15/16. FINANCIAL CRISIS

Question 1

financial crisis

Answer 1

major disruptions in financial markets characterized by sharp declines in asset prices and firm failures (bankruptcies)

Question 2

when does a financial crisis occur?

Answer 2

when information flows in financial markets experience a large disruption

Question 3

asymmetric information in financial markets

Answer 3

creates barriers between investors and firms with productive investment opportunities

Question 4

asymmetric info can articulate itself in 2 forms

Answer 4

1. adverse selection
2. moral hazard

Question 5

adverse selection

Answer 5

when one party in a transaction has better info than the other party

seller might trick the investor into thinking that the asset being sold is better than it actually is

Question 6

moral hazard

Answer 6

when one party has the incentive to behave differently once an agreement is made

Question 7

3 phases of financial crisis

Answer 7

1. initial phase
2. banking crisis
3. debt deflation

Question 8

3 seeds of financial crisis

Answer 8

1. mismanagement of financial liberalization or innovation
2. asset price boom and bust
3. increase in uncertainty

Question 9

Mismanagement of financial liberalization or innovation

Answer 9

• Deregulation (elimination of legal restrictions on how to behave in financial markets)
• introduction of new types of securities that may be difficult to understand for investors

Question 10

consequences of mismanagement

Answer 10

can lead to credit boom where risk management is lacking:
- banks lend too much money (raises the risk of payback of loans)
- loan losses accrue and asset values fall –> reduction in capital
- deleveraging = banks cut or stop lending
- banks receive less deposits from customers

Question 11

asset price boom and bust

Answer 11

• pricing bubble starts = asset values > fundamental values
• stock market bubble takes place when market participants drive stock prices above their value –> unrealistic expectations on growth and future dividends
• bubble bursts and prices fall, corporate net worth falls as well.
  Moral hazard increases = firms start gambling with share and bondholders money

Question 12

increase in uncertainty

Answer 12

can lead to stock market crashes or failure of a major financial institution –> difficult to form expectations and therefore to invest

moral hazard and adverse selection increase, reducing lending activity

Question 13

2. banking crisis

Answer 13

deteriorated balance sheets –> lead financial institutions into insolvency –> lead to bank panic:

-depositors are unsure which banks are insolvent = they withdraw all funds immediately
-cash balances fall –> banks must sell assets quickly –> further deterioration
-years to full recovery

Question 14

3. debt deflation

Answer 14

occurs when there’s a sharp decline in asset prices but debt levels don’t adjust –> increasing debt burdens

• prices and wages fall with the price level, but nominal size of bonds and loans and coupon/interest payments are fixed –> borrowers faces increasing pressure on their ability to repay what they have borrowed

-can lead to vicious cycle