L19 - The Financial Crisis

Question 1

What did Rogoff (2008) say about Financial Crises?

Answer 1

• 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!

Question 2

What are the 4 types of financial crises?

Answer 2

• 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.

Question 3

What are the general implications of a crisis?

Answer 3

• 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.

Question 4

Summary of the cause of the Financial crisis?

Answer 4

• 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.

Question 5

What is a Financial Crisis?

Answer 5

• 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

Question 6

What don’t we know when it comes to Financial Crises?

Answer 6

• 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.

Question 7

What are Financial Crises often preceded by?

Answer 7

• 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.

Question 8

What is the history of price bubbles?

Answer 8

• 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.

Question 9

What can cause a price bubble?

Answer 9

• 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?)

Question 10

How can investor behaviour causes a price bubble?

Answer 10

• 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

Question 11

What triggers a bust?

Answer 11

• 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.

Question 12

What role does credit play in financial crises?

Answer 12

• 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.

Question 13

What can trigger a credit boom?

Answer 13

• 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

Question 14

How do structural factors play a part in credit booms?

Answer 14

• 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.

Question 15

What is a currency crisis?

Answer 15

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.

Question 16

What is a balance of payment crisis?

Answer 16

A so-called sudden stop (or capital account or balance of payments crisis) can be defined as a large (and often unexpected) decline in international capital inflows or a sharp reversal in aggregate capital flows to a country, likely taking place in conjunction with a sharp rise in its credit spreads.

Question 17

What are debt crises?

Answer 17

Debt crisis is a situation in which a government (nation, state/province, county, or city etc.) loses the ability of paying back its governmental debt.

Other crises are associated with adverse debt dynamics or banking system turmoil. A foreign debt crisis takes place when a country cannot (or does not want to) service its foreign debt, sovereign, private, or both. Greece is an obvious example.

Question 18

What is are banking crises?

Answer 18

• In a systemic banking crisis, actual or potential bank runs and failures can induce banks to suspend the convertibility of their liabilities, or compel the government to intervene to prevent them from doing so by extending liquidity and capital assistance on a large scale. (Northern Rock)
• Banking crises are quite common, but perhaps the least understood type of crisis. Banks are inherently fragile, making them subject to runs by depositors. Moreover, the problems of individual banks can quickly spread to the whole banking system.

Question 19

What can institutional weaknesses increase?

Answer 19

• Although public safety nets, including deposit insurance, can limit this risk, public support comes with distortions that can actually increase the likelihood of a crisis. Institutional weaknesses can also elevate the risk of a crisis.
• For example, banks depend heavily on the informational, legal, and judicial environments to make prudent investment decisions and collect on their loans.
• With institutional weaknesses, risks can be higher. Although banking crises have occurred over the centuries and exhibited some common patterns, their timing remains hard to predict empirically as recent evidence amply demonstrates.

Question 20

Why are Financial Institution inherently fragile?

Answer 20

• Financial institutions are inherently fragile entities, giving rise to many possible coordination problems. Because of their roles in maturity transformation and liquidity creation, financial institutions operate with highly leveraged balance sheets.
• Hence, banking and other similar forms of financial intermediation can be precarious undertakings. Fragility makes coordination, or lack thereof, a major challenge in financial markets.
• Coordination problems arise when investors or institutions take actions like withdrawing liquidity or capital merely out of fear that others will also take such actions. This is exactly what happened in the UK (and other countries) in 2008.
• Given this fragility, a crisis can easily occur in which large amounts of liquidity or capital are withdrawn because of a self-fulfilling belief. It happens because investors fear it will happen.
• Small shocks, whether real or financial, can translate into turmoil in markets and a financial crisis.

Question 21

What is an example of a coordination problem?

Answer 21

• A simple example of a coordination problem is a bank run. It is a truism that banks borrow short and lend long.
• This maturity transformation reflects the preferences of consumers and borrowers.
• However, it makes banks vulnerable to sudden demands for liquidity, that is, runs.
• A run occurs when a large number of customers withdraw their deposits because they believe the bank is, or might become, insolvent.
• As a bank run proceeds, it generates its own momentum, leading to a self-fulfilling prophecy: as more people withdraw their deposits, the likelihood of default increases, encouraging further withdrawals.
• This sequence can destabilise a bank to the point that it faces bankruptcy because it cannot liquidate assets fast enough to cover its short-term liabilities. (c.f. Northern Rock.)

Question 22

How to financial institutes, markets and policymakers cope with the fragilities of the financial institutes?

Answer 22

• These fragilities have long been recognized, and markets, institutions, and policymakers have developed many coping mechanisms.
• Market discipline encourages institutions to limit vulnerabilities. At the firm level, intermediaries have adopted risk-management strategies to reduce their fragility.
• Furthermore, microprudential regulation, with supervision to enforce rules, is designed to reduce the risky behaviour of individual financial institutions and can help engineer stability
• Deposit insurance can eliminate the concerns of small depositors and can help reduce coordination problems.
• Lender-of-last-resort facilities (i.e., central banks) can provide short term liquidity to banks during periods of elevated financial stress.
• Policy intervention by the public sector, such as public guarantees, capital support, and purchases of nonperforming assets, can mitigate systemic risk when financial turmoil hits

Question 23

Does Regulation help reduce the fragility of financial institutes?

Answer 23

• Regulations aim to reduce fragility (for example, limits on balance sheet mismatches stemming from the interest rate, exchange rate, or maturity mismatches, or certain activities of financial institutions).
• However, as stressed in earlier lectures, regulation and supervision often lag behind innovation. Support from the public sector can also have distortionary effects. Moral hazard caused by a state guarantee (e.g., explicit or implicit deposit insurance) may, for example, lead banks to assume too much leverage

Question 24

What are some triggers for a banking crisis?

