Financial Crisis

Question 1

What are the dynamics of a Financial Crisis?

Answer 1

- STEP 1; Initiation of a financial crisis
- Mismanagement of financial liberation/innovation (increasing risky lending)
- Waves of Defaults drive down bank’s net worth- triggering deleveraging
- Low net worth for banks is risky, so reduces its own STfunding along with bank lending
- Asset Price bubble bursts, reducing the firms NW, reducing leverage
- Encouraged to increase risk of assets
- Increased uncertainty
- STEP 2; Banking crisis
- Balance sheets reduce, tending FIs to insolvency
- Savers withdraw and banks sell assets
- Asset prices fall and banks sell more
- STEP 3; Debt deflation
- Price level falls, increasing the debt burden due to fixed repayment- causing a drag on recovery

Question 2

What happened during the 1929-1933 Great Depression?

Answer 2

• Stock market fell from 100% to 10%
• Not exclusive to the US due to the global commodity trade
• Initial decline in asset prices
• Bank failures turned to bank runs
• Huge economic contraction as world trade and unemployment rose

Question 3

What happened during the 2007-2009 Global Financial Crisis?

Answer 3

• Period of Extreme stress in global financial markets
• Downturn in US housing market was the catalyst
• Often reliance of Governments to bail out banks
• Slow recovery and millions of jobs were lost
• Caused by excessive risk taking, increased borrowing and policy error

Question 4

What are common responses to crisis by policymakers?

Answer 4

• Easing MP
• Unconventional MP
• Expansionary FP
• Strong oversight of financial firms

Question 5

What Causes crisis in emerging markets?

Answer 5

• Stems from either poor management of fiscal imbalances
• Poor management leads to a risky credit boom and poor screening sees a rise in the information problem
• Severe fiscal imbalances stem from unsustainable G
• Banks buy bonds, if debt value is falling, then so does the bank value
• Could also stem from high external IRs, decreasing a firms net worth and creating uncertainty

Question 6

A currency crisis will often follow in emerging markets. What happens then?

Answer 6

• External capital flows out, which is the main cause of a currency crisis
• Goverment can reduce interest rates to ease bank pressures, but this worsens
• Government could buy domestic currency; which would drain foreign reserves
• Government could also increase the IR, forcing bank insolvency
• Usually, banks just let it happen- leading to a large devaluation

Question 7

What are common features of financial crises in emerging markets?

Answer 7

• Currency mismatch, debt in foreign currency but income is in domestic
• Firms/Individuals face higher debt
• Net worth of firms fall and the information problem rises
• ‘Twin Crisis’ grows
• Debt burden increases, leading to higher inflation
• In an attempt to curb inflation, IR is raised, which increases the cost of funds
• Banks are likely to fail, indivduals go bankrupt

Question 8

How can financial Crises be prevented?

Answer 8

• Prudential Banking regulation & supervision through enhanced monitoring and risk management system
• Limit the currency mistamtch through monetary policy, promoting stability
• Sequential financial liberalisation through creating trusted infrastructure

Question 9

What are the implications of a financial Crisis?

Answer 9

• GDP falls and unemployment skyrockets
• Increased inflation due to higher import prices
• Hiked interest rate, harming the balance sheet
• Severe socio-economic consequences

Question 10

What are some key facts about the Crisis in Korea?

Answer 10

• Stock market index fell from 1000 to 400 in just 3 years
• Won depreciated by 50%; increased foreign debt by 50%
• GDP fell 6%