Financial Crises. In this section, you will learn: common features of financial crises how...
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Transcript of Financial Crises. In this section, you will learn: common features of financial crises how...
Financial Crises
In this section, you will learn:
common features of financial crises
how financial crises can be self-perpetuating
various policy responses to crises
about historical and contemporary crises, including the U.S. financial crisis of 2007-2009
how capital flight often plays a role in financial crises affecting emerging economies
Common features of financial crises Asset price declines
involving stocks, real estate, or other assets may trigger the crisis often interpreted as the ends of bubbles
Financial institution insolvencies a wave of loan defaults may cause bank failures hedge funds may fail when assets bought with
borrowed funds lose value financial institutions interconnected,
so insolvencies can spread from one to another
Common features of financial crises Liquidity crises
if its depositors lose confidence, a bank run depletes the bank’s liquid assets
if its creditors have lost confidence, an investment bank may have trouble selling commercial paper to pay off maturing debts
in such cases, the institution must sell illiquid assets at “fire sale” prices, bringing it closer to insolvency
Financial crises and aggregate demand Falling asset prices reduce aggregate demand
consumers’ wealth falls uncertainty makes consumers and firms
postpone spending the value of collateral falls, making it harder for
firms and consumers to borrow
Financial institution failures reduce lending banks become more conservative since more
uncertainty over borrowers’ ability to repay
Financial crises and aggregate demand Credit crunch: a sharp decrease in bank lending
may occur when asset prices fall and financial institutions fail
forces consumers and firms to reduce spending
The fall in agg. demand worsens the financial crisis falling output lower firms’ expected future earnings,
reducing asset prices further falling demand for real estate reduces prices more bankruptcies and defaults increase, bank panics
more likely
Once a crisis starts, it can sustain itself for a long time
CASE STUDY
Disaster in the 1930s Sharp asset price declines: the stock market fell
13% on 10/28/1929, and fell 89% by 1932
Over 1/3 of all banks failed by 1933, due to loan defaults and a bank panic
A credit crunch and uncertainty caused huge fall in consumption and investment
Falling output magnified these problems
Federal Reserve allowed money supply to fall, creating deflation, which increased the real value of debts and increased defaults
Financial rescues: emergency loans The self-perpetuating nature of crises gives
policymakers a strong incentive to intervene to try to break the cycle of crisis and recession.
During a liquidity crisis, a central bank may act as a lender of last resort, providing emergency loans to institutions to prevent them from failing.
Discount loan: a loan from the Federal Reserve to a bank, approved if Fed judges bank solvent and with sufficient collateral
Financial rescues: “bailouts”
Govt may give funds to prevent an institution from failing, or may give funds to those hurt by the failure
Purpose: to prevent the problems of an insolvent institution from spreading
Costs of “bailouts” direct: use of taxpayer funds indirect: increases moral hazard, increasing
likelihood of future failures and need for future bailouts
“Too big to fail” The larger the institution, the greater its links to
other institutions Links include liabilities, such as deposits or
borrowings
Institutions deemed too big to fail (TBTF) if they are so interconnected that their failure would threaten the financial system
TBTF institutions are candidates for bailouts. Example: Continental Illinois Bank (1984)
Risky Rescues Risky loans: govt loans to institutions that may
not be repaid institutions bordering on insolvency institutions with no collateral Example: Fed loaned $85 billion to AIG (2008)
Equity injections: purchases of a company’s stock by the govt to increase a nearly insolvent company’s capital when no one else is willing to buy the company’s stock Controversy: govt ownership not consistent with
free market principles; political influence
The U.S. financial crisis of 2007-2009 Context: the 1990s and early 2000s were a time
of stability, called “The Great Moderation”
2007-2009: stock prices dropped 55% unemployment doubled to 10% failures of large, prestigious institutions like
Lehman Brothers
The subprime mortgage crisis
2006-2007: house prices fell, defaults on subprime mortgages, huge losses for institutions holding subprime mortgages or the securities they backed Huge lenders Ameriquest and New Century
Financial declared bankruptcy in 2007
Liquidity crisis in August 2007 as banks reduced lending to other banks, uncertain about their ability to repay Fed funds rate increased above Fed’s target
Disaster in September 2008
After 6 calm months, a financial crisis exploded:
Fannie Mae, Freddie Macnearly failed due to a growing wave of mortgage defaults, U.S. Treasury became their conservator and majority shareholder, promised to cover losses on their bonds to prevent a larger catastrophe
Lehman Brothers declared bankruptcy, also due to losses on MBS Lehman’s failure meant defaults on all Lehman’s
borrowings from other institutions, shocked the entire financial system
Disaster in September 2008 American International Group (AIG)
about to fail when the Fed made $85b emergency loan to prevent losses throughout financial system
The money market crisis Money market funds no longer assumed safe, nervous depositors pulled out (bank-run style) until Treasury Dept offered insurance on MM deposits
Flight to safetyPeople sold many different kinds of assets, causing price drops, but bought Treasuries, causing their prices to rise and interest rates to fall to near zero
The flight to safety:BAA corporate bond and 90-day T-bill rates
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An economy in freefall Falling stock and house prices reduced consumers’
wealth, reducing their confidence and spending.
