REVISION- Topic F- Financial Crisis Flashcards
(39 cards)
1
Q
Name the 3 phases of crises in advanced economies
A
- Initiation
- Banking Crisis
- Debt deflation
2
Q
Describe the 3 causes of initiation.
A
- Mismanagement of financial innovations/ liberalization
- Asset boom/ bust
- Uncertainty
3
Q
How does a financial crisis occur?
A
a financial crisis occurs due to a large disruption to information flows, increasing asymmetric information in the financial markets. This increases financial frictions and stops financial systems from functioning efficiently.
4
Q
What is a financial crisis?
A
major disruptions in financial markets characterized by a sharp declines in the nominal asset prices and firm
failures
5
Q
Best example of a financial crisis?
A
2008 financial crisis
6
Q
How can mismanagement of financial innovations and liberalisation lead to the initiation of a crisis?
A
- liberalisation in the short-run can lead to banks to go on a lending spree (credit boom)
- the inexperience with new financial innovations can mean banks do not have the expertise or incentive to manage the risk effectively
7
Q
Name a major problem with government safety nets like deposit insurance.
A
- With this insurance there is a greater moral hazard incentive for banks and they may take on greater risks.
8
Q
Describe the asset boom and bust in stage 1 of a financial crisis.
eg of one
A
- a pricing bubble starts, where an assets nominal values rapidly exceed their fundamentals dramatically, ie if the demand does not justify the price spike
- when the bubble bursts, prices fall dramatically along with financial institutions assets, plummeting down to their real value
- this all leads to lower lending and further economic contraction
- best eg is the housing market bubble in 2008
9
Q
What causes uncertainty in the initiation of a crisis?
A
- failures of large, stable financial firms, eg Lehmann brothers in the 2008 crisis
- this triggers panic and increases asymmetric information and moral hazard
- again lending dries up and economic contraction
10
Q
What do all of the attributes of initiation lead to?
A
- they all lead to increased moral hazard and adverse selection problems
- this leads to a decline in economic activity
11
Q
Describe the banking failure stage of a financial crisis.
A
- due to the decline in economic activity, banks start to make losses on loans as people cannot pay them back
- from here banks start becoming insolvent and begin to fail, firms also fail
- this leads to a bank panic, people taking money out of the banks rapidly, exacerbating the solvency problems
- fewer banks means more asymmetric info, more moral hazard and less lending and economic activity contraction
12
Q
Describe the third stage of the crisis, debt deflation.
A
- sharp economic contractions leads to a huge decline in price level- deflation
- people think lower prices is good
- however, some debts are in nominal terms and price is falling then the real debt burden increases for households and firms
- net worth of households and firms declines further
- further asymmetric information and moral hazard
- leading to lending and economic activity to decline for a long time
13
Q
What are the two possible triggers of financial crisis in emerging economies?
A
- Credit Boom and Bust
2. Severe fiscal imbalances
14
Q
Describe the credit boom and bust route of financial crises in emerging economies.
A
- In emerging economies banks play a more important role because securities markets are not established
- It all starts with the liberalisation of the financial system, opening the financial system up to capital and firms flows
- weak supervision and lack of experience from the government leads to a credit/ lending boom
- the excessive lending and lack of supervision means many borrowers were unable to repay their loans and the bank lost a lot of money. To mitigate this, they severely cut lending and charge high interest rates on loans to make up for the excessive lending
- on top of this, powerful bank owners stop supervisors from doing their job properly to benefit the bank owners, so they may not be acting in public interest.
- principle-agent problem
15
Q
Describe the severe fiscal imbalances route of financial crises in emerging economies.
A
- large government deficits/ debts mean governments force banks to buy government debt
- when investors lose confidence in government’s repayment ability
- they may take money out of country, save and even sell domestic currency
- speculators attack
- real debt burden increases, banks lose and their net worth decreases, they may go insolvent and fail
- reduction in lending and depositors lose money, decreasing household networth
16
Q
Name two other factors that could be responsible for initiating a financial crisis
A
- uncertainty linked to unstable political systems, making it hard to monitor credit
- a decrease in a firm’s net worth, ie due to a fall in their stock price increases adverse selection and moral hazard, also it reduces collateral banks can seize, impairing their balance sheets
17
Q
How does bank balance sheet deterioration trigger a currency crisis?
A
- deterioration of bank balance sheets triggers a currency crisis
- government cannot raise interest rates to increase demand for their currency as it will force banks into insolvency
- this is because they do not have the capital to offer that rate of return
- speculators see this weakness and attack
18
Q
How do severe fiscal imbalances lead to currency crises?
A
- when foreign and domestic investors lose confidence in the government’s ability to pay debts off they sell domestic currency and pull money out of country
- currency falls in value
- this leads to speculative attacks
19
Q
2 causes of a currency crisis?
