04. Exam - International Financial Crises Flashcards
What is a financial crisis?
Usually involves a banking crisis, a debit crisis and/or an exchange rate crisis. They result in disintermediation and a slow down in economic activity that may be severe.
What is a banking crisis?
Occurs when banks fail and disintermediation spreads.
What is an exchange rate crisis?
Collapse of country’s currency
What are contagion effects?
The spread of a crisis from one country to another. This may happen through trade flows, currency and exchange rate movements or a change in the perceptions of foreign investors.
What is the international financial architecture?
It is the complex of institutions, international organisations, governments and private economic agents that make up the international financial system.
What do many of the international financial architecture reforms revolve around?
A set of proposed changes to the IMF and other multilateral institutions with a role in international finance relations.
What is intermediation?
The role of the banks as institutions that concentrate savings from many sources and lend money to investors.
What is disintermediation?
A failure on the part of the banking system that prevents savings from being channeled into investment.
What is a debt crisis?
A financial crisis brought on by unsustainable levels of debt. The debt may be either privately or publicly funded.
How does an exchange rate crisis occur (for each different type of currency exchange)?
- Under a fixed exchange rate system, crisis entails the loss of international reserves and devaluation.
- Under a flexible exchange rate system, crisis means an uncontrolled, rapid depreciation of the currency.
- Countries with a pegged exchange rate may be more vulnerable to a crisis.
What are the two origins of international financial crisis?
1) Macroeconomic imbalances such as large budget deficits caused by overly expansionary fiscal policies; and
2) volatile flows of financial capital that move in and out of a country quickly.
Crises caused by macroeconomic imbalances are often accompanied by what
An exchange rate system that intensifies the country’s vulnerability.
Explain how the 2007 crisis partially fits with a macroeconomic imbalance scenario?
Investment was facilitated by global imbalances where countries with high savings rates and large current account surpluses lent to countries with large current account deficits and significant demand for investment.
- In 2007 the housing bubble collapsed
- Banks were unable to lend (becoming insolvent)
- Resulted in steep decline in customer / business spending
What is sovereign debt?
A debt crisis in which the government cannot pay back its loans.
What is the fundamental cause of a crisis caused by volatile capital flows?
- the financial capital is highly volatile and technological advances have reinforced this volatility. A weak financial sector also intensifies these problems.
When banks take on short-term international debt to fund long-term domestic loans, what are the three unsettling possible scenarios?
1) there are multiple possible outcomes (multiple equilibria)
2) A self-fulfilling crisis
3) The crisis affects banks that are fundamentally sound, but have mismatches between maturities of assets and debts - they are illiquid but not insolvent.
What is Moral Hazard?
It is the incentive to act in a manner that creates personal benefits at the expense of the common good - ie. banks have an incentive to make riskier investments when they know they will be bailed out.
What is a way to avoid moral hazard in banks?
Increasing the capital requirements, so that banks have more capital available. Basel accord 1989 & updated in 2010 (Basel III) have made banking systems more robust by setting new standards for bank supervision, information disclosure and stress tests.
What are the three best practices to reduce the problem of moral hazard?
- capital requirements
- supervisory review
- information disclosure requirements
What is a crawling peg exchange
An exchange fixed to a major world currency or a basket of currencies.
Why does the crawling peg increase vulnerability to a financial crisis (2)?
- requires monetary authorities to exercise discipline in issuing new money; anti-inflationary tendencies are exacerbated by international slow deflation; a sever overvaluation of the real exchange rate may result;
- Exiting crawling peg is also difficult - a government leaving it may lose the confidence of investors.
What are capital controls?
They are controls which may be imposed to prevent capital movements in the financial account. The control inflows and outflows.
What are the inflow restrictions (capital control)
They reduce the inflow of short-run capital which would add to the stock of liquid, possibly volatile capital. These tend to work better than outflow restrictions.
What is the impact of outflow controls and when are these best used?
They may help reduce the impact of a crisis when it occurs.
What are possible domestic policies for crises management?
- Cutting the deficit
- Raising the interest rates to help defend the currency
- Letting the currency float.
What are the problems with implementing domestic policies to manage a crisis?
- they may not be politically feasible
- sudden capital flight is hard to cure
- collapsing currency may be defended by raising interest rates, but this may cause other issues such as bankruptcy.
There are new international policies in the reform of the international architecture to avoid and manage a financial crisis, the great variety of the reform proposals tend to focus on what two issues?
1) the role of an international lender of last resort
2) conditionality - ie the changes in economic policy that a borrowing nation must meet in order to receive loans from the lender of last resort.
What is a lender of last resource?
A source of loanable funds after all commercial sources of lending become unavailable - this includes the central bank (domestically) and the IMF with the support of high-income countries (internationally).
What do opponents and proponents of the lender of last resort say?
- opponents - cite moral hazard issues
- proponents - lender can reduce moral hazard by requiring increased financial sector regulations
Debate on the IMF’s role as a lender of last resort and moral hazard centres on two areas?
- the rules for IMF loans depend on the size of the loan. Countries pay a subscription (quota) to join. The quota depends on the size of the economy & its strength.
- loan size is up to 300% of their quota unless extraordinary circumstances (eg Mexico)
What are the conditions that the IMF requires?
- Changes to monetary & fiscal policies - financial sector
- changes to exchange rate policies - international trade
- Change to structural policies - public enterprises
How does the IMF go about making the loans to countries?
In tranches (installments of the total loan) with each tranche hinging on the completion of reform targets.
What two points do critics of the IMF’s conditionality state?
1) the need to comply with conditionality’s may intensify the recessionary effects of a crisis; and
2) Conditionality may entail high social costs on the poorest in society.
What do supporters of the IMF’s conditionality state (2) and how do critics respond to this?
- Crises could be avoided by a pre-qualification criteria;
- Assistance conditional on sound financial sector policies
However critics respond by saying that pre-qualification will not deter speculative attacks on a country’s currency and that the IMF cannot ignore countries who fail to qualify.
There is a need for greater transparency to make a country’s financial standing clearer to potential lenders - what are two ways that this is occurring?
1) Basel Capital Accord includes issues of transparency and data reporting
2) Data dissemination standards by the IMF for data reporting are under development.
What are two options for resolving a conflict between lenders (eg the private sector insist they are paid first)
- Standstills - IMF’s recognition that a country in crisis temporarily stop making repayments on its debt
- Collective action clauses - lenders agree on collective mediation among themselves and the debtor in the event of a crisis.
After the Asian crises financial reform was at the top of the world’s agenda - what progress has been made and why?
Little - and attention is being focused on security, terrorism, energy and climate change.
The first visible stage of the financial crisis of 2007 was the subprime crisis - explain this.
Housing loans were made in the US to borrowers with less than prime ratings. Banks and other non-bank entities packaged these loans and sold shares in the entire package. This securitisation allowed buyers to receive a return based on the interest the borrowers paid.
What is sovereign wealth funds?
savings held by governments.
