12 Flashcards
(67 cards)
What is a financial crisis?
A financial crisis is a major disruption in financial markets characterized by sharp declines in asset prices and firm failures, often due to a large disruption in information flows and an increase in financial frictions.
What are financial frictions in the context of a financial crisis?
Financial frictions are asymmetric information problems that create barriers to the efficient allocation of capital, making it harder for markets to function properly during a crisis.
Timeline of the 2007-2009 Financial Crisis
August 2007: Defaults in the US subprime mortgage market.
December 2007: Recession began.
September 2008: US stock market crash.
The period from 2007 to 2009 is known as the “Great Recession.”
What triggered the European Sovereign Debt Crisis?
The crisis was triggered by increased budget deficits due to the 2007–2009 financial crash, fears of government defaults, rising interest rates, reduced tax revenues, and financial institution bailouts.
What countries were affected by the European Sovereign Debt Crisis?
The crisis began in Greece in September 2009, spreading to Ireland, Portugal, Spain, and Italy, leading to severe recessions and very high unemployment rates.
How did the European Sovereign Debt Crisis threaten the Euro?
The crisis created significant stress in the European Union, putting the viability of the Euro at risk due to concerns over defaults and the economic stability of member countries.
What happens during the initial phase of a financial crisis?
The crisis begins with a sharp disruption in financial markets, often due to a sudden loss of confidence in financial institutions or asset prices, leading to a sharp decline in market values and triggering further destabilization.
What occurs during the banking crisis stage of a financial crisis?
During a banking crisis, financial institutions face severe losses in asset values, leading to a collapse of the banking sector, bank failures, or a drastic reduction in lending (deleveraging).
What is debt deflation in the context of a financial crisis?
Debt deflation occurs when there is a sharp decline in the price level, which increases the real value of debt, causing more defaults and further economic distress.
Why is net worth (capital) important in understanding financial crises?
Net worth, or capital, is critical because it represents the financial cushion of firms or banks. A decrease in net worth (capital) can lead to deterioration of balance sheets, which reduces economic activity leading to a reduction in lending.this means lenders stop collecting information about borrowers = asymmetric infromation
What are the effects of a decline in net worth during a financial crisis?
A decline in net worth leads to deterioration in banks’ balance sheets, resulting in deleveraging (cuts in lending), reduced economic activity, and an increase in asymmetric information as lenders stop gathering information about borrowers.
What leads to a credit boom and bust in the initial phase of a financial crisis?
Mismanagement of financial liberalization and innovation, which includes the elimination of market restrictions and introduction of new financial products. This often causes institutions to take higher risks due to lack of expertise, leading to moral hazard problems and government safety nets weakening market discipline
How does a government safety net contribute to moral hazard in a financial crisis?
A government safety net protects financial institutions, causing lenders and savers to not punish risky behavior. This results in banks having incentives to take on more risks, leading to losses on loans, reduced asset value, lower net worth (capital), and eventually a credit freeze.
How does an asset-price boom contribute to a financial crisis?
Asset prices can become inflated due to investor psychology and credit booms, driving market values above their fundamental value. Eventually, the bubble bursts, leading to a sharp decline in asset prices, which reduces net worth and the value of collateral.
What happens when an asset-price bubble bursts during a financial crisis?
The burst causes a sharp decrease in asset prices, which leads to a reduction in net worth and the value of collateral, exacerbating the financial crisis.
How does increased uncertainty trigger the initial phase of a financial crisis?
A sudden increase in uncertainty, such as the failure of a major financial institution (e.g., Lehman Brothers in 2008), leads to reduced lending and economic activity, often causing stock market crashes and a decrease in net worth.
How does an unanticipated decline in the value of the domestic currency contribute to a financial crisis?
A decline in currency value increases the debt denominated in foreign currency, especially in developing economies, which leads to a decrease in net worth.
What happens to some financial institutions during a banking crisis?
Some financial institutions go bankrupt due to negative net worth.
How does uncertainty affect financial institutions in a banking crisis?
Uncertainty about financial institutions increases asymmetric information.
What is a bank run, and what does it cause?
A bank run is when depositors withdraw funds rapidly, leading to more bank insolvencies.
How do asset write-downs and fire sales affect the crisis?
They cause a decline in asset prices, reducing net worth and leading to more insolvencies.
What happens when fewer banks remain after failures?
There is less information about borrowers, increasing asymmetric information.
How does the sorting of “good” and “bad” businesses help end the crisis?
The failure of bad banks and firms reduces uncertainty, helping the stock market recover and improving balance sheets.
stages of financial crisis
stage 1: credit boom and bust, asset-price boom and bust, increase uncertainty
stage 2: banking crisis
stage 3: debt deflation
