Topic 8: Condensed

Question 1

What was Japan like pre crisis (during the boom)

Answer 1

Credit to GDP rose sharply
GDP per capita rose sharply
Asset prices rose sharply

Question 2

What was Japanese regulation pre boom

Answer 2

credit provision tightly regulated
prudential bank regulation
lending and deposit rates capped
firms need special permits to issue bonds
limits on international inflows and outflows

Question 3

what was the japanese financial liberalization

Answer 3

Deposit rate caps abolished
restrictions on bond issuance abolished
limits on international flows ablished

Question 4

what were the consequences of financial liberalization in japan

Answer 4

slow liberalization for savers meant that deposits remained a significant source of bank funding

faster liberalization for borrowers meant that large firms left banks for the bond markets and banks had to find other borrowers, which caused a rise in real estate loans and lending to smaller firms

overall increased lending in economy

Question 5

what were the macroeconomic policies and dynamics in japan during boom

Answer 5

flexible exchange rate - high USD interest rates caused appreciation of USD vs JPY

Plaza accord -> agreement between G5 countries to depreciate USD, caused JPY to appreciate 46% vs USD

This caused japan exports and GDP to stop growing, which caused japan to cut rates by 3%, large fiscal stimulus, and GDP started growing again

Question 6

what was the trigger of the japan crisis

Answer 6

increase in japanese rates in 1989

stock market fell 50%
commercial real estate fell 60%
financial accelerator ran in reverse

Question 7

what happened to Japanese banks in crisis / how was crisis

Answer 7

took longer for bank failures to appear vs sweden, but crisis lasted longer and was worse

credit cooperations resolved, funds came from private banks and BoJ, solvent banks became concerned that their contributions could endanger their solvency

Jusen crisis: non-bank FIGs making loans, resolved, funds came from taxpayers -> public resentment

5 large banks resolved/recapitalised
capital injection by the state to recap

Question 8

stabilisation measures in japan

Answer 8

debt guarantee for all banks announced in 1997
financial assistance package of 30tn, however banks were reluctant to apply for assistance in order to not be singled out

Question 9

what was extend and pretend in japan

Answer 9

prudential regulation of banks capital was not enforced vigorously -> banks overstated capital to avoid issuing new equity by not acknowledging losses on their bad loans

Question 10

possible reasons for non vigorous capital regulation in japan

Answer 10

lack of political will to commit taxpayer money to save banks
given limited funds, forcing banks to acknowledge losses on loans could lead to bank failures and panics

Question 11

why is extend and pretend costly for the real economy

Answer 11

zombie firms less productive than healthy firms
they have no incentive to issue new equity and invest (debt overhang)

zombie firms crowd out healthy firms
receive subsidised bank loans, their bank capital was not available for loans to other firms, lower healthy firm profitability by competing with them in goods and labour markets

Question 12

what was regulation like in sweden pre boom

Answer 12

credit provision tightly regulated by state
prudential regulation of banks (8% capital for corporate loans, 1-4% for mortgages depending on LTV)

bank holding of gov and MBBs must be greater than a certain fraction of assets
lending could not exceed a ceiling
lending and deposit rates capped
firms need special permits to issue bonds
limits on international flows

Question 13

swedish financial liberalization

Answer 13

deposit rate caps abolished
liquidity ratios abolished
lending ceilings and lending rate caps abolished
limits on flows abolished

Question 14

impact of financial liberalization in sweden

Answer 14

annual credit growth increased
bank employment increased
banks became more reliant on wholesale funding instead of deposits, increasing fraction of wholesale funding came from abroad

Question 15

macroeconomic policies in sweden during boom

Answer 15

pegged but adjustable exchange rate
high inflation
central bank depended currency peg by keeping rates high
fiscal deficit until 1986

Question 16

macro dynamics post liberalization in sweden

Answer 16

increase in credit -> increase in asset prices (fin acc)

increase in credit -> increase in AD -> increase inflation -> decrease in real rates -> increase in credit

increase in inflation -> loss of international competitiveness -> trade deficit

Question 17

triggers of swedish crisis

Answer 17

increase in european interest rates due to german unification
fiscal tightening in response to high inflation
decrease in tax benefits of deducting interest payments from 50% to 30%

Question 18

what happened to the macro in the crisis of sweden

Answer 18

GDP fell 1.1%
investment fell 9.8%
bank lending fell
real estate and stock market fell

Question 19

what was swedish currency crisis

Answer 19

uncertainty about semi pegged rates ->speculative attacks on SEK ->swedish central bank hiked rates

fears that banks may not be able to continue borrowing internationally -> state provided debt guarantee for all banks

further speculative attacks on SEK -> this time didnt hike -> SEK devalued

high rates made banking crisis worse
davaluation hurt swedish frims borrowing in foreign currency

Question 20

what was swedish debt guarantee

Answer 20

for all banks, goal was to ensure banks could continue borrowing and avoid runs

conditions -> only for solvent banks, state had to inspect banks, banks had to pay for cost of guarantee

there was limited use however - economy started to recover in 1993

Question 21

what are the costs of regulation (pre lib) for both

Answer 21

Lending ceilings → Some positive NPV investments are not undertaken.

Lending ceilings → Banks have no incentives to raise their market share and design better products.

New institutional arrangements are created to circumvent the regulations
Non-regulated lenders have an advantage over regulated ones → Pressure to abolish lending ceilings.

Question 22

similarities in boom japan vs sweden

Answer 22

Financial liberalization generated additional lending

Macroeconomic policies facilitated the credit boom.
Monetary policies:
Japan: Low interest rate limited the JPY’s appreciation.
Scandinavia: Pegged exchange rate.

Question 23

what are the benefits of setting up a bad bank

Answer 23

Avoid extend-and-pretend.
Force banks to acknowledge losses on their bad loans.
Banks can otherwise roll-over bad loans to zombie firms.

Avoid fire-sales.
Assets are not sold at depressed prices.
Assets can be sold slowly, as economy begins to recover.

Exploit economies of scale.
Manage many similar loans.
Coordination between lenders is easier when there is only one lender

Better incentives.
Employees at the bad bank: Acknowledge that loans are bad, and maximize
revenue from managing them.

Free up bank capital for loans to new firms.

Question 24

similarities in crisis and clean up between japan and sweden

Answer 24

Similarities:
One-off measures at early stages of the crisis.
More systematic and drastic measures at later stages.
Debt guarantee.
Sharp increase in funds made available by the state

Question 25

differences in crisis and clean up between japan and sweden

Answer 25

Japanese crisis took longer to manifest and lasted for longer.
Drastic measures were taken later.
Extend-and-pretend was more prevalent.

Cost of the crisis, gross of asset sales proceeds, was 4% of GDP in Sweden
and 17% in Japan.

Question 26

benefits of financial liberalization

Answer 26

If credit ceilings are abolished, then bank credit will grow quickly because
banks will not be restricted by the ceilings and will make more loans.

The benefits of financial liberalization is that some positive net present value projects
that were not financed because of the credit ceilings will be financed.

Question 27

risks of financial liberalization

Answer 27

The risks of financial liberalization is that because of short-termism, over-optimism or faulty regulation, credit growth may be excessive, with low lending standards.

This can lead to over-accumulation of debt in the economy and a credit crunch accompanied by a deep
recession.