The role of the banking sector performance in the crisis of 2007
The drying-up of liquidity and freezing of the interbank markets during the crisis of 2007 led to the debasement of banks' balance sheets. At the same time, both bank lending and business production suffered from the drop in consumer demand. The near-collapse of Bear Stearns and failure of Lehman Brothers are both characterized as liquidity shocks that had a greater impact on financially fragile non-financial firms. In the second half of 2008, after a series of bankruptcies of large financial institutions, the U.S. Treasury poured capital infusions into domestic financial institutions under the Capital Purchase Program (CPP), thus helping to avert a complete collapse of the U.S. banking sector. Government regulators had to distinguish between those banks deserving of being bailed out and those that should be allowed to fail. The results of this study show that the CPP favored larger financial institutions whose potential failure represented higher degrees of systemic risk. This allocation of CPP funds was cost-effective from the point of view of taxpayers, as such banks reimbursed the government for their CPP bailouts sooner than expected. In contrast, smaller banks that were heavily into mortgage-backed securities, mortgages, and non¬performing loans were less likely to be bailed out. Finally, the effectiveness of the CPP is analyzed in chapter 4 in terms of restoring banks' loan provisions. Banks that have a higher level of capitalization tend to lend more both during the crisis and in normal rimes. Moreover, bailed-out banks that repurchased their shares from the V.S. Treasury provided more loans during the crisis than those banks that did not.