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Financial Crises
In this section, you will learn:
 common features of financial crises
 how financial crises can be self-perpetuating
 various policy responses to crises
 about historical and contemporary crises,
including the U.S. financial crisis of 2007-2009
 how capital flight often plays a role in financial
crises affecting emerging economies
Common features of financial crises
 Asset price declines
 involving stocks, real estate, or other assets
 may trigger the crisis
 often interpreted as the ends of bubbles
 Financial institution insolvencies
 a wave of loan defaults may cause bank failures
 hedge funds may fail when assets bought with
borrowed funds lose value
 financial institutions interconnected,
so insolvencies can spread from one to another
Common features of financial crises
 Liquidity crises
 if its depositors lose confidence, a bank run
depletes the bank’s liquid assets
 if its creditors have lost confidence, an
investment bank may have trouble selling
commercial paper to pay off maturing debts
 in such cases, the institution must sell illiquid
assets at “fire sale” prices, bringing it closer to
insolvency
Financial crises and aggregate demand
 Falling asset prices reduce aggregate demand
 consumers’ wealth falls
 uncertainty makes consumers and firms
postpone spending
 the value of collateral falls, making it harder for
firms and consumers to borrow
 Financial institution failures reduce lending
 banks become more conservative since more
uncertainty over borrowers’ ability to repay
Financial crises and aggregate demand
 Credit crunch: a sharp decrease in bank lending
 may occur when asset prices fall and financial
institutions fail
 forces consumers and firms to reduce spending
 The fall in agg. demand worsens the financial crisis
 falling output lower firms’ expected future earnings,
reducing asset prices further
 falling demand for real estate reduces prices more
 bankruptcies and defaults increase, bank panics
more likely
Once a crisis starts, it can sustain itself for a long time
CASE STUDY
Disaster in the 1930s
 Sharp asset price declines: the stock market fell
13% on 10/28/1929, and fell 89% by 1932
 Over 1/3 of all banks failed by 1933, due to loan
defaults and a bank panic
 A credit crunch and uncertainty caused huge fall in
consumption and investment
 Falling output magnified these problems
 Federal Reserve allowed money supply to fall,
creating deflation, which increased the real value
of debts and increased defaults
Financial rescues: emergency loans
 The self-perpetuating nature of crises gives
policymakers a strong incentive to intervene to
try to break the cycle of crisis and recession.
 During a liquidity crisis, a central bank may act
as a lender of last resort, providing emergency
loans to institutions to prevent them from failing.
 Discount loan: a loan from the Federal
Reserve to a bank, approved if Fed judges bank
solvent and with sufficient collateral
Financial rescues: “bailouts”
 Govt may give funds to prevent an institution
from failing, or may give funds to those hurt by
the failure
 Purpose: to prevent the problems of an
insolvent institution from spreading
 Costs of “bailouts”
 direct: use of taxpayer funds
 indirect: increases moral hazard, increasing
likelihood of future failures and need for future
bailouts
“Too big to fail”
 The larger the institution, the greater its links to
other institutions
 Links include liabilities, such as deposits or
borrowings
 Institutions deemed too big to fail (TBTF)
if they are so interconnected that their failure
would threaten the financial system
 TBTF institutions are candidates for bailouts.
