benefit is this type of
regulation intended to provide?

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Credit allocation regulation refers to the requirement faced by FIs to lend to certain sectors of the
economy, which are considered to be socially important. These may include housing and
farming. Presumably the provision of credit to make houses more affordable or farms more
viable leads to a more stable and productive society.
18. Which intermediaries best fulfill the intergenerational wealth transfer function? What is
this wealth transfer process?
Life insurance and pension funds often receive special taxation relief and other subsidies to assist
in the transfer of wealth from one generation to another. In effect, the wealth transfer process
allows for the accumulation of wealth by one generation to be transferred directly to one or more
younger generations by establishing life insurance policies and trust provisions in pension plans.
Often this wealth transfer process avoids the full marginal tax treatment that a direct payment
would incur.
19. What are two of the most important payment services provided by FIs? To what extent do
these services efficiently provide benefits to the economy?
The two most important payment services are cheque clearing and wire transfer services. Any
breakdown in these systems would produce gridlock in the payment system with resulting
harmful effects to the economy at both the domestic and potentially the international level.
20. What is denomination intermediation? How do FIs assist in this process?
Denomination intermediation is the process whereby small investors are able to purchase pieces
of assets that normally are sold only in large denominations. Individual savers often invest small
amounts in mutual funds. The mutual funds pool these small amounts and purchase a well
diversified portfolio of assets. Therefore, small investors can benefit in the returns and low risk
which these assets typically offer.
21. What is negative externality? In what ways does the existence of negative externalities
justify the extra regulatory attention received by FIs?
A negative externality refers to the action by one party that has an adverse affect on some third
party who is not part of the original transaction. For example, in an industrial setting, smoke
from a factory that lowers surrounding property values may be viewed as a negative externality.
For FIs, one concern is the contagion effect that can arise when the failure of one FI can cast
doubt on the solvency of other institutions in that industry.
22. If financial markets operated perfectly and costlessly, would there be a need for FIs?
To a certain extent, financial intermediation exists because of financial market imperfections. If
information were available at no cost to all participants, savers would not need intermediaries to
act as either their brokers or their delegated monitors. However, if there are social benefits to
intermediation, such as the transmission of monetary policy or credit allocation, then FIs would
exist even in the absence of financial market imperfections.

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23. Why are FIs among the most regulated sectors in the world? When is net regulatory burden
positive?
FIs are required to enhance the efficient operation of the economy. Successful FIs provide
sources of financing that fund economic growth opportunities that ultimately raise the overall
level of economic activity. Moreover, successful FIs provide transaction services to the economy
that facilitate trade and wealth accumulation.
Conversely, distressed FIs create negative externalities for the entire economy. That is, the
adverse impact of an FI failure is greater than just the loss to shareholders and other private
claimants on the FI's assets. For example, the local market suffers if an FI fails and other FIs also
may be thrown into financial distress by a contagion effect. Therefore, since some of the costs of
the failure of an FI are generally borne by society at large, the government intervenes in the
management of these institutions to protect society's interests. This intervention takes the form of
regulation.
However, the need for regulation to minimize social costs may impose private costs to the FIs
that would not exist without regulation. This additional private cost is defined as a net regulatory
burden. Examples include the cost of holding excess capital and/or excess liquid assets (e.g.
cash) and the extra costs of providing information. Although they may be socially beneficial,
these costs add to private operating costs. To the extent that these additional costs help to avoid
negative externalities and to ensure the smooth and efficient operation of the economy, the net
regulatory burden is positive.
24. What forms of protection and regulation do the regulators of FIs impose to ensure their
safety and soundness?
Regulators have issued several guidelines to insure the safety and soundness of FIs:
a. FIs are required to diversify their assets. For example, federally-regulated FIs must follow
OSFI’s Guidelines on Large Exposure Limits.
b. FIs are required to maintain minimum amounts of capital to cushion any unexpected losses.
In the case of banks, OSFI’s standards require a minimum core and supplementary capital
based on the size of an FI’s risk-weighted assets. Federally-regulated life insurance and
property and casualty insurance companies are also required by OSFI to maintain specific
minimum capital.
c. Regulators have set up guarantees such as the deposit insurance provided by the Canada
Deposit Insurance Corporation (CDIC).
d. Regulators such as OSFI and CDIC also engage in periodic monitoring and surveillance,
such as on-site examinations, and request periodic information from FIs.
25. How do regulations regarding barriers to entry and the scope of permitted activities affect
the charter value of FIs?

