4.5.4 Financial crisis

Question 1

financial crisis

Answer 1

• Great recession → 2008-2009
  Booom in economic demand, and high risk loans and mortgages → subprime mortgages
• Borrowers had poor credit histories and could not pay back their loans after house prices crashed in 2006
• Banks needed bailouts from banks
• Interest rates were 5% in 2008 when crisis had started → dropped to 0.5% eventually
• Lehman brothers became bankrupt in america and BOE cut interest rates
• Northern rock in UK went bankrupt
• In 2009 banks wuld not lend, unemployment increased and little confidence in the economy
• QE used to inject cash into economy since monetary policy seemed ineffective
• Since then, more regulatory bodies to reduce risk of banks failure

Question 2

types of financial crisis

Answer 2

• balance of payments crisis —> low exports and high imports
• corporate debt crisis
• household debt crisis
• To make price of currency go up (currency crisis)
• Increase interest rates
• government can purchase currency

Question 3

root causes of financial crisis

Answer 3

1. High confidence so higher risk purchases made
   - Years of low interest rates
   - irrational exuberance and animal spirits
2. lax supervision and regulation of financial institutions —> regulatory failure and capture
   - excessive risk taking and leverage of the banks - esp sub prime lending
   - global current account imbalances and global savings
3. distorted incentives of credit rating agencies
   - want to increase revenue by lending to riskier mortgagees —-> subprime mortgages
   - saturated market so only sub prime mortgages could be given
4. house prices increasing due to speculation and then a sudden drop in financial crisis
   - Banks make it easier to get a mortgage so more people buy homes → housing prices rose and base rate went up to tackle inflation → house prices fell as less demand for them due to contractionary policies

Question 4

financial crisis timeline

Answer 4

1. Increase in bad loans. —> reduction in loans paid back due to bad credit of mortgages
2. banks liquidity decreases as they cannot receive back their loans
3. banks become more careful and less likely to loan as cannot get loans back —> credit crunch
   - 5% non performing bank loans during financial crisis —> bad debt
4. recession in US —> spreads to developed economies
5. northern rock UK with giant subprime sector —> run on NR and crisis spread to UK
6. banks bundle up mortgages and buy mortgage packages from American banks as they are an asset
   - banks internationally bought these as they assumed American bank mortgages were checked with due diligence but were not in truth
   - This led to recession spreading globally
7. banks became overly cautious —> banks wouldn’t loan money to businesses to invest as they didn’t want more bad debt
8. small businesses couldn’t borrow to invest into themselves —> economic growth slowed

Question 5

sovereign debt crisis

Answer 5

• Greece, Ireland, Portugal, Spain, Italy, Cyprus, Slovenia
• Greek informal economy is large —> reduced tax revenue which can lead to a lot of debt due to government borrowing to spend
• Greece in eurozone —> stronger economies had to bail out Greece eg Spain, impacted Europe

Question 6

moral hazard and too big to fail

Answer 6

Moral hazard → person/organisation has no incentive to act prudently or honestlt because they will not have to pay for their mistakes

Too big to fail → cost to the whole economy of a big bank failing is so great that the government cannot allow it to happen; bailing out the bank

Question 7

economic and social risks from financial stability

Answer 7

• Government bails out banks in financial crisis, and tax payers carry out that cost
• Loss of risk of savings due to uncertainty —> banks cannot use savings to invest
• Government promises to pay £85000 of your savings to increase confidence
• creditors —> unpaid debts
• shareholders —> do not get anything and assets are not at risk due to limited liability
• lose equity up until value of their share

Question 8

financial crisis and business investment

Answer 8

• Higher cost of credit —> banks raised interest rates on borrowing to make spending and investment harder
• ignored goverenment who said banks needed to increase lending, as they had been bailed out
• weak regulation

Question 9

economic policy response to financial crisis

Answer 9

• Unconventional monetary easing —> decrease policy interest rates and quantitative easing
• fiscal stimulation —> china and in the USA
• bailout of private sector —> government had borrowed huge amount leading to austerity
• Cameron in 2010
• Nationalisation of some banks eg NatWest and Lloyds

Question 10

why is banking regulation

Answer 10

• Bankers became concerned with profit and moral hazard increased
• Increased faith in new financial products that could spread risk when economic activity was high, but when economic activity levelled out, risks reappeared
• To deal with financial crisis, regulation now
• Requires banks to hold a higher reserve
• Banks are regulated regularly to make sure they can still survive future difficulties
• Need to establish confidence and trust, so banks are moe likely to lend and people more likely to borrow etc
• Need freedom of information → asymmetric information allowed banks to sell financial products without letting consumers know what they were
• Eg small print in terms and conditions