Example: Continental Illinois Bank (1984)
Risky Rescues
 Risky loans: govt loans to institutions that may not
be repaid
 institutions bordering on insolvency
 institutions with no collateral
 Example: Fed loaned $85 billion to AIG (2008)
 Equity injections: purchases of a company’s
stock by the govt to increase a nearly insolvent
company’s capital when no one else is willing to buy
the company’s stock
 Controversy: govt ownership not consistent with
free market principles; political influence
The U.S. financial crisis of 2007-2009
 Context: the 1990s and early 2000s were a time
of stability, called “The Great Moderation”
 2007-2009:
 stock prices dropped 55%
 unemployment doubled to 10%
 failures of large, prestigious institutions like
Lehman Brothers
The subprime mortgage crisis
 2006-2007: house prices fell, defaults on
subprime mortgages, huge losses for institutions
holding subprime mortgages or the securities
they backed
 Huge lenders Ameriquest and New Century
Financial declared bankruptcy in 2007
 Liquidity crisis in August 2007 as banks reduced
lending to other banks, uncertain about their
ability to repay
 Fed funds rate increased above Fed’s target
Disaster in September 2008
After 6 calm months, a financial crisis exploded:
 Fannie Mae, Freddie Mac
nearly failed due to a growing wave of mortgage
defaults, U.S. Treasury became their conservator
and majority shareholder, promised to cover losses
on their bonds to prevent a larger catastrophe
 Lehman Brothers
declared bankruptcy, also due to losses on MBS
 Lehman’s failure meant defaults on all Lehman’s
borrowings from other institutions, shocked the
entire financial system
Disaster in September 2008
 American International Group (AIG)
about to fail when the Fed made $85b emergency
loan to prevent losses throughout financial system
 The money market crisis
Money market funds no longer assumed safe,
nervous depositors pulled out (bank-run style) until
Treasury Dept offered insurance on MM deposits
 Flight to safety
People sold many different kinds of assets, causing
price drops, but bought Treasuries, causing their
prices to rise and interest rates to fall to near zero
26-Jun-09
6-Jun-09
17-May-09
27-Apr-09
1
7-Apr-09
2
18-Mar-09
6
26-Feb-09
7
6-Feb-09
17-Jan-09
28-Dec-08
8-Dec-08
18-Nov-08
29-Oct-08
9-Oct-08
19-Sep-08
30-Aug-08
10-Aug-08
21-Jul-08
1-Jul-08
11-Jun-08
interest rate (%)
The flight to safety:
BAA corporate bond and 90-day T-bill rates
10
9
8
Corporate bond
interest rate
5
4
3
Treasury bill
interest rate
0
An economy in freefall
 Falling stock and house prices reduced consumers’
wealth, reducing their confidence and spending.
 Financial panic caused a credit crunch;
bank lending fell sharply because:
 banks could not resell loans to securitizers
 banks worried about insolvency from further
losses
 Previously “safe” companies unable to sell
commercial paper to help bridge the gap between
production costs and revenues
The policy response
 TARP – Troubled Asset Relief Program (10/3/2008)
 $700 billion to rescue financial institutions
 initially intended to purchase “troubled assets” like
subprime MBS
 later used for equity injections into troubled
institutions
 result: U.S. Treasury became a major shareholder
in Citigroup, Goldman Sachs, AIG, and others
 Federal Reserve programs to repair commercial
paper market, restore securitization, reduce
mortgage interest rates
The policy response
 Monetary policy:
Fed funds rate reduced from 2% to near 0% and
has remained there
 The fiscal stimulus package (February 2009):
 tax cuts and infrastructure spending costly nearly
5% of GDP
 Congressional Budget Office estimates it boosted
real GDP by 1.5 – 3.5%
The aftermath
 The financial crises eases
 Dow Jones stock price index rose 65% from
3/2009 to 3/2010
 Many major financial institutions profitable in
2009
 Some taxpayer funds used in rescues will
probably never be recovered, but these costs
appear small relative to the damage from the
crisis
4
Dec-2007
Jan-2008
Feb-2008
Mar-2008
Apr-2008
May-2008
Jun-2008
Jul-2008
Jul-2008
Aug-2008
Sep-2008
Oct-2008
Nov-2008
Dec-2008
Jan-2009
Feb-2009
Mar-2009
Apr-2009
May-2009
Jun-2009
Jul-2009
Aug-2009
percent of labor force
10
27
8
24
unemployment
rate (left scale)
6
21
average
duration of
unemployment
(right scale)
2
18
15
weeks
The aftermath: unemployment persists
The aftermath
 Constraints on macroeconomic policy
 Huge deficits from the recession and stimulus
constrain fiscal policy
 Monetary policy constrained by the zero-bound
problem: even a zero interest rate not low
enough to stimulate aggregate demand and
reduce unemployment
 Moral hazard
 The rescues of financial institutions will likely
increase future risk-taking and the need for future
rescues
Reforming financial regulation:
Regulating nonbank financial institutions
 Nonbank financial institutions (NBFIs) do not enjoy
federal deposit insurance, so were less regulated
than banks
 Since the crisis, many argue for bank-like
regulation of NBFIs, including:
 greater capital requirements
 restrictions on risky asset holdings
 greater scrutiny by regulators
 Controversy: more regulation will reduce
profitability and maybe financial innovation
Reforming financial regulation:
Addressing “too big to fail”
 Policymakers have been rescuing TBTF
institutions since Continental Illinois in 1984.
