Since the credit crunch which started with the decline in the US real estate market that impacted worldwide financial institutions. This chain reaction of events resulted in a global financial crisis which have impacted not only the financial sector and US real estate market but has also influenced other sectors. These events have had an impact of economic growth of all companies and have lowered their future expectations for the coming years.
Even though we are currently in a period of lower economic growth with more future uncertainty, in the past decade we have had multiple crises such as the Russian Ruble crisis of 1997 which resulted in the default of the Russian state and fall of Long Term Capital Management, which led a large shockwave across global financial markets. But also the collapse of the Dot-com bubble around 2001 has led financial markets in distress after a few very prosperous years. The main problem in this case is that banks are strongly intertwined with companies (that borrow money) and the general population (depositors, investors and stakeholders). In simple and plain English it means that when the economy is hit, banks are also hit as the money they can make on the multiplication effect of lending money decreases as people are less eager to borrow money. So this reduces the cash flow of banks as they cannot lend as much money that generates the highest return and at the same time they are more strict in lending money as they tend to strongly investigate the creditworthiness of its lenders as a possible loss of money, due to bankruptcy can be detrimental to a bank’s tier 1 capital requirements.
If we take a trip around the world we find different examples of troubled banks causing a stronger spiraling down economy. In Asia, and to be specific in Japan, we have seen that most companies (conglomerates) are formed around a bank or group of banks which can help improve internal efficiency among companies and the bank(s) but form a risk when they all face the effects of a global downturn. In the US we have seen the case of Lehman Brothers and Bear Stearns who both fell from grace and at the same time hurting other global financial institutions as they are strongly interlinked with each other with mutual fund investments, bank holdings, debt obligation and share ownership. Even Dutch insurance companies, such as Aegon and ING, where strongly affected by the fall of Lehman Brothers. Additionally there were also cases of Dutch financial institutions that fell apart due to the global debt crisis, such as DSB bank, famously known for personal loans (in Dutch: persoonlijke lening ) and mortgages ( in Dutch called ‘hypotheken’ ), which it used to sell to the consumer market. Before its fall, DSB bank was estimated to be worth around 500 million euros.
An almost decade old paper by Mathias Drehman (2002): “Will an optimal deposit insurance always decrease the probability of systematic banking crisis” proposes the use of what we now define as a minimal capital requirement that banks need to maintain to avoid a possible systematic banking crisis. In plain English this means that banks need to keep enough money in their safe to avoid when another bank collapses a chain reaction can be somewhat avoided. Drehman (2002) explains that contagious bank runs can be avoided when the correlation of bank’s portfolio is not strongly correlated with a bank that is in financial distress (minimal capital requirement not in a bank’s safe). This minimum capital requirement we now know as Basel I and especially Basel II (the second of the Basel Accords) made by the Basel Committee on Banking Supervision.