Part 3 - Selected Trends affecting Financial Markets

The financial crisis of 2007 was triggered by an asset price bubble in real estate. Describe what were the main causes in the financial markets (and issues with banks in particular) which contributed to this crisis. (2022)

Financial crisis in 2007 was a multi-layered and systematic collapse involving:

• macroeconomic distortion: prolonged low interest rates fuelled a real estate bubble + excessive risk appetite across markets

• flawed regulation: shadow banking and off-balance sheet vehicles operated outside regulatory perimeters + systemic risk was not monitored

• failure of gatekeepers: rating agencies mis-rated structured products + auditors and other gatekeepers did not flag the build-up of risk

Bank-specific issues:

• excessive risk-taking: banks were highly leveraged, securitisation (originate-to-distribute) spread toxic assets system-wide + heavy reliance on ST wholesale funding created fragility

• poor governance: boards lacked oversight of risk + internal controls failed to constrain dangerous exposures

• incentives issues: ST bonus culture rewarded volume over quality

What were the main reforms undertaken in Europe in the regulatory and supervisory areas for banks after the 2007 crisis and the 2010 crisis? (2023 – p.6 & 7)

key changes:

• Tighter oversight of financial markets including derivatives, securitisation, proprietary trading, hedge funds, private equity & credit rating agencies

• Stricter prudential rules: higher capital requirements (incl. counter-cyclical buffers), living wills (resolution plans) for large institutions, increased deposit guarantees (to €100,000)

• Corporate governance reforms: improved risk oversight, board accountability & management responsibility

• Streamlining of supervisory frameworks: reducing fragmentation and local bias

to further integrate + stabilise the EUzone financial sector, the EU developed the EU Banking Union based upon 4 pillars:

• pillar 1 - Single Rulebook: harmonised prudential rules for all EU banks (CRR, CRD IV/V, BRRD), supported by EBA

• pillar 2 - Single Supervisory Mechanism (SSM): ECB directly supervises the largest Eurozone banks (85% of total assets)

• pillar 3 - Single Resolution Mechanism (SRM): centralised framework to manage bank failures (managed by the Single Resolution Bank, funded by the Single Resolution Fund)

• pillar 4 - European Deposit Insurance Scheme (EDIS): harmonised guarantee up to €100,000 per depositor per bank + funded ex ante and ex post

How banks have been incentivised to lend during the COVID-19 period? (2023 – p.10)

• State loan guarantees (70–90%): states absorbed most credit risk, removing the key barrier to lending

• Access to cheap funding: near-zero rates, low-cost lending facilities + Quantitative Easing made lending financially attractive

• Regulatory obligations: banks were required to accept loan applications rapidly + provide financing with limited conditions

→ Trade-off: banks gained liquidity but were pushed into low/non-profitable activities, increasing credit risk with limited upside

What is the European Passport in financial services and its purpose? (2023, 2024 – p.10)

Mechanism that allows financial institutions (activity: banking, insurance, investment management, infrastructure services) authorised in one EU Member State to operate freely across all other Member States without needing separate approval

• Part of: The EU's Banking Union and Capital Markets Union (CMU)

Explain what is the “Equivalence” concept adopted in relation to cross-border services for banks in the Brexit agreement? (2021, 2022 – p.11)

Mutual recognition of a non-EU country's regulatory framework based on comparability with EU standards — not identical rules.

• How it works: EU assesses the third country's framework and may grant market access by regulation and involves political discretion.

(3 post-Brexit access models: WTO terms (no special access), Equivalence Framework, or Free Trade Agreement (rejected by EU) → currently: no comprehensive equivalence framework is in place as the EU has recognised very few UK regulations as equivalent)

Why some banks have moved their staff from London to Frankfurt, Brussels or Paris after Brexit? (2025 – p.11)

Because they lost the European Passport.

