📘 Module 4 Study Guide – The 2008 Financial Crisis

🧩 SECTION 1: BANK BALANCE SHEETS & RISKS

1.1 Stylized Bank Balance Sheet

Assets	Liabilities
Currency	Deposits
Reserves	Loans from Other Banks
U.S. Treasuries	Loans from Central Bank
Short-Term Loans / Repos	Other Loans (e.g., bonds)
Long-Term Assets (e.g., ABS)	Equity

1.2 Major Risks

Risk	Condition	Basel III Rule
Capital Inadequacy	Asset values fall → not enough Equity to cover losses	\(\\frac{Equity}{Long\\text{-}Term\\ Assets} \\geq 8\\%\)
Liquidity Risk	Liquid assets < Depositor Withdrawals	\(Currency + Reserves + Treasuries + STA > 5\\% \\times Deposits\)
Stable Funding Risk	Long-term assets funded by short-term liabilities	\(Deposits + LT\\ Liabilities + Equity > LT\\ Assets\)

🔍 Liquid Assets vs Stable Funding

Term	Meaning	Examples
Liquid Assets	Assets that can be sold or accessed quickly	Cash, Reserves, U.S. Treasuries
Stable Funding	Liabilities that are unlikely to disappear suddenly	Deposits, Long-Term Liabilities, Equity

🔁 SECTION 2: HOW BANKS FAIL – SIGNAL FLOW

Capital Inadequacy Risk

↓ Long-Term Asset Value
→ ↓ Total Asset Value
→ If Equity < Losses
→ Bank becomes insolvent

Liquidity Risk

↑ Withdrawals
→ Need for Liquid Assets
→ If Cash/Treasuries < Withdrawals
→ Forced Sale of LT Assets → Fire Sale → ↓ Asset Prices

Stable Funding Risk

↑ Short-Term Borrowing
→ Can’t Refinance in Crisis
→ Insolvency or default risk ↑

💥 SECTION 3: CONTAGION MECHANISMS

Contagion Channel	Trigger	Impact
Loan Default	Bank A cannot repay interbank loan from Bank B	Bank B takes a loss → ↓ Capital
Fire Sale	One bank sells LT Assets	Market value ↓ → Other banks mark down
Wholesale Lending Freeze	Interbank market dries up	Borrowing banks fail to refinance
CDS Insurer Failure	Insurer (e.g., AIG) collapses	Banks lose insurance → Exposure ↑

💼 SECTION 4: FED BALANCE SHEET OPERATIONS

4.1 Repos & Reverse Repos

Tool	Effect on Fed Balance Sheet	Purpose
Repo (Fed Buys)	↑ Assets (Repo), ↑ Reserves (Liability)	Inject liquidity, lower FFR
Reverse Repo (Sell)	↓ Assets (RRP), ↓ Reserves	Remove liquidity, raise FFR

4.2 Quantitative Easing (QE)

QE → Fed buys risky or long-term assets
→ ↑ Bank Reserves
→ ↑ Liquidity
→ ↓ Long-Term Yields

Used when:

Fed Funds Rate = Floor (IORB)
OMOs ineffective in stimulating credit

🏦 SECTION 5: MONETARY POLICY FRAMEWORK

Corridor vs Floor System

Corridor System	Floor System
Scarce Reserves	Ample Reserves
FFR set via OMOs	FFR set via IORB + ON RRP
\(Discount > FFR > IORB\)	\(FFR \\approx IORB\)

Diagram (Conceptual):

Corridor:
Discount Rate (Ceiling)
↓
Fed Funds Rate
↓
IORB Rate (Floor)

Floor:
FFR ≈ IORB ≈ ON RRP

🔓 SECTION 6: POLICY EFFECTS ON BALANCE SHEET

OMO Purchase (Treasuries) → ↑ Reserves → ↓ FFR
↑ Discount Rate → ↑ Ceiling → ↑ FFR
↑ Required Reserve Ratio → ↑ Demand for Reserves → ↑ FFR
↑ IORB → ↑ Floor → ↑ FFR (in floor regime)

🔍 SECTION 7: THE 2008 CRISIS – ROOT CAUSES (TABLE FORMAT)

Event	Effect	Reasoning
Housing Bubble ↑	More ARMs and subprime loans issued	Lenders believed home prices would keep rising
Bubble bursts	Home prices ↓	Supply of homes ↑, demand ↓
Home prices ↓	Borrowers can’t refinance	Loans exceed new home values (underwater)
ARM resets	Payments ↑	Low initial rates expired
Payments ↑	Defaults and foreclosures ↑	Borrowers can’t afford new monthly cost
Defaults ↑	ABS prices ↓	Investors panic, try to sell
ABS prices ↓	Bank losses ↑	ABS held as bank assets lose value