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The profitability of existing firms will be increased as the direct and indirect costs of establishing
competition increase. Direct costs include the actual physical and financial costs of establishing a
business. In the case of FIs, the financial costs include raising the necessary minimum capital to
receive a charter. Indirect costs include permission from regulatory authorities to receive a
charter. As these barriers to entry are stronger, the charter value for existing firms is higher.
26. What six extraordinary actions were taken by central banks and governments during the
financial crisis? Explain why these actions were necessary.
During the financial crisis in 2008, the failure of the investment bank, Lehman Brothers, caused
regulators to believe that the major global FIs were too big to fail. The six actions that were
taken by central banks and governments were liquidity injection, by providing additional
facilities for FIs to borrow from the central bank. The central banks acted as lenders of last resort
since money markets and inter-bank markets were disrupted. Since FIs needed appropriate
collateral to borrow, central banks increased the types of collateral that they would accept. This
allowed FIs to borrow more which gave them cash to lend to customers. In order to head off
bank runs from uninsured depositors, the amount of deposit insurance provided was increased in
many countries (e.g. the U.S.). In some countries, the central banks or governments provided
guarantees of all deposits and liabilities (e.g. Ireland) in order to further reduce the potential for
runs on the banks. In some cases, governments provided equity capital to FIs (e.g. AIG, the U.S.
insurance company) and so became shareholders. As well, governments set up funds to buy toxic
assets from FIs in order to clean up their balance sheets and enable them to begin lending again,
thus keeping the economy growing.
27. What events resulted in banks’ shift from the traditional banking model of “originate and
hold” to a model of “originate and distribute?”
As FIs adjusted to regulatory changes, one result was a dramatic increase in systemic risk of the
financial system, caused in large part by a shift in the banking model from that of “originate and
hold” to “originate to distribute.” In the traditional model, banks take short term deposits and
other sources of funds and use them to fund longer term loans to businesses and consumers.
Banks typically hold these loans to maturity, and thus have an incentive to screen and monitor
borrower activities even after a loan is made. However, the traditional banking model exposes
the institution to potential liquidity, interest rate, and credit risk. In attempts to avoid these risk
exposures and generate improved return-risk tradeoffs, banks shifted to an underwriting model in
which they originated or warehoused loans, and then quickly sold them. Indeed, most large
banks organized as financial service holding companies to facilitate these new activities. More
recently activities of shadow banks, nonfinancial service firms that perform banking services,
have facilitated the change from the originate and hold model of commercial banking to the
originate and distribute banking model. These innovations removed risk from the balance sheet
of financial institutions and shifted risk off the balance sheet and to other parts of the financial
system. Since the FIs, acting as underwriters, were not exposed to the credit, liquidity, and
interest rate risks of traditional banking, they had little incentive to screen and monitor activities
of borrowers to whom they originated loans. Thus, FIs failed to act as specialists in risk
measurement and management.

