Week 1: the common causes of financial crises

Question 1

Why do we study financial crises

Answer 1

the things happen with appalling frequency. They have devastating human costs. in 2/3 unemployment never returns to pre crisis level

Question 2

How much does unemployment usually rise during a major crisis?

Answer 2

5 % points

Question 3

What about house prices?

Answer 3

Usually fall about a 1/3

Question 4

How much doe equity prices fall during a major crisis?

Answer 4

About half

Question 5

How much does government debt increase during a major crises

Answer 5

it almost doubles.

Question 6

How said that stability breeds instability?

Answer 6

Hyman Minsky

Question 7

What role does memory have in financial crises?

Answer 7

A very important one.

Question 8

How do financial systems basically work?

Answer 8

Financial Systems as you all know, they play this critical function in the economy. They take the savings of savers and loan or invest those recourses in activity that has some positive return. People lend them that money for
a very short period, they expect it to be available on demand. And banks and
other firms take those resources and lend them for longer periods of time
to support people who wanna borrow to finance the purchase of a home or a
business, that wanna build a new factory. That’s the basic function
of the financial system.

Question 9

What is the typical structure of a bank and what does that mean in terms of security?

Answer 9

he structure of a typical bank, which is described here, has this thin base of common equity. A set of other forms of borrowing, long
and short, deposits, secured, unsecured. And those finance the assets which are depicted on the left. This basic structure, by design,
is fundamentally fragile because that equity cushion is thin and a large share of the remaining source of funds used to finance the loans of the assets of the institution can run, can be withdrawn in a crisis. And a bank doesn’t have the ability to sell assets quickly to meet a withdrawal of funds in extremis, thus, the inherent fragility of a financial system.

Question 10

What does a narrower base mean?

Answer 10

That narrower base signifies

a greater vulnerability to shocks, greater fragility.

Question 11

How important is the financial system to the rest of the economy?

Answer 11

Now this matters in part because
the financial system is so closely linked with
the rest of the economy. It’s like the power grid in the economy. If the lights go out,
the power system fails, it’s very hard for the rest of the economy to function.

Question 12

Explain the doom loop

Answer 12

So economic growth slows because of
some adverse shock, the economy slows. That creates the fear of loses. Depositors start to
withdraw their funds from what they perceive to be the weaker institutions. Those institutions try to sell assets or withdraw loans, call funding, to meet the demand for withdrawals of funds. That pushes down asset prices, the price of financial securities. In response to that, banks lend less. They pull back. That reinforces,
intensifies the slowdown of the economy. That makes more institutions look weaker. The cycle continues. It’s a classic, vicious, self-reinforcing cycle in
the context of financial distress.

Question 13

What does the initial response of policymaklers do to the crises?

Answer 13

hird thing that matters is the response
of policy makers to that shock or that distress. And as that earlier chart shows, policy
makers tend to mismanage the response. In fact, often the initial response,
the initial inclination of policy makers is to do things that
makes the crisis worse. Why is that, or how does that manifest? Sometimes, it’s just because policy makers
just react too slowly, it’s hard for them to appreciate
the magnitude of the crisis.

Question 14

What are other reasons why policymakers fail?

Answer 14

Sometimes, it’s because they’re
understandably concerned about moral hazard, about the effects on incentives about acting too aggressively. Sometimes it’s because of
a basic conservatism in policy, people think it’s better to move slowly, you take less risk in doing that. Sometimes its because of a basic lack of knowledge among policy makers about what works, about what makes sense. Because again, it’s quite rare that the very severe crisis, the classic panic, happens to the same
country in a short period of time.

Question 15

What are typical causes for financial crises?

Answer 15

Low interest rates can contribute to financial crises. Sometimes you see a huge amount of fraud and predation. There’s huge diverse mix of incentive problems in financial systems. Moral hazard’s one of those, the classic concern risk that people lend to institutions with
less sense of risk in doing so, because they expect to be protected from their losses. There’s lots of evidence of regulatory failure. Regulatory mismanagement in thinking about
the risk of crises, cause of crises. But a fundamental thing is this set of beliefs. The set of beliefs that can contribute to a long boom in leverage and borrowing.

