The 2008 Financial Crisis: How Credit and Lending Rules Changed

FT Contributor
Eyeglasses, credit cards, and car keys sit on top of a mess of credit reports and loans.

The 2008 financial crisis was a global event. Most major economies in the world felt a significant impact. Many governments created new regulations to aid in the economic recovery and to ensure that similar market crashes did not occur in the future.

One of the most significant causes of the recession was a housing bubble. Real estate prices dropped, and the number of mortgage defaults rose because people with subprime loans could not afford the payments and had no hope of recouping their initial investment because of the housing price dive.

To make matters worse, many asset-backed securities (ABS) contained subprime mortgages and other types of loans. Banks and investors owned these securities, and when the housing market crashed, banks and investors lost a lot of money. Some banks even went out of business.

Before 2008, lenders had very lax rules about qualifying for mortgages or loans. The lack of regulations governing lending was one of the most significant causes of the recession. Therefore, most of the new financial laws after 2008 had to do with mortgages and consumer lending, especially high-risk subprime loans.

As the recession wore on, banks became wary of lending to consumers who would have easily qualified for loans before 2008, so the government had to create a stimulus package to help the economy get back on track and encourage lenders to remain active.

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New Regulatory Bodies

Both the US and EU created new regulations and regulatory bodies to ensure that banking, securitization of debt, and lending activities did not lead to another recession. These reforms focused on both consumer protections and economic recovery.

Dodd-Frank Wall Street Reform and Consumer Protection Act

The Dodd-Frank Act, signed by President Obama in 2010, was officially known as the Dodd-Frank Wall Street Reform and Consumer Protection Act. The act has many different facets, and experts still debate its effectiveness and necessity.

One of the agencies that came out of Dodd-Frank that affects consumers the most is the Consumer Financial Protection Bureau (CFPB), which makes sure that banks and lenders do not do predatory lending and do not engage in overly risky lending practices. The CFPB oversees lending and credit agencies, banks, and companies that provide personal loans and payday loans.

Dodd-Frank also created the Office of Credit Ratings, which makes sure credit agencies provide accurate credit scores. Because of Dodd-Frank, you usually need a better credit score to qualify for a loan now than before 2008, but the act also makes it less likely that you will end up with an unmanageable interest rate, high fees, or unfair loan terms.

Another aspect of Dodd-Frank required banks to have a shutdown plan in case of another financial slump. The act also mandated that they create emergency reserves to cover costs during bear markets and other economic slowdowns.

Finally, Dodd-Frank led to the creation of the Financial Stability Oversight Council (FSOC), which studies risks in the banking industry and audits large banks.

Emergency Economic Stabilization Act

The Emergency Economic Stabilization Act was a bailout for banks. The U.S. Treasury bought asset-backed securities (ABS) to increase liquidity in the market and keep major financial institutions from failing. The Treasury started the Troubled Asset Relief Program (TARP), which bought these loans.

These purchases made it easier for banks to continue to offer credit to borrowers. After the recession, some banks were wary of lending to anyone except those with the best credit scores. TARP made it easier for them to justify accepting mortgage applications from people who did not have stellar credit, but who would have easily qualified for loans before the crisis.  

European Banking Authority

Established in 2011, the goal of the European Banking Authority (EBA) is to monitor banks in the European Union and predict any issues early before they lead to significant economic slumps. The Paris-based group collects and discloses data to improve transparency, and they promote cooperation between national banking systems within the EU. The EBA also mediates disputes between member countries.

The European Securities and Markets Authority

The European Securities and Markets Authority (ESMA) is an independent authority that serves the needs of investors in the EU while also making sure they abide by rules and regulations. The ESMA helps to create a single rulebook that investors in all member countries need to follow. The ESMA is also concerned with creating a secure market infrastructure and ensuring transparency within markets.

The ESMA consists of a board of supervisors with representatives from each member country and other EU regulatory authorities. The board works with market stakeholders and member countries to enhance preparations for future economic crises and to lead the response when such financial emergencies occur.

European Insurance and Occupational Pensions Authority

The European Insurance and Occupational Pensions Authority (EIOPA) is an independent agency in Frankfurt, Germany that provides financial advice to the EU’s decision-making bodies, including the European Commission, the European Parliament and the Council of the European Union.

In addition to working on overall market transparency and stability, the EIOPA puts particular emphasis on ensuring the rights of insurance customers and people with pensions (and their beneficiaries). In this way, the EIOPA is more directly consumer-oriented than the other EU regulatory agencies that came out of the 2008 financial crisis.

The Bail-In Method

The bail-in method is an alternative to a bailout. In the bailout of a financial institution, external sources, such as other banks or the government, which uses taxpayer dollars, “rescue” the failing financial institution by giving it funds to keep operating.

In a bail-in, the bank rescues itself, in a sense. A bail-in requires the cancellation of debts that it owes to creditors. The goal is to limit the use of taxpayer money to help private entities.

Bailouts were a primary tool for dealing with the 2008 crisis. The idea was that by helping banks, the government would save the country from worse economic problems, such as depression. However, the widespread use of taxpayer money to prop up banks proved very unpopular, and authorities sought ways to incorporate bail-ins, which place more burden on investors and creditors rather than on taxpayers. The EU, for example, is considering a framework that includes bail-ins as part of an early intervention strategy for struggling banks.

The Rise of Alternative Lending

The 2008 financial crisis led to some creative solutions for small businesses and individual borrowers. Small companies and startups were deeply affected by the institutional changes brought about by 2008. Because of tightening lending practices, it became a lot harder to get loans.

Businesses had to get creative. The results of this creativity include things like peer-to-peer lending, crowdfunding, and merchant cash advances.

Peer-to-peer lending involves individual investors who help fund loans to consumers or small businesses via peer-to-peer lending platforms. These platforms usually require a credit check, but they make it possible for individuals to get loans and also give loans and purchase debt without the help of a large financial institution.

Crowdfunding also relies on individuals to fund product development and startups. Usually, many individuals give a small amount to a project via the internet. Some crowdfunding projects solicit donations, while others offer equity or reward investors with incentives such as early access to the product or other bonuses.

Another funding option for small businesses is the merchant cash advance. During and after the 2008 recession, small businesses received cash advances that they paid back with a percentage of credit or debit card transactions. This method of alternative funding proved popular, and now merchant cash advances are usually short-term financing (two years or less) that merchants pay back with a percentage of their sales. They typically pay small amounts on a daily or weekly basis, which provides the benefit of cash flow to the lender.

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