The Financial System : Opportunities and Dangers The Financial System Makes Saving Equal Investment

• The financial system makes it easier for lenders (those who have the
Chapter 20 of Macroeconomics, 9th edition, by N. saving funds) and borrowers (those who need funds for investment) to find
Gregory Mankiw each other
• Both groups benefit when the financial system does its job well
Chapter Outline • When the financial system fails, both groups suffer
What does the financial system do?
The Financial Financial Crises: Case Study:
• The financial system serves multiple purposes:
System: What is Six common Great Recession
it? features of 2008-9 – It helps entrepreneurs find the money needed to turn business
ideas into reality
– It helps entrepreneurs pursue business projects without having to
personally carry too much of the risks associated with their
Policies to projects
Policies to
recover from a
prevent a crisis – It helps to protect lenders from irresponsible borrowers
crisis – It helps to foster economic growth by channeling savings to the
most valuable projects and cutting off funds for the less valuable
The Financial System projects

• The financial system is the collection of institutions that facilitate the flow Financing Investment
of funds between lenders and borrowers.
• The financial system helps entrepreneurs find the money needed to turn
The Financial System: Saving business ideas into reality

• When people earn income, they typically don’t want to consume their • The money may take the form of
entire income all at once.
– Debt finance (the entrepreneur sells bonds to raise money), and
• But they may have no idea what to do with the unconsumed income.
– Equity finance (the entrepreneur sells stocks to raise money)
• This unconsumed income is called saving
• The flow of funds takes place through
The Financial System: Investment
– Financial markets
• On the other hand, there are people who may wish to spend money on
various potentially valuable projects but either have no money of their own • Stock market, bond market
or may wish to spend their personal funds on projects other than their own
• The money that these people need for their spending plans is called – Financial intermediaries
investment
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Opportunities and Dangers
Chapter 20 of Macroeconomics, 9th edition, by N. Gregory Mankiw
• Banks, mutual funds, pension funds, insurance companies
What does the financial system do?
• The financial system serves multiple purposes:
– It helps entrepreneurs find the money needed to turn business
ideas into reality
– It helps entrepreneurs pursue business projects without having to
personally carry too much of the risks associated with their
projects
– It helps to protect lenders from irresponsible borrowers
– It helps to foster economic growth by channeling savings to the
most valuable projects and cutting off funds for the less valuable
projects
Sharing Risk
• The financial system helps entrepreneurs pursue business projects without
having to personally carry too much of the risks associated with their
projects
• The financial system also enables savers to diversify—that is, lend their
money to a variety of borrowers—thereby reducing the risks of lending
• Suppose it is your dream to start a restaurant.
• Even if you have enough savings of your own to pay for the restaurant, it
might still be better to share the risks—and the rewards—of the restaurant
venture with others
• And others may wish to share the risks of your restaurant venture if they
believe that the returns would be good
• The financial system—that is, the financial markets and financial
intermediaries—may put you in touch with other investors
• They would provide you money to get your restaurant started in return for
part ownership – This is equity finance
• This way you would not have to carry the full risk of your restaurant on
your own shoulders
Opportunities and Dangers
Chapter 20 of Macroeconomics, 9th edition, by N. Gregory Mankiw
• Even if you are not an entrepreneur, the financial system can help you use
your savings to acquire ownership of a diversified portfolio of business
enterprises
• This will help you keep your idiosyncratic risks low But systemic risks
may remain
What does the financial system do?
• The financial system serves multiple purposes:
– It helps entrepreneurs find the money needed to turn business
ideas into reality
– It helps entrepreneurs pursue business projects without having to
personally carry too much of the risks associated with their
projects
– It helps to protect lenders from irresponsible borrowers
– It helps to foster economic growth by channeling savings to the
most valuable projects and cutting off funds for the less valuable
projects
Dealing With Asymmetric Information
• Borrowers can hide crucial information— about their abilities and their
plans—from potential lenders
• As a result, unsuspecting lenders can get ripped off
• If that happens often enough, all lending would eventually end and the
financial system would be unable to do what it is supposed to do
• The financial system—especially financial intermediaries, such as banks,
and watchdogs, such as government regulators and the courts—can help
lenders by
– ensuring that lenders get adequate information about potential
borrowers
– keeping a watchful eye on borrowers to ensure that they do
nothing stupid or reckless with borrowed money
– punishing dishonest treatment of lenders
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• When entrepreneurs hide information about themselves or the projects for
which they are seeking money, lenders face the problem of adverse
selection
• When entrepreneurs hide information about how hard they intend to work
to make their projects successful, lenders face the problem of moral hazard
• Why would an entrepreneur borrow money for his/her project?