Answer 24

In this context institutions that feel they are too big to fail or unwind can take excessive risks, thereby creating systemic vulnerabilities.

More generally, fragilities in the banking system can arise because of policies at both the micro and macro levels.

• Although funding and liquidity problems can be triggers or proximate causes of a crisis, a broader perspective shows that banking crises often relate to problems in asset markets.
• Banking crises may appear to originate from the liability side, but they might sometimes reflect solvency issues. Banks run into problems when many of their loans fail to perform and/or when their assets quickly lose their value.

Question 25

What was the cause of the banking crisis in 2007-09?

Answer 25

• Problems in asset markets, such as those related to the subprime and other mortgage loans, also played a major role during the 2007–09 crisis.
• These types of problems in asset markets can go undetected for some time, and a banking crisis often comes into the open through the emergence of funding difficulties among a large fraction of banks as occurred when the property market collapsed precipitating the 2007-09 crisis
• . Furthermore because the financial sector receives many forms of public support, policy distortions that can lead to crises easily arise.
• In the context of the 2007–09 financial crisis in the United States, large government support for housing finance (through the government-sponsored enterprises Fannie Mae and Freddie Mac) has been argued to lead to excessive risk taking.

Question 26

What were the general causes of the 2007-09 Crisis that were similar to previous crises?

Answer 26

• The 2007–09 financial crisis had many elements common to other crises. Much has been written about the causes of the 2007–09 crisis.
• Although observers differ on the exact weights, the list of factors common to previous crises is generally similar and we have already discussed these. In summary these are:
  
  • Asset-price increases that turned out to be unsustainable;
  • Credit booms that led to excessive debt burdens;
  • Build ups of marginal loans and systemic risk;
  • The failure of regulation and supervision to keep up with financial innovation and get ahead of the crisis when it erupted

Question 27

What were the general causes of the 2007-09 Crisis that different from previous crises?

Answer 27

Four key new aspects often mentioned are:

• The widespread use of complex and opaque financial instruments;
• The increased interconnectedness among financial markets, nationally and internationally, with the United States at the core;
• The high degree of leverage of financial institutions;
• The central role of the household sector

Question 28

What were the similar implications of the 07-09 crisis and previous ones?

Answer 28

• Despite the obvious differences between crises, the macroeconomic variables follow similar patterns. Large output losses are common and other macroeconomic variables (consumption, investment, and industrial production) typically register significant declines.
• Financial variables like asset prices and credit usually follow qualitatively similar patterns across crises, albeit with variations in duration and severity.

Question 29

What do Financial Crises do to an economy?

Answer 29

• Financial crises have large economic costs with large effects on economic activity. Many recessions follow from financial crises and financial crises often tend to make these recessions worse than a ‘normal’ business cycle recession.
• The average duration of a recession associated with a financial crisis is some six quarters, two more than a normal recession.
• There is also typically a larger output decline in recessions associated with crises than in other recessions and the cumulative loss of a recession associated with a crisis (computed using lost output relative to the pre-crisis peak) is also much larger than that of a recession without a crisis.

Question 30

Hows do Financial Crises affect macroeconomic variables?

Answer 30

• Crises are generally associated with significant declines in a wide range of macroeconomic aggregates.
• Recessions following crises exhibit much larger declines in consumption, investment, industrial production, employment, and exports and imports compared with those recessions without crises. (look how deep the recession of 2008 was.)
• For example, the decline in consumption during recessions associated with financial crises is typically seven to ten times larger than those without such crises in emerging markets. In recessions without crises, the growth rate of consumption slows down but does not fall below zero.
• In contrast, consumption tends to contract during recessions associated with financial crises, another indication of the significant toll that crises have on overall welfare.
• Large declines in global output also occur during financial crisis episodes. The 2007–09 global financial crisis was associated with the worst recession since World War II, causing a 2 percent decline in world per capita GDP in 2009.
• Recent studies also document that recoveries following crises tend to be weak and slow, with long-lasting effects.

Question 31

What are the Financial effects of a crisis?

Answer 31

• Crises are associated with large downward corrections in financial variables. The most notable drag on the real economy from a financial crisis is the lack of credit from banks and other financial institutions.
• Recoveries in aggregate output and its components following recessions associated with credit crunches tend to take place before the revival of credit growth and turnaround in house prices.
• These temporal patterns are similar to those for house price busts, that is, economic recoveries start before house prices bottom out during recessions coinciding with sharp drops in house prices. (Look at recovery from the 2007-09 crisis.)

Question 32

Can we Predict a Financial Crisis?

Answer 32

• It has long been a challenge to predict the timing of crises.
• Knowing whether and when a crisis may occur would obviously have great benefits: measures can be put in place to prevent a crisis from occurring in the first place or to limit the damage if it does happen. Much can be gained from better detecting the likelihood of a crisis.
• Yet, despite significant effort, no single set of indicators can explain the various types of crises, or can do so consistently over time.
• Periods of turmoil often arise endogenously, with possibilities of multiple equilibria and many nonlinearities.
• Although it is now easier to document vulnerabilities, such as increasing asset prices and high leverage, predicting the timing of crises with some accuracy remains difficult.
• If you can devise a model that does this, that will be a great PhD!

Question 33

What did (Mckibbin, 2010) say the causes of the crises were?

Answer 33

1. The bursting of the housing bubble causing a reallocation of capital and a loss of household wealth and drop in consumption.
2. A sharp rise in the equity risk premium (the risk premium of equities over bonds) causing the cost of capital to rise, private investment to fall and demand for durable goods to collapse.
3. A reappraisal of risk by households causing them to discount their future labor income and increase savings and decrease consumption.