🧷 SECTION 8: BASEL III – REGULATORY FIXES

Problem	Basel III Solution
Capital Risk	\(\\frac{Equity}{Risk\\text{-}Weighted\\ Assets} \\geq 8\\%\)
Liquidity Shortage	LCR: Liquid Assets ≥ 30-day expected outflows
Funding Mismatch	NSFR: Stable Funding ≥ Long-Term Assets

🧮 SECTION 9: KEY EQUATIONS

Capital Adequacy
\(\\frac{Equity}{Long\\text{-}Term\\ Assets} \\geq 8\\%\)
Liquidity Coverage
\(Currency + Reserves + Treasuries + STA > 5\\% \\times Deposits\)
Stable Funding
\(Deposits + LT\\ Liabilities + Equity > LT\\ Assets\)
Money Supply & Fed Funds Rate
- In corridor system: ↑ Money Supply → ↓ FFR
- In floor system: ↑ Money Supply → no change in FFR (unless IORB adjusted)
Repo Impact
- Repo ↑ → Fed Lending ↑ → Bank Reserves ↑ → FFR ↓
🧠 Master Logic Map: Fed & Bank Balance Sheets, QE/QT, and Crisis Dynamics

🏦 1. The Federal Reserve’s Balance Sheet

Category	Type	Examples
Assets	Asset	U.S. Treasuries, ABS/MBS, Repos (loans to banks)
Liabilities	Liability	Currency in circulation, Bank Reserves, RRPs

🏢 2. Commercial Bank Balance Sheet

Category	Type	Examples
Assets	Asset	Reserves at Fed, Loans to public, Treasuries, ABS
Liabilities	Liability	Deposits, Short-term debt, Loans from Fed
Equity	Capital	Shareholder equity

🔄 3. How Fed Actions Impact Bank Balance Sheets

Fed Action	Fed Asset ↑	Fed Liability ↑	Bank Asset ↑	Bank Liability/Effect
QE (buy Treasuries)	Treasuries	Reserves	Reserves	↑ Lending capacity
QE (buy ABS)	ABS	Reserves	Reserves	↓ Risk on bank balance sheet
Repo (loan to bank)	Repos	Reserves	Reserves	↑ Short-term funding
RRP (borrow from bank)	Treasuries ↓	RRPs	Reserves ↓	↓ Liquidity
QT (sell assets)	Treasuries ↓	Reserves ↓	Reserves ↓	↓ Lending, ↑ interest rates

📉 4. Corridor vs. Floor System

Feature	Corridor	Floor
Reserve Level	Scarce	Ample (due to QE)
Control Mechanism	Adjust reserve supply (OMOs)	Set IORB to guide rate
FFR Location	Between discount rate & IORB	At or just above IORB
Used When	Pre-2008, normal times	Post-2008, QE/QE periods

📈 5. Cause-and-Effect Table

Event	Direct Effect	Resulting Impact
Fed buys Treasuries (QE)	↑ Bank reserves	FFR ↓, lending ↑
Fed buys ABS	↓ Risky assets on bank balance sheets	Lending to private sector ↑
Repo (Fed → bank)	↑ Bank reserves (loan to bank)	Short-term liquidity ↑
RRP (bank → Fed)	↓ Bank reserves	FFR ↑, liquidity ↓
Bank loses deposit funding	↑ Reliance on wholesale funding	Liquidity & stable funding risk ↑
Bank loses asset value	↓ Equity	Capital inadequacy risk ↑
More reserves in system	FFR sticks to floor	Corridor mechanism ineffective
Bank exposed to failed counterparty	↓ Asset (loan), maybe no liability offset	Capital risk, liquidity risk
QE in floor regime	No effect on FFR	Works through credit easing (long-term lending)

💣 6. During Crisis — What’s Happening?

Crisis Trigger	Fed Response	Balance Sheet Outcome
Banks can’t roll ST debt	Repo / QE	Fed assets ↑, bank reserves ↑
MBS prices crash	Fed buys MBS (QE)	Bank sells risk → gains cash & stability
Interbank market freezes	Fed adds reserves	FFR hits floor → lending shifts to private sector
Fed balance sheet expands	QE	System moves to floor regime
Fed balance sheet contracts	QT	Liquidity ↓, rates ↑, risk re-enters banking system

🧪 7. Key Visual Cue for MCQs

If Fed buys something → assets ↑, reserves ↑, liquidity ↑
If reserves ↑ a lot → floor system, Fed must move IORB to adjust rates
If bank’s asset disappears but liability remains → capital risk
If liability gone too → only risk is liquidity (short-term mismatch)
If deposit limits are imposed → bank relies on hot money → contagion risk ↑

✅ Final Tips

Ask: What’s the Fed buying/selling? → Which balance sheet line changes?
Look at reserves to judge if in corridor or floor
Connect asset sales/purchases to interest rates or risk transfer
Use the signal:
Fed action → Bank reserve position → Lending → Interest Rate