Before Brexit: UK-based banks used the European Passport to provide services across the EU from London

After Brexit: UK became a third country, meaning UK firms lost passporting rights and became subject to third-country access rules, which severely restrict EU market access

To maintain the ability to serve EU clients, banks had to:

• Establish licensed EU legal entities (subsidiaries) in EU member states

• This required staff and physical presence on the ground in cities like Frankfurt, Paris, and Brussels

Describe what are the benefits of a securitisation of loans for banks and investors. (2022, 2024 – p.12)

For banks:

• Diversifies funding sources and reduces reliance on deposits

• Improves liquidity by turning long-term loans into cash

• Transfers risks (credit, market, liquidity) off balance sheet

• Generates service and origination fees

For investors:

• Offers tailored credit exposure through tranches

• Enhances portfolio diversification

• Potentially higher yields than equivalent non-securitised assets

For the broader economy:

• Frees up bank capital, supporting additional lending

• Broadens risk-sharing across the financial system

• Helps lower the cost of credit to the real economy

Describe what is the «Too Big to Fail » concept in banking supervision and which regulations have been adopted in Europe to minimise the negative consequences of this approach. (2022, 2024, 2025 – p.17)

Concept: A bank is TBTF when its size, market share, or interconnections make its collapse a systemic threat → Governments step in to prevent failure, creating:

• Moral hazard: banks may take excessive risk knowing they'll be bailed out

• Competitive distortion: TBTF banks benefit from lower funding costs

Regulation - 2 pronged strategies:

Prevention → reduce probability of failure:

• Higher capital requirements for systemically important banks

• Loss-absorbing capacity requirements

• Enhanced supervision and stress testing

Resolution → improve management of failure:

• Resolution regimes aim to allow large banks to fail without destabilising the system or triggering bailouts

What is the Originate and Distribute model in relation to credit activities? Please explain how the “redistribution” takes place.  (2023, 2024, 2025 – p.18)

Concept: Instead of keeping loans on their balance sheets (originate-to-hold), banks originate loans and then distribute them to third-party investors. The focus shifts to underwriting and distributing rather than long-term holding.This supports:

• capital efficiency,

• reduced long-term risk exposure, and

• fee income generation.

Redistribution: via securitisation

• Bank originates loans

• Loans are sold to a Special Purpose Vehicle (SPV)

• SPV pools the loans and issues bonds (CDOs, ABS, MBS) backed by that pool

• Bonds are tranched and sold to investors based on their risk appetite

• Bank continues servicing the loans, collecting payments and passing them to the SPV

• Risk is transferred off the bank's balance sheet to capital market investors

Do you think private debt funds provide a good alternative to banks? What are the risks attached to private debt funds? (2025 – p.18)

Good alternative? YES, because

• Fill the gap banks left after pulling back from riskier lending

• Flexible, tailored financing for borrowers

• Higher yields + diversification for investors

However, recent returns were disappointing.

Risks:

• Use leverage → amplifies losses

• No capital requirements → more aggressive lending

• Light regulation (shadow banking) → systemic risk if unmonitored

• Illiquid → hard to value/sell in stress

• Regulatory gaps → less investor protection than banks

Give me two examples about how banks are disintermediated? (2024 -p.17, 18 & 19)

1. Debt Capital Markets

Companies issue bonds directly to investors instead of borrowing from banks. Larger / creditworthy firms access bigger volumes, longer maturities, and potentially lower costs, bypassing banks entirely.

2. Private Debt Funds

Asset managers, insurance companies, and pension funds lend directly to companies and infrastructure projects, either by buying loans from banks or originating them directly, without a banking licence.

What is crowdfunding and why does it disintermediate banks? (2023 – p.19 & 20)

What it is: Online platforms that enable individuals or institutions to finance projects or companies directly. Main types:

• donation-based: contribution without financial return

• lending-based (Peer-to-Peer): individuals / institutions lend money via platform

• investment (equity/bond)-based: investors buy equity / debt via platform

• invoice trading: platforms allow businesses to sell unpaid invoices to receive early cash

Why it disintermediates banks:

• P2P platforms match borrowers and lenders directly, they do not lend themselves.

• Banks are cut out entirely: no deposit-taking, no credit intermediation, no banking licence needed

• Technology replaces the traditional bank infrastructure.

