L22 - Financial Crises as Market Failure Flashcards
Why does it matter if the 2007-2009 financial crisis was a caused by market failure?
the answer is of crucial importance to policy makers because financial regulation that does not address a specific market failure risks causing new inefficiencies with unintended consequences that will impact on the financial sector generally and, through this, on the broader economy
What was a source of criticism during the financial crisis?
- there was criticism of the nature of financial sector regulation and this implies a need to consider further measures to expand regulatory oversight of the financial sector.
- Previously, regulation focused primarily on the health of individual financial institutions. However, since the crisis regulatory reform efforts have focused more on stability in the financial sector as a whole, that is, the approach has shifted to what is now known as ‘macroprudential’ or ‘systemic risk’ regulation.
- This is a seismic shift in policy and would have been unthinkable before the crisis. So what is it that motivated this change in the approach to financial regulation and policy?
How is macroprudential regulation different to how the financial sector was original regulated?
- macroprudential regulation hinges on the notion of externalities, or spillovers.
- If a firm’s shareholders and creditors alone face the costs of its failure, the firm is likely to fully account for the risks of its operations, leaving no room (in principle at least) for macroprudential regulation.
- But if financial difficulties can affect other companies, individuals, or the real economy in ways that the firm’s stakeholders are not forced to compensate for, or ‘internalize’, the firm might be encouraged to take excessive risks.
- These risks might increase the fragility of the financial system and make it more prone to widespread crises like the one in 2007-09.
What are Market failures often caused by?
- Market failures often are caused by what economists call externalities—a situation where an economic agent is affected by the actions of others not only through price changes but also directly.
One classic example is an industrial plant that emits pollution. The plant only charges its customers enough to cover its private production costs, ignoring the costs ‘paid’ by its neighbours who breathe the polluted air.
This externality will lead the factory to produce more pollution than is socially optimal. By mandating lower pollution levels or by levying a tax equal to the size of the externality, regulators may force firms to internalize the social costs of pollution, resulting in a more efficient level of emissions.
When should a government interfere in a market?
Aside from pursuing social goals of redistributing wealth, government intervention in markets is generally warranted only when there is a market failure—a situation where markets lead to inefficient allocations.
How has the approach to analysing externalities changed since the Financial Crisis?
a new approach to analysing externalities has evolved and the language of the subject has identified market failure stemming from a ‘pecuniary externality.’ associated with the financial system’s core function of maturity transformation.
These pecuniary externalities are the primary catalyst leading to under-provision of liquidity and financial crisis.
What are pecuniary externalities?
A pecuniary externality occurs when the actions of an economic agent cause an increase or decrease in market prices. For example, an influx of city-dwellers buying second homes in a rural area can drive up house prices, making it difficult for young people in the area to get onto the property ladder.
How was Adverse selection lead to Market Failure in the wake of the Financial Crisis?
- Main causes of the financial crisis was the attempt to encourage homeownership by less than credit-worthy borrowers in the US - this is clearly a case of adverse selection
What was the adverse selection problem of the subprime mortgage market?
- The bare bones of the problem is that subprime loans were made involving little or no down payment. Loan to value tended to be around 100 percent, with a zero or very low (teaser) interest rate the first two years. This increased the likelihood of default.
- However, the agreement was that after two years, interest rates would increase from as low as 1 percentage point to 6 percentage points or more above the federal funds rate. This further increased the probability of default and foreclosure.
- It is well known that in periods of recession, the same problem of adverse selection arises when banks try to discriminate among their customers by raising the interest rates of their loans, which tend to attract mainly those who have a higher probability of defaulting on the loan.
How did the Subprime Mortgage Provision lead to Market Failure in the wake of the Financial Crisis?
- The second failure occurred in the originated and securitised subprime mortgages market, both in terms of government regulation and supervision.
- On the one hand, the majority of mortgages were not originated by the banks but by agents and brokers working on commission.
