5 Financial Crisis Flashcards
Five stages (start: exogenous shock to macroeconomic system)
- credit expansion (asset prices)
- Euphoria (overtrading)
- Distress (unexpected failures)
- Discredit (liquidation)
- panic (desire for cash=
Factors causing Financial Crisis
Asset market effects on balance sheets Deterioration in FI’s balance sheets Banking crisis Increases in uncertainty Increases in interest rates Government fiscal imbalances
Financial CrisisCrisis– the asymmetric information approach
Afinancial crisis occursoccurswhen an increaseincreasein asymmetric information fromfromadisruptiondisruptionin the financial
system causes severe adverse selectionselectionand moral hazard problems that render financial markets
incapableincapableof channelingchannelingfunds effciently from saverssaversto borrowersborrowers(householdshouseholdsand firms with
productive investment opportunitiesopportunities)
When financial markets failfailto function efficientlyefficiently,economic activity contracts sharply
Asset market effects on borrowers’ balance sheets
decline in stock market –> lenders less willing to lend (collateral value declines) parallel increases moral hazard (borrowing firms make risky investments)
- -> lenders decrease lending
- -> investment and aggregate output decline
Deterioration in FI’s balance sheets
asset price decline leads to write down of balance sheet of FI, –> lenders habe a substantial contraction in their capital –> lenders have fewer resources to lend and lending will decline –> investment declines which shows economic activity
Banking crisis
if deterioration of the Fis balance sheet is severe enough, they will start to fail –> contagion risk increases –> less supply available for borowers, leads to higher interest rates –> even sharper decline in lending and economic activity
Increases in uncertainty
hard for lenders to screen bad loan –> lenders less willing to lend –> investment and aggregate output decline (decline in economic activity)
Increase in interest rates
Riskier firms have WTH –> increase in adverse selection –> lenders are less willing to lend –> decline in economic activity
Government fiscal imblances
Demand fro individual investors for government bonds will fall –> government force FI to purchase those bonds –> if price of bonds decline, deterioration of the Fiscal balance sheet will occur –> Investment and aggregate output decline
Government fiscal imbalances also leads to foreign exchange crisis
Investors pull money out of country –> decline din domestic currency value –> deterioration of balance sheet of firms that have debt in foreign currency –> increase adverse selection and moral hazard –> ALLLLL DECLINES
The Great Depression The Mother of all Financial Crisis
In 1928 and 1929 prices doubled in the U S stock market
Federal Reserve pursued a ( tight monetary policy to raise interest rates leading to the stock
market crash in October 24 1929 Black Thursday
Although the decline in the stock market had been reversed by 1930 the economic recession
became worse and spread to the banking system
From October 1930 to March 1933 a sequence of bank panics followed (more than one third of U S banks
went out of business)
The contraction of the banking system reduced the amount of financial intermediation
The economic contraction worsened adverse selection and moral hazard problems in the credit markets
intensified adverse selection and moral hazard problems decreased the ability of financial markets to
channel funds to firms with productive investment opportunities
Consumption and investment levels dropped, causing steep declines in industrial output and employment
unemployment rose to 25 of the labor force
WAY OUT :
The Securities Act of 1933
A ll issuers of securities have to disclose sufficient information to potential investors
regarding their own financial status
All public securities offers have to be registered with the Securities and Exchange
Commission ( the main regulatory authority to oversee stock exchanges, credit
rating agencies ( and private regulatory organizations involved in overlooking
practices of auditing securities and accounting
The Glass Steagall Act 1933 1999
Prohibited commercial banks from underwriting or dealing in corporate securities,
which were activities exclusively reserved for investment banks
Created the Federal Deposit Insurance Corporation ( to guarantee each bank
deposit account up to a certain maximum amount
Government stabilization of the housing market
The US government established several public and quasi public institutions to assist
families which otherwise would have been unable to purchase their homes
–> enhanced housing market and financial innovation
The Subprime Financial Crisis of 2007 2008
Mismanagement of financial innovation in the mortgage markets
new class of riskier residential mortgages –> subprime mortgages , that were securizised by large FI –> security bundles –> called mortgage-backed securities
–> demand for that was so high that lenders needed more money and lend to riskier borrowers : moral hazard went up: poor history of credit history
–> Collateralized debt obligations (CDOs)
–> house pricing bubble
–> default of mortgages
–>. banks balance sheet deteriorated, large Fis failed, crisis spread globally
From the Subprime Financial Crisis of 2007 2008 to the European Sovereign Debt Crisis
First: countries that invested in US and domestic mortgage-related securities
Problems arising from the malfunctioning of the sovereign debt market
price channel: increase in government bonds price is followed by increase in funding costs for banks (which are then passed on with some lag to bank lending rates)
liquidity channel: government bonds are prime collateral in repo markets. –> reduction in available collateralized credit
balance sheet channel:
