REVISION- Topic F- Financial Crisis Flashcards
Name the 3 phases of crises in advanced economies
- Initiation
- Banking Crisis
- Debt deflation
Describe the 3 causes of initiation.
- Mismanagement of financial innovations/ liberalization
- Asset boom/ bust
- Uncertainty
How does a financial crisis occur?
a financial crisis occurs due to a large disruption to information flows, increasing asymmetric information in the financial markets. This increases financial frictions and stops financial systems from functioning efficiently.
What is a financial crisis?
major disruptions in financial markets characterized by a sharp declines in the nominal asset prices and firm
failures
Best example of a financial crisis?
2008 financial crisis
How can mismanagement of financial innovations and liberalisation lead to the initiation of a crisis?
- liberalisation in the short-run can lead to banks to go on a lending spree (credit boom)
- the inexperience with new financial innovations can mean banks do not have the expertise or incentive to manage the risk effectively
Name a major problem with government safety nets like deposit insurance.
- With this insurance there is a greater moral hazard incentive for banks and they may take on greater risks.
Describe the asset boom and bust in stage 1 of a financial crisis.
eg of one
- a pricing bubble starts, where an assets nominal values rapidly exceed their fundamentals dramatically, ie if the demand does not justify the price spike
- when the bubble bursts, prices fall dramatically along with financial institutions assets, plummeting down to their real value
- this all leads to lower lending and further economic contraction
- best eg is the housing market bubble in 2008
What causes uncertainty in the initiation of a crisis?
- failures of large, stable financial firms, eg Lehmann brothers in the 2008 crisis
- this triggers panic and increases asymmetric information and moral hazard
- again lending dries up and economic contraction
What do all of the attributes of initiation lead to?
- they all lead to increased moral hazard and adverse selection problems
- this leads to a decline in economic activity
Describe the banking failure stage of a financial crisis.
- due to the decline in economic activity, banks start to make losses on loans as people cannot pay them back
- from here banks start becoming insolvent and begin to fail, firms also fail
- this leads to a bank panic, people taking money out of the banks rapidly, exacerbating the solvency problems
- fewer banks means more asymmetric info, more moral hazard and less lending and economic activity contraction
Describe the third stage of the crisis, debt deflation.
- sharp economic contractions leads to a huge decline in price level- deflation
- people think lower prices is good
- however, some debts are in nominal terms and price is falling then the real debt burden increases for households and firms
- net worth of households and firms declines further
- further asymmetric information and moral hazard
- leading to lending and economic activity to decline for a long time
What are the two possible triggers of financial crisis in emerging economies?
- Credit Boom and Bust
2. Severe fiscal imbalances
Describe the credit boom and bust route of financial crises in emerging economies.
- In emerging economies banks play a more important role because securities markets are not established
- It all starts with the liberalisation of the financial system, opening the financial system up to capital and firms flows
- weak supervision and lack of experience from the government leads to a credit/ lending boom
- the excessive lending and lack of supervision means many borrowers were unable to repay their loans and the bank lost a lot of money. To mitigate this, they severely cut lending and charge high interest rates on loans to make up for the excessive lending
- on top of this, powerful bank owners stop supervisors from doing their job properly to benefit the bank owners, so they may not be acting in public interest.
- principle-agent problem
Describe the severe fiscal imbalances route of financial crises in emerging economies.
- large government deficits/ debts mean governments force banks to buy government debt
- when investors lose confidence in government’s repayment ability
- they may take money out of country, save and even sell domestic currency
- speculators attack
- real debt burden increases, banks lose and their net worth decreases, they may go insolvent and fail
- reduction in lending and depositors lose money, decreasing household networth
Name two other factors that could be responsible for initiating a financial crisis
- uncertainty linked to unstable political systems, making it hard to monitor credit
- a decrease in a firm’s net worth, ie due to a fall in their stock price increases adverse selection and moral hazard, also it reduces collateral banks can seize, impairing their balance sheets
How does bank balance sheet deterioration trigger a currency crisis?
- deterioration of bank balance sheets triggers a currency crisis
- government cannot raise interest rates to increase demand for their currency as it will force banks into insolvency
- this is because they do not have the capital to offer that rate of return
- speculators see this weakness and attack
How do severe fiscal imbalances lead to currency crises?
- when foreign and domestic investors lose confidence in the government’s ability to pay debts off they sell domestic currency and pull money out of country
- currency falls in value
- this leads to speculative attacks
2 causes of a currency crisis?
