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CHAPTER 14
Financial Instability and Strains on the Financial
System
Learning Objectives
 The ways in which financial intermediaries (FIs) deal with risk and why risk cannot be
eliminated
 The reasons why financial interemediation recurrently leads to financ ial crisis
 What the moral hazard problem is and how it may exacerbate financial cris es
 The causes of the savings and loan (S&L) crisis of the 1980s
 Other potential causes of future financial cris es in a globalized financial system
Chapter Outline
I.
II.
III.
IV.
V.
Memory Is the Thing You Forget With
Financial Intermediation, Risk, and Financial Crises
The Problem of Moral Hazard in Financial Intermediation
The Savings and Loan Debacle
Other Areas of Concern
A.
Off-Balance-Sheet Activities
B.
Derivatives
C.
The Eurodollar and Eurobond Markets
Answers to Review Questions
Discuss ways in which each of the following risks can be reduced: default risk, interest
rate risk, liquidity risk, and exchange rate risk.
Default risk can be reduced by diversifying or by utilizing experts to evaluate and assess the
credit-worthiness of potential borrowers and potential investments.
Interest rate risk can be reduced through the use of adjustable rate loans or the judicious use of
futures, forwards, options, swaps, and securitizations.
In addition to borrowing funds from the Fed, depository institutions can also rely on their
ability to borrow nondeposit liabilities to meet liquidity needs. Also, short term assets can be
held to reduce liquidity risk.
Futures and options can be used to hedge exchange rate risk.
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Chapter 14
Why does financial intermediation inherently involve risk? Are FIs better at evaluating
risk than you are? Why or why not?
Financial intermediation inherently involves risk because the future is uncertain and because
financial claims are layered. To make my payments, I rely on getting paid by you and vice
versa. If an FI only makes loans or purchases financial assets with little or no apparent risk, it
is passing up opportunities for profits.
FIs do evaluate financial risks better than the average person does because FIs are trained in
evaluating risks.
What is a financial crisis? Why does an economic downturn often lead to a financial
crisis? Explain why the reverse is also true.
A financial crisis is a critical upset in a fina ncial market that is characterized by sharp declines
in asset prices and widespread defaults.
A general slump in the economy can create a financial crisis. One party defaults because of a
downturn in the economy and sets off a chain reaction of defaults. At other times, the causation
may flow in the opposite direction. In this case, a financial crisis, such as a dramatic fall in
stock prices or a random large bankruptcy causing a chain reaction of defaults, leads to a
general slump in business activity or a recession.
Can sharp increases in interest rates increase the risk of a financial crisis? Explain.
Sharp increases in interest rates can increase the risk of a financial crisis. Interest rate
increases lead to an increase in the adverse selection proble m.
Under Regulation Q, were interest rate ceilings for S&Ls higher or lower than for
commercial banks? Why?
Interest rate ceilings for S&Ls were higher than for commercial banks. The purpose of this
differential was to encourage savers to deposit funds in to S&Ls, which then could be used to
make mortgage loans, thus encouraging home ownership.
Is a financial crisis more likely to be triggered by inflation or deflation? Explain.
A financial crisis is more likely to be triggered by deflation than by inflati on because with
deflation comes debt deflation, which is a real increase in debt burdens caused by falling
incomes and prices. With deflation, wages and prices fall, but the value of debts, which are
denominated in dollars, does not fall. Hence deflation, causes a real increase in the value of
debts and may jeopardize the debtor’s ability to repay their debts.
What does “too big to fail” mean? What are the costs of such a policy? Under what
circumstances would your funds be safer in a small local bank tha t only loaned in the
local area than in a large bank with a diverse portfolio of loans including foreign
loans?
"Too big to fail" is the position adopted by FDIC regulators in 1984 whereby the failure of a
large bank would be resolved using the purchase an d assumption method rather than the payoff
method. The costs of such a policy are that the FDIC —or whoever the insurer is—pays the
take-over institution the difference between the assets and the liabilities of the failed
institution. Another cost is that large banks may be encouraged to take additional risks if they
Financial Instability and Strains on the Financial System
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know that deposits over $100,000 are de facto insured. This is a moral hazard problem in that
if large depositors believe their deposits over $100,000 are de facto insured, they do not have
an incentive to watch the behavior of the bank with regards to risk taking.
If I had over $100,000 in deposits at a large troubled bank, and the FDIC was going to use the
payoff method rather than finding a buyer for the troubled institution, my funds would be safer
in a small local bank that only made loans in the local area. Unlike the purchase and
assumption method, with the payoff method, I would lose all funds over $100,000.
What is moral hazard? Why does deposit insurance inherently involve moral ha zard?
What factors contribute to moral hazard on the international level?
Moral hazard is the reduction of market discipline experienced by Fls that goes hand -in-hand
with deposit insurance.
Deposit insurance inherently involves moral hazard because depo sit insurance encourages
banks (and other Fls) to make riskier loans. With deposit insurance, depositors do not keep
tabs on how banks manage their funds as much as they would if their deposits were not
insured. Also, managers may take more risks because they know if they lose, their depositors
are protected with deposit insurance.
Discuss the factors that contributed to the S&L debacle during the 1980s.
The fundamental causes of the S&L crisis were related to their underlying business. Namely,
S&Ls borrowed short and lent long. In an era of rising interest rates, this will cause
institutions to fail as they see the value of their assets shrink relative to their liabilities. When
interest rates rise, the value of the long term mortgages that S&Ls hold will fall at their same
time they are required to pay more for their short term deposits. Hence in an era when interest
rates are rising, as in the 1970s and early 1980s, the S&Ls would be doomed to fail.
Other factors also played a part to the collaps e of the industry. One of these factors was the
extension of new lending powers to the thrifts in the early 1980s that allowed them to make
loans that were previously the domain of banks. With the increased lending powers, S&Ls
moved into areas where they had not previously lent and there seemed to be an adverse
selection problem in that the S&Ls were left with loans that the banks did not want. Also,
these new powers that allowed for more risk taking also seem to have attracted some dishonest
folk to the industry. Finally, regulators were slow to move in and shut down troubled thrifts,
which caused eventual losses to be greater than they otherwise would have been. Congress was
also slow to act.
Answers to the question will vary depending on aspects emph asized by each student.
Define derivatives. Why can they be risky? Does the United States regulate Eurodollar
and Eurobond markets?
Derivatives are financial contracts whose value is derived from the values of other underlying
assets. Examples include financial futures and options contracts. When derivatives are used
for speculation about future prices, major losses might occur.
The United States does not regulate the Eurodollar and Eurobond markets because they are not
in the United States and government regulators have regulatory powers only over domestic
deposits and financial instruments.
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Chapter 14
What factors led to the collapse of Lincoln Savings?
As a state-chartered institution, Lincoln Savings was permitted
to directly invest in real estate and other high-risk ventures.
Lincoln Savings, under the ownership of Charles Keating, made
many high-risk investments including junk bonds, desert land in
Arizona, hotels, common stock, currency futures, and real estate
developments, including those of American Continental.
As soon as the Federal Home Loan Bank Board, which regulated
Lincoln Savings realized that Lincoln Savings was in trouble,
they tried to seize the institution. Keating responded by seeking
and receiving the help of influential politicians to whom he had
made large political contributions. Because of the delays in
resolving the insolvency, taxpayers ended up paying much more
than otherwise.
Thus, the fundamental factors that led to the collapse were over
investments in real estate and other risky ventures, bad (corrupt) management, and the
intervention of several politicians who had received political contributions from Lincoln
Savings that delayed the regulatory response.
S&Ls had limited experience making commercial loans, while commercial banks were
extremely experienced. Explain how this difference could have exacerbated the
adverse selection problem for the S&Ls.
Since banks are better trained to chose between "bad" and "good" commercial loans, they can
take what they consider good loans and pass off the bad loans to S&Ls. Having a pool of loans
weighted heavily by "bad" loans exacerbates the adverse selection problem for the S&Ls.
Can derivatives cause massive losses if they are used only to hedge?
Derivatives cannot cause massive losses if they are used only for hedging. If used for this
purpose, they reduce the risk of losses and losses are less than what they otherwise would be.
It is only when derivatives are used to speculate that they can lead to large losses.
What caused the Japanese financial crisis of the 1990s? Compare and contrast the causes
of the Japanese banking crisis with the causes of the U.S S&L crisis in the 1980s.
The Japanese financial crisis of the 1990s was the result of a collapsed “bubble economy .”
Expansion in the Japanese economy led to dramatic and excessive price increases in the stock
and real estate markets in the 1980s. The speculative bubble of the 1980s burst when the
Central Bank of Japan raised interest rates in mid -1989. This led to a fall in stock prices and
real estate prices which then transmitted itself to the real sector of the economy, causing
recession and unemployment and crisis within the banking system
The U.S. S&L crisis of the 1980s was not the result of a collapse speculative bubble. Rather ,
the S&L crisis resulted from increases in interest rates, excessive risk taking, and regulatory
lapses. For a more detailed explanation, see Review Question 9.
What trading strategies did Long Term Capital Management employ? Why did the Fed
arrange a bailout?
Financial Instability and Strains on the Financial System
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Long Term Capital Management (LTCM) was a hedge fund that believed that prices of various
securities were related to one another based on risk, maturity, and liquidity. Thus , LTCM
would make a profit by exploiting unusual price differences betwe en related securities on the
assumption that rates would return to their traditional alignment. In effect, LTCM would buy
“underpriced” bonds and sell “overpriced” bonds, thereby making a profit as long as the spread
between the two categories of bonds narrowed. Another strategy used by LTCM was the
reliance on short-term bank loans for investment purposes.
This strategy failed in summer 1998 when the Asian crisis caused interest rates to move in non traditional ways. The high degree of leveraging pec uliar to LTCM also made it particularly
vulnerable to interest rate changes.
In order to prevent liquidation of LTCM’s $200 billion in securities and possible panic reaction
in global financial markets, the Fed had to intervene and brokered a deal betwe en 16 leading
U.S. banks and LTCM. The deal took effect in September 1998, with 16 U.S. banks offering a
$3.5 billion loan/bailout package to LTCM. Thus, the Fed intervened because it feared the
effects on the global financial system of the failure of LT CM.
Answer to Analytical Question
If all prices and my income fall by 25 percent, by what percent does the real value of my
debt increase?
Given that the nominal value of my debt has not changed, if all prices and my income fall by
25 percent, then the real value of my debt, which is d enominated in dollars, increases by 25
percent.