Question 16

What is a classical characteristic of a systemic financial crisis?

Answer 16

In the systemic financial crisis,
you typically had a long rise in debt, relative to income, a long rise
in borrowing relative to income. Typically, that’s been financed in forms
that are vulnerable to runs and panics. Those two things create a greater risk
of contagion across institutions. That makes the damage to the real
economy potentially much, much greater. And importantly, it makes monetary policy much less effective in trying
to mitigate the economic damage. Because in a situation where
people have borrowed a lot and built up a lot of leverage,
behavior is less responsive to the typical tool central banks have to lower
interest rates as the economy weakens.

Question 17

What are the things that help distinguish how things churn out when a boom or mania tips into a panic or a crash. ?

Answer 17

1. One is the size and extent of the buildup of vulnerabilities, that’s intuitive and simple.
2. A second is the tools and financial capacity available to policy makers, to governments and to central banks to respond.
3. And a third, is what do they do with that authority? What do they do with that financial capacity? What are the choices they make? How wise and deft are those choices?

Question 18

What is a difference in dealing ?

Answer 18

They’re different, in part, because the response required to break a panic, the response required to protect people, protect the economy from the damage caused by financial crises is fundamentally different from the response that’s appropriate in the typical financial shock. In a panic, and this is kinda intuitive to many people, policy has to be much more aggressive in trying to reduce the risk of damage to the economy. And the type of strategies you adopt, as I’ll describe, are fundamentally different.

Question 19

What are the differences in dealing with a normal financial shock as opposed to a systemic financial shick?

Answer 19

Here’s a way of thinking how the overlap is sort of limited between the strategies that work in a major financial crisis and the strategies that work in the more typical shock, and the fundamental tension and conflict between those two strategies. So in response to a typical financial shock, generally, you want to let failure happen. You want to haircut the creditors of failing banks, you want to allow the markets to adjust. You want to resist the pressure to intervene because it’s important and it’s healthy for the economy to go through that adjustment. For people that took too many risks to bear the full consequences of those risks. You might let the automatic stabilizers work in fiscal policy, those are things that automatically provide a little bit of assistance to the economy as growth slows. The central bank might want to do the normal standard liquidity provision to market certain institutions, and depending on the nature of, depth of the recession, the central bank might want to lower interest rates too.
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But in a systemic financial crisis, you have to think about a fundamentally different set of tools. You have to think about a much more aggressive, much larger fiscal stimulus, much more aggressive, much less conventional monetary policy response. In terms of the financial system, you have to err on the side of providing guarantees and protections to limit the risk of runs, to limit the incentive to run. And you have to be very, very careful in allowing failure that could spread contagion, destabilize the rest of the system.

Question 20

What followed the crisis in the 1930s?

Answer 20

A period of relative calm. That does not mean that there were no financial crises. But those losses were very small, very mild, very moderate relative to the losses you saw in the Great Depression.

Question 21

Why is the “calm” period important for explaining the financial crisis of 2008?

Answer 21

This is important, because it led people to believe as memory of the severe crisis faded that we were living in a calmer, more benign, less risky financial environment.

Question 22

What cab you say about volatility between 1985 and 2005?

Answer 22

It was generally very low. There seemed to be less risk. Because of that you saw the long rise of housing prices.

Question 23

Why did people think house prices would rise?

Answer 23

People were more confident that the value of homes would rise, therefore they were more confident they could borrow a large amount relative to their income and lenders were more confident they could lend a large portion of someone’s income because that was backed by what they expected to be a rising value of that financial asset.

Question 24

What is the Moiunt Fuji chart?

Answer 24

boom in borrowing relative to income

Question 25

What was the most increased in that borrowing?

