L19 - The Financial Crisis Flashcards
What did Rogoff (2008) say about Financial Crises?
- Financial crises come in all shapes and sizes and, as Rogoff (2008) notes “They are an equal opportunity menace”.
- This simply tells us that financial crises impact on all countries rich or poor, developed or less developed. Crises do not discriminate.
- They can have domestic or external origins, and stem from private or public sectors. They come in different degrees of severity, evolve into different forms, and can rapidly spread across borders.
- They often require immediate and comprehensive policy responses, call for major changes in the financial sector and fiscal policies, and can compel global coordination of policies.
- In a nutshell, that’s the most recent financial crisis and for certain it won’t be the last!
What are the 4 types of financial crises?
- Currency crises
- Balance of payments crises
- debt crises
- banking crises
Irrespective of the classification used, different types of crises are likely to overlap. Many banking crises, for example, are also associated with currency crises. The coincidence of multiple types of crises leads to further challenges of identification.
What are the general implications of a crisis?
- The macroeconomic and financial implications of crises are typically severe and share many common features across various types.
- Large output losses are common to many crises, and other macroeconomic variables typically register significant declines.
- Financial variables, such as asset prices and credit, usually follow qualitatively similar patterns across crises, albeit with variations in duration and severity of declines.
Summary of the cause of the Financial crisis?
- The crisis was triggered by the collapse of Lehman Brothers in September 2008 and this sent a wave of fear around global financial markets.
- Banks virtually stopped lending to each other. The risk premium on interbank borrowing rose sharply to 5 per cent, whereas typically it is close to zero.
- In different countries, the appropriate authorities scrambled to inject liquidity into financial markets, but the damage was done.
- The risk premium on corporate bonds shot up even more interbank rates to over 6 per cent.
- Large CAPEX projects were shelved, the corporate sector virtually stopped borrowing, trade credit was hard to obtain and, with falling demand, particularly for investment goods and manufacturing durables like cars, trade volumes collapsed and economies plunged into recession.
What is a Financial Crisis?
- A financial crisis is often an amalgam of events, including substantial changes in credit volume and asset prices; severe disruptions in financial intermediation, notably the supply of external financing; large-scale balance sheet problems; and the need for large-scale government support.
- Although these events can be driven by a variety of factors, financial crises often are preceded by asset and credit booms that then turn into busts.
- This certainly true of the most recent financial crisis which, as you well know by now, was preceded by a property boom
What don’t we know when it comes to Financial Crises?
- There is no point in pretending we know everything about the underlying causes of crises.
- Although fundamental factors - macroeconomic imbalances, internal or external shocks - are often observed, many questions remain about the exact causes of crises.
- Financial crises sometimes appear to be driven by “irrational” factors, including sudden runs on banks; contagion and spillovers among financial markets; limits to arbitrage during times of stress; the emergence of asset busts, credit crunches, and fire sales; and other aspects of financial turmoil.
- Indeed, the idea of what Keynes referred to as “animal spirits” (as a source of financial market movements) has long occupied a significant space in the literature attempting to explain crises.
What are Financial Crises often preceded by?
- Financial crises are often preceded by asset and credit booms that eventually turn into busts.
- Many theories focusing on the sources of crises have recognized the importance of booms in asset and credit markets
- . Most recently, the property boom preceded the financial crisis.
- However, explaining why asset price bubbles or credit booms are allowed to continue and eventually become unsustainable and turn into busts or crunches has been challenging to say the least.
- The question naturally arises of why neither financial market participants nor policymakers foresee the risks and attempt to slow down the expansion of credit or the increase in asset prices that precedes the crisis.
What is the history of price bubbles?
- Sharp increases in asset prices (bubbles) often followed by crashes, have been experienced for centuries.
- Asset prices sometimes seem to deviate from what fundamentals would suggest and exhibit patterns different from predictions of standard models with perfect financial markets.
- Patterns of exuberant increases in asset prices, often followed by crashes, have occurred throughout history and have been well-documented c.f. the Dutch Tulip Mania from 1634 to 1637, the French Mississippi Bubble in 1719–20, and the South Sea Bubble in the United Kingdom in 1720.
What can cause a price bubble?
