Download Understanding Financial Crises.

Econ 492:
Financial Crises
Lecture 1
12 January 2011
David Longworth
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integrity under the University Senate’s Academic Integrity Policy Statement.
Overview
I.
II.
III.
IV.
Introduction
Financial System: Overview
Causes of Financial Crises
Prediction of Financial Crises
Note: AG indicates Franklin Allen and Douglas Gale
(2009), Understanding Financial Crises. KA indicates
Charles P. Kindleberger and Robert Aliber (2005),
Manias, Panics, and Crashes.
Economics 492 Lecture 1
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l. Introduction
• Introductions
Economics 492 Lecture 1
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l. Introduction
• Introductions
• August 2007
Economics 492 Lecture 1
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l. Introduction
• Introductions
• August 2007
• Outline of Course (handout)
Economics 492 Lecture 1
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l. Introduction
• Outline of Course (after Fin. Sector Overview)
(Prediction)
Causes
Transmission
Prevention
Policy
Response
Economics 492 Lecture 1
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l. Introduction
•
•
•
•
The paper
Presentation and discussion
Participation
Schedule
–
–
–
–
Lecture next week
26 January: your (one paragraph) topic due
2 February: your 2-page outline due
2 February – 2 March (and beyond): weekly
consultations
– 9 March – 30 March: presentations
– 6 April: paper due in class
Economics 492 Lecture 1
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II. Financial System: Overview
• Roles played by the financial system
• Bank balance sheets (assets and liabilities)
• Risks faced by banks
Economics 492 Lecture 1
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II. Financial System: Overview
• Roles played by the financial system
– Channelling savings into investment/Efficient
allocation over time (consumption/saving,
production) (role played by markets, banks, pension
funds)
– Transferring risk (role played by markets and by banks
and insurance companies)
– Making markets and providing liquidity (and its
various guises and definitions) (role played by markets
and by banks)
– Maturity transformation (role played by banks)
– Effecting payments (role played by banks)
Economics 492 Lecture 1
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II. Financial System: Overview
• Roles played by the financial system
– Channelling savings into investment/Efficient
allocation over time (consumption/saving,
production) (role played by markets and by banks)
Economics 492 Lecture 1
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II. Financial System: Overview
• Two periods: 0 and 1, with income Y given in
those periods.
• Bank willing to lend any amount at int. rt. 𝑖
• Consumer borrows or lends (𝐶0 − 𝑌0 ) in
period 0. Intertemporal budget constraint
is:
• (𝐶0 − 𝑌0 )(1 + 𝑖) ≤ (𝑌1 – 𝐶1 )
or
• 𝐶0 − 𝑌0 ≤
1
(𝑌1
1+𝑖
– 𝐶1 )
Economics 492 Lecture 1
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II. Financial System: Overview
• 𝐶0 − 𝑌0 ≤
1
(𝑌1
1+𝑖
– 𝐶1 )
𝐶1
1 + 𝑖 𝑌0 + 𝑌1
𝑌0 +𝑌1 /(1 + 𝑖) 𝐶0
Economics 492 Lecture 1
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II. Financial System: Overview
• Maximize utility subject to budget constraint
𝐶1
• Maximum is at point of tangency of indifference curve
and the budget constraint
1 + 𝑖 𝑌0 + 𝑌1
𝑌0 +𝑌1 /(1 + 𝑖) 𝐶0
Economics 492 Lecture 1
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II. Financial System: Overview
• Optimum Production over time
𝑌1
• Production Possibility Curve
𝑌0
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II. Financial System: Overview
• Value maximization and utility maximization
»
𝑌1
Separation theorem: “firm’s decision to maximize its
value is separate from shareholders’ decisions to
maximize their utility.” (AG)
𝑌0
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II. Financial System: Overview
• Roles played by the financial system
– Transferring Risk (role played by markets and by banks
and insurance companies)
• Risk sharing
– There is always uncertainty about the future, e.g. income
– Contingent commodity: “a good whose delivery is contingent on
the occurrence of a particular state of nature” (AG)
– Two equivalent ways to achieving an efficient allocation of risk
» If there are complete markets for contingent commodities,
i.e. there are markets for each contingent commodity, and
consumers only have to satisfy their budget constraint
» If there are Arrow securities for each state, securities which
are a “promise to deliver one unit of money if a given state
occurs and nothing otherwise.” (AG)
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II. Financial System: Overview
• Roles played by the financial system
– Transferring Risk (role played by markets and by banks and
insurance companies)
• Attitudes towards risk (risk aversion)
– It is typically assumed that individuals are “risk averse”, i.e., they tend to avoid
risk unless there is some advantage in taking it on. Evidence for “risk aversion”