- These agents weren’t regulated the banks were and were only required to obtain an administrative local state permit to sell financial products.
- There main aim was therefore to sell a mortgage to a family and charge a commission without due consideration of whether the mortgage holder could pay it.
- Thus, they failed to meet a key requirement in the banking business of investing short-term deposits in long-term credits and loans with low likelihoods of default in relation to their profitability.
What did the majority of families assume was covered by the Subprime Mortgages?
- On the other side of the coin, the majority of families who assumed these mortgages had 100 percent of loan to value of their homes covered, plus the costs, with zero or near-zero teaser interest rates during the first two years.
- This clearly provided a powerful incentive to sign the mortgage contract since it offered a one way bet: Purchasers could live in their home for two years for free or almost free and after the two years the assumption would be that they could sell it with a slight profit above the mortgage.
- Assuming real estate property values continued to rise, mortgagees could then move on to another mortgage and repeat the same process with their next home.
How did the banks that funded subprime mortgage lead to a Moral Hazard Market Failure in the wake of the Financial Crisis?
- However, banks and other financial intermediaries that had funded these mortgages had converted them and many other loans into securities, which were then sold to special purpose vehicles off their balance sheets, where the risks to financial intermediaries were discarded and passed to others willing to buy them.
- These mortgages were packaged with thousands of other credits from different categories, such as consumer and credit card loans, and sliced by structuring them into tranches of different credit rating levels that could be broken up into separate components for investors according to their different appetite for risk.
- There are clear echoes in all of this of a moral hazard problem.
Why was it a major market and government failure that it was assumed that securitising mortgages and selling them removed the risk burden?
- Why was this an erroneous assumption. At the time that many of them were removing the securities from their balance sheets, they were creating, off balance sheet, specific investment vehicles (SIVs) involving inordinately high levels of leverage.
- These were used to invest in long-term assets, funded in the short-term commercial paper market with the long-term asset as collateral.
- In this way, the banks could leverage their capital much more than their balance sheets would indicate, and beyond the minimum capital requirements mandated by Basel I and Basel II.
- In other words, financial intermediaries were effectively creating a parallel, off-balance-sheet banking system that would take short-term resources and invest them in long-term risky assets that were neither regulated nor subject to supervision.
- The only assurance given to their supervisors was that, if the short-term funding in the commercial paper market dried up, the same bank would assure the provision of the necessary liquidity to pay for the short-term funding maturities in those vehicle
How else did the Specific Investment Vehicle create a market failure?
- These vehicles tended to produce another significant market failure in some banks since, paradoxically, in order to obtain higher long-term returns on their assets, the managers of many of these special vehicles were buying the same structured products based on subprime mortgages.
- Through these vehicles, financial intermediaries taking on the same risk they had intended to transfer by securitising and selling them to a third party.
- Furthermore, in order to remove the subprime risk from their balance sheet, the banks were not taking into account that their own vehicles were, incredible as it seems, taking back the risk again without the knowledge of the banks’ internal risk management team and their internal and external auditors.
- Just for emphasis and clarity: The banks were creating securitised assets which had ‘toxic’ elements and were then buying these same assets created by other banks and offered for sale by them!
What happened on August 9th 2007 which highlighted the problems of SIV?
- When ratings on these products deteriorated as sub-prime mortgage defaults increased, these toxic assets were no longer of interest to investors and on August 9th 2007, the market value of securitised assets plummeted by $300bn leaving the banks unable to refinance them and compelling the Federal Reserve and the ECB to inject billions of dollars and euros into these banks in order to avoid serious solvency-related issues.
- Had the banks been forced to reintroduce the securities into their balance sheets (a separate question is why they were removed in the first place (answer: profit)) the banks would have consumed regulatory capital that they did not have and this would almost certainly have resulted in an even greater credit crunch than what ultimately occurred.
- The creation of these vehicles and the securitisation process which facilitated the creation of a parallel banking system is a regulatory failure of breath taking proportions!
