Chapter 17 Flashcards
shadow banking
composed of a wide variety of types of financial firms: investment banks (lehman brothers), hedge funds (LTCM), and money market funds
- vulnerable to bank runs bc they perform maturity transformations
- banks do not accept deposits
maturity transformations
the transformation of short-term liabilities into long-term assets
ex: convert deposits into bank loans that earn interest
trade off between rate of return and liquidity
banks allow people to to have ready access to their funds (liquidity) even while those funds are being used to make loans for productive purposes
-without banks, this would be hard
what depository banks do:
- accpet the savings of individuals, promising to return them on demand
- but put most of those funds to work by taking advantage of the fact that not everyone will want access to those funds at the same time
- **borrow on a short term basis from depositors and lend on a long term basis to others ***
shadow bank
nondepository financial institution that engages in maturity transformation
- lenders to shawdow banks benefit from liquidity (their loans get reapid often overnight) and higher return compared to other ways of investing thier funds
- become popular because there were not as many regulations for shadow banks (like reserve requirements)
How a shadow bank can fail
if lenders suddenly decide one day that its no longer safe to lend the shadow bank money, the bank can no longer fun its operations. Unless it can sell assets immediately to raise cash, it will quickly fail
banking crisis
occurs when a large part of the depository banking sector or the shadow banking sector fails or threatens to fail
-rare (unlike bank failures)
explanations for bank crises:
- asset bubble
- financial contagion
asset bubble
in an asset bubble, the price of an asset is pushed to an unreasonably high level due to expectations of further price gains
ex: housing
- when bubble bursts, prices fall –> this undermines the confidence in financial institutions which can lead to financial contagion
financial contagion
a vicous downward spiral among depository banks or shadow banks: each bank’s failure worsens fears and increases the likelihood that another bank will fail
- rises from the logic of bank runs
- shadow banking sector is especially prone because its unregulated
financial panic
a sudden and widespread disruption of the financial markets that occurs when people suddenly lose faith in the liquidity of financial institutions and markets
-almost always involves a banking crisis
severe banking crises almost always lead to disruptions in the _______ markets
stock and bonds
-lead to cycle of deleveraging
in more advanced countries, banking crises almost always occur as a consequence of _____
an asset bubble
-typically in real estate
since 2008, what banking sectors in the US have grown/shrank
- depository banking sector has grown
- shadow banking shrank
severe banking crisis
a crisis in which a large fraction of the banking system either fails outright or suffers a major loss of confidence and must be bailed out by the government
- lead to deep recessions followed by slow recoveries
- followed by a 7% rise in unemployment
Three main reasons that a banking crisis leads to recession:
- credit crunch
- debt overhang
- loss of monetary policy effectiveness
credit crunch
potential borrowers either can’t get credit at all or must pay very high interest rates
-unable to borrow or unwilling to pay high rates, businesses and consumers cut back on spending, pushing the economy into recession
debt overhang
occurs when a vicious circle of deleveraging leaves a borrower with high debt but diminished assets
- lowers value of assets and undermines banks solvency
- or debt overhand for consumers and their lower priced houses that they can’t pay off
- leads to a fall in spending and a recession as consumers and businesses cut back
loss of monetary policy effectiveness
usually monetary policy is used to fight the negative demand shocks caused by a fall in consumer investment spending …but can’t
central banks and government take three main kinds of action in an effort to limit the fallout from banking crises:
- they act as a lender of last resort
- they offer gaurentees to depositors and others with claims on banks
- an extreme crisis, a central bank will step in and provide financing to private credit markets
lender of last resort
an institution, usually a country’s central bank, that provides funds to financial institutions when they are unable to borrow from the private credit markets
- the central bank can provide cash to a bank that is facing a run by depositors but is fundamentally solvent, so the bank doesnt have to sell assets
- lifeline – works to prevent a loss of confidence in the banks solvency
government gaurentees
- gov can step in a guarentee a banks liabilities if people believe the bank is insolvent and will fail
- governments that take on banks risks often take ownership of the banks they are rescuing — almost always temporary
provider of direct financing
- lending to shadow banks
- buying commercial paper
- buying debt
- the fed provided credit to keep the economy afloat
aftershocks of 2008 financial crisis for Europe
- fears of bad pulic debts
- greece
- spain –> investors were worried about the solvency of spanish government and a possible default, driving up interest rates
stimulus fans claims:
- continuing poor performance of economies - high unemployment, low inflation
- expansionary fiscal policy
austerity appeals:
- common source of all problems are gov. debts
- cuts in gov spending would improve investor confidence and keep interest rates on gove debt low
repo
very short term loans
(overnight)
what made the shadow banking sector vulnerable:
- repo
- being outside the londer-of-last resort system
- lack of regulation
Four main elements of the Dodd Frank bill (wall street consumer protection act)
- consumer protection
- derivatives regulation
- regulation of shadow banks
- resolution authority over nonbank financial institutions that face bankrupcy
consumer protection
- borrowers accpeted offers they didnt understand
- new law protects borrowers
derivatives regulation
derivatives have to be bought and sold in open, transparent markets
regulation on shadow banks
can designate financial institutions as “systematically important” aka they could start a crisis –which will be subject to regulation
resolution authority
empower govs to seize control of financial institutions that require a bailout