is that most consumers buy insurance
– Risk aversion is associated with the declining marginal utility of consumption
» Mathematically, this means that the second derivative of the utility
function (utility as a function of consumption) is negative
– Risk aversion can be measured in two ways:
» The degree of absolute risk aversion is the negative of the second
derivative divided by the first derivative
» The degree of relative risk aversion is the negative of the second
derivative times consumption divided by the first derivative
– A risk-neutral consumer cares only about the expected value of his/her
consumption: U(C) = C
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II. Financial System: Overview
• Roles played by the financial system
– Transferring Risk (role played by markets and by
banks and insurance companies)
• Insurance and pooling risk
– When there is a large number of consumers that can be
assumed to be independent, the law of large numbers can be
used to predict the average outcome
– This is what insurance companies do, pooling large numbers
of (largely) independent risks, so that the aggregate outcome
is approximately constant (each individual could be given a
constant level of consumption)
Economics 492 Lecture 1
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II. Financial System: Overview
• Roles played by the financial system
– Transferring Risk (role played by markets and by banks
and insurance companies)
• Portfolio choice
– Suppose that there are two assets: a safe (riskless) asset that has
the same payoff in both states of the world, and a risky asset that
has a high payoff in one state of the world and a low payoff in a
second state of the world
» “The investor will hold a positive amount of the risky asset if
and only if the expected return of the risky asset is greater
than the return to the safe asset.” (AG)
» If the safe asset has a zero net return, then the investor will
hold it only if the risky asset suffers a capital loss in the low
payoff state.
Economics 492 Lecture 1
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II. Financial System: Overview
• Roles played by the financial system
– Making Markets and Providing Liquidity
• Liquidity definitions
– Assets are liquid “if they can easily be converted into
consumption without loss of value.” (AG)
– Consumers have a preference for liquidity to the extent that
they have uncertainty about the timing of their consumption
and therefore want to hold liquid assets.
• Financial institutions (banks) can rely on law of large
numbers to provide liquidity to consumers while
investing some of their savings in illiquid assets
Economics 492 Lecture 1
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II. Financial System: Overview
• Roles played by the financial system
– Making Markets and Providing Liquidity
• Theory of banking relies on:
– “A theory of liquidity preference, modeled as uncertainty about the timing of
consumption.” (AG)
– “The representation of a bank as an intermediary that provides insurance to depositors
against liquidity (preference) shocks.” (AG)
» “By accepting an ‘insurance contract’ in the form of promises of consumption
contingent on the date of withdrawal, the investor is able to achieve a better
combination of liquidity services and returns on investment than he could achieve
in autarky or in the asset market.” (AG)
– “A maturity structure of bank assets, in which less liquid asses earn higher returns.” (AG)
» Banks have relatively liquid liabilities and relatively illiquid assets. “They borrow
short and lend long.” (AG)
• Asset markets and market makers provide liquidity to agents who may be
holding otherwise illiquid assets (stock markets—ownership of firms’ physical
capital; bond markets—otherwise illiquid loans)
Economics 492 Lecture 1
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II. Financial System: Overview
• Roles played by the financial system
– Maturity transformation (role played by banks)
• As we have already seen, banks tend to have shorterterm liabilities than the maturity of their assets
– Effecting Payments (role played by banks)
• This is another reason why consumers place deposits
with banks. It is extremely difficult for consumers not to
transact with banks because of this. Currency and
demand deposits are close to perfect substitutes, but it
is difficult to make large payments with currency.
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II. Financial System: Overview
• Bank balance sheets (assets and liabilities)
Assets
Liabilities
Non-mortgage loans
Short-term retail deposits
Mortgage loans
Long-term retail deposits
Risk-free bonds
Short-term wholesale deposits
Short-term risky bonds
Bonds
Long-term risky bonds
Foreign currency liabilities
Derivatives and repos
Derivatives and repos
Foreign currency assets
Equity (capital)
Total Assets
equals Total Liabilities
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II. Financial System: Overview
• Canadian banks: balance sheet(Sep. ‘10, $bn.)