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Chapter Two
Deposit-taking Institutions
Learning Objectives
LO1: Discuss the size, structure, and composition of the banking industry in Canada.
LO2: Discuss the nature and importance of off-balance-sheet assets and liabilities for Canadian
banks.
LO3: Explain the types of regulations that are applied to banks in Canada.
LO4: Explain how credit unions and caisses populaires differ from banks.
Chapter Outline
Introduction
Banks
• Size, Structure, and Composition of the Industry
• Balance Sheet and Recent Trends
• Other Activities
• Regulation
• Industry Performance
Credit Unions and Caisses Populaires
• Size, Structure, and Composition of the Industry and Recent Trends
• Balance Sheets
• Regulation
• Industry Performance
Global Issues: The Financial Crisis
Appendix 2A: Financial Statement Analysis Using a Return on Equity (ROE) Framework
Appendix 2B: Who Regulates Bank Financial Groups in Canada?
Appendix 2C: Technology in Commercial Banking
INTERNET EXERCISE
1. Go to the website of the Office of the Superintendent of Financial Institutions (OSFI) at
http://www.osfi-bsif.gc.ca/ and find the most recent monthly balance sheet for Canadian
chartered banks. Click on “Financial Institutions” to see the drop-down menu. Under the
heading, “View Institutions”, click on “Financial Data”. Scroll down and click on “Banks.”
Click on “Submit” to download the latest Consolidated Balance Sheet. Repeat the process for
foreign banks by selecting “Foreign Bank Branches” and select the most recent balance

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sheet. Compare the balance sheet of the domestic banks with that of the foreign banks. How
have the assets changed from Table 2–4?
2. Go to Credit Union Central of Canada’s website at http://www.cucentral.ca/ and download
the most recent information on number, assets, and membership in credit unions and caisses
populaires using the following steps. Click on “Policy & Advocacy” and select
“Publications” from the drop down menu. Find and download the pdf fie for the latest
System Brief that is available to the public. How has the number of CUs and CPs, their size,
and membership changed?

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Solutions for End-of-Chapter Questions and Problems: Chapter Two
1. What are the differences between Schedule I, Schedule II, and Schedule III banks?
Schedule I banks are domestic Canadian banks who are widely-held and chartered in Canada
under the Bank Act. They are able to offer the full range of services permitted under the Bank
Act. Schedule II banks are subsidiaries of a foreign bank who are authorized to conduct business
under the Bank Act in Canada. A Schedule III bank is a foreign bank branch that is authorized to
accept deposits in excess of $150,000 under the Bank Act. All banks in Canada are regulated by
the Office of the Superintendent of Financial Services (OSFI).
2. What changes have banks implemented to deal with changes in the financial services
environment?
Corporations have utilized the commercial paper markets with increased frequency rather than
borrow from banks. In addition, many banks have sold loan packages directly into the capital
markets (securitization) as a method to reduce balance sheet risks and to improve liquidity.
Finally, the decrease in loan volume during the early 1990s and early 2000s was due in part to
the recession in the economy.
Further, as deregulation of the financial services industry occurred during the 1990s, the position
of banks as the primary financial services provider eroded. North American banks of all sizes
increased the use of off-balance sheet activities in an effort to generate additional fee income.
Letters of credit, futures, options, swaps and other derivative products are not reflected on the
balance sheet, but do provide fee income for the banks.
3. What are the major uses of funds for banks in Canada? What are the primary risks to the
bank caused by each use of funds? Which of the risks is most critical to the continuing
operation of a bank?
Loans and investment securities are the primary assets of the banking industry. Non-mortgage
loans are relatively more important. Mortgage loans are also a large part of the banks’ assets.
Each of these types of loans creates credit, and to varying extents, liquidity risks for the banks.
The security portfolio normally is a source of liquidity and interest rate risk, especially with the
increased use of various types of mortgage backed securities and structured notes. In certain
environments, each of these risks can create operational and performance problems for a bank.
4. What are the major sources of funds for banks in Canada? How is the landscape for these
funds changing and why?
The primary sources of funds are deposits. The amount of retail (consumer) demand deposits
declines when small investors look for higher returns and move their funds into fixed term
deposits and other higher yielding investments such as mutual funds. In general, a significant
portion of consumer demand deposits are core funding for Canadian banks. The banks also
purchase wholesale funds such as corporate deposits and interbank deposits. Short-term