How is technology impacting banks? (2021 – p.20, 21 & 22)

Technology is forcing banks to reinvent themselves

1. Impacts on the value chain:

• Client interface + expectations: 24/7 + mobile-first experiences

• Products & services: expansion into digital offerings, third-party platform integration

• Operations: automation reduces costs; banks becoming aggregators of financial services

• Risk & compliance (RegTech): AI-driven fraud detection, monitoring, regulatory reporting

2. Impacts the market positioning → new competitors in the market:

• FinTechs: focused, efficient services (payments, lending), often partnering with banks

• BigTechs (Apple, Amazon, Google): leveraging data and platform scale to offer financial services

• Digital-native banks: lean infrastructure, lower costs

Describe the competitive advantages + disadvantages of FinTech compared to banks (including in terms of regulation)? (2022, 2023, 2024 – p.23)

PRO:

FinTech firms thrive by leveraging technology and targeting specific, profitable segments of the market:

• customer centric digital experience

• lower operating costs

• agility and innovation: pick-and-choose approach of high-margin areas

FinTech evolve in regulatory environment:

• regulatory support and promotion: PSD2 forces banks to share client data with authorised FinTechs (PISPs/AISPs).

• lighter regulatory burden: no banking licence, no Basel III

CONS:

FinTech face several structural and strategic hurdles:

• Narrow product focus: Bank cross-sell multiple products per client, FinTechs average fewer

• Governance and compliance gaps: Many FinTechs struggle with robust risk management and regulatory standards

• Margin pressure and funding constraints: Many FinTechs operate in highly competitive sectors with fallings fees

• Growing regulatory scrutiny: As FinTechs scale, they face tighter rules on data protection, transparency and consumer rights

Describe the impacts (including the risks) of the ecological transition on banks and how banks can help this transition. How banks can facilitate the ecological transition? (2022, 2023, 2024 – p.24, 25 & 26)

Risks to banks from ecological transition:

• Physical risks: climate events damage collateral and impair borrowers' ability to repay

• Transition risks: shift to green economy devalues carbon-intensive assets → stranded assets on bank balance sheets

• Liability risks: litigation against polluting firms banks are exposed to

How banks can facilitate the transition:

• Green lending: finance renewable energy, energy-efficient infrastructure, green real estate

• Green bonds/loans: issue or underwrite instruments tied to ESG objectives

• ESG integration: embed sustainability criteria in credit risk assessment and portfolio management

• Stewardship: use shareholder influence to push investee companies toward greener practices

• Reporting: SFDR and taxonomy regulations require banks to disclose sustainability risks and classify green activities, directing capital toward compliant projects

What is the purpose of the taxonomy regulations in the EU in the contact of the ecological

transition? (2025 – p.25 & 26)

Provides a common classification system defining what economic activities qualify as "environmentally sustainable" → preventing greenwashing + directing capital toward genuinely green investments

Key functions:

• Sets technical screening criteria for six environmental objectives (CC mitigation, CC adaptation, biodiversity protection, sustainable water use, pollution prevention, circular economy transition)

• Requires financial institutions to disclose what share of their activities/products are taxonomy-aligned (→ When substantially contribute to at least 1 objective, Do No Significant Harm to the others + Comply with minimum social safeguards)

• Creates a common language for investors, banks, and corporates on sustainability

Why are the EU Taxonomy Regulations (ESG) important for banks? (2022 – p.25 & 26)

• Disclosure obligations: Banks must report the share of their loans and investments that are taxonomy-aligned (Green Asset Ratio) → transparency for investors and regulators

• Risk management: Taxonomy forces banks to identify and assess exposure to non-aligned (brown) assets → better climate risk pricing

• Avoid greenwashing: Standardised criteria prevent banks from labelling products "green" without meeting defined thresholds

• Capital allocation: Guides banks to shift lending toward taxonomy-aligned activities, supporting the transition

• Regulatory compliance: Non-compliance or inadequate disclosure triggers supervisory scrutiny (ECB, EBA climate stress tests)

Name 3 financial instruments used by banks to promote the ecological transition. (2021 – p.26)

• Green bonds and securitisation

• Green loans and sustainability-linked loans

• ESG mutual funds and ETFs

• Sustainable investments in private markets

What are green bonds ? (2021)

= fixed-income instruments where proceeds are exclusively used to finance green / sustainable projects (e.g. renewable energy, energy efficiency, clean transport)

What are the benefits attached to cryptocurrencies? (2023, 2024 – p.27)

• Decentralised: No single authority controls issuance or validation.