Assets
Liabilities
649.5 Non-mortgage loans
644.8 Demand & not. deposits
528.5 Mortgage loans
584.3Other (typ. L-t.)deposits
301.7 Risk-free bonds (gov’t)
548.3 Sub. Debt & other liab.
180.9 Risky bonds & stocks
378.4 Other (incl. derivatives)
57.7 Other
1045.1 Foreign currency assets 1082.0 Foreign currency liab.
167.0 Shareholder equity
3084.1 Total Assets
equals 3084.1 Total Liabilities
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II. Financial System: Overview
• Risks faced by banks:
– credit risk
– funding liquidity risk
– market liquidity risk
– market risk
– risk to the value of collateral (including housing)
– exchange rate risk (if not matched)
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II. Financial System: Overview
• Risks faced by banks:
– credit risk (CR): risk of loss due to a debtor’s non-payment of a
loan or a bond or a derivative product
• Applies to everything on asset side of balance sheet except risk-free
bonds
– funding liquidity risk (FLR): risk that over a specific horizon a
bank will be unable to settle its obligations with immediacy
(from Drehmann and Nikolaou, 2009)
• Applies to risk of not having the ability to raise deposits or bond or
equity funding (liability side of balance sheet) or to sell off highly
liquid assets (such as risk-free assets) when required to meet
obligations
– Banks with fewer highly liquid assets, with high amounts of short-term
wholesale deposits, and with high amounts of longer-term liabilities coming
to maturity (mat) have higher levels of funding liquidity risk
• Note the obvious connection to bank runs
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II. Financial System: Overview
• Risks faced by banks:
– market liquidity risk (MLR): risk that the market will
not trade an asset, or not trade it near the preexisting price
• Banks face this risk on risky bonds and on derivatives
• There are various measures of asset liquidity (Wikipedia)
– Bid-offer spread: a measure of transactions cost
– Market depth: refers to the amount of an asset that can be
transacted at various bid-offer spreads
– Immediacy: refers to the amount of time needed to trade a
certain amount of an asset at a particular price
– Resilience: refers to the speed at which prices return to preexisting levels after a large amount is transacted
Economics 492 Lecture 1
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II. Financial System: Overview
• Risks faced by banks:
– market risk (MR): risk that the value of a portfolio
will change due to changes in overall market risk
factors (stock prices, interest rates, foreign
exchange rates, and commodity prices). This is
systematic risk that cannot be diversified.
• Banks face this on their portfolios of bonds and
derivatives
• Particularly important for categories that need to be
marked-to-market for accounting purposes (trading
book) because they are not going to be held to maturity
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II. Financial System: Overview
• Risks faced by banks:
– value of collateral risk (VCR) (including housing and
securities): risk that the collateral that backs loans
that banks have made will change, giving the bank
more exposure to credit risk.
• Banks face this on mortgage loans (if uninsured), car loans,
derivative products and repos
– exchange rate risk (ERR): risk that a bank’s value will
change when the amount of its foreign currency
assets differ from the amount of its foreign currency
liabilities (in a given foreign currency) adjusted for
derivative positions relevant for covering this risk
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II. Financial System: Overview
Assets
Liabilities
Non-mortgage loans (CR)
Short-term retail deposits (FLR)
Mortgage loans (VCR, CR)
Long-term retail deposits (FLR mat)
Risk-free bonds (MR) (-FLR)
Short-term wholesale deposits (FLR)
Short-term risky bonds (MR, MLR,
CR)
Bonds (FLR mat)
Long-term risky bonds (MR, MLR,
CR)
Foreign currency liabilities (ERR)
Derivatives and repos (MR, MLR,
VCR, CR)
Derivatives and repos (MR)
Foreign currency assets (ERR)
Equity (capital)
Economics 492 Lecture 1
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III. Causes of Crises
Asset price
bubbles
Innovation, deregulation,
poor risk assessment,
asymmetric payoffs
Rapid credit
growth
Financial crisis
and
transmission
Easy monetary or
exchange rate
policy
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III. Causes of Crises
• Rapid growth in credit (aggregate or sector
specific) seems to be present in almost all
financial crises, especially the ones associated
with banking crises or asset price bubbles
– Kindleberger and Aliber: “For historians each
event is unique. In contrast economists maintain
that there are patterns in the data and particular
events are likely to introduce similar responses.
History is particular; economics is general.”
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III. Causes of Crises
• Minsky focused on procyclical changes in the
supply of credit
– In the expansion, investors gain optimism, raise
estimates of profitability of investments, borrow
more
• Lenders also gain optimism, lowering risk assessments
and becoming less risk averse, and lend more
– In the contraction, investors lose their optimism,
lower estimates of profitability, borrow less
• Lenders have increased loan losses and become more
cautious, lending less
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III. Causes of Crises
• Minsky believed that the procyclical changes
in the supply of credit led to financial fragility
and an increased probability of a crisis (KA,
Ch. 3)
– Cycle started by a displacement: an exogenous
outside shock
– This displacement leads people to believe there
are improved profit opportunities in at least one
important sector of the economy. Borrowing rises.
