Chapter 12 Flashcards
Concisely describe Stage One of a financial crisis
to begin with there is an increase in uncertainty, Asset-Price decline and deterioration in financial institutions’ balance sheets. This all leads to worsening of adverse selection and moral hazard and lending contracts.
What is Credit Boom and Bust?
when an economy introduces new types of loans or other products, known as financial innovations, or when countries engage in financial liberalisation, the elimination of restrictions on financial markets or institutions, it can prompt institutions to go on a lending spree known as a credit boom. These risky decisions causes losses on loans to mount meaning institutions need to deleverage (cut back on their lending to borrowers-spenders). Now with less capital, these banks become riskier, causing lender savers to pull out their funds. Resulting declining economic activity.
What is an Asset-Price Boom and Bust?
Prices of assets and equity shares and real estate can be driven by investor psychology well above their fundamental economic values. This rise above is called an asset price bubble. When this bubble bursts, asset prices realign with their fundamental economic values, stock and real estate prices tumble and companies see their net worth decline. These lead to knock on effects, like further risky investments, to deleveraging and overall steeping the decline in economic activity.
What occurs in stage 2 of a Financial Crisis.
Banking Crisis.
Deteriorating balance sheets and tougher business conditions lead some institution into insolvency. Unable to pay off depositors and other creditors, some banks go out of business, this can lead to bank panic.
this forces the banks to sell of assets quickly to raise necessary funds. These fire sales of assets may cause their price to decline so much that more banks become insolvent and result in multiple bank failures and full-fledged bank panic.
What occurs in stage three of a Financial Crisis.
Debt Deflation.
Occurs when a substantial unanticipated decline in the price level sets in, leading to a further deterioration in firms’ net worth because of the increased burden on indebtedness. Once again this leads to an increase in adverse selection and moral hazard.
What are 3 causes of the 2007-2009 Financial Crisis?
- Financial Innovation in the mortgage markets
- Agency problems in the mortgage markets
- Asymmetric information and credit rating agencies
What is a CDO?
A collateralised debt obligation involves an entity called a special purpose vehicle (SPV_, which buys a collection of assets such as corporate bonds and loans, commercial real estate bonds, and mortgage backed securities.
The SPV then separates cash flows from these assets into tranches.
What were the agency problems in the mortgage markets?
Mortgage brokers quite often didn’t make enough effort to evaluate whether a borrower could pay off the mortgage, since they planned to quickly sell the loans to investors in the form of mortgage backed securities.
What part did Credit-Rating Agencies play during the financial crisis?
the rating agencies were subject to conflicts in interest because of the large fees they earned from advising clients on how to structure that they were rating themselves. This meant they did not have sufficient incentives to make sure their ratings were accurate.
List the effects of the 2007-2009 Financial Crisis
- Residential housing prices: boom and bust
- Deterioration of financial institutions’ balance sheets
- Run on the shadow banking system
- Global financial markets
- Failure of high profile firms
what were short term response and recovery from the 2007-9 crisis?
Financial bailouts - various large banks were rescued such as Goldman Sachs, RBS, Citigroup, Merrill Lynch and Morgan Stanley. Many state owned Sovereign Wealth Funds also went bankrupt. the SWF of Dubai got s $10 billion bailout from the investment firm Dubai World.
Fiscal Stimulus Spending - to boost individual economies, most governments used fiscal stimulus packages that combined government expenditure and tax cuts.
What was the global long term response to the financial crisis?
Global financial regulatory framework.
In future it requires reducing hazardous effects of financial instruments and reigning in of financial institutions’ risk taking activities. Internationally, proactive and globally binding supervision strategies must be designed.
What is a CDS?
A CDS is a contract through which the seller commits themself to compensate the buyer (usually a creditor) in the event of a loan default (by a debtor) or another negative credit event (contractually defined). Like most swap contracts, the buyer of the CDS make regular payments to the seller, in exchange for the seller’s payment in the case of default. Like CDOs, again, economic agents who are not directly interested in the underlying loan, for investment purposes, can purchase CDSs. In this case, we speak of “naked CDSs.”
Describe how Monetary and Fiscal policy can stabilise the global financial system in the long term at the national level.
Monetary Policy - regulators are requesting monetary authorities to include financial stability in their mandate in addition to price stability. Accomplishable by building up emergency liquidity and foreign exchange reserve buffers and by paying interest to banks and financial institutions for holding legal reserve requirements
Fiscal Policy - fiscal debt must be reduced so that additional