• Pseudonymous: Users are identified via blockchain addresses, not personal names.

• Fast & Global: Transactions can be completed across borders in minutes.

• Low cost: Fewer or no banking fees, especially for international transfers

• Irreversible: Once confirmed, a blockchain transaction can’t be reversed.

• Secure: Advanced cryptography protects ownership and data.

• Inclusive: Accessible to anyone with internet access, offering alternatives to the unbanked

What are the risks (including the legal risks) attached to cryptocurrencies? (2023, 2024 – p.27)

Legal and regulatory uncertainty:

• Classification varies (currency, property, commodity, or security)

• Tax treatment differs across countries (e.g. capital gains tax in the US).

• Regulatory gaps expose investors and users to inconsistent protections.

Volatility and speculation:

• Most cryptocurrencies have no underlying asset or state guarantee.

• Prices can swing wildly, making them risky for savings or payments.

Fraud, money laundering, and lack of investor protection:

• Anonymity makes it easier to misuse for illicit purposes.

• Many platforms are unregulated, and in case of fraud, legal recourse is limited.

Operational risk and technological dependency:

• Vulnerable to cyberattacks, lost private keys, and network failures.

• Public confidence in the blockchain’s integrity is essential.

How can bank have a role in the development or management of crypto currencies? (2025 – p.27 & 28)

• Custody services: Holding crypto assets on behalf of clients (institutional or retail)

• Brokerage/trading: Offering crypto buying/selling through existing banking platforms

• Issuance of stablecoins: Banks can issue their own stablecoins backed by fiat reserves

• Central Bank Digital Currencies (CBDCs): Commercial banks may act as intermediaries in CBDC distribution — central bank issues, commercial banks distribute to clients

• Settlement infrastructure: Using blockchain/DLT for interbank settlement and clearing

• Tokenisation of assets: Banks can tokenise traditional assets (bonds, real estate) on blockchain to improve liquidity and transferability

• Financing crypto firms: Lending to or investing in crypto/blockchain companies

Explain what the “Know Your Customer” rules (what their purpose is) are and what do they require? (2022, 2023, 2025 – p.28 & 29)

Purpose:

• Prevent financial institutions from being used for money laundering, terrorist financing, and other financial crimes

• Promote transparency and traceability of transactions

• Ensure compliance with national and international regulatory frameworks

Rules:

• Customer identification & verification: Collect and verify identity of clients (name, address, ID documents) before onboarding

• Beneficial ownership: Identify the real owner behind legal entities

• Risk assessment: Classify customers by risk level (low/medium/high) → enhanced due diligence for high-risk clients

• Ongoing monitoring: Continuously monitor transactions for suspicious activity

• Politically Exposed Persons (PEPs): Apply enhanced scrutiny to individuals in prominent public positions

• Reporting obligations: File Suspicious Activity Reports (SARs) with financial intelligence units when red flags arise

What is the purpose of Corporate Governance rules and why these rules are particularly important for banks? Explain what is Corporate Governance (2022, 2023, 2024 – p.29)

Corporate Governance:

= system of rules and processes directing and controlling a company, it defines:

• how objectives are set and achieved

• how performance and risk are monitored

• how accountability is ensured

= shapes the relationship between shareholders, board of directors + executive management

→ It is about balancing the interests of these parties while ensuring the LT sustainability of the business

Key control functions of Corporate Governance:

• Internal audit reviews processes and controls across the firm.

• Risk management ensures risks are identified, measured, and mitigated.

• Compliance monitors compliance with laws, regulations, and internal policies.

• Financial control ensures integrity and transparency of financial reporting.

Failures in governance were a key contributor to the 2008 financial crisis, notably:

• Boards lacking expertise and failing to challenge management

• Inadequate attention to risk oversight

• Compensation structures that incentivised ST profits and excessive risk-taking