– This expansion of credit fuels the boom
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III. Causes of Crises
• Minsky
– Euphoria might develop: investors buy in
expectation of capital gains
• Loan losses incurred by the lenders decline and they
respond and become more optimistic and reduce the
minimum downpayments and the minimum margin
requirements
• There can be a move away from normal rational
behaviour to manias or bubbles
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III. Causes of Crises
Displacement
Expected Profit
Opportunities
Mania or bubble
(eventually
ends)
Economics 492 Lecture 1
Borrowing
increases:
fuels boom
Expected capital
gains lead
investors to buy
36
III. Causes of Crises
Hedge
finance
Speculative
finance
Ponzi
finance
Economics 492 Lecture 1
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III. Causes of Crises
• The rapid growth in credit (aggregate or sector specific) can
arise from a number of factors:
– financial deregulation,e.g.
• Led to bubbles in real estate and stocks in Nordic countries
– Japanese banking regulators had eased restrictions on Japanese banks abroad
– Nordic banking regulators had eased restrictions on domestic banks
borrowing abroad
– Loans to Nordic borrowers fueled the bubbles
– Banks failed
– Financial innovation, e.g.
• In the most recent crisis
–
–
–
–
–
Sub-prime loans
Adjustable rate mortgages in the United States (with teaser rates)
Asset-backed Commercial Paper (with unspecified assets backing it) in Canada
CDOs: collateralized debt obligations
SIVs
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III. Causes of Crises
• The rapid growth in credit (aggregate or sector specific) can arise
from a number of factors:
– poor assessment of risk (risk management, black swans)
• VAR calculations: value-at-risk calculations were based on short historical
periods that did not include “stressed periods” of abnormally high volatility
• These and other calculations were often based on the “normal” statistical
distribution, but the empirical distributions were often fat-tailed, meaning that
large movements were more likely than were taken into account
• Black-swan phenomena: because they haven’t been seen (like black swans,
which were native to Australia) and so they will never be seen
• Correlations tend towards one in crises, so the benefits from diversification
tend towards disappearing
• Generally, an overemphasis on statistical models (sometimes, overly simple
ones), with not enough emphasis on thinking about what could go wrong with
a given portfolio, especially in areas where there had been financial
innovations
– Movements in interest-rate spreads (over government yields) on new products don’t tell
one much about what potential future movements could be
Economics 492 Lecture 1
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III. Causes of Crises
• The rapid growth in credit (aggregate or sector
specific) can arise from a number of factors:
– too big to fail and other asymmetric payoffs
• Too big to fail
– Managers and shareholders believe that their bank is too-bigto-fail and that they will be bailed out by the government if
they are in danger of failing. Therefore they take more risks.
– Bondholders believe that they will be bailed out by the
government and are therefore willing to lend more to banks at
narrow spreads over risk-free rates even when the banks are
expanding credit rapidly
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III. Causes of Crises
• The rapid growth in credit (aggregate or sector
specific) can arise from a number of factors:
– too big to fail and other asymmetric payoffs
• Compensation schemes for management and traders
are asymmetric and not risk-adjusted
– Compensation is based on business volume and current
profits, even when investments are longer-term. CEOs and
traders may have left (or may leave) when the chickens come
home to roost.
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III. Causes of Crises
• The rapid growth in credit (aggregate or sector
specific) can also arise from easy monetary
policy or inappropriate exchange rate policy
(especially fixed exchange rates)
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IV. Prediction of Financial Crises
• Three key articles on prediction are Borio and
Lowe (2002 BIS WP) and Borio and Drehmann
(2009 BIS WP 284, 2009 March BIS Quarterly
Review)
• Important inputs into their work were the
dating of financial crises by Bordo et al. (2002
Economic Policy) and work by Kaminsky and
Reinhart (1999 AER)
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IV. Prediction of Financial Crises
• The main result from the Borio-Drehmann
piece is that, when credit-to-GDP ratios
relative to trend and real property prices
relative to trend and real stock prices relative
to trend are quite high, the probability of a
banking crisis is quite elevated.
• Table A.1 in BIS WP No 284
• Reinhart-Rogoff show that This time is Not
different in many different dimensions
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