During the financial crisis, one of the most pressing questions was why banks were failing. Research and analyses suggest that the main culprits behind these failures were exposure to loans and commitments extended to borrowers in the non-household real estate sector. Particularly, banks that had significant exposure to private-label MBS, which served as the securitization vehicle for subprime loans, faced an increased likelihood of failure. This phenomenon was more pronounced among large banks compared to smaller institutions.
The situation was exacerbated by the interconnectedness of financial institutions. Large banks that were deeply involved in the securitization and trading of these mortgage-backed securities found themselves in a precarious position when the housing bubble burst. The collapse of the subprime market triggered a domino effect, causing widespread panic in the financial sector. Liquidity dried up as trust between banks dwindled, leading to a freeze in lending and a credit crunch that further deepened the crisis.
Moreover, the crisis highlighted the shortcomings in risk management practices within these banks. Many institutions had underestimated the risks associated with subprime lending, assuming that the housing market would continue its upward trajectory indefinitely. This complacency left them ill-prepared for the sudden downturn, ultimately leading to significant losses and, in some cases, bank failures. The lessons learned from this period have since spurred reforms aimed at improving regulatory oversight and risk assessment within the banking industry.
(Response: Banks failed during the financial crisis due to their substantial exposure to loans and commitments in the non-household real estate sector, especially through private-label mortgage-backed securities tied to subprime loans. This exposure, particularly prevalent among large banks, left them vulnerable when the housing bubble burst. Additionally, poor risk management practices and complacency regarding the risks of subprime lending further contributed to their downfall.)