- severe fiscal imbalances
2. bank balance sheet deterioration
Describe the third stage of a crisis in emerging economies, a fully-fledged financial crisis.
- speculative attacks lead to peg failing and a sharp devaluation of currency
- sharp increase in debt burden due to currency mismatch (as most debt contracts will be denominated in a more advanced economies currency)
- banks fail, individual assets fall, adverse selection and moral hazard problems lead to lending problems and reduction in investment
What are the three stages of a financial crisis in emerging economies?
- credit boom and bust or severe fiscal imbalances
- currency crisis
- fully-fledged
Why do banks need depositor insurance?
- If depositors cannot guarantee they will receive their money back if the bank has liquidity problems then they will stop using banks
- asymmetric information and moral hazard problems seen in previous crises will also make depositors confidence extremely low
- this insurance increases confidence and injects funds into the banking system
What is a twin crisis?
- when an emerging economy experiences a currency crisis and a financial crisis simultaneously
What is deposit insurance?
What harmful effects does it prevent (2 of them)?
A government safety net to prevent bank panic and the contagion effect, by protecting the depositor. It ensures that if even if a bank has liquidity problems consumers will receive compensation for their deposits.
What exacerbates bank panic?
- Banks operate on a sequential service restraint (first come first serve) giving people fear and incentive to withdraw as soon as possible before they run out of funds
Provide an example of a short-term government safety net other than depositor insurance that has been used recently.
- Fiscal stimulus spending, combining tax cuts and gov spending
- was used massively during the COVID-19 in the form of furlough packages
Name two long-term responses to stabilize the financial system.
- enhancing infrastructure
- develop financial education and consumer protection rules
Describe a way in which central banks have cooperated to protect the international financial system.
provide eg
- supervisory cooperation:
- central banks share information and ensure policies are mutually consistent with national objectives
eg: financial stability board (FSB) by G20
Explain a drawback of government safety nets.
- for example, depositor insurance leads to moral hazard problems where banks will engage in riskier behaviour as they know they can be bailed out
- the depositors also have moral hazard incentive as they assume no risk
- therefore they will not monitor or consider the discipline of the market place fully
How does a major financial institution being ‘too big too fail’ threaten the lower levels of the economy?
provide eg
- governments cannot let huge financial institutions fail as they are too integral to the larger financial system
- therefore, they may bail them out even when they are not entitled to be
- they will then pass the losses onto depositors and creditors
- further increases their moral hazard incentive
- think 2008, big short
Name three methods of financial regulation regulators use to reduce the risk of a crisis.
- restrictions on asset holdings
- consumer protection, no need to explain you know this
- financial supervision: prompt corrective action
Explain how restrictions on asset holdings reduce risk of crisis.
- promotes diversification so firms/ individuals do not have all their eggs in one basket
- single obligor limit- restricts how much a bank can lend to an individual or entity, this reduces moral hazard problems as banks cannot risk take as much
Explain how financial supervision reduces risk of crisis.
- huge problems can occur if a financial institution runs low on capital
- therefore, the depositor insurer will trigger prompt corrective action to intervene before the institution gets in trouble
- they do this through chartering and examinations
Chartering- screening proposals for new institutions to prevent adverse selection
Examinations- can be scheduled and unscheduled to monitor restrictions on asset holding and capital requirements to prevent moral hazard
Define Microprudential policy
- focused on the saftey and soundness of individual institutions, not the financial system as a whole
- attempts to safeguard firms from excessive and idiosyncratic risk
Give 3 examples of microprudential policy.
- bank-level regulatory standards for bank capital adequacy (the minimum reserves of capital a financial institution must have)
- rules on who can hold assets and how they can be traded
- certification of those working in financial sectors
What were the two problems with microprudential policy and what was the solution?
- the global financial crisis proved that the soundness of individual institutions was not enough to stabilise the financial system as a whole
- because many established, well-capitalised firms had liquidity shortages
- on top of this there was lots of concern banks were not following these policies stringently
- the solution- MACROprudential policy
Define macroprudential policy.
- aims to address financial system as a whole by looking at interconnectedness of financial institutions
Explain the boom leverage cycle running up to a financial crisis
- asset prices rise = reserves of financial institutions (capital buffers) rise = lending rises = asset prices rise further
vice versa for bust
How does macroprudential policy short-circuit a leverage cycle?
provide example
- adjusting capital to make them countercyclical and stop the positive feedback loops
- for example, during bust macroprudential supervision may be used to raise new capital for the whole financial system to prevent banks from having to cut lending
