The Financial System And The Macroeconomy

Question 1

The Financial System

Answer 1

• The institutions in the economy that facilitate the flow of funds
• From savers -> households and firms with income they do not need to spend immediately
• To borrowers -> firms that need funds to finance investment projects, other households to purchase durables, the government to finance deficits

Question 2

Role of the Financial System

Answer 2

• Economies with good financial systems will have:
  A higher investment rate, as more funds as are available for investors
  Higher efficiency, as agents with low-productivity options can transfer their assets to those with high-productivity ones

Question 3

Components of the Financial System

Answer 3

• Financial markets, through which households and firms directly provide funds to firms and to the government e.g. bond markets, stock markets
• Financial intermediaries, though which households and firms indirectly provide funds (through savings) to firms, other households, and governments (indirectly lending) e.g. Banks, insurance companies

Question 4

Why do we need intermediaries?

Answer 4

Asymmetric information:
When one party to a transaction has more information about it than the other party

Need to screening investors who know their projects are less likely to succeed, are more eager to finance the projects with other people’s funds

Need for Monitoring: entrepreneurs investing other people’s money are not as careful as if they were investing their own funds

Moral hazard & adverse selection present in lending relations -> lenders don’t know much about borrowers

Question 5

Why do we need intermediaries?

Answer 5

• Intermediaries help mitigate the effects of asymmetric informations
• Example: banks
• Screening borrowers for adverse hidden attributes that savers might not detect
• Restricting how loan proceeds are spent on monitoring the borrowers
• Particularly important for borrowing by small businesses and households
• Peer-to-peer lending could reduce the need for intermediaries (possible through technology)

Question 6

Banks

Answer 6

• Play a central role in the payments system of the economy and in providing loans to households and to firms
• Identity profitable lending opportunity: Meeting the wants of savers and borrowers
• Engage in maturity transformation: Borrow short-term (i.e., deposits) and long-term (i.e., mortgages) Banks accept deposits, which it promises to repay at short or no notice, and makes long-term loans (which can be repaid over many years)
• However, this can backfire in a bank run if they become insolvent
• Illiquidity of assets can be a problem if firm cannot change the assets to cash fast enough
• Banks are interconnected around the world because they often borrow from each other
• The banking system is like a network of an electricity grid: failure of one of the elements, creates pressure on other elements and can lead to a cascade of subsequent failures

Question 7

Balance Sheet Glossary

Answer 7

• Loans: the value of the loans the bank made
• Securities: the value of the financial assets the bank bought

Reserves:

• Cash in the bank’s vaults, safes, and ATMs
• Reserves deposited at the central banks
• Deposits: the value of current and saving accounts that customers have with the bank
• Debt: debts other than deposits, e.g. from issuing bonds
• Capital: Difference between assets and liabilities

Question 8

Confusing-Terminology Warning

Answer 8

• Most of macro
• Capital = equipment and structures
• Economics of Banking
• Capital = owner’s equity, or difference between assets and liabilities

Question 9

Where does bank capital come from?

Answer 9

• Share issuance

- Reinvested retained earning and asset appreciation

Question 10

Leverage

Answer 10

• The use of borrowed money to supplement existing funds for purposed of lending or buying assets
• Borrow cheap (e.g. deposits) and lend dear (e.g. bank loans)
• The more the leverage, the greater the profits (borrow cheaply, lend expensively - profit margin creation)

Question 11

Leverage and Vulnerability

Answer 11

• Being highly leverage makes banks vulnerable (using borrowed money to make transactions) —> Don’t actually have much capital as a safety net
• When assets (have) < liabilities (owe), the bank is insolvent

Question 12

Leverage ratio

Answer 12

• Leverage ratios = assets/capital

Question 13

More terminology

Answer 13

Insolvency - unable to pay debts owed
Illiquidity - assets most easily converted into cash
Insolvency is not equal to illiquidity (can be liquid and still unable to pay debts owed)
Liabilities - deposits which banks are obliged to pay interest on
Assets - loans on which they receive interest
Securities - bonds, debentures, notes, options, shares and warrants

Question 14

Origins of FInancial Crises

Answer 14

• Financial crises often follow periods of excessive optimism or irrational exuberance
• Financial intermediaries use leverage to make increasingly aggressive loans to firms and households
• Households and financial intermediaries invest heavily in the stock market, often financed by borrowing
• Households borrow to buy larger and more expensive
• Households, financial intermediaries, and other firms become heavily indebted
• banks too leveraged, too much borrowing by households and firms

Question 15

Asset-Price Booms and Busts

Answer 15

• A frequent feature of the run-up to a financial crisis is a speculative asset-price bubble
• Stock-market bubbles (e.g. Nasdaq in late 1990s)
• Housing-price bubbles (e.g. mid-2000s)

Question 16

Possible triggers for the crisis

Owe the bank a grand, they’ll take you to court, owe the bank 3 million, they’ll take you to dinner

Answer 16

• Loans defaults
• Some of the most reckless loans prove un-payable
• Mild macroeconomic shocks may also cause loan defaults
• Bursting of asset price bubbles
• Speculators awaken to un-sustainability of the bubble