- Bubbles might emanate from either micro or macro sources.
- For example, bubbles might stem from agency issues. In this context, one possibility is that risk shifts such when agents borrow to invest (e.g., margin lending for stocks, mortgages for housing etc) but can default if rates of return are not sufficiently high with the result that prices can escalate rapidly. (Does that sound familiar?)
- Managers who are rewarded on the upside more than on the downside (somewhat analogous to the limited liability of financial institutions) bias their portfolios toward risky assets, which might trigger a bubble. (Does that sound familiar again?)
How can investor behaviour causes a price bubble?
- Investors’ behaviour can also drive asset prices away from fundamentals, at least temporarily.
- Frictions in financial markets (notably those associated with information asymmetries) and institutional factors can affect asset prices.
- Mechanisms such as herding among financial market players, informational cascades, and market sentiment can affect asset prices are well-documented in financial theory.
- Virtuous feedback loops further propel things forward resulting in rising asset prices and increasing net worth positions that allow financial intermediaries to leverage up and buy more of the same assets play a significant role in driving the evolution of bubbles
What triggers a bust?
- Busts following bubbles can be triggered by relatively small shocks as nervousness spreads throughout the market even in response to the rate of increase in bubble driven prices.
- Asset prices may experience small declines due to changes in either fundamental values or sentiment.
- Changes in international financial and economic conditions, for example, might drive prices down. The channels by which small declines in asset prices can trigger a crisis are again well-documented.
- Given information asymmetries, for example, a small shock can lead to market freezes. Adverse feedback loops may then arise, in which asset prices exhibit rapid declines and downward spirals.
- Notably, a drop in prices can trigger a fire sale as financial institutions experiencing a decline in asset values struggle to attract short-term financing.
- Sudden changes can lead to a cascade of forced sales and liquidations of assets leading to further declines in prices, with consequences for the real economy.
What role does credit play in financial crises?
- A rapid increase in credit is another common thread running through the narratives of events that precede financial crises. Leverage build ups and greater risk-taking through rapid credit expansion, in concert with increases in asset prices, often precede crises.
- The recent crisis witnessed a period of significant growth in credit (and external financing), followed by busts in credit markets along with sharp corrections in asset prices.
What can trigger a credit boom?
- Credit booms can be triggered by a wide range of factors, including shocks and structural changes in markets. Shocks that can lead to credit booms include changes in productivity, economic policies, and capital flows.
- Some credit booms tend to be associated with positive productivity shocks. Sharp increases in international financial flows can amplify credit booms.
- Most national financial markets are affected by global conditions, so asset bubbles can easily spill across borders.
- Fluctuations in capital flows can amplify movements in local financial markets when inflows lead to a significant increase in the funds available to banks, relaxing credit constraints for corporations and households.
- The rapid expansion of credit and sharp growth in house and other asset prices were indeed associated with large capital inflows in many countries before the 2007–09 financial crisis.
- Accommodative monetary policies, especially when in place for extended periods, have been linked to credit booms and excessive risk-taking.
- The channel works as follows: Interest rates affect asset prices and borrowers’ net worth, in turn affecting lending conditions.
- the low interest rate in US in 2001-04, is said to have been a major factor behind the rapid increase in house price and household leverage
How do structural factors play a part in credit booms?
- Structural factors have also played a part in credit booms that precede a crisis. High on the list here is financial liberalisation and innovation.
- Financial liberalisation and financial innovation can trigger credit booms and lead to excessive increases in leverage by facilitating more risk-taking. Financial liberalisation has been found to often precede crises in empirical studies.
- Historically, regulation, supervision, and market discipline have been slow to react to greater competition and innovation and vulnerabilities in credit markets can arise because of this.
- Another mechanism commonly linking booms to crises is a decline in lending standards. Greater competition in financial services, although generally enhancing efficiency and stability in the long term, can contribute to financial fragility over shorter periods
- . This was especially evident in the run-up to the crisis erupting in the USA.
What is a currency crisis?
a currency crisis involves a speculative attack on the currency resulting in a devaluation (or sharp depreciation); or forces the authorities to defend the currency by expending large amounts of international reserves, or sharply raising interest rates, or imposing capital controls.