A
- severe fiscal imbalances
2. bank balance sheet deterioration
20
Q
Describe the third stage of a crisis in emerging economies, a fully-fledged financial crisis.
A
- speculative attacks lead to peg failing and a sharp devaluation of currency
- sharp increase in debt burden due to currency mismatch (as most debt contracts will be denominated in a more advanced economies currency)
- banks fail, individual assets fall, adverse selection and moral hazard problems lead to lending problems and reduction in investment
21
Q
What are the three stages of a financial crisis in emerging economies?
A
- credit boom and bust or severe fiscal imbalances
- currency crisis
- fully-fledged
22
Q
Why do banks need depositor insurance?
A
- If depositors cannot guarantee they will receive their money back if the bank has liquidity problems then they will stop using banks
- asymmetric information and moral hazard problems seen in previous crises will also make depositors confidence extremely low
- this insurance increases confidence and injects funds into the banking system
23
Q
What is a twin crisis?
A
- when an emerging economy experiences a currency crisis and a financial crisis simultaneously
24
Q
What is deposit insurance?
What harmful effects does it prevent (2 of them)?
A
A government safety net to prevent bank panic and the contagion effect, by protecting the depositor. It ensures that if even if a bank has liquidity problems consumers will receive compensation for their deposits.
25
What exacerbates bank panic?
- Banks operate on a sequential service restraint (first come first serve) giving people fear and incentive to withdraw as soon as possible before they run out of funds
26
Provide an example of a short-term government safety net other than depositor insurance that has been used recently.
- Fiscal stimulus spending, combining tax cuts and gov spending
- was used massively during the COVID-19 in the form of furlough packages
27
Name two long-term responses to stabilize the financial system.
- enhancing infrastructure
| - develop financial education and consumer protection rules
28
Describe a way in which central banks have cooperated to protect the international financial system.
provide eg
- supervisory cooperation:
- central banks share information and ensure policies are mutually consistent with national objectives
eg: financial stability board (FSB) by G20
29
Explain a drawback of government safety nets.
- for example, depositor insurance leads to moral hazard problems where banks will engage in riskier behaviour as they know they can be bailed out
- the depositors also have moral hazard incentive as they assume no risk
- therefore they will not monitor or consider the discipline of the market place fully
30
How does a major financial institution being 'too big too fail' threaten the lower levels of the economy?
provide eg
- governments cannot let huge financial institutions fail as they are too integral to the larger financial system
- therefore, they may bail them out even when they are not entitled to be
- they will then pass the losses onto depositors and creditors
- further increases their moral hazard incentive
- think 2008, big short
31
Name three methods of financial regulation regulators use to reduce the risk of a crisis.
- restrictions on asset holdings
- consumer protection, no need to explain you know this
- financial supervision: prompt corrective action
32
Explain how restrictions on asset holdings reduce risk of crisis.
- promotes diversification so firms/ individuals do not have all their eggs in one basket
- single obligor limit- restricts how much a bank can lend to an individual or entity, this reduces moral hazard problems as banks cannot risk take as much
33
Explain how financial supervision reduces risk of crisis.
- huge problems can occur if a financial institution runs low on capital
- therefore, the depositor insurer will trigger prompt corrective action to intervene before the institution gets in trouble
- they do this through chartering and examinations
Chartering- screening proposals for new institutions to prevent adverse selection
Examinations- can be scheduled and unscheduled to monitor restrictions on asset holding and capital requirements to prevent moral hazard
34
Define Microprudential policy
- focused on the saftey and soundness of individual institutions, not the financial system as a whole
- attempts to safeguard firms from excessive and idiosyncratic risk
35
Give 3 examples of microprudential policy.
1. bank-level regulatory standards for bank capital adequacy (the minimum reserves of capital a financial institution must have)
2. rules on who can hold assets and how they can be traded
3. certification of those working in financial sectors
36
What were the two problems with microprudential policy and what was the solution?
- the global financial crisis proved that the soundness of individual institutions was not enough to stabilise the financial system as a whole
- because many established, well-capitalised firms had liquidity shortages
- on top of this there was lots of concern banks were not following these policies stringently
- the solution- MACROprudential policy
37
Define macroprudential policy.
- aims to address financial system as a whole by looking at interconnectedness of financial institutions
38
Explain the boom leverage cycle running up to a financial crisis
1. asset prices rise = reserves of financial institutions (capital buffers) rise = lending rises = asset prices rise further
vice versa for bust
39
How does macroprudential policy short-circuit a leverage cycle?
provide example
- adjusting capital to make them countercyclical and stop the positive feedback loops
- for example, during bust macroprudential supervision may be used to raise new capital for the whole financial system to prevent banks from having to cut lending
