chp12 Flashcards
what are financial frictions?
when there’s a disruption to efficient capital allocations
what type of information is involved with financial frictions?
assymetric information
assymetric information
adverse selection and moral hazard
why is it unclear if loans will be paid back?
banks don’t know if they are loaning money to a high or low risk person
what do banks do if they can’t decide whether a person is high or low risk to give a loan to?
not loan out any funds at all
if banks don’t give out loans (because they’re being cautious) what will happen?
inefficient number of loans being made, affecting general levels of
consumption for items such as houses and cars. This is an example of a financial friction.
banks don’t give out loans to be cautious. Less loans mean consumption of things are affected. what is this an example of?
financial friction
financial crisis
when economic activity suffers from an information problem
what does a financial crisis cause?
tremendous financial frictions
name the 3 stages involved in a financial crisis (IBD)
initial phase
banking crisis
debt inflation
What do we observe in the initial phase of a financial crisis? (Mr. A)
more uncertainty
reduction in the balance sheets of banks
asset-price decline.
what is a result of the initial phase of a financial crisis?
causes asymmetric information
leads to banking stage 2: crisis
what do we observe in the banking crisis stage of a financial crisis (W GF)
worsened asymmetric information.
general fall in economic activity (output or consumption)
fallout amongst banking institutions
What is a result of the banking crisis stage of a financial crisis?
leads to 3rd stage: debt inflation
what do we observe in the debt inflation stage of a financial crisis?
unexpected decline (negative shock) in price level (think about the opposite of inflation).
what is a result of the debt inflation stage of a financial crisis?
even worse asymmetric information and falls to economic activity occur.
what can we find from monetary policy for a financial crisis?
the Federal Reserve attempt to counteract the effects of financial crisis to reach a “steady-state” again.
what does the Federal Reserve try to do during a financial crisis?
counteract effects to reach a “steady- state”
(initial phase) define financial innovation
creating new forms of loans and financial products in an economy
(initial phase) define financial liberalisation
reducing and removing restrictions on banking institutions
explain financial innovation
banks offer loans with a new alternative collateral such as Calvin Klein hoodies. Josh now may be able to take out loans
by using hoodies as a guarantee for the loan in case of default.
explain financial liberalisation
If before a bank was only allowed to lend 80% of its total funds and now can instead lend up to 100%, then this reflects a change in the required reserves requirement. This gives
greater flexibility to banks to issue loans. This is a form of financial liberalization.
what is credit boom a possible side-effect of?
financial liberalisation
(initial phase) define credit boom
possible side-effect of financial liberalization in which banks choose to make many loans in comparison to a period before the removal of restrictions
(initial phase) define deleveraging
a condition by which banks reduce the number of loans made to individuals or the amount of loans
(initial phase) define asset price bubble
an asset’s price exceeds that of its fundamental value
what does deleveraging tend to follow?
a credit boom, as banks have lent out most of its funds or capital
why is it hard to say if asset price bubble actually exist or not?
only easy to see them after a decline happens or there’s a crash in value
give an exmaple of asset-price bubble
people paying £4mil for a home that has a fundamental value of £3mil
(banking crisis and debt inflation) define fire sale
bank chooses to quickly sell its assets in order to increase its funds or capital
(banking crisis and debt inflation) define debt inflation
price-level decreases (the opposite of inflation) leads to a decline in the value or net worth of firms
example of debt inflation
If the products a firm sells are suddenly priced or valued at a lesser amount, then the overall worth of the firm decreases.
For example, if General Motors produces cars that previously retailed for $20,000 and deflation leads to their retailing at $18,000, then it may be the case that General Motors suddenly declines in worth as a firm.
(banking crisis and debt inflation) define haircut
situation where required collateral exceeds the amount of a loan
example of a haircut situation
Josh has a 2-door convertible sports car (worth $45,000) and just decided to buy a second car (priced at $30,000) for day-to-day use.
When Josh goes to the local bank to take out a loan for the car, the bank requires that Alan use the full worth of the sports car as collateral to take out a loan to buy the second car. The bank is exercising a haircut because the value of the collateral sports car exceeds that of the
new car.
(banking crisis and debt inflation) define financial derivative
a financial instrument which is tied in payoff to a previously issued security
(banking crisis and debt inflation) what is Troubled Asset Relief Program (TRAP)
federal government enabled the U.S.
Treasury to purchase subprime mortgage assets from struggling banking institutions
what was TRAP made in response to?
07/08 financial crisis
(banking crisis and debt inflation) define stress test
a test performed on a financial institution or bank to inspect potential losses and necessary capital to survive in periods of financial friction or crisis
why are stress tests implemented? what do they reduce?
stop potentially problematic activity of banks in issuing loans.
describe example of a stress test
(what is a bank doing, what will the stress test check)
if a bank is loaning too much or is making loans to individuals with certain credit ratings, a stress test will check to see if the bank could continue to operate if suddenly a crisis occurred.
what’s the ultimate goal of the stress test
to help banks to recognise when they are acting haphazardly and curb this behaviour