Financial panic caused a credit crunch; bank lending fell sharply because: banks could not resell loans to securitizers banks worried about insolvency from further
losses
Previously “safe” companies unable to sell commercial paper to help bridge the gap between production costs and revenues
The policy response TARP – Troubled Asset Relief Program (10/3/2008)
$700 billion to rescue financial institutions initially intended to purchase “troubled assets” like
subprime MBS later used for equity injections into troubled
institutions result: U.S. Treasury became a major shareholder
in Citigroup, Goldman Sachs, AIG, and others
Federal Reserve programs to repair commercial paper market, restore securitization, reduce mortgage interest rates
The policy response Monetary policy:
Fed funds rate reduced from 2% to near 0% and has remained there
The fiscal stimulus package (February 2009): tax cuts and infrastructure spending costly nearly
5% of GDP Congressional Budget Office estimates it boosted
real GDP by 1.5 – 3.5%
The aftermath
The financial crises eases Dow Jones stock price index rose 65% from
3/2009 to 3/2010 Many major financial institutions profitable in
2009 Some taxpayer funds used in rescues will
probably never be recovered, but these costs appear small relative to the damage from the crisis
The aftermath: unemployment persistsD
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The aftermath Constraints on macroeconomic policy
Huge deficits from the recession and stimulus constrain fiscal policy
Monetary policy constrained by the zero-bound problem: even a zero interest rate not low enough to stimulate aggregate demand and reduce unemployment
Moral hazard The rescues of financial institutions will likely
increase future risk-taking and the need for future rescues
Reforming financial regulation: Regulating nonbank financial institutions Nonbank financial institutions (NBFIs) do not
enjoy federal deposit insurance, so were less regulated than banks
Since the crisis, many argue for bank-like regulation of NBFIs, including: greater capital requirements restrictions on risky asset holdings greater scrutiny by regulators
Controversy: more regulation will reduce profitability and maybe financial innovation
Reforming financial regulation: Addressing “too big to fail” Policymakers have been rescuing TBTF
institutions since Continental Illinois in 1984.
Since the crisis, proposals to limit size of institutions to prevent them from
becoming TBTF limit scope by restricting the range of different
businesses that any one firm can operate
Such proposals would reverse the trend toward mergers and conglomeration of financial firms, would reduce benefits from economics of scale & scope
Reforming financial regulation: Discouraging excessive risk-taking Most economists believe excessive risk-taking is a
key cause of financial crises.
Proposals to discourage it include: requiring “skin in the game” – firms that arrange
risky transactions must take on some of the risk reforming ratings agencies, since they
underestimated the riskiness of subprime MBS reforming executive compensation to reduce
incentive for executives to take risky gambles in hopes of high short-run gains
Reforming financial regulation: Changing regulatory structure There are many different regulators, though not by
any logical design.
Many economists believe inconsistencies and gaps in regulation contributed to the 2007-2009 financial crisis.
Proposals to consolidate regulators or add an agency that oversees and coordinates regulators.
CASE STUDY
The Dodd-Frank Act (July 2010) establishes a new Financial Services Oversight
Council to coordinate financial regulation
a new Office of Credit Ratings will examine rating agencies annually
FDIC gains authority to close a nonbank financial institution if its troubles create systemic risk
prohibits holding companies that own banks from sponsoring hedge funds
requires that companies that issue certain risky securities have “skin in the game” and retain at least 5% of the default risk
Financial crises in emerging economies Emerging economies: middle-income countries
Financial crises more common in emerging economies than high-income countries, and often accompanied by capital flight.
Capital flight: a sharp increase in net capital outflow that occurs when asset holders lose confidence in the economy, caused by rising govt debt & fears of default political instability banking problems
Capital flight
Interest rates rise sharply when people sell bonds
Exchange rates depreciate sharply when people sell the country’s currency
Contagion: the spread of capital flight from one country to another occurs when problems in Country A make people
worry that Country B might be next, so they sell Country B’s assets and currency, causing the same problems there
like a bank panic
Capital flight and financial crises Banking problems can trigger capital flight
Capital flight causes asset price declines, which worsens a financial crisis
High interest rates from capital flight and loss in confidence cause aggregate demand, output, and employment to fall, which worsens a financial crisis
Rapid exchange rate depreciation increases the burden of dollar-denominated debt in these countries
Crisis in Greece
Caused by rising govt debt, fear of default
Asset holders sold Greek govt bonds, which caused interest rates on those bonds to rise
Facing a steep recession, Greece could not pursue fiscal policy due to debt, or monetary policy due to membership in the Eurozone
Crisis in Greece
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The International Monetary Fund International Monetary Fund (IMF):
an international institution that lends to countries experiencing financial crises established 1944 the “international lender of last resort”
How countries use IMF loans: govt uses to make payments on its debt central bank uses to make loans to banks central bank uses to prop up its currency in
foreign exchange markets
SECTION SUMMARY
Financial crises begin with asset price declines, financial institution failures, or both. A financial crisis can produce a credit crunch and reduce aggregate demand, causing a recession, which reinforces the financial crisis.
Policy responses include rescuing troubled institutions. Rescues range from riskless loans to institutions with liquidity crises, giveaways, risky loans, and equity injections.
SECTION SUMMARY
Financial rescues are controversial because of the cost to taxpayers and because they increase moral hazard: firms may take on more risk, thinking the government will bail them out if they get into trouble.
Over 2007-2009, the subprime mortgage crisis evolved into a broad financial and economic crisis in the U.S. Stock prices fell, prestigious financial institutions failed, lending was disrupted, and unemployment rose to near 10%.
SECTION SUMMARY
Financial reform proposals include: increased regulation of nonbank financial institutions; policies to prevent institutions from becoming too big to fail; rules that discourage excessive risk-taking; and new structures for regulatory agencies.
Financial crises in emerging market economies typical include capital flight and sharp decreases in exchange rates, which can be caused by high government debt, political instability, and banking problems. The International Monetary Fund can help with emergency loans.