 Since the crisis, proposals to
 limit size of institutions to prevent them from
becoming TBTF
 limit scope by restricting the range of different
businesses that any one firm can operate
 Such proposals would reverse the trend toward
mergers and conglomeration of financial firms,
would reduce benefits from economics of scale &
scope
Reforming financial regulation:
Discouraging excessive risk-taking
 Most economists believe excessive risk-taking is a
key cause of financial crises.
 Proposals to discourage it include:
 requiring “skin in the game” – firms that arrange
risky transactions must take on some of the risk
 reforming ratings agencies, since they
underestimated the riskiness of subprime MBS
 reforming executive compensation to reduce
incentive for executives to take risky gambles in
hopes of high short-run gains
Reforming financial regulation:
Changing regulatory structure
 There are many different regulators, though not by
any logical design.
 Many economists believe inconsistencies and
gaps in regulation contributed to the 2007-2009
financial crisis.
 Proposals to consolidate regulators or add an
agency that oversees and coordinates regulators.
CASE STUDY
The Dodd-Frank Act (July 2010)
 establishes a new Financial Services Oversight
Council to coordinate financial regulation
 a new Office of Credit Ratings will examine rating
agencies annually
 FDIC gains authority to close a nonbank financial
institution if its troubles create systemic risk
 prohibits holding companies that own banks from
sponsoring hedge funds
 requires that companies that issue certain risky
securities have “skin in the game” and retain at
least 5% of the default risk
Financial crises in emerging economies
 Emerging economies: middle-income countries
 Financial crises more common in emerging
economies than high-income countries, and
often accompanied by capital flight.
 Capital flight: a sharp increase in net capital
outflow that occurs when asset holders lose
confidence in the economy, caused by
 rising govt debt & fears of default
 political instability
 banking problems
Capital flight
 Interest rates rise sharply when people sell bonds
 Exchange rates depreciate sharply when people
sell the country’s currency
 Contagion: the spread of capital flight from one
country to another
 occurs when problems in Country A make people
worry that Country B might be next,
so they sell Country B’s assets and currency,
causing the same problems there
 like a bank panic
Capital flight and financial crises
 Banking problems can trigger capital flight
 Capital flight causes asset price declines, which
worsens a financial crisis
 High interest rates from capital flight and loss in
confidence cause aggregate demand, output,
and employment to fall, which worsens a
financial crisis
 Rapid exchange rate depreciation increases the
burden of dollar-denominated debt in these
countries
Crisis in Greece
 Caused by rising govt debt, fear of default
 Asset holders sold Greek govt bonds, which
caused interest rates on those bonds to rise
 Facing a steep recession, Greece could not
pursue fiscal policy due to debt, or monetary
policy due to membership in the Eurozone
Crisis in Greece
Govt budget deficit,
% of GDP
16
Interest rates on
10-year govt bonds
9
14
8
12
7
Greece
10
6
8
5
6
4
Jan-06
Jul-05
Jan-05
Jul-04
Jan-04
Germany
Jul-03
2009
2008
2007
2
2006
0
2005
2
3
Jan-03
4
The International Monetary Fund
 International Monetary Fund (IMF):
an international institution that lends to countries
experiencing financial crises
 established 1944
 the “international lender of last resort”
 How countries use IMF loans:
 govt uses to make payments on its debt
 central bank uses to make loans to banks
 central bank uses to prop up its currency in
foreign exchange markets
SECTION SUMMARY
 Financial crises begin with asset price
declines, financial institution failures, or
both. A financial crisis can produce a credit
crunch and reduce aggregate demand, causing a
recession, which reinforces the financial crisis.
 Policy responses include rescuing troubled
institutions. Rescues range from riskless loans to
institutions with liquidity crises, giveaways, risky
loans, and equity injections.
SECTION SUMMARY
 Financial rescues are controversial because
of the cost to taxpayers and because they
increase moral hazard: firms may take on more
risk, thinking the government will bail them out if
they get into trouble.
 Over 2007-2009, the subprime mortgage crisis
evolved into a broad financial and economic crisis
in the U.S. Stock prices fell, prestigious financial
institutions failed, lending was disrupted, and
unemployment rose to near 10%.
SECTION SUMMARY
 Financial reform proposals include: increased
regulation of nonbank financial institutions;
policies to prevent institutions from becoming too big
to fail; rules that discourage excessive risk-taking;
and new structures for regulatory agencies.
 Financial crises in emerging market economies
typical include capital flight and sharp decreases in
exchange rates, which can be caused by high
government debt, political instability, and banking
problems. The International Monetary Fund can
help with emergency loans.