Financial crises in history Flashcards
What is the definition af a financial crisis?
When things are up in the air and things that were previously not possible can happen.
It can either go back to normal or to a completely other state.
Demarcation limes in time: Crises create a before and after
E.g. Covid-19, financial crisis in 2008 etc.
After the crisis the world is not what it used to be.
How often do financial crises occur?
In any given year the probability that any country will have an economic crisis is 5%. That means that every 20 years there will on average be a crisis.
Why are financial crises so painful?
They have long term effects on growth (permanent loss of GDP) - even if an economy catches up on the slope of growth, financial crises create a huge drop that does not go away.
What does the balance sheets of banks consist of?
Assets: What the bank has
- E.g. loans, bonds and cash reserves
Liabilities: Where the bank gets it’s assets from
- E.g. deposits, equity
What are the greatest risks of banks?
Fear 1: Losing so much of your assets (maybe due to bad investments) that you are out of capital
Fear 2: Bank-runs: That too many people come to collect their money at the same time, and you don’t have enough liquidity to accommodate
What is the essence in the Diamond-Dybvig model (bank runs)
Banks have liquidity risks:
- Depositors can ask for their money back at any time → but the bank may not have the liquidity to pay the depositors → risk of bank runs
Liquidity preferences of depositors is unknown to banks
- The only assumption they have: People’s liquidity preferences are not correlated (e.g. they will not all come at the same time).
Why can depositors start to distrust banks (and make bank runs)?
Sometimes people run to the bank at the same time to collect their deposits, even though the bank is healthy and has not yet lost money → why?
- Because people want to go and take their money before the market drops → that creates a Lemming-effect → people do what other people do and be the first in the queue.
- So even though the banks still look okay, then people speculate when the bank will lose money, so they get there before it actually happens → makes the bank go bankrupt even if it was totally healthy (because no bank has enough liquidity for all to come at once).
What could be a solution to bank run problems?
Deposit insurance: The government steps in and keeps you liquid. The government acts as an insurance/lender of last resort. So you don’t have an incentive to run to the bank, when you panic.
That increases the incentives for banks to take bigger risks with their investments etc. Because the government acts as an insurance.
What is the IMF definition of a systemic financial crisis?
When the whole system is in trouble and not just single banks
IMF-definition:
- Significant signs of financial distress in entire banking system
- Significant policy-responses to losses in the banking system
5 global crises the last 140 years
What has empirically been shown to be a determinant of banking crisis?
Empirical results: Increases in lending/credit boom is a determinant of banking crises
- Before all the big financial crises there is a large increase in bank lending
- X: Increase in lending (credit booms) –> Y: Bigger likelihood of financial crises
What theoretical views exist on why financial crises happens? (3 views)
The liquidity view: bad shocks are to blame
The capital view: bankers have insufficient skin in the game
The behavioral view: a cycle of overoptimism
What are the main arguments in the liquidity view in regards to why financial crises happen?
Bad shocks make the financial crises.
Exogenous shocks come and make people run to the bank –> then more and more people run to the bank (Lemming effect), and the banks run out of money.
In that view of the world everything was fine in the US economy in 2008 - if the banks only had more liquidity, then everything would have been fine.
Critique of this view:
- They can’t explain why the first people start running to the bank
- People agree, that there is an element of this in all financial crises (Lemming-effect) but it is not an adequate explanation of why crises happen.
What are the main arguments in the capital view in regards to why financial crises happen?
Crises happen because bankers have insufficient incentives to behave well.
Insufficient “skin in the game”
- If you have insurance that somebody else will fix your problem, then you don’t have incentives to behave responsibly. Instead you take huge risks –> then they generate credit booms.
Asymmetric gamble for bankers:
- If things goes fine, it’s fine
- If things go bad, the government steps in and saves them → insufficient incentives to not take risks. You have nothing personally to lose (maybe just your job).
- Because of the government backstock, the bankers have asymmetric incentives.
This is the view we have used since 2008.
What are the main arguments in the behavioral model in regards to why financial crises happen?
This is what we now (the academic research community) believe to be the heart of the crisis story.
Collective deviations of the correct probabilistic assessment of the future.
- People get too excited and neglect the fact that things can go wrong.
- People have overly optimistic expectations about the future: credit booms happen when people collectively misjudge the risk - we get a bit too optimistic about the future, and ultimately that over-optimism can not be sustained.
Crises are not the outcome of risk taking by bankers (like the capital view believes), but of credit-fueled booms and busts where everybody is caught in the same optimistic narrative and thus drops our guards.
Minsky model: New innovations –> growth and profit –> optimism –> more people invest –> credit booms
What are the real economic effects of financial crises on GDP?
Supply-side arguments:
- Crisis makes banks kaput and then you can’t borrow money etc.
- Less credit supply from banks (credit crunch) → affects which investments and production that can be made.
Demand-side arguments:
- Even if the banks are okay after a crisis we might have a long time of repair on the demand side.
- Companies and household have to repair their finances to account for the loss of the break in the market → they save mor and spend less.
