Week 12: The global financial system

Question 1

What are the differences between Financial system and monetary system?

Answer 1

1. Monetary system: deals with money supply and exchange rates; it’s how different currencies are valued against each other
2. Financial system: Involves the flow of money, investments, and credit within and across borders in the short run
   - It evolved from the gold standard to the Bretton Woods system to the “non-system” to finally, the Financial Revolution of the 1970s: a shift to deregulated and global financial markets, increasing the interconnectedness and complexity of financial systems

Question 2

What is financial contagion?

Answer 2

• The spread of financial crises from one country to others through trade, investment, or economic relations
• Crises can spread more easily if countries have similar financial institutions and face similar economic issues

Question 3

What are the differences between Financial contagion and crisis?

Answer 3

1. Financial Crisis - a major disruption in financial markets leading to a sharp decline in asset values, failures of financial institutions, and severe economic downturns such as recessions, unemployment, and loss of confidence in the financial system (ex. banking crises, currency crises, stock market crashes)
   - A financial crisis in one country can lead to financial contagion, spreading the effects to other countries consequently a contagion can make a localized crisis a global issue
2. Financial Contagion - the spread of financial shocks from one country to another, leading to global financial instability that is transmitted through trade links, cross-border investments, and loss of market confidence (ex. spread of the 1997 Asian financial crisis, 2008 global financial crisis)

Question 4

What are the banking crisis?

Answer 4

• Occurs when many banks in a country become insolvent or face severe liquidity issues, leading to a loss of depositor confidence and mass withdrawals, often requiring government intervention to prevent a collapse of the financial system
• This situation can severely disrupt economic activity and lead to prolonged economic instability

Question 5

What are bank runs?

Answer 5

• When a large number of customers withdraw their deposits simultaneously over fears that the bank will become insolvent
• Often accompany currency crises, where people withdraw deposits fearing currency devaluation

Question 6

What are the systemic crisis?

Answer 6

A widespread crisis that affects the entire financial system, not just individual institutions

Question 7

What are credit crunches?

Answer 7

When banks reduce the availability of loans due to increased risk, leading to reduced economic activity

Question 8

What are assets?

Answer 8

What the bank owns (buildings, computers, cash in their tills, government bonds, other financial assets, etc.) + what people owe to the bank (loans, mortgages, overdrafts, etc.)

Question 9

What are speculative attacks in financial crisis?

Answer 9

Investors sell off a currency en masse, anticipating its devaluation

Question 10

What are the main causes of recession?

Answer 10

• Inflation, sometimes hyperinflation
• Decrease of saving and investment levels
• Currency crises are usually connected to crises in the financial system

Question 11

What are the first generation of currency crises theories?

Answer 11

• Fundamental Problems caused by government actions like excessive deficits
• Investors lose confidence, leading to massive capital outflows and economic collapse
• Latin-American Debt Crisis 1982: example of a first-generation crisis where government debt led to financial instability

Question 12

What are the Second generation of currency crises theories?

Answer 12

• No Immediate Fundamental Problem, crises arise from changes in expectations rather than current economic issues
• Self-Fulfilling Expectations: beliefs about a policy’s sustainability lead to actions that cause its failure
• Examples: ERM II crisis 1992, Mexican crisis 1994, where policies were doubted and led to crises

Question 13

What are the Third generation of currency crises theories?

Answer 13

• Institutional Problems: issues within financial institutions contribute to crises
• Asset Bubbles: unsustainable increases in asset prices followed by a crash
• Moral Hazard: when entities take excessive risks believing they are protected from negative consequences
• Weak Financial System contributes to the severity and spread of crises
• Example: East Asian Crisis 1997: Triggered by financial and institutional weaknesses

Question 14

What are asset bubbles?

Answer 14

• Occurs when the prices of assets, such as real estate, stocks, or commodities, inflate rapidly to levels far beyond their intrinsic value, driven by excessive demand and speculation
• Eventually, the bubble bursts, causing prices to fall drastically and leading to significant financial losses for investors

Question 15

What is moral hazard?

Answer 15

• Tendency of individuals or entities to take greater risks or act recklessly when they believe that they are protected from the consequences of their actions in the form of insurance, bailouts, or government guarantees, leading to behaviors that would not occur in the absence of such protection
• For example, banks might engage in risky lending practices if they believe they will be bailed out by the government in case of failure, thereby increasing the likelihood of financial crises

Question 16

How to end a currency crisis?

Answer 16

1. Devalue: set a new, lower exchange rate for the currency
2. Adopt a floating Exchange Rate: allow the currency value to fluctuate according to the market
3. Impose restrictions on Currency Transactions: limiting the ability to buy/sell foreign currency
4. Obtain loans to bolster reserves; ie. borrowing to increase central bank reserves
5. Restore confidence in the existing exchange rate
6. Use the IMF to help stabilize economies through financial support and policy advice

Question 17

What are the problems to be solved in Financial crisis?

Answer 17

1. Global supervision and transparency
2. Global rules and intervention to avoid systemic problems
3. Bretton woods compromise- Tobin tax

Question 18

What is Tobin tax?

Answer 18

• A proposed tax on foreign exchange transactions, typically involving currency conversions designed to discourage currency speculation by imposing a small levy on each transaction, thus making short-term trading less profitable
• The primary aim of the tax is to reduce short-term speculative trading and stabilize financial markets
• Its implementation and effectiveness remain subjects of debate among economists and policymakers

Question 19

Describe the IMF:

Answer 19

• 1994
• original role: facilitate international monetary cooperation, promote exchange rate stability, and provide temporary financial assistance to member countries facing balance of payments problems
• The fund: each member contributes funds to the IMF, reflecting their economic size
• Structural adjustment programs: loans provided with conditions to implement economic reforms

Question 20

Describe the reforms of the IMF after the 2008 crisis:

Answer 20

• Reallocation of Quotas: adjusting contributions and voting power of member countries
• New Assistance Programs: flexible credit lines for crisis support
• Enhanced Surveillance: monitoring economic policies to prevent crises
• Changing Policy Focus: adapting IMF policies to new global economic realities

Question 21

What is the “flexible credit line” in the IMF?

Answer 21

• Financial instruments provided by the IMF to MS with strong economic policies and a track record of sound policy implementation
• They offer pre-approved access to IMF resources without the need for the country to enter into a formal IMF-supported program
• Serve as a precautionary measure, providing immediate liquidity support to countries facing external shocks or market turbulence, helping to bolster investor confidence and stabilize financial markets

Question 22

Describe the Basel Accords:

Answer 22

• A set of international banking regulations established by the Basel Committee on Banking Supervision (BCBS), aimed at promoting stability and strengthening the global banking system
• Provide guidelines for capital adequacy requirements, risk management, and regulatory oversight to mitigate the potential for banking crises
• Impose standards on how much capital banks must hold relative to their risk exposure, with the goal of ensuring that banks have enough reserves to withstand financial shocks and prevent systemic failures
• BIS - Bank for International Settlements, providing banking services to central banks
• Stress Tests - simulating financial stress to test bank resilience
• Capital Adequacy - ensuring banks have enough capital to cover risks

Question 23

What were the focus of Basel I, II and III?

Answer 23

The Basel Accords set international banking standards to promote stability and reduce risk.
1. Basel I: focused on ensuring banks had enough capital to cover credit risks.
2. Basel II: expanded on this by introducing better risk management practices through three pillars: capital requirements, supervisory oversight, and market transparency.
3. Basel III: developed after the 2008 financial crisis, strengthened capital requirements, introduced liquidity measures, and added safeguards to address systemic risks and prevent excessive leverage.

Question 24

What are Capital controls?

Answer 24

• Measures taken by a government to regulate the flow of foreign capital into or out of the domestic economy
• It can be a capital inflow or outflow controls

Question 25

What is Capital inflow control?

Answer 25

• Manages foreign capital entering the economy
• Includes restrictions on foreign investment and currency purchases
• Aims to stabilize exchange rates and protect domestic industries
• Supports monetary policy effectiveness and financial stability

Question 26

What is Capital outflow control?

Answer 26

• Regulates the flow of capital leaving the country
• Often involves limits on currency conversion and profit repatriation
• Designed to prevent capital flight and stabilize the domestic financial system
• Can have unintended consequences such as deterring foreign investment

Question 27

What are exchange controls?

Answer 27

• Government-imposed restrictions on the conversion or movement of currencies within a country’s economy
• Ex. regulations on currency conversion, foreign exchange transactions, and the movement of capital across borders