Question 17

Insolvencies at financial institutions

Answer 17

• Loan defaults + asset price declines = losses

- Losses + high leverage = insolvencies

Question 18

Housing price and bank insolvencies

Answer 18

• Mortgages: loans where house acts as collateral
• Mortgage defaults
• When house prices are steady -> no problem for banks
• When house prices have fallen -> balance-sheet losses

Question 19

House prices in the Financial Crisis

Answer 19

1) BNP Paribas was unable to pay bond holders of one investment fund

2) Banks were highly leveraged (used borrowed capital for investment) and were extremely vulnerable to a fall in the value of investment in financial assets (i.e., house prices) accumulated on balance sheets:
Banks takes out mortgage with a collateral on asset
When borrower defaults, collateral passes to the creditor
Banks now recover these collateral assets which have no use to them
3) Large fall in asset value will make bank insolvent: house prices fell as much as 35% in the US
4) Banks’ net worth decreases due to a fall in collateral prices
Banks’ assets decreases, while liabilities remain

Question 20

Contagion

Answer 20

• Insolvencies at some banks
• Directly cause losses to other banks which may been lending to them
• Reduce confidence in other banks by lenders and depositors
• How exposed are they failing institutions?
• How similar were their lending practices institutions?
• Withdrawing of deposits and other forms of short-term lending
• Banks are interdependent

Question 21

Bank Runs and Illiquidity

Answer 21

Illiquidity:
- Not having sureness reserves to service redemptions
Bank runs:
- When short-term creditors (including depositors) redeem their funds en masse

A run can occur:

• When short-term creditors doubt the bank’s solvency
• Or even when they fear other short-term creditors will run

Question 22

Fire Sales

Answer 22

• As insolvent banks liquidated, their assets get sold
• To replace their shrinking reserves, and stave off illiquidity, even solvent banks must sell assets
• Selling by many banks -> called fire sales -> causes steep price declines

Question 23

Bank’s characteristics

Answer 23

1) Short-term liabilities (your savings) vs Long-term assets (bank’s lending) -> They do Maturity Transformation

2) Banks rely on the money market: Lending from each other on short-term bases to fund themselves
Relies a lot on trust in the solvency of other banks: the ability to pay
If probability of defaulting (bank fails to repay debts) is high across markets, nobody would lend: Credit Crunch
Banks count the solvency of other banks: liquidity dried up
During a Credit Crunch: there is a sharp decrease in lending to firms and households

Question 24

Frictions by Asymmetrical Information

Answer 24

1) Adverse selection - Hidden Characteristics
(Transacting with those less desirable)
Government does not know the characteristics (i.e., investment habits) of bankers

2) Moral Hazard - Hidden Action
(Changes in behaviour after transactions)
Banks perform risky transaction knowing that the government will bail them out if they fail

Financial intermediaries are reverent because:

1) screening projects (i.e. analysis for project before loan)
2) monitoring financial status of borrowers (i.e., checking balance sheet, etc)

Question 25

Credit Crunch

Answer 25

• Firms relied on insolvent banks which can no longer borrow
• Even solvent banks try to turn as much of their loans as possible into reserves
• When loans are repaid, funds are kept as reserves instead of re-loaned
• Any cash injection from depositors or lenders kept as reserves
• So firms and households finds it harder and harder to get funding

Question 26

A vicious cycle

Answer 26

Recession = with less credit avail was, consumer and business spending declined, reducing AD -> Result: output falls, unemployment rises
Crisis: banks insolvent/illiquid, stop lending, reduction in I and C, AD reduces, loss output, unemployment

• The recession reduces profits, asset values, and household incomes, which increases in defaults, bankruptcies, and stress on financial institutions
• The financial system’s problems and the economy’s downturn reinforce each other

Question 27

Policy responses to a crisis

Answer 27

1) Conventional counter-cyclical policy
- The central bank can expand the money supply to lower interest rates
- The government can increase spending and cut taxes

2) Lending of last resort (solvent but illiquid)
- Runs on banks can create a liquidity crisis, in which solvent banks have insufficient funds to satisfy depositors’ withdrawals
- The central bank make direct loans to these banks, acting lender of last resort
- The government can also pitch in with banks and other financial (and sometimes non-financial) actors

3) Nationalisation and publicly-funded recapitalisations (insolvent)
- Insolvent banks:
- Government makes up the difference between assets and liabilities, plus some, and becomes sole owner of the bank (nationalisation)
- Near-insolvent banks:
- The government increases the bank’s capital and becomes co-owner of the bank (publicly-funded recapitalisation

4) subsidies to lending
- The government offers subsidies to banks that lend to firms and households

Question 28

In sum

Knowledge is the most important thing

Answer 28

1) Financial system is necessary to facilitate transactions,and lending and borrowing
2) Banks work by trust on its solvency
3) Banks should always have more assets than liabilities to maintain solvency
4) Frictions re the key causes of financial crisis because of asymmetrical information