Question 11

minsky and theory of financial instability

Answer 11

• Financial markets are prone to instability and crisis due to long periods of stability and prosperity
• a key macro objective —> 15 years of slow steady growth up until 2007 so banks got more optimistic and took more risks
• investors become really confident and take on more risk
• lend to less reliable market —> subprime market
• lending and credit criteria becomes more relaxed due to overconfidence —> this increases risk
• expect higher profits and pay, commission and gaining credit to reinvest

Question 12

issue of relying on banks to mitigate risk

Answer 12

• bank debt increases as they cannot receive bank repayments
• this is in opposition to the fact that banks are supposed to mitigate risk
• moral hazard of banks increase as BOE is a lender of last resort —> banks have no incentive to decrease risk, as they know banks will bail them out
• gov and consumers bear majority of costs —> cost of bailing out banks and a decrease in loans given to consumers
• causes economic downturn
  increased lending increases spending and investment, further increasing demand and causing inflationary pressures DPI to increase
• negative externalities increase, causing market failure, increase government intervention and increased regulation

Question 13

problems of regulation of financial markets

Answer 13

• Cannot totally eliminate risk
• increased stability of market limits growth
• decreased risk does not allow for increased lending, investment, C,- and increased AD
  regulation needed before this as banks assumed to be rational risk mitigators
• if global, it is harder to regulate, easier or UK banks eg Lloyds, TSB, making them spread their investment and retail arm eg hsbc

Question 14

keynesian approach (gov intervention)

Answer 14

• strong monetary and fiscal stimulus -> public sector spending needed when private sector demand is weak
• focus on labour intensive infrastructure projects with a potentially high fiscal multiplier effect
• initial spend is an initial boost in demand, but it would generate a lot of demand in the long run
• initial boost is a lot multiplied in long run
• want to support animal spirits and prevent a collapse in demand
• bailout the private sector to prevent catastrophic job loss
• If government do not intervene, it will have a catastrophic effect on demand —> long periods of recession and depression

However expansionary policy may be limited:
- limited government ability to borrow more to engage in exp fiscal policy
- since borrowing was hard during financial crisis
however this can lead to increase cash in circulation, increasing inflation

Question 15

free market approach

Answer 15

• avoid bailouts as they lead to moral hazard and survival of zombie businesses (cannot be sustained without government intervention)
• will leads to another FC and will keep bad and inefficient businesses from dying out
• fast forward structural economic/market reforms to promote competition and raise productivity
• will increase economic growth in long run
• against countercyclical macro stimulus —> especially ultra low interest rates as this distorts the allocation of capital
• distorting interest rates as does not allow them to work as risk tools
• slashing interest rates distorts their initial function

however
- Lack of initial regulation caused FC in the first place, more regulation is needed

Question 16

response of governments to 2008 financial crisis

Answer 16

• $1.1 trillion injection of financial aid into global economy
• allow IMF and WB and others to increase lending to vulnerable countries
• resources of the IMF trebled from $250 bn to $700 bn
• China agreed to provide $40 bn of the new loans given to the IMF
• agreed reform of the global banking system —> controls of hedge funds, better accounting standards, tighter rules for credit rating agencies
• $200 bn of trade finance over two years to help reverse the steepest decline in word trade since 1945
• fiscal stimulus of $5bn to help poorest nations create green jobs

Question 17

UK - Darling and Brown

Answer 17

• direct government ownership (RBS and Lloyds) to bail out banks —> ensure they had sufficient capital to continue lending to businesses and households
• £20bn VAT cut and spending
  more government control over banks
• slower recovery but lead to austerity in 2010 with Cameron
• BOE implemented monetary policy —> lowering interest rates to as low as 0.5% and introducing quantitative easing
• deposit protection: gov will ensure up to £85,000 of consumer spending if a bank fails
• financial services act 2012 to reforms financial sector and increase transparency and oversight in financial industry

Question 18

US - Obama

Answer 18

• loans via TARP —> $475 billion in bailout relief
• $787 billion in tax cuts, spending and state aid
• more reliance on private-sector recovery
• faster recovery but political backlash
• Dodd- Frank Wall Street reform and consumer protection act —> regulate financial sector activities and protect consumers
• However trump has eased some of the burdens created from banks through the DF
• increased threshold of when banks need to be regulated from $50 mullion to $250 million