Financial Crises Flashcards
what is a financial crisis
Financial crises are, at a certain level, extreme manifestations of interactions between the financial sector and the real economy.
discuss bank runs
As a bank run proceeds, it generates its own momentum, leading to a self-fulfilling prophecy. This can destabilise the bank to the point where it faces bankruptcy as it cannot liquidate assets fast enough to cover its short-term liabilities (fire sales of assets).
- Often preceded by Asset and Credit Booms.
what are two main explanations of a financial crisis
asset price bubbles
credit booms
discuss the explanation of asset price bubbles
- Rational Behaviour
- Frictions in Financial Markets as well as on the role of institutional factors.
- Others make reference to the existence of irrational behaviour.
discuss the explanation of credit booms
- Shocks including Changes in Economic Policies and Capital Flows.
- Accommodative Monetary Policies
- Sharp increases in International Financial Flows.
- Structural factors include Financial Liberalisation and Innovation.
what is Minsky’s Financial Instability Hypothesis (FIH)
The theory explains how the financial relationships between economic units can lead to growing indebtedness, rendering the macro system more fragile and prone to crisis.
- According to Minsky’s, the increase in financial fragility is endogenous and not the result of exogenous shocks or irrational behaviour.
what are Minsky’s 3 finance regimes
hedge finance regimes
speculative finance regimes
ponzi finance regimes
discuss hedge finance regimes
inflows are expected to be higher than the sum of interest and principal repayment commitments. A hedge unit is deemed viable and debt financing is not expected.
discuss speculative finance regimes
Inflows can cover the interest payments but not the principal repayment commitments. As a result, a speculative economic unit is expected to take on new debt in order to cover (partially or totally) the amortisation of debt commitments.
discuss ponzi finance regimes
Inflows can repay neither the interest nor the principal repayment commitments and must refinance its entire position with new debt. The Ponzi finance regime corresponds to the more financially fragile situation. Ponzi finance regimes are named after fraudster Charles Ponzi.
discuss the application of Minsky’s FIH
Minsky’s original analysis refers to closed economies, but it can be easily extended to open economies. Within an open economy framework, a period of prolonged exchange rate stability may lead to over optimistic assessments of the stability of the domestic currency value of foreign commitments.This might endogenously decrease the margins of safety of firms and make the passage from a fragile to an unstable system much more rapid in the event of an exogenous shock. In an open economy framework, such an exogenous shock can be either a rise in interest rates or a depreciation of the currency.
can FIH be easily extended in order to take into account the household debt
Various economists argue that Minsky’s Hypothesis can be extended to incorporate the role of household debt.
- For instance, one could use Minsky’s perception of euphoric expectations in the analysis of the relationship between households and banks. When everything goes well (e.g. house prices increase) households and banks become more willing to enter into new debt contracts.
