Chapter 12

Question 1

When does a financial crisis occur

Answer 1

large disruption to information flows in financial markets

capitals not allocated efficiently, creating financial friction

markets stop functioning, economy activity falls

Question 2

3 stages of financial crisis

Answer 2

1. initiation
   - credit boom and bust, asset price boom and bust, increased uncertainty
2. banking crisis
3. debt inflation

Question 3

credit boom and bust

Answer 3

begun by the rapid expansion of lending, leading to credit boom

inadequate risk management led to overly risky lending

Question 4

Asset price bubble

Answer 4

w/ credit boom came an increased demand for assets

once these prices decline, financial institutions capital declines, activity declines, economy collapses

Question 5

uncertainty and its impact

Answer 5

with bank failures, information is hard to find which leads to uncertainty, then financial frictions, reduced lending, then reduced economic activity

Question 6

banking crisis

Answer 6

after credit and asset booms and eventual busts, leads to deteriorating balance sheets and insolvency

this leads to bank panic and bank runs

asset prices fall further, worsening adverse selection and financial crises, decline in investment, economy collapses

Question 7

Debt inflation

Answer 7

economic downturn leads to steep price declines, so real burden of liabilities increases

decline in networth and worsening the moral hazards and adverse selection problems, decline in lending and economic activities

Question 8

steps until 2007-2009 financial crisis

Answer 8

1. financial innovations due to advances in technology and mortgage markets
2. agent principal problems w/ assymetric information
3. agent principal problems and credit rating agencies

Question 9

why did housing bubble burst

Answer 9

housing prices began to decline in 2006, homeowners owed more than their house was worth, leading to defaults

this translated to banks balance sheets, lower funds available, economy contracted, crisis spread globally

Question 10

microprudential supervision

Answer 10

supervision focuses on the safety and soundness of individual financial institutions and assesses the riskiness of their activities

capital ratio

not enough to present a financial crisis

Question 11

macroprudential supervision

Answer 11

focuses on safety and soundness of entire financial system

controls total capital adequacy, sufficient liquidity, capital requirement countercyclical

Question 12

5 parts to Dodd-Frank wall street reform and consumer protection act of 2010

Answer 12

• consumer protection
• resolution authority
• systematic risk regulation
• Volcker rule
• derivatives

Question 13

Dodd-Frank - consumer protection

Answer 13

The legislation requires
lenders to make sure that
the borrowers can repay
mortgages. (verification of
income, credit scores, job
status,..)

Question 14

Dodd-Frank - resolution authority

Answer 14

Give the US government the
authority to seize troubled
institutions especially those
posing a risk to the overall
health of the financial
system.

Question 15

dodd-frank - systematic risk regulation

Answer 15

Monitoring markets for asset
price bubbles and the build
up of systemic risk.

Question 16

Dodd-Frank Volcker Rule

Answer 16

Limit the ability on banks to
trade with their own money.
(Volcker believed banks
should not take large
trading risk when they
receive benefits of FDIC

Question 17

dodd-frank derivatives

Answer 17

Limit the trading of
derivatives such as credit
default swaps.