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liabilities other than deposits may decline as banks institute the liquidity requirements of Basel
III (see Chapters 12 and 20).
5. How does the liability maturity structure of a bank’s balance sheet compare with the
maturity structure of the asset portfolio? What risks are created or intensified by these
differences?
Deposit and non-deposit liabilities tend to have shorter maturities than assets such as loans. The
maturity mismatch creates varying degrees of interest rate risk and liquidity risk.
6. What types of activities normally are classified as OBS activities?
Off-balance-sheet activities include the issuance of guarantees that may be called into play at a
future time, and the commitment to lend at a future time if the borrower desires.
a. How does an OBS activity move onto the balance sheet as an asset or liability?
The activity becomes an asset or a liability upon the occurrence of a contingent event,
which may not be in the control of the bank. In most cases the other party involved with
the original agreement will call upon the bank to honour its original commitment such as a
loan commitment or a letter of credit.
b. What are the benefits of OBS activities to a bank?
The initial benefit is the fee that the bank charges when making the commitment. If the
bank is required to honour the commitment, the normal interest rate structure will apply to
the commitment as it moves onto the balance sheet. Since the initial commitment does not
appear on the balance sheet, the bank avoids the need to fund the asset with either deposits
or equity. Thus the bank avoids possible additional deposit insurance premiums while
improving the earnings stream of the bank.
c. What are the risks of OBS activities to a bank?
The primary risk to OBS activities on the asset side of the bank involves the credit risk of
the borrower. In many cases the borrower will not utilize the commitment of the bank until
the borrower faces a financial problem that may alter the creditworthiness of the borrower.
Moving the OBS activity to the balance sheet may have an additional impact on the interest
rate and foreign exchange risk of the bank, and as well, may pose a liquidity risk if the FI
has difficulty making the funds available to the borrower. Further, at the heart of the
financial crisis were losses associated with off-balance-sheet mortgage-backed securities
created and held by FIs. Losses resulted in failure, acquisition, or bailout of some of the
largest global FIs and a near meltdown of the world’s financial and economic systems.
7. How is mobile and online banking expected to provide benefits in the future?

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The extent of the impact of mobile and online banking remains unknown. However, the
existence of new technology allows banks to open markets and to develop products that did not
exist prior to the Internet. Efforts have focused on the retail customer and business customers
and have changed cash management for both. The trend should continue with the advent of
faster, more customer friendly products and services, and the continued technology education of
customers.
8. What factors are given credit for the strong performance banks in the early 2000s?
The lowest interest rates in many decades helped bank performance on both sides of the balance
sheet. On the asset side, many consumers refinanced homes and purchased new homes, an
activity that caused fee income from mortgage lending to increase and remain strong.
Meanwhile, the rates banks paid on deposits shrank to all-time lows. In addition, the
development and use of new financial instruments such as credit derivatives and mortgage
backed securities helped banks move credit risk off their balance sheets. Finally, information
technology helped banks manage their risk more efficiently through better and quicker access to
financial markets.
9. How does the asset structure of CUs compare with the asset structure of banks?
The relative proportions of credit union assets are similar to banks with loans and mortgages
representing the major portion of assets. However, nonmortgage loans of credit unions are
predominantly consumer loans. On the liability side of the balance sheet, credit unions differ
from banks in that they have less reliance on large term deposits, and have only a small amount
of debt from any source. The primary sources of funds for credit unions are small term deposits
and chequing and savings accounts.
10. Compare and contrast the performance of Canadian DTIs with U.S. and global FIs during
and after the financial crisis.
Quickly after it hit the U.S., the financial crisis spread worldwide. As the crisis started, banks
worldwide saw losses driven by their portfolios of structured finance products and securitized
exposures to the subprime mortgage market. Losses were magnified by illiquidity in the markets for
those instruments. As with U.S. banks, this led to substantial losses in their marked to market
valuations. In Europe, the general picture of bank performance in 2008 was similar to that in the
U.S. That is, net income fell sharply at all banks. The largest banks in the Netherlands, Switzerland
and the United Kingdom had net losses for the year. Banks in Ireland, Spain and the United
Kingdom were especially hard hit as they had large investments in mortgages and mortgage-backed
securities. Because they focused on the domestic retail banking, French and Italian banks were less
affected by losses on mortgage-backed securities. Continental European banks, in contrast to UK
banks, partially cushioned losses through an increase in their net interest margins.
A number of European banks averted outright bankruptcy thanks to direct support from the
central banks and national governments. During the last week of September and first week of
October 2008, the German government guaranteed all consumer bank deposits and arranged a
bailout of Hypo Real Estate, the country’s second largest commercial property lender. The
United Kingdom nationalized mortgage lender Bradford & Bingley (the country’s eighth largest

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mortgage lender) and raised deposit guarantees per account. Ireland guaranteed deposits and debt
of its six major financial institutions. Iceland rescued its third largest bank by purchasing 75
percent of the bank’s stock and a few days later seized the country’s entire banking system. The
Netherlands’, Belgium’s, and Luxembourg’s central governments together agreed to inject
US$16.37 billion into Fortis NV (Europe’s first ever cross-border financial services company) to
keep it afloat. However, five days later this deal fell apart, and the bank was split up. The Dutch
bought all assets located in the Netherlands for approximately US$23 billion. The central bank in
India stepped in to stop a run on the country’s second largest bank ICICI Bank, by promising to
pump in cash. Central banks in Asia injected cash into their banking systems as banks’
reluctance to lend to each other led the Hong Kong Monetary Authority to inject liquidity into its
banking system after rumours led to a run on Bank of East Asia Ltd. South Korean authorities
offered loans and debt guarantees to help small and midsize businesses with short term funding.
The United Kingdom, Belgium, Canada, Italy, and Ireland were just a few of the countries to
pass an economic stimulus plan and/or bank bailout plan. The Bank of England lowered its target
interest rate to a record low of 1 percent hoping to help the British economy out of a recession.
The Bank of Canada, Bank of Japan, and Swiss National Bank also lowered their main interest
rate to 1 percent or below. All of these actions were a result of the spread of the U.S. financial
market crisis to world financial markets.
The worldwide economic slowdown experienced in the later stages of the crisis meant that
bank losses became more closely connected to macroeconomic performance. Countries across the
world saw companies scrambling for credit and cutting their growth plans. Additionally,
consumers worldwide reduced their spending. Even China’s booming economy slowed faster than
had been predicted, from 10.1 percent in the second quarter of 2008 to 9 percent in the third
quarter. This was the first time since 2002 that China’s growth was below 10 percent and dimmed
hopes that Chinese demand could help keep world economies going. In late October, the global
crisis hit the Persian Gulf as Kuwait’s central bank intervened to rescue Gulf Bank, the first bank
rescue in the oil rich Gulf. Until this time, the area had been relatively immune to the world
financial crisis. However, plummeting oil prices (which had dropped over 50 percent between July
and October) left the area’s economies vulnerable. In this period, the majority of bank losses were
more directly linked to a surge in borrower defaults and to anticipated defaults as evidenced by the
increase in the amount and relative importance of loan loss provision expenses.
International banks’ balance sheets continued to shrink during the first half of 2009 (although at
a much slower pace than in the preceding six months) and, as in the U.S., began to recover in the
latter half of the year. In the fall of 2009, a steady stream of mostly positive macroeconomic
news reassured investors that the global economy had turned around, but investor confidence
remained fragile. For example, in late November 2009, security prices worldwide dropped
sharply as investors reacted to news that government-owned Dubai World had asked for a delay
in some payments on its debt. Further, throughout the spring of 2010 Greece struggled with a
severe debt crisis. Early on, some of the healthier European countries tried to step in and assist
the debt ridden country. Specifically, in March 2010 a plan led by Germany and France to bail
out Greece with as much as US$41 billion in aid began to take shape. However, in late April
Greek bond prices dropped dramatically as traders began betting a debt default was inevitable,
even if the country received a massive bailout. The selloff was the result of still more bad news
for Greece, which showed that the 2009 budget deficit was worse than had been previously
reported, and as a result politicians in Germany began to voice opposition to a Greek bailout.
Further, Moody’s Investors Service downgraded Greece’s debt rating and warned that additional

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2-7
cuts could be on the way. Greece’s debt created heavy losses across the Greek banking sector. A
run on Greek banks ensued. Initially, between €100 and €500 million per day was being
withdrawn from Greek banks. At its peak, the run on Greek banks produced deposit withdrawals
of as high as €750 billion a day, nearly 0.5 percent of the entire €170 billion deposit base in the
Greek banking system.
Problems in the Greek banking system then spread to other European nations with fiscal
problems, such as Portugal, Spain, and Italy. The risk of a full blown banking crisis arose in
Spain where the debt rating of 16 banks and four regions were downgraded by Moody’s Investor
Service. Throughout Europe, some of the biggest banks announced billions of euros lost from
write downs on Greek loans. In 2011, Crédit Agricole reported a record quarterly net loss of
€3.07 billion ($4.06 billion U.S.) after a €220 million charge on its Greek debt. Great Britain’s
Royal Bank of Scotland revalued its Greek bonds at a 79 percent loss—or £1.1 billion ($1.7
billion U.S.)—for 2011. Germany’s Commerzbank’s fourth quarter 2011 earnings decreased by a
€700 million due to losses on Greek sovereign debt. The bank needed to find €5.3 billion euros
to meet the stricter new capital requirements set by Europe’s banking regulator. Bailed out
Franco-Belgian bank Dexia warned it risked going out of business due to losses of €11.6 billion
from its break-up and exposure to Greek debt and other toxic assets such as U.S. mortgage-
backed securities. Even U.S. banks were affected by the European crisis. In late 2010, U.S. banks
had sovereign risk exposure to Greece totaling $43.1 billion. In addition, exposures to Ireland
totaled $113.9 billion, to Portugal totaled $47.1 billion, and to Spain $187.5 billion. Worldwide,
bank exposure to these four countries totaled $2,512.3 billion. Default by a small country like
Greece cascaded into something that threatened the world’s financial system.
Worried about the effect a Greek debt crisis might have on the European Union, other
European countries tried to step in and assist Greece. On May 9, 2010, in return for huge budget
cuts, Europe's finance ministers and the International Monetary Fund approved a rescue package
worth $147 billion and a “safety net” of $1 trillion aimed at ensuring financial stability across
Europe. Through the rest of 2010 and into 2012, Eurozone leaders agreed on more measures
designed to prevent the collapse of Greece and other member economies. In return, Greece
continued to offer additional austerity reforms and agreed to reduce its budget deficits. At times,
the extent of these reforms and budget cuts led to worker strikes and protests (some of which
turned violent), as well as changes in Greek political leadership. In December 2011, the leaders
of France and Germany agreed on a new fiscal pact that they said would help prevent another
debt crisis. Then French President Nicolas Sarkozy outlined the basic elements of the plan to
increase budget discipline after meeting with German Chancellor Angela Merkel in Paris. The
pact, which involved amending or rewriting the treaties that govern the European Union, was
presented in detail at a meeting of European leaders and approved. Efforts by the EU and
reforms enacted by the Greek and other European country governments appear to have worked.
As on December 18, 2012, Standard & Poor's raised its rating on Greek debt by six notches to B
minus from selective default Tuesday. S&P cited a strong and clear commitment from members
of the euro zone to keep Greece in the common currency bloc as the main reason for the upgrade.
In contrast to the global impacts above, the major disruption in Canada came from the freezing
of the non-bank sponsored asset-backed commercial paper market (See Chapter 26 for details).
Approximately $35 billion of ABCP was unable to be rolled over in 2008 and the issue was not
resolved until 2010. No banks failed in Canada as a result of the global liquidity and credit crisis.

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