Answer 25

But most of the increase in that borrowing, by individuals and by companies, was financed by other parts of the national system. By investment banks, by the government mortgage guarantors, Fannie and Freddie Mac, by non-bank financial institutions like GE Capital. And that’s important because those institutions existed outside the safety net, the safeguards established after the great depression. And they were financed in ways that made them much more vulnerable to runs and panics.

Question 26

What was another factor besides the rise of shadow banking?

Answer 26

Alongside this rise in shadow banking, there was a substantial increase in short term deposit like liabilities that people thought they could withdraw on demand without any risk of loss. And that was critical to making the system vulnerable to the type of run and panic that ensued in the fall of 08.

Question 27

What about interest rates and savings?

Answer 27

Now again, there were a lots of causes in these cases. We had a long trade where monetary policy was very accommodative, where real interest rates in the US and around the world were very, very low. There was a huge increase in savings in the most populous parts of the world, and over time a larger portion of those savings removing outside their home country to invest in places like United States.

Question 28

What about moral hazards etc:?

Answer 28

There was a huge amount of fraud and predation in the US financial system. There were pockets of moral hazard most compellingly in the mortgage guarantors Fannie and Freddie. There were a mess of other incentive problems throughout the financial system, and we had a very Balkanized segmented regulatory structure.

Question 29

Why did we allow the system to become so vulnerable?

Answer 29

Part of the reason is because prior to the crisis, the U.S. financial system was designed with relatively limited tools to constrain the build up and risk. The Federal Reserve and the bank supervisors had tools and authority to apply capital and liquidity requirements to banks, and to bank holding companies but those institutions represented only a relatively small share of the American financial system. We didn’t have the ability to limit leverage in investment banks, in the government sponsored financial enterprises like Fannie and Freddie, in the investment banks and non-bank financial institutions in some of the big insurance companies.

Question 30

What happened because of the structure of the financial system?

Answer 30

Look what happens in a system design like that way where you can have the unregulated, or the less regulated competing, with the regulated. Look what happens when you can only constrain risk taking in part of this system, in a context where there is this fundamental belief, this confidence, this exuberance about the stability about the economy and the prospect of rising asset prices.
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If you can string part of the system, a lot of that growth gets financed in the periphery, where it’s less constrained and less regulated. You can see, over time, what happened in the American financial system is that the relative importance of the non-bank financial system, some people call it the shadow financial system. Investment banks, non-bank financial institutions, Fannie, Freddie, they all grew in relative importance, over time, because they were less constrained by the authorities.

Risk tends to fins its ways around.

Question 31

What is the tricky part?

Answer 31

The important thing about this challenge is that the tighter you set the limits on part of the system, you’ll make that part of the system safer. You could make banks more stable but you’ll shrink the market share of banks. You’ll shrink the effective scope of those restrictions over time because over time, risk will migrate around them, and the relative size of those two different parts of the system will change in relative importance.

Question 32

What did they do to create more risk?

Answer 32

We pushed for stronger risk management practices in banks and investment banks. We made some early efforts to try to introduce more stress testing to try to get these institutions to think more about the risks of a severe crisis. We made a major and very successful effort to reduce risk in derivatives. We worked to limit the provision of leverage by banks to institutions like hedge funds, concerned by the risks we saw in the LTCM crisis in the late 90s.

Question 33

What was the regulatory problem?

Answer 33

But supervision was focused too narrowly on compliance issues, like in money laundering and less focused on things about the stability of the entire system on systemic risk. We didn’t raise capital requirements on banks and bank holding companies, despite these growing risks. We didn’t look for authority from the Congress to set limits on capital and leverage on funding where they did not apply. We didn’t raise down payment requirements on people who were borrowing to finance the purchase of a house. We didn’t effectively limit risk taking in repo markets, and securities, finance markets, other markets that were critical to the way the system functioned. You can think that our biggest mistake, in some sense, was failure in imagination. We failed to contemplate the possibility that we could face a classic panic and run like what made the Great Depression so terrible. We thought that was inconceivable, unforeseeable, an, therefore, we didn’t build the system to be strong enough to reduce the risk of that type of classic panic.