Credit Risk Measurement In and Out of the Financial Crisis: New Approaches to Value at Risk and Other Paradigms, Third Edition

CHAPTER 1

Setting the Stage for Financial Meltdown

INTRODUCTION

In this first chapter we outline in basic terms the underlying mechanics of the ongoing financial crisis facing the financial services industry, and the challenges this creates for future credit risk models and modelers.

Rather than one crisis, the current financial crisis actually comprises three separate but related phases. The first phase hit the national housing market in the United States in late 2006 through early 2007, resulting in an increase in delinquencies on residential mortgages. The second phase was a global liquidity crisis in which overnight interbank markets froze. The third phase has proved to be the most serious and difficult to remedy and was initiated by the failure of Lehman Brothers in September 2008. The lessons to be learned for credit risk models are different for each of these phases. Consequently, we describe first how we entered the initial phase of the current crisis. In the upcoming chapters, we discuss the different phases and implications of the global financial crisis that resulted from the features that characterized the run-up to the crisis.

THE CHANGING NATURE OF BANKING

The traditional view of a bank is that of an institution that issues short-term deposits (e.g., checking accounts and certificates of deposit) that are used to finance the bank’s extension of longer-term loans (e.g., commercial loans to firms and mortgages to households). Since the traditional bank holds ...