Week 11: Financial Crises and Systemic Risk Flashcards
How does a financial crisis occur?
• A financial crisis occurs when information flow in financial markets experience a particularly large disruption, with the result that financial frictions increase sharply and financial markets stop functioning
Stage one of financial crisis for Advanced Economies:
explain Mismanagement of financial liberalization or innovation.
• The seeds of a financial crisis can begin with
mismanagement of:
– Financial liberalization (elimination of restrictions or
deregulation)
or
– Financial innovation (introduction of new types of loans or other financial products.)
• Either can lead to a credit boom, where risk
management is lacking.
- Loan loss ↑ > Asset value ↓ > Capital (net worth) ↓ > Bank funding ↓ > Bank lending ↓ >Economic
activities ↓
Stage one of financial crisis for Advanced Economies:
Asset Pricing Boom and Bust
• A pricing bubble starts, where asset values exceed
their fundamental prices.
- Bubble bursts
and prices ↓ > Corporate net
worth and collateral ↓ > Moral hazard ↑ > FIs tighten lending standard > Lending ↓ > Economic
activities ↓
Stage one of financial crisis for Advanced Economies: Initiation
• After start of recession, a crash in share market,
failure of a major FI.
- Uncertainty ↑ > Adverse selection ↑ > Lending ↓ > Economic
activities ↓
Explain stage two for Advanced Economies: Banking Crisis
• Deteriorating balance sheets lead financial institutions into insolvency. If severe enough, these factors can lead to a bank panic.
– Panics occur when depositors are unsure which banks are insolvent, causing all depositors to withdraw all funds immediately.
– As cash balances fall, FIs must sell assets quickly, further deteriorating their balance sheet.
– Adverse selection and moral hazard become severe; it takes years for a full recovery.
Explain Stage Three for Advanced Economies: Debt Deflation
• If the crisis also leads to a sharp decline in prices
level, debt deflation can occur, where asset prices
fall, but debt levels do not adjust, increases debt
burdens and deterioration in firms’ net worth.
– Debt levels are typically fixed, not indexed to asset
values.
– Price level drops lead to an increase in adverse
selection and moral hazard, which is followed by
decreased lending.
– Economic activity remains depressed for a long time.
explain stage One Initiation for Emerging Economies: Path A Mismanagement of Financial
Liberalisation or Globalisation
• Financial globalisation
– Eliminating restrictions on domestic FIs and markets.
– Opening up economies to flows of foreign capital and
foreign financial firms.
• A weak credit culture (e.g. mismanagement of
lending process, lax banking supervision from
government, etc.) and capital inflows exasperate
the credit boom that follows liberalization, leading
to risky lending.
explain stage One Initiation for Emerging Economies Path B: Severe Fiscal Imbalances
- Government faces a large deficit and forces banks to buy government bonds.
- If confidence falls, the government bonds are sold by investors, leading to a price decline.
- As a result, banks (holding these debts) balance sheets deteriorate, and the usual lending freeze follows.
Stage Two for Emerging Economies: Currency Crisis
• Speculative attack: FX markets will soon start
taking bets on the depreciation of the currency of
the emerging market. Over supply begins, the
value of the currency falls, and a currency crisis
ensues.
• Currency crises can be triggered by deterioration
of bank B/S and severe fiscal imbalances.
• Government can defend devaluation by using
foreign currency reserve or increasing interest
rates, but they have limits.
Stage Three for Emerging Economies: Full Financial Crisis
• Currency mismatch: Many emerging market firm denominate their debt in foreign currency (such as U.S. dollars). An unexpected currency devaluation increases their debt burden, leading to a decline in their net worth.
What are the systematic risk indicators?
• Systemic risk indicators (or macro-prudential
indicators, MPIs) can be categorised by:
– Time-dimension indicators: measure how
systemic risk evolves over the financial cycle.
• Provide degree of procyclicality and benchmark at what
point risk-taking, debt levels or asset price
developments are excessive or unsustainable.
– Cross-sectional indicators: measure how
systemic risk is distributed within the financial
system
What are the aims of Macro-prudential Policy?
– Reduce the likelihood of a financial crisis
– Increase the resilience of banks and
households
– Limit the scale of severe economic downturns
– Limit the serious and lasting consequence of
boom-bust cycles
Explain the Macro-Prudential Instruments CFR & CCB
• Core funding ratio (CFR)
– Requires to fund out of stable (“core”) funding sources
over the cycle.
– To reduce vulnerability to disruption in funding markets.
• Counter-cyclical capital buffer (CCB)
– Requires additional capital when excessive credit growth is
leading to a build-up of systemic risk.
Explain the Macro-Prudential Instruments SCR & LVR
• Sectoral capital requirement (SCR)
– Requires additional capital against lending to a specific
sector or segment in which excessive credit growth is
leading to a build-up of systemic risk.
• Loan-to-value (LVR) ratio restriction
– A temporary limits on high loan-to-value
residential mortgage lending.
– Owner occupier loans: 20% deposit / 20% of
bank’s total new lending.
– Investor loans: 30% deposit / 5% of bank’s total
new lending.
What is Open Bank Resolution (OBR)
• A tool for responding to a bank failure
– Allows the bank to be open for full-scale or limited business on
the next business day after being placed under statutory
management.
– Customers will be able to gain full or partial access to the
accounts and other services, while an appropriate long-term
solution is identified.
• The statutory management will assess bank’s losses, and a
conservative portion of account balances will be frozen. The
frozen fund is to cover any losses beyond what bank’s capital
position could absorb.
