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Chapter 12
International
Financial
Crises
Learning Objectives
• Define three types of crises.
• Distinguish a crisis caused by economic
imbalances from one caused by volatile
capital flows.
• List and explain three measures countries
can take to reduce their exposure to
financial crises.
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12-2
Learning Objectives
(cont.)
• Explain the need for reforms in the
architecture of international finance and
international financial institutions.
• Describe the main forces behind the global
financial crisis that began in 2007.
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12-3
Introduction: The Challenge to
Financial Integration
• Economic integration has enhanced growth
and development, but also made it easier
for crises to spread across borders
• Financial crises (currency crisis) Financial
crises have brought down governments,
ruined economies, and destroyed individual
lives
• Contagion effects of crises do not conform
to a single pattern, and are thus difficult to
predict
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12-4
Introduction: The Challenge to
Financial Integration (cont.)
• Many reform proposals are usually proposing
reforms of the international financial
architecture
• They often revolve around a set of proposed
changes to the International Monetary Fund (IMF)
and other multilateral institutions with a role in
international financial relations
• Does the world economy need a lender of last
resort? What type of conditions should a lender
impose on the recipients of its assistance?
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12-5
Definition of a Financial Crisis
Financial crises have a variety of potential
characteristics, but they usually involve
•an exchange rate crisis
•a banking crisis
•a debt crisis
•some combination of the three
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Definition of a Financial Crisis
(cont.)
• Banking crisis: The banking system
becomes unable to perform its role of
intermediation and its normal lending
functions
• Disintermediation: Banks unable to serve
as intermediaries between savers and
investors
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Definition of a Financial Crisis
(cont.)
Exchange rate crisis
–A sudden and unexpected collapse in the value of
a nation’s currency
Debt crisis
–Occurs when debtors cannot pay and must
restructure their debt
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12-8
Definition of a Financial Crisis
(cont.)
• Under a fixed exchange rate system,
crisis entails the loss of international
reserves and devaluation
• Under a flexible exchange rate system,
crisis means an uncontrolled, rapid
depreciation of the currency
• Countries with a pegged exchange rate
may be more vulnerable to a crisis
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12-9
Sources of International
Financial Crises
Two origins of international financial crises:
1. Crises caused by macroeconomic
imbalances such as large budget deficits
caused by overly expansionary fiscal
policies
2. Crises caused by volatile flows of financial
capital that move in and out of a country
quickly
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12-10
Crises Caused by Macroeconomic
Imbalances
• A number of crises over the last decades
have been triggered by severe
macroeconomic imbalances
• These are often accompanied by an
exchange rate system that intensifies the
country’s vulnerability
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Crises Caused by
Macroeconomic Imbalances
(cont.)
• The current crisis which began in 2007
partially fits this description depending on
the country and the time period
• Investment was facilitated by global
imbalances in which countries with high
savings rates and large current account
surpluses lent to countries with large
current account deficits and significant
demand for investment
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12-12
Crises Caused by
Macroeconomic Imbalances
(cont.)
• The 2007 financial crisis began when the
housing bubble collapsed
• Banks were unable to lend as they either
became insolvent or close to insolvent
• Resulting in a steeper decline in consumer
and business spending
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12-13
Crises Caused by
Macroeconomic Imbalances (cont.)
• First phase, imbalances in most countries
were a result of private sector decisions
regarding saving and investment
• Second phase, government imbalances
come into play as tax collections decline
and spending on social programs and
health care rises due to automatic
stabilizers
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12-14
Crises Caused by
Macroeconomic Imbalances (cont.)
• Unsustainable deficits are not inevitable and
depend on many other factors, such as the
health of the banking system and the
resiliency of the economy
• Sovereign default - a debt crisis in which
the government cannot pay back its loans
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Crises Caused by
Volatile Capital Flows
• The fundamental cause of this type of crisis
is that financial capital is highly volatile and
technological advances have reinforced this
volatility
• A weak financial sector can also intensify
problems
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Crises Caused by
Volatile Capital Flows
(cont.)
• When banks take on short-term
international debt to fund long-term
domestic loans, several unsettling scenarios
are possible:
1. There are multiple possible outcomes (multiple
equilibria)
2. A self-fulfilling crisis
3. The crisis affects banks that are fundamentally
sound, but have mismatches between maturities of
assets and debts; illiquid but not insolvent
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12-17
FIGURE 12.1 Pesos Per Dollar:
December 12, 1994 to March 22, 1995
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Domestic Issues in Crisis Avoidance:
Moral Hazard and Financial Sector Regulation
• Problems in financial sector regulation
include:
– Moral hazard: The incentive to act in a manner
that creates personal benefits at the expense of
the common good (banks have an incentive to
make riskier investments when they know they
will be bailed out)
– General agreement to eliminating moral hazard in
financial institutions: increase capital
requirements to raise the level of capital
available in time of crisis
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12-19
Domestic Issues in Crisis Avoidance: Moral
Hazard and Financial Sector Regulation (cont.)
• The problem of moral hazard- inescapable if a
general policy of protecting the financial system
from collapse exist
• Basel Capital Accord: Formulated in 1989 by
bank regulators from industrialized countries;
adopted by more than 100 countries
• The New Basel Capital Accord of 2010(Basel
III) updated the previous standards
• Basel Accords try to make banking systems more
robust by setting new standards for bank
supervision, information disclosure, and stress
tests.
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12-20
Domestic Issues in Crisis Avoidance: Moral
Hazard and Financial Sector Regulation (cont.)
• The recommended three best practices to
reduce the problem of moral hazard:
– Capital requirements: Require the owners of
banks to invest a certain percentage of their own
capital in the bank
– Supervisory review: Oversight mechanism to
assist with risk management and to provide
standards for daily business practices
– Information disclosure: Requires banks to
disclose operational information to lenders,
investors, depositors
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12-21
Exchange Rate Policy
• The crawling peg increases vulnerability to
financial crises in two ways:
1. Requires monetary authorities to exercise
discipline in the issuance of new money; antiinflationary tendencies exacerbated by
intentional slow devaluation; a severe
overvaluation of the real exchange rate may
result
2. Exiting crawling peg is difficult: A government
leaving it may lose the confidence of investors
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Capital Controls
• Capital controls may be imposed to
prevent capital movements in the financial
account
– Inflow restrictions tend to work better than
outflow ones- they reduce the inflow of shortrun capital which would add to the stock of
liquid, possibly volatile capital
– Outflow restrictions may help reduce the impact
of a crisis when it occurs
-Malaysia weathered the Asian Crisis through outflow
restrictions
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12-23
TABLE 12.1 Current Account Balances
and Currency Depreciations
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TABLE 12.2 Real GDP Growth
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Domestic Policies for
Crisis Management
• Crises caused by macroeconomic policies
can be cured by:
–Cutting the deficit
–Raising interest rates to help defend the currency
–Letting the currency float
The problem is that the economic austerity of
budget cuts and higher interest rates may not be
politically feasible
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12-26
Domestic Policies for
Crisis Management (cont.)
• Crises caused by sudden capital flight are
harder to cure
- Collapsing currency can be defended through
interest rate hikes, but these may cause
bankruptcies and other problems
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12-27
Reform of the International
Financial Architecture
• Reform of the international financial
architecture: New international policies for
avoiding and managing financial crises
• The great variety of reform proposals focus
on two issues:
– The role of an international lender of last
resort
– Conditionality: the changes in economic policy
that borrowing nations are required to make in
order to receive loans from the lender of last
resort
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12-28
Lender of Last Resort
• Lender of last resort: A source of loanable
funds after all commercial sources of
lending become unavailable
– The central bank in the national economy
– The IMF, with the support of high-income
countries, in the international economy
-A country unable to make a payment on
its international loans or lacking
international reserves asks the IMF to
intervene
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12-29
Lender of Last Resort
(cont.)
• Opponents of international lender of last
resort cite moral hazard problems
– Trusting in a bailout, failing firms have an
incentive to gamble on high-stakes, high-risk
ventures
• Proponents of international lender of last
resort state that moral hazard can be
decreased by financial sector regulations,
such as the Basel Capital Accord
– If the owners of financial firms risk a substantial
loss in the event of financial meltdown, they are
less likely to take on excessive risk.
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12-30
Lender of Last Resort
(cont.)
• Debate on the IMF’s role as a lender of last
resort and moral hazard centers on:
– The rules for IMF loans is the size of the loan.
Countries pay a subscription, called a quota , to
join the IMF. quota depends mainly on the size
of the economy and its strength.
– Loan size up to 300 percent of their quota unless
extraordinary circumstances (Mexican, Asian,
contagion potential crises)
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12-31
Conditionality
• Conditionality: The changes in economic policy
that borrowing nations are required to make in
order to receive loans from the lender of last resort
– Typically covers monetary and fiscal policies,
exchange rate policies, and structural policies
affecting the financial sector, international trade,
and public enterprises
– The IMF makes loans in tranches: instalments of
the total loan
-Each tranche hinges on the completion of reform targets
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12-32
Conditionality
(cont.)
• Critics of conditionality argue
– The need to comply with conditionalities may
intensify the recessionary effects of a crisis
– Conditionality may entail high social costs on
the poorest members of the society
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12-33
Conditionality
(cont.)
• Proponents of conditionality argue
- Crises could be avoided by a pre-qualification
criteria
- To receive assistance, countries must meet
requirements of sound financial sector policies
- However, critics claim that (1) pre-qualification
will not deter speculative attacks on the country's
currency and (2) The IMF could not ignore crises
cases that failed to pre-qualify
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12-34
Conditionality
(cont.)
• There is a need for greater transparency to
make a country’s financial standing clearer
to potential lenders
– Basel Capital Accord includes issues of
transparency and data reporting
– Data dissemination standards: The IMF´s
standards for data reporting; currently under
development
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12-35
Conditionality
(cont.)
• The need to coordinate private sector
involvement: private sector creditors’
insistence they be paid first makes it more
difficult to resolve a crisis
• How to resolve the conflict between lenders?
– Standstills: IMF’s recognition that a crisis
country temporarily stop making repayments on
its debt
– Collective action clauses: Lenders would have
to agree on collective mediation among
themselves and the debtor in the event of a
crisis
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12-36
Reform Urgency
• Immediately following the Asian Crisis,
financial reform was at the top of everyone’s
agenda
• A decade later, as the Asian crisis faded in
memory, the urgency for reform diminished
and not much had happened by the time the
crisis in the U.S. housing market exploded in
2007
• Attention has been diverted to other areas:
-Security, terrorism, energy, climate
change
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12-37
The Global Crisis of 2007
• The most recent financial crisis began in the
United States in the fall of 2007
• The first visible stage was called the
subprime crisis in reference to housing
• Loans made in the United States to
borrowers with less-than-prime credit ratings
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12-38
The Global Crisis of 2007
(cont.)
• Banks and other “non-bank financial entities”
(car financing firms, consumer credit firms,
insurance companies, and others) entered
the market
• Their strategy was not to profit from the
interest they earned on the home loans, but
to group a large number of loans together
and sell shares in the entire package. This is
known as securitization
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12-39
The Global Crisis of 2007
(cont.)
Securitization
•Accomplished with home loans, car loans, consumer
credit loans, and other types of debt
•Buyers receive a return based on the interest the
ultimate borrowers—home owners, car owners, credit
card owners, pay to their lenders
•The company creates the securitized package of
loans; sell shares to anyone willing to buy (another
bank, a foreign-based insurance company, a foreign
government)
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12-40
The Global Crisis of 2007
(cont.)
• The savings held by governments are called
sovereign wealth funds
• Private entities accumulated a large supply of
international reserves by
- increasing their savings
- large current account surpluses to purchase
dollars, U.S. Treasury securities, and other secure,
highly liquid financial assets
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12-41
TABLE 12.3 Current Account Deficits,
2000-2007 (Billions of U.S. $)
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