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Lecture 1 Financial and Banking Crises An Introduction 2017
Lecture 1 Financial and Banking Crises An Introduction 2017
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Module aims
This module aims to provide:
a theoretical and historical approach to explaining why banks and
financial markets are inherently vulnerable to crises,
to analyse the role of policy makers and institutions and
examine the role of monetary policy, bank supervision and regulation
in mitigating or exacerbating crises.
At the end of the module you should be able to
understand:
the main theoretical models in which asymmetric information
and coordination failures create a role for intermediaries and
produce problems such as bank runs, asset price bubbles and
herding. Different policy options for dealing with
financial/banking crises will also be outlined.
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The approach adopted within these
sessions.
Financial crises and banking regulation
are highly complex and opinionated areas
of discussion and debate.
Many issues are not fully agreed and
critical discussion of different questions
is essential.
These sessions will consider key
topics/questions/issues raised and try to draw
out a critical discussion of these topics.
.
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Assignment
The module will be assessed through one course work
assignment, one group presentation and final exam.
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Reading for the module
The consequences of the Global Financial Crisis
(Oxford) (Wyn Grant & Graham K. Wilson)
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Today we will consider:
Introduction and Module Outline.
Why are Banks Important?
The Frequency of Financial and
Banking Crises
Different Types of Financial Crisis
The Increasing Importance of Financial
and Banking Crises
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Intermediation and intermediaries
In this module we are interested in bank-like financial
intermediaries i.e. firms with the following
characteristics:
Banks borrow from one group of agents and
lend to another group of agents
The lending and borrowing relationships are with large
numbers of agents using debt contracts
The claims issued to borrowers and to lenders have
different payoffs
Banks are often large, suggesting diversification
on each side of the balance sheet
A large portion of the liability side of the balance
sheet is demand deposits and securities 13
What are private banks?
Banks are one group of financial institutions that
provide access to the financial markets.
A system without financial institutions would
not work very well for three reasons:
Individual transactions between saver-lenders and borrower-
spenders would be extremely expensive.
Lenders need to evaluate the creditworthiness of borrowers
and then monitor them to ensure that they dont abscond
with the funds and individuals are not equipped to do this.
Most borrowers want to borrow long term, while lenders favour
short term loans
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Financial intermediation
This process entails four functions:
The pooling of risks, with each depositor of a bank having an
indirect claim on all the mortgages, business loans, or credit
card receivables owed to the bank rather than a claim on one
specific mortgage or loan.
Maturity transformation via balance sheet intermediation,
with banks lending at longer average maturities than they
borrow
Maturity transformation via the provision of market
liquidity, which gives the holder of a contractually long-term
asset the option of selling it immediately in a liquid market.
Risk return transformation via the creation of a different mix
of debt and equity investment options for savers than arise from
the liabilities of the borrower. 15
The transformation of savings into
investment
Savings Investment
Delegated Monitors
Consumption Smoothing
Information Producers
Liquidity Provision
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Delegated monitors
Financial intermediaries act as delegated monitorsi.e.
they monitor borrowers on behalf of investors who lend to
the financial intermediary.
A monitor is needed because of information asymmetries.
Because banks handle the borrowers transactions account they
act as the firms book-keeper and have a greater comprehension of
the risks of lending than the depositor.
In undertaking this function banks provide economies of
scope or synergies between deposits and lending
businesses.
A financial intermediary can commit to repay depositors only
if it is an effective monitor.
Otherwise it will make losses on its assets and be unable to
redeem all deposits. 18
Direct Finance Each Lenders Monitors its
Borrower Lender 1
N identical firms seek to borrow. Borrower 1
Each firm is monitored at cost K. Lender M
M investors or lenders are required for
Lender 1
each borrower. Borrower N
The total number of investors required is Lender M
NM so all loans provided.
Total cost of monitoring is NMK
Delegated Monitoring
When a bank emerges it can
monitor each borrower at a cost Borrower 1
Lender 1
NK.
Lender M
Lenders can monitor the banks
using a debt or deposit contract Bank
(cost C) Lender 1
Borrower N
Total cost under delegated
monitoring is NK + C Lender M
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Information Producers
Financial intermediaries produce (costly) information
about potential investments that could not be produced
efficiently by securities markets.
If information about investment opportunities is not free, it may be
worthwhile to produce and sell it.
Information producers need to have credibility that the information is
reliable.
The information producer needs to know that information produced will
not be re-sold.
Financial intermediaries can overcome these problems: they solve
the reliability and appropriability problem in information
production.
This requires the intermediary (information producer) to have a
minimum amount of wealth at risk (i.e. to make a loan). The
information may be acquired over time through repeated
lendingcustomer relationship. 20
Consumption Smoothing.
Satisfying consumption needs may require ending investments
unless consumers save via financial intermediationi.e.
intermediation provides insurance against shocks to a consumers
consumption path.
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Liquidity Provision.
The desire of economic agents to contract and
trade generates a need for a payments system
(otherwise agents would need to barter).
Economic agents who need to consume may face
trading losses if other agents know this and seek
to use that knowledge to make profits.
Financial intermediaries overcome the moral hazard
problem that prevents firms (consumers) with excess
liquidity lending to other firms (consumers) that
need liquidity.
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What do banks really contribute?
How should we understand and measure the contribution the
financial sector makes to economic wellbeing? There are several
views we will discuss:
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Bank Crisis affects all nations! Share of years in a banking crisis
since 1800 or Independence (Reinhart and Roggoff 2011.)