– has no personal funds
– has enough personal funds, but wants to diversify risks
– knows something negative about the project that he/she is hiding
from lenders (adverse selection)
– has no intention to work hard for the project (moral hazard)
• A lender can partially avoid the problems of adverse selection and moral
hazard by lending money to an intermediary, such as a bank, and letting
the bank deal with the borrower
• The bank may have the resources to dig up hidden information about the
borrower and the project
• The bank may be able to ensure that the borrower will work hard to make
the project a success
• In some cases, asymmetric information may hurt an honest borrower
• An entrepreneur may be honest and hard working, but may be unable to
convince potential lenders that she is honest and hard working
• Here too, bank finance may be the solution
• A bank may be willing to lend money to this borrower because the bank
has resources to monitor the borrower, who in this case happens to be
genuinely hard working
• Government regulators and the law enforcement system have obviously
important roles to play in dealing with adverse selection and moral hazard.
What does the financial system do?
• The financial system serves multiple purposes:
– It helps entrepreneurs find the money needed to turn business ideas into
reality
– It helps entrepreneurs pursue business projects without having to
personally carry too much of the risks associated with their projects
– It helps to protect lenders from irresponsible borrowers
Opportunities and Dangers
Chapter 20 of Macroeconomics, 9th edition, by N. Gregory Mankiw
– It helps to foster economic growth by channeling savings to the
most valuable projects and cutting off funds for the less valuable
projects
Fostering Economic Growth
• The financial system helps to foster economic growth by channeling
savings to the most valuable projects and cutting off funds for the less
valuable projects
• When asymmetric information is not a problem, a market for loanable
funds in which people are free to lend and borrow should ensure the
success of economically valuable projects and the failure of economically
wasteful projects
• For example, if in a well-functioning loanable funds market the
equilibrium interest rate is 4%, then
– the projects that can earn profits higher than 4% will succeed, and
– the projects that cannot do so will fail
– It cannot be that a less profitable project gets funded and a more
profitable project does not
• In this way, a free market will automatically
• allocate funds so as to foster economic growth
Case Study: Microfinance
• In poor countries, financial markets are undeveloped, primarily because of
asymmetric information problems and weak or nonexistent government
efforts to deal with asymmetric information
• In 1976, Muhammad Yunus, an economics professor in Bangladesh,
started Grameen Bank to remedy the situation
• The Bank was successful in funding entrepreneurs to build small-scale
businesses and improve their lives
• Grameen Bank and Prof. Yunus were awarded the Nobel Peace Prize in
2006
• How did Grameen Bank succeed in solving the problem of asymmetric
information?
• Loans were given to groups rather than
• individuals
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• All members of the group that took a loan would be responsible for timely • Financial crises are often preceded by a period of euphoria, called a
repayment speculative bubble, during which the prices of assets rise above their
• So, a group would only admit members that the other members knew to be fundamental values
sound – The fundamental value of an asset is the price that would prevail if
• In this way, the group-lending idea helped solve the asymmetric people relied only on objective analyses of the cash flows the asset
information problem can be expected to generate
• Moreover, Grameen Bank gives loans in small amounts that are repaid— • If people start buying assets not for the expected cash flows from the asset
and renewed—after short intervals but because they hope to sell the asset later at a higher price, an asset’s
• Therefore, a continuing relationship develops between the bank’s loan price can rise above its fundamental value
officers and the borrowers • However, such speculative bubbles inevitably crash when euphoria ends
• Moreover, as small amounts are loaned out at any given time, losses are and doubts set in
low • In the Great Recession of 2008-09, a speculative bubble developed in
home prices
FINANCIAL CRISIS: SIX COMMON FEATURES
Financial Crisis
• A financial crisis is a major disruption of the financial system’s ability to
make money flow between lenders and borrowers
• Examples:
– Great Depression 1930s
– Great Recession 2008-09
Six Common Features • Banks fueled the boom because they failed to do their job of identifying
irresponsible borrowers and refusing their loan requests.
