Week 5

Financial Crises

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Week 5 Chapters 12 and 13

Financial Crises

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Learning Objectives
12.1 Define the term financial crisis.
12.2 Identify the key features of the three stages of a financial crisis.
12.3 Evaluate the causes and consequences of the global financial
crisis of 2007–2009.
12.4 Distinguish between the progress of crisis between the developed
and developing countries.
What Is a Financial Crisis?
• A financial crisis occurs when there is a particularly large
disruption to information flows in financial markets, with
the result that financial frictions increase sharply and
financial markets stop functioning.

Financial Crisis: Definition, Causes, and Examples (investopedia.com)

Financial Crisis are common
• List of economic crises - Wikipedia
Dynamics of Financial Crises
• Stage One: Initiation of a Financial Crisis
– Credit Boom and Bust: Mismanagement of financial
liberalization/innovation leading to asset price boom
and bust
– Asset-price Boom and Bust
– Increase in Uncertainty
• Stage two: Banking Crisis
• Stage three: Debt Deflation
Sequence of Events in Financial Crises in Advanced Economies
The Great Depression

• How did a financial crisis unfold during the Great

Depression and how it led to the worst economic
downturn in the history of most advanced industrial
countries?
• This event was brought on by:
– The U.S. Stock market crash
– Worldwide decline in asset prices
– Bank failures
– Economic contraction and debt deflation
Great Depression (1930s)

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
The Global Financial Crisis of 2007–2009:
Causes

• Financial innovations emerge in the mortgage markets

– Subprime mortgage
– Mortgage-backed securities
– Collateralized debt obligations (CDOs)
The Global Financial Crisis of 2007–2009:
Causes

• Housing price bubble forms

– Increase in liquidity from cash flows surging to the
United States
– Development of subprime mortgage market fueled
housing demand and housing prices
The Global Financial Crisis of 2007–2009:
Causes
• Agency problems arise
– “Originate-to-distribute” model is subject to principal-
(investor) agent (mortgage broker) problem
– Borrowers had little incentive to disclose information
about their ability to pay
– Commercial and investment banks had weak incentives
to assess the quality of securities
• Asymmetric Information and Credit-rating Agencies
– Reliance on credit ratings were extensive
– Failed to understand new products, assigned unrealistic
ratings
– Skewed incentives (working with banks)
 Last to
take
losses
Aaa

Pool of
sub-

Loss Position
Aa
prime
mortgage A

s Baa

Ba

First to
take
Pre-2006 forecasts of losses
sub-prime defaults

Actual defaults much

larger
than pre-2006 forecasts
The Global Financial Crisis of 2007–2009:
Causes
• Distorted incentives for consumers and financial sector
employees for leverage
– Consumers failed to watch out for themselves:
▪ Few people have any knowledge of the balance
sheets of the banks where they do business or of the
finances of the firms in which they invest through the
purchase of equity or debt securities.
– Managers of financial firms saw a need to drive up returns
on their equity to satisfy shareholders.
▪ That led to an explosion in debt financing.
▪ Higher leverage yields higher returns to the owners.
– This private incentive to increase leverage created not
only fragile institutions but also an unstable financial
system.
The Global Financial Crisis of 2007–2009:
Causes
• Manager compensation schemes
– Compensation schemes further encouraged managers
to forsake long run prospects for short-run return.
– Equity holders and asset managers were unduly
rewarded for risk-taking: they received a portion of the
upside, but the downside belonged to the creditors.
– Managers of assets in a given asset class were
rewarded for performance exceeding benchmarks
representing average performance in that investment
category.
 The Global Financial Crisis of 2007–2009:
Causes
• Limitations of risk measurement, management and regulation
– Risk measurement and management:
▪ Measuring, pricing and managing risk all require modern
statistical tools based largely on historical experience.
▪ Even when long data histories are available, the belief that
the world evolves slowly but permanently means down-
weighting the importance of the distant past.
▪ The implication is that a long period of relative stability will
lead to the perception that risk is permanently lower, driving
down its price.
– The major risks – those that require substantial compensation –
are large, infrequent events – Tail Events.
– The statistical models needed for measuring, pricing and
managing risk will be inaccurate because of a lack of data.
 The Global Financial Crisis of 2007–2009:
Causes
• Governance of risk:
– The structural problem was that risk officers did not have
sufficient day-to-day contact with top decision-makers, often
because they did not have sufficiently senior positions in their
organisations.
• Weakness of regulation:
– Financial institutions found it relatively easy to move activities
outside the regulatory perimeter.
– The regulatory capital requirement did limit the build-up of
leverage on bank balance sheets.
– However, lower leverage meant lower profitability, so bank
managers found ways to increase risk without increasing the
capital they were required to hold.
The Global Financial Crisis of 2007–2009:
Effects

• After a sustained boom, housing prices began a long

decline beginning in 2006.
• The decline in housing prices contributed to a rise in
defaults on mortgages and a deterioration in the balance
sheet of financial institutions.
• This development in turn caused a run on the shadow
banking system.
– Repurchase agreements
– Haircuts (related to the collateral value)
• Crises spreads globally
The Global Financial Crisis of 2007–2009:
Effects

• Deterioration of financial institutions’ balance sheets:

– Write downs
– Sell of assets and credit restriction
• High-profile firms fail
– Bear Stearns (March 2008)
– Fannie Mae and Freddie Mac (July 2008)
– Lehman Brothers, Merrill Lynch, AIG, Reserve Primary
Fund (mutual fund), (September 2008)
• Bailouts in the US, UK and Europe
The Global Financial Crisis of 2007–2009:
Effects

• Height of the 2007–2009 Financial Crisis

– The stock market crash gathered pace in the fall of
2008, with the week beginning October 6, 2008,
showing the worst weekly decline in U.S. history.
– Surging interest rates faced by borrowers led to sharp
declines in consumer spending and investment.
– The unemployment rate shot up, going over the 10%
level in late 2009 in the midst of the “Great
Recession, the worst economic contraction in the
United States since World War II.
Government Intervention

• Short-Term Responses and Recovery

– Financial Bailouts: In order to save their financial
sectors and to avoid contagion, financial support was
provided by many governments to bail out banks, other
financial institutions, and even the so-called “too-big-to-
fail” firms that were severely affected by the financial
crisis.
– Fiscal Stimulus Spending: To boost their individual
economies, most governments used fiscal stimulus
packages that combined government expenditure and
tax cuts.
Stabilizing the Global Financial System:
Long-Term Responses
• With the individual emergency national bailouts to rescue
national economies and financial sectors, global leaders
looked to building a more stable and robust global
financial system. Steps taken by governments included
– Implement sound macroeconomic policies
– Enhance their financial infrastructure
– Develop financial education and consumer protection
rules
– Enact macro- and microprudential regulations
Stabilizing the Global Financial System:
Long-Term Responses
• At the international level
– proactive globally-binding supervision was designed
(Basel III)
– financial market discipline enforced
– systemic risk managed
• To avoid collective action problems and to ensure that
policy actions are mutually consistent with national
growth objectives, aggregate plans began to be drafted
simultaneously.
Future Regulations and Policy Areas at
the International Level
• The gravity of the 2007-08 crisis requires a more radical
overhaul of the financial supervisory and regulatory
system at the international level.
• Such overhaul would also help decrease the risks of
regulatory arbitrage, through which financial actors take
advantage of loopholes in national regulatory systems.
• Steps have recently been taken in this direction by
regulators around the world, in four areas
Future Regulations and Policy Areas at
the International Level
• Bilateral and multilateral supervisory coordination
– Several initiatives of cross-country supervisory coordination
have been adopted since the crisis, to help deal with liquidity
shortages and global risk profiles
– However, such initiatives are of limited effect, given their
voluntary, non-binding nature

• Collective supervisory cooperation

– The G20 set up the Financial Stability Board in 2009
– Aims to reveal regulatory gaps & harmonize financial regulation
Future Regulations and Policy Areas at
the International Level
• Collectively coordinated macroeconomic plans
– Needed to contribute to financial stability
– Mutual Assessment Plan launched by the G20 in
2009
• Self-discipline
– Required to avoid the irresponsible and unethical
behavior of bankers in the years leading to the 2007-
08 crisis.
Sequence of Events in Emerging Market Financial Crises
Dynamics of Financial Crisis in Emerging
Market Economies
• Stage one: Initial Phase
– Severe Fiscal Imbalances
▪ Governments in need of funds sometimes force
banks to buy government debt.
▪ When government debt loses value, banks lose
and their net worth decreases.
– Additional factors:
▪ Increase in interest rates (from abroad)
▪ Asset price decrease
▪ Uncertainty linked to unstable political systems
Dynamics of Financial Crisis in Emerging
Market Economies
• Stage two: Currency Crisis (Fixed currency systems)
– Deterioration of bank balance sheets triggers
currency crises:
▪ Government cannot raise interest rates (doing so
forces banks into insolvency)…
▪ … and speculators expect a devaluation.
– Severe fiscal imbalances triggers currency crises:
▪ Foreign and domestic investors sell the domestic
currency.
Dynamics of Financial Crisis in Emerging
Market Economies
• Stage three: Full-Fledged Financial Crisis
– The debt burden in terms of domestic currency
increases (net worth decreases).
– Increase in expected and actual inflation reduces
firms’ cash flow.
– Banks are more likely to fail:
▪ Individuals are less able to pay off their debts
(value of assets fall).
▪ Debt denominated in foreign currency increases
(value of liabilities increase).
Learning Objectives
12.1 Define the term financial crisis.
12.2 Identify the key features of the three stages of a financial crisis.
12.3 Evaluate the causes and consequences of the global financial
crisis of 2007–2009.
12.4 Distinguish between the progress of crisis between the developed
and developing countries.