United Kingdom
Uruguay Turkey
Sweden
Peru Spain
Russia
Panama Romania
Portugal
Mexico Poland
Norway
Guatemala
The Netherlands
Italy
Ecudor
Hungary
Costa Rica Greece
Germany
Chile France
Finland
Brazil Denmark
Belgium
Argentina Austria
0 10 20 30 40 0 10 20 30 29 40
Bank Crisis affects all nations!
Share of years in a banking crisis since 1800 or Independence
(Reinhart and Roggoff 2011.)
Thailand Zimbabwe
Taiwan Zambia
Sri Lanka Tunisia
Singapore South Africa
The Phillipines
Nigeria
New Zealand
Morocco
Myanmar
Mauritius
Malaysia
Kenya
Korea
Egypt
Japan
Indonesia Cote d'Ivore
India Central African
China Angola
Australia Algeria
0 10 20 30 40 0 10 20 30 30 40
Economic theories of banking crises
There are many explanations as to why banking/financial
crises occur or are triggered.
Severe financial and banking crises rarely occur in
isolation and amplify current concerns within an
economy.
Laeven and Valencia (2008) report financial crises arise
from many sources both individually and in
combination. These include unsustainable
macroeconomic policies, excessive credit booms, large
capital inflows, policy paralysis and balance sheet
fragilities.
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This has led to many types of crisis being defined.
Following Laeven and Valencia (2008) and others, we
divide financial crises into a number of categories:
A systemic banking crisis
A currency crisis where the currency depreciates by at least
30% in a year.
A sovereign debt crisis when a country needs to
default or restructure its national debt.
Asset-Price Crashes.
Increased capital mobility and financial liberalisation
Capital flow bonanzas
Monetary Policy
Bank runs
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Systematic banking crisis
A systemic banking crisis is defined as a default
on borrowing by a large number of a nations
banks, financial institutions or firms
A systematic banking crisis develops when a
large number of banks default or many
financial institutions simultaneously cannot
honour their contracts.
Subsequently the level of non-performing loans rises
and the capital in a banking system is exhausted.
This may be associated with a fall in asset prices or
a slowdown or reversal in capital flows. 33
Asset-Price Crashes.
Asset price crashes typically occur when an
asset-price bubble pops.
During a bubble asset prices rise far above the
present value of expected income from the assets.
Bubbles pop as at some point sentiment shifts:
people worry and start selling,
prices fall;
declining prices shake confidence,
a vicious circle of selling and panic emerges.
These equity and housing price cycles are frequently linked
with banking crises.
For example the real estate bubble in 2005 in the USA is seen as a key cause of
the 2007 crisis, the Japanese banking crisis of 1992 was linked to a real estate
and stock market boom and cases also exist in Norway (1987), Spain
(1977), Finland and Sweden (1991). 34
An example of an asset price boom:
Japanese asset prices (source BoE 2012)
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Increased capital mobility and
financial liberalisation
Financial liberalisation and increased capital
may also engender or trigger banking crises.
Kaminsky and Reinhart (1999) considered 26 banking crises
since 1970 and reported 18 of these crises were linked to
financial liberalisation in the previous 5 years.
It is reported:
That it is unusual for financial liberalisation to go
smoothly.
The probability of a banking crisis conditional on
financial liberalisation is significantly higher than the
unconditional probability of a banking crisis.
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Capital flow bonanzas
Reinhart and Reinhart (2009) examined 81 nations between 1960-
2006 and reported whether a sustained capital inflow into an
economy prior to a banking crisis was critical in determining
whether a banking crisis actually occurred.
The probability of a banking crisis conditional on a cash
flow bonanza is significantly higher than the unconditional
probability of banking crisis (without a capital bonanza).
This effect is most marked for lower and medium income nations
rather than higher income nations which may be able to manage
such capital flows within more developed financial markets.
Overall 61% of nations have a higher propensity for banking
crisis if this event is preceded by a cash bonanza.
This finding would be higher if we considered post 2007 data.
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From Reinhart and Reinhart (2009)
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Institutional Factors
Calomiris and Haber (2014) argue the institutional framework within
which banks operate is critical to whether a banking system is prone to
banking crisis or otherwise. Banks can be fragile by design.
Calomiris and Haber argue banks require certain property rights such as
the enforcement of credit contracts, to thrive. These rights can only be
provided by strong governments which bankers can convince to act in
their interests.
The fragility of the banking system or otherwise is therefore an outcome
of a political process the Game of Bank Bargains.
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Capital Flight
In the last 20 years, financial crises have hit many
emerging market economies, including Mexico in
1994, East Asian countries 1997-98, Russia in 1998;
Ecuador in 1999, and Argentina in 2001.
These crises have an additional key element
capital flight.
Bank failures
from liquidity
and/or
G
insolvencies
A Wealth Uncertainty
B Net worth and collateral of borrowers
C Fewer banks, banks more cautious
D Firms and consumers cant finance spending
E Spending determines output in the short run
F Recession leads to firm earnings demands for real estate
G Recession leads to bank revenue loan defaults
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Economic effects of financial crises
0.3%
0.2%
0.1%
0.0%
1985
1989
1991
1993
1997
1999
2001
2005
2007
2009
2013
1987
1995
2003
2011
Recession Individual Insolvency rate
Bankruptcy Rate DRO Rate
IVA Rate
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Review Questions
Why is banking important for an economy?
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