• Although each financial crisis is unique, most financial crises share certain
• Why?
common elements
– Banks assumed that home prices would keep rising.
– Under that assumption, it would not matter if a borrower
Asset-price Insolvencies defaulted.
Falling
booms and in financial
confidence – The bank would simply take the house the defaulter had bought
busts institutions
and sell it off at a now higher price, thereby making a profit.

A vicious Insolvencies in financial institutions

Credit crunch Recession
circle
• Eventually, home prices stopped rising and then started to fall
• Borrowers then owed more money than the value of the house they’d
Asset-price booms and busts bought with the loan
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Opportunities and Dangers
Chapter 20 of Macroeconomics, 9th edition, by N. Gregory Mankiw
• Such borrowers stopped repaying their loans
– Mortgage loans are “non-recourse”
– Better to just return the house keys to the bank
• Of course, banks could take the homes (collateral) and sell them
• But then banks would lose money because home prices had fallen
• When banks’ assets (the homes) lose value, their capital (owners’ equity)
turns negative – See Ch. 4
• At that point, the bank is insolvent
• Many financial institutions turned insolvent
– Financial institutions have assets and liabilities
• Assets are what others owe them
• Liabilities are what they owe others
– When the value of assets falls below the value of liabilities, the
financial institution is insolvent
– When a financial institution becomes insolvent, it is forced to shut
down
– When financial institutions shut down, the economy suffers
• Suppose you and your friends decide to start a bank
• You and your friends put $1,000 of your own money in the business.
– This is called capital
• You borrow $39,000.
– These are your liabilities
• You lend $40,000.
– That is, you buy $40,000 in assets
• Your leverage ratio = assets/capital = 40
• Suppose your assets then increase in value by
• $400
– a mere +1%
• The return on your capital is +40%!!!
• This is the magic of leverage
• But the magic of leverage cuts both ways
• If your assets decrease in value by $1,000 (or, a mere -2.5%) to $39,000,
you have just enough money to repay the $39,000 you’d borrowed
• So, after repaying your debts, you’ll have nothing left. You will lose all
your capital (or, a loss of -100%)
Opportunities and Dangers
Chapter 20 of Macroeconomics, 9th edition, by N. Gregory Mankiw
• The heavy reliance on leverage by financial institutions at the time of the
Great Recession meant that many such institutions became insolvent when
home prices began to fall
Falling confidence
• Some bank deposits are insured by the government
• But not all
• As banks and other financial institutions faced the threat of insolvency,
many lenders withdrew their deposits (a run)
• This reduced the ability of businesses to get loans for business projects
• Troubled financial institutions also had to sell their assets (loans) at fire
sale prices to get cash to repay fleeing lenders
– Banks use short-term deposits to give long-term loans
– When short-term deposits dry up for troubled banks, they are
forced to sell their long-term loans (to less troubled financial
institutions) at fire sale prices
• But the fire sale of assets reduces asset prices
• And, as we saw before, this fall in asset prices can make many financial
institutions, that are otherwise healthy, insolvent
• In this way, trouble spreads like infectious disease
• Moreover, if the number of financial institutions is small, each will have
lots of financial dealings with the others
• In that case, if one institution becomes insolvent, the others would also be
hurt and may themselves become insolvent
Falling Confidence: Measuring it
5

The TED Spread is the interest rate on 3-month interbank loans minus the interest
rate on 3-month Treasury bills. Lenders will not lend to risky borrowers unless
they get a high interest rate. So, the TED Spread rises when lending to banks is
considered particularly risky.
Credit Crunch
• With spreading insolvency shutting down one financial institution after
another, and falling confidence causing depositors to take money out of
financial institutions, would-be borrowers—even those with profitable
investment projects—would have trouble getting loans
• During the Great Recession, loans for home buyers dried up almost
completely, as it became clear that home prices do not always go up
Recession
• Many households were unable to borrow money to buy homes or to even
buy simple things
• Many businesses were unable to borrow money to build new factories or
buy machines, furniture, etc.
