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The Financial Industry is experiencing a massive revolution in the last decade. With technologies like Cryptocurrency, Blockchain now becoming more and more popular, banks are starting or already did start considering these new solutions in the transaction era. One question you might ask is: why is this happening now? Why this decade? In order to answer that we need to take a few steps back and use an imaginary time machine.

Before we start I want to say that this topic is really close to my heart, not only because it is a related subject to my studies, but also because I personally experienced the effect of this crisis. In 2010 I obtained my Diploma in Business, Finance and Management, only 2 years after the crisis. My thesis was entitled Subprime Crisis and the bailout of US banks (translated). The reason why I decided to bring this topic was that this event made me question our current system, it changed my perspective of the banks and finally shaped my career decisions.

Having said that, let's set our time machine to the year 1971 and let’s go!

Deregulation of the financial system

The opening of the financial markets began with the dissolution of the Bretton Woods system, 1971. As a result, the gold exchange standard, which based the dollar’s value on the value of gold, was now terminated. The dollar used to be the equivalent value of a coin of gold, but now dollars don’t have any intrinsic value and have become a FIAT currency. In the 80s the Depository Institutions Deregulation and Monetary Control Act changed regulations upon banks based on the events of 1929 and because of the inflation of the 70s.

One of these changes was that it allowed institutions to charge any loan interest rates they chose and more freedom of movement of the financial capitals, which started to increase significantly at that time. In the meantime, between 1985 and 1990 the EU central banks were freed from Government and started to have their own executive power. Banks and Funds could then be acquired by privates.

The Commodity Futures Modernization Act of 2000 (CFMA) made sure that OTC derivatives were unregulated, meaning no exchange supervision was required. 30 years have passed but more and more changes are yet to come.

The financial system today

The 3 main parts of the financial systems are:

• The big international banks
• Institutional investors
• and the Shadow Financial System, based on private organisations that offer the same services as a bank but they aren’t one such as hedge funds.

The American Banking system has 2 types of banks: Commercial and Business banks. The firsts are controlled by the FED, but the latter are controlled and supervised by the Securities and Exchange Commission (SEC). This differentiation happened in 1999 and created an important dualism for the next events.

Subprime Loans

Subprime Mortgages are loans accessible to people that couldn’t have access to prime loans. The word ‘sub’ implies the inferiority of these loans. This category wasn’t only limited to loans but was spread out to all the different products a bank could offer such as credit card, car finance etc...

These instruments were given to people that didn’t have a healthy financial background, in exchange for higher interest rates and fees. These services were classified as derivatives and no supervision was required. As a result, the request for Subprime loans started to increase year by year. Below, a graph I used in my thesis:

The maximum peak was reached in 2005 with a total value of $665 Billion of Subprime Mortgages opened, compared with 2001 this is a 300% increase.

Real-estate bubble

From 2000 to 2006 a positive and strong expectation of the market helped increase prices of houses by an average of 15% each year. This trend created the perfect conditions to make subprime loans convenient and less risky. If payments of the loans were behind schedule, the banks could take ownership of the house and sell it for a much higher price.

Lowest interest rates in history

In 2001 the Federal Reserve System (FED) decided to adopt a policy that would guarantee an economic stimulus, by lowering the interest rates. This was done until 2004 but was enough to help the creation of the bubble. The graph below shows the data publicly available here. If you watch closely you can see that 2004 reached the lowest interest rate since 1990.

The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight

What caused the Subprime crisis?

To prevent inflation from running, the FED decided to increase the interest rates in 2004 to decrease the liquidity in the market. This started a domino effect: the first signals started in the spring of 2007 when the house prices decreased by 8.4% initially and at the end of the year, by 18.4%. FED and the European Central Bank started to inject money into the system, but it was too small of intervention and too late.

Mortgages started to cost more, the values of the securities based on these mortgages started to collapse. People started to sell them. Companies started to have great losses. Securities became toxic, meaning they had no value. In September 2008 the Lehman Brothers, one of the biggest banks in the US at the time, declared bankruptcy. Banks started to assess their portfolio and check for toxic securities, they then stopped trusting one another and borrowed money. Also, they started to sell the securities considered healthy, by losing value on Wall Street. Business banks were then converted into commercial banks so that they could be helped by the FED. Morgan Stanley and Goldman Sachs became commercial banks. Business Banks ceased to exist.

From financial crisis to an economic crisis

In order to understand how this crisis moved from being financial to being economic, there are few important notions to understand.

Securitization is the process in which a mortgage is converted into marketable securities, ready to be sold to investors. Subprime mortgages were considered triple-A securities. Totally safe. This was caused by the total absence of supervision mentioned earlier.

The last thing is the financial leverage formula, which is pretty simple. It’s the result of the debt divided by the equity. Meaning how much debt your bank or company has. Banks in 2007-8 reached a debt equal to 30 times their entire equity and in EU even more. To put this into perspective, a bank with equity of 100 and a leverage of 30, with an increase of 1% in activities, would have a 30% profit on the equity. On the other side, a 10% decrease would translate into a value of 3 times the total equity.

The effects of the Subprime crisis were terrific, the entire world economy had a loss of -11%. The US government planned a bailout of $700 Billion to fix the domestic crisis.

What’s happening in the world today?

Today we can experience some similarities to 2008. We have the lowest interest rate in history both in the US and UK.

US interest rates

In the UK the Bank of England is declaring the interest rate to be at 0.1%, check here. A real estate bubble is currently running in the UK, with more and more mortgages that help people to take higher value houses than they could afford with help-to-buy schemes etc…

These are only similarities and they don’t imply a possible crisis, but we also live in a very optimistic market and the inflation is alarming.

Blockchain and crypto

In all of this, Banks are starting to understand the real possibilities and advantages that the blockchain has to offer. Actually, JPMorgan just concluded its blockchain test. In 2020 Wells Fargo invested in Elliptic a blockchain firm. More and more banks are turning to the crypto-world, Barclays, Revolut, National Bank Of Canada and Goldman Sachs.

Conclusion

The financial sector failed in the past and history has told us that technology has always had a disruptive touch. Having said that, blockchain and crypto are the next revolution after the internet and social media: they are already creating new jobs and new opportunities. There is a lot of speculation still in cryptocurrencies, but as with the 2000 crisis with the Dot bubble, the internet didn’t vanish. Blockchain, like the internet, proved to be full of potential, but also full of challenges.