REVISION- Topic F- Financial Crisis

Question 1

Name the 3 phases of crises in advanced economies

Answer 1

1. Initiation
2. Banking Crisis
3. Debt deflation

Question 2

Describe the 3 causes of initiation.

Answer 2

• Mismanagement of financial innovations/ liberalization
• Asset boom/ bust
• Uncertainty

Question 3

How does a financial crisis occur?

Answer 3

a financial crisis occurs due to a large disruption to information flows, increasing asymmetric information in the financial markets. This increases financial frictions and stops financial systems from functioning efficiently.

Question 4

What is a financial crisis?

Answer 4

major disruptions in financial markets characterized by a sharp declines in the nominal asset prices and firm
failures

Question 5

Best example of a financial crisis?

Answer 5

2008 financial crisis

Question 6

How can mismanagement of financial innovations and liberalisation lead to the initiation of a crisis?

Answer 6

• liberalisation in the short-run can lead to banks to go on a lending spree (credit boom)
• the inexperience with new financial innovations can mean banks do not have the expertise or incentive to manage the risk effectively

Question 7

Name a major problem with government safety nets like deposit insurance.

Answer 7

• With this insurance there is a greater moral hazard incentive for banks and they may take on greater risks.

Question 8

Describe the asset boom and bust in stage 1 of a financial crisis.

eg of one

Answer 8

• a pricing bubble starts, where an assets nominal values rapidly exceed their fundamentals dramatically, ie if the demand does not justify the price spike
• when the bubble bursts, prices fall dramatically along with financial institutions assets, plummeting down to their real value
• this all leads to lower lending and further economic contraction
• best eg is the housing market bubble in 2008

Question 9

What causes uncertainty in the initiation of a crisis?

Answer 9

• failures of large, stable financial firms, eg Lehmann brothers in the 2008 crisis
• this triggers panic and increases asymmetric information and moral hazard
• again lending dries up and economic contraction

Question 10

What do all of the attributes of initiation lead to?

Answer 10

• they all lead to increased moral hazard and adverse selection problems
• this leads to a decline in economic activity

Question 11

Describe the banking failure stage of a financial crisis.

Answer 11

1. due to the decline in economic activity, banks start to make losses on loans as people cannot pay them back
2. from here banks start becoming insolvent and begin to fail, firms also fail
3. this leads to a bank panic, people taking money out of the banks rapidly, exacerbating the solvency problems
4. fewer banks means more asymmetric info, more moral hazard and less lending and economic activity contraction

Question 12

Describe the third stage of the crisis, debt deflation.

Answer 12

1. sharp economic contractions leads to a huge decline in price level- deflation
2. people think lower prices is good
3. however, some debts are in nominal terms and price is falling then the real debt burden increases for households and firms
4. net worth of households and firms declines further
5. further asymmetric information and moral hazard
6. leading to lending and economic activity to decline for a long time

Question 13

What are the two possible triggers of financial crisis in emerging economies?

Answer 13

1. Credit Boom and Bust

2. Severe fiscal imbalances

Question 14

Describe the credit boom and bust route of financial crises in emerging economies.

Answer 14

1. In emerging economies banks play a more important role because securities markets are not established
2. It all starts with the liberalisation of the financial system, opening the financial system up to capital and firms flows
3. weak supervision and lack of experience from the government leads to a credit/ lending boom
4. the excessive lending and lack of supervision means many borrowers were unable to repay their loans and the bank lost a lot of money. To mitigate this, they severely cut lending and charge high interest rates on loans to make up for the excessive lending
5. on top of this, powerful bank owners stop supervisors from doing their job properly to benefit the bank owners, so they may not be acting in public interest.
   - principle-agent problem

Question 15

Describe the severe fiscal imbalances route of financial crises in emerging economies.

Answer 15

1. large government deficits/ debts mean governments force banks to buy government debt
2. when investors lose confidence in government’s repayment ability
3. they may take money out of country, save and even sell domestic currency
4. speculators attack
5. real debt burden increases, banks lose and their net worth decreases, they may go insolvent and fail
6. reduction in lending and depositors lose money, decreasing household networth

Question 16

Name two other factors that could be responsible for initiating a financial crisis

Answer 16

1. uncertainty linked to unstable political systems, making it hard to monitor credit
2. a decrease in a firm’s net worth, ie due to a fall in their stock price increases adverse selection and moral hazard, also it reduces collateral banks can seize, impairing their balance sheets

Question 17

How does bank balance sheet deterioration trigger a currency crisis?

Answer 17

1. deterioration of bank balance sheets triggers a currency crisis
2. government cannot raise interest rates to increase demand for their currency as it will force banks into insolvency
3. this is because they do not have the capital to offer that rate of return
4. speculators see this weakness and attack

Question 18

How do severe fiscal imbalances lead to currency crises?

Answer 18

1. when foreign and domestic investors lose confidence in the government’s ability to pay debts off they sell domestic currency and pull money out of country
2. currency falls in value
3. this leads to speculative attacks

Question 19

2 causes of a currency crisis?

Answer 19

1. severe fiscal imbalances

2. bank balance sheet deterioration

Question 20

Describe the third stage of a crisis in emerging economies, a fully-fledged financial crisis.

Answer 20

1. speculative attacks lead to peg failing and a sharp devaluation of currency
2. sharp increase in debt burden due to currency mismatch (as most debt contracts will be denominated in a more advanced economies currency)
3. banks fail, individual assets fall, adverse selection and moral hazard problems lead to lending problems and reduction in investment

Question 21

What are the three stages of a financial crisis in emerging economies?

Answer 21

1. credit boom and bust or severe fiscal imbalances
2. currency crisis
3. fully-fledged

Question 22

Why do banks need depositor insurance?

Answer 22

• If depositors cannot guarantee they will receive their money back if the bank has liquidity problems then they will stop using banks
• asymmetric information and moral hazard problems seen in previous crises will also make depositors confidence extremely low
• this insurance increases confidence and injects funds into the banking system

Question 23

What is a twin crisis?

Answer 23

• when an emerging economy experiences a currency crisis and a financial crisis simultaneously

Question 24

What is deposit insurance?

What harmful effects does it prevent (2 of them)?

Answer 24

A government safety net to prevent bank panic and the contagion effect, by protecting the depositor. It ensures that if even if a bank has liquidity problems consumers will receive compensation for their deposits.

Question 25

What exacerbates bank panic?

Answer 25

• Banks operate on a sequential service restraint (first come first serve) giving people fear and incentive to withdraw as soon as possible before they run out of funds

Question 26

Provide an example of a short-term government safety net other than depositor insurance that has been used recently.

Answer 26

• Fiscal stimulus spending, combining tax cuts and gov spending
• was used massively during the COVID-19 in the form of furlough packages

Question 27

Name two long-term responses to stabilize the financial system.

Answer 27

• enhancing infrastructure

- develop financial education and consumer protection rules

Question 28

Describe a way in which central banks have cooperated to protect the international financial system.

provide eg

Answer 28

• supervisory cooperation:
• central banks share information and ensure policies are mutually consistent with national objectives
  eg: financial stability board (FSB) by G20

Question 29

Explain a drawback of government safety nets.

Answer 29

• for example, depositor insurance leads to moral hazard problems where banks will engage in riskier behaviour as they know they can be bailed out
• the depositors also have moral hazard incentive as they assume no risk
• therefore they will not monitor or consider the discipline of the market place fully

Question 30

How does a major financial institution being ‘too big too fail’ threaten the lower levels of the economy?

provide eg

Answer 30

• governments cannot let huge financial institutions fail as they are too integral to the larger financial system
• therefore, they may bail them out even when they are not entitled to be
• they will then pass the losses onto depositors and creditors
• further increases their moral hazard incentive
• think 2008, big short

Question 31

Name three methods of financial regulation regulators use to reduce the risk of a crisis.

Answer 31

• restrictions on asset holdings
• consumer protection, no need to explain you know this
• financial supervision: prompt corrective action

Question 32

Explain how restrictions on asset holdings reduce risk of crisis.

Answer 32

• promotes diversification so firms/ individuals do not have all their eggs in one basket
• single obligor limit- restricts how much a bank can lend to an individual or entity, this reduces moral hazard problems as banks cannot risk take as much

Question 33

Explain how financial supervision reduces risk of crisis.

Answer 33

• huge problems can occur if a financial institution runs low on capital
• therefore, the depositor insurer will trigger prompt corrective action to intervene before the institution gets in trouble
• they do this through chartering and examinations

Chartering- screening proposals for new institutions to prevent adverse selection

Examinations- can be scheduled and unscheduled to monitor restrictions on asset holding and capital requirements to prevent moral hazard

Question 34

Define Microprudential policy

Answer 34

• focused on the saftey and soundness of individual institutions, not the financial system as a whole
• attempts to safeguard firms from excessive and idiosyncratic risk

Question 35

Give 3 examples of microprudential policy.

Answer 35

1. bank-level regulatory standards for bank capital adequacy (the minimum reserves of capital a financial institution must have)
2. rules on who can hold assets and how they can be traded
3. certification of those working in financial sectors

Question 36

What were the two problems with microprudential policy and what was the solution?

Answer 36

• the global financial crisis proved that the soundness of individual institutions was not enough to stabilise the financial system as a whole
• because many established, well-capitalised firms had liquidity shortages
• on top of this there was lots of concern banks were not following these policies stringently
• the solution- MACROprudential policy

Question 37

Define macroprudential policy.

Answer 37

• aims to address financial system as a whole by looking at interconnectedness of financial institutions

Question 38

Explain the boom leverage cycle running up to a financial crisis

Answer 38

1. asset prices rise = reserves of financial institutions (capital buffers) rise = lending rises = asset prices rise further

vice versa for bust

Question 39

How does macroprudential policy short-circuit a leverage cycle?

provide example

Answer 39

• adjusting capital to make them countercyclical and stop the positive feedback loops
• for example, during bust macroprudential supervision may be used to raise new capital for the whole financial system to prevent banks from having to cut lending