• So, aggregate planned expenditure fell
• A recession began
• GDP fell
• Unemployment rose
• Officially the economy began to recover in June 2009
• But in reality, that recovery has been very weak
Opportunities and Dangers
Chapter 20 of Macroeconomics, 9th edition, by N. Gregory Mankiw
A vicious circle
• A recession sets off a vicious circle
• Businesses fail and can’t repay their loans
• This further intensifies the insolvency of financial institutions, which had
helped cause the recession in the first place
• As people lose their jobs, they default on their debts, again adding to the
vicious circle.
CASE STUDY: WHO IS TO BLAME FOR THE CRISIS OF 2008-2009?
• Possible culprits include:
– The Federal Reserve: it may have kept interest rates too low for
too long after the 2001 recession, thereby fueling the housing
bubble
– Home buyers: they were too stupid to realize that home prices
could fall at some point and that they’d be better off renting
– Mortgage brokers: knowing that they could sell to investment
banks the loans they’d made—and being greedy and unprincipled
—they paid no attention to loan quality
– Investment banks: they were greedy and unprincipled enough to
package the mortgage loans and sell them to gullible buyers (such
as pension funds) who believed what the rating agencies said
about the mortgage loan packages
– Rating agencies: they gave high grades to mortgage assets that
later turned out to be highly risky.
• Maybe they were just stupid.
• Others say they were greedy for the investment banks’
6
• business and did not want to make them angry.
– Regulators: government regulators were not paying any attention
to the rampant misbehavior of the private sector.
• These regulatory bodies were often underfunded.
• There was a general ideology that hated regulation.
– Government policy makers: for decades, politicians in both the
Republican and Democratic parties sought to use government
policies to encourage home ownership over renting.
• This may have partially fed the home price bubble
POLICY RESPONSES TO A CRISIS
• Policy makers used many tools to fight the crisis:
– Conventional fiscal policy
– Conventional monetary policy
– Central bank’s lender-of-last-resort role
– Injections of government funds
• Conventional fiscal policy
– Taxes were cut
– Government spending was increased
– But this meant increased budget deficits, which would make
already high government debt even higher and, therefore, raise the
possibility of a government debt crisis
• Conventional monetary policy
– Short-term nominal interest rates were cut till they reached zero
– But nominal interest rates cannot be reduced below zero
• Central bank’s lender-of-last-resort role
– Banks take short-term deposits from savers and lend money for
long-term business projects
– So, if falling confidence leads to a sudden withdrawal of deposits,
even a solvent bank would face a liquidity crisis
– The bank may have to sell its assets at fire sale prices, which could
crash asset prices, and turn the liquidity crisis into an insolvency
crisis
• Central bank’s lender-of-last-resort role
Opportunities and Dangers
Chapter 20 of Macroeconomics, 9th edition, by N. Gregory Mankiw
– A central bank could prevent such a dire outcome by printing
money and lending it to banks that face a liquidity crisis
• When the central bank makes loans when nobody else would, it is acting
as a lender of last resort
• Central bank’s lender-of-last-resort role
– During the Great Recession, the Fed made lots of such loans, not
only to banks, but to other financial institutions that faced liquidity
crises
• These institutions are called shadow banks because they take short-term
deposits and make long-term loans, just like banks
• Example: money market mutual funds. Fed became a lender of last resort
to these funds, when depositors fled
• Injections of government funds
– When borrowers default on their bank loans, a bank may have to
shut down, in which case its depositors would lose their money
– That could have ripple effects because the depositors would cut
back on their spending plans
– The FDIC insures bank deposits up to a limit.
• This limit was raised from $100k to $250k in 2008
– This reduces the adverse ripple effects of bank failure
• Injections of government funds
– But the FDIC does not insure all deposits at a failed bank.
– Therefore, some adverse ripple effects could still occur
– When those ripple effects are likely to be large enough, the bank is
called too big to fail and the government uses its money to rescue
it
• Injections of government funds
– Moreover, if it becomes impossible for businesses to borrow
money to finance their projects— especially somewhat risky ones
—business investment spending could crash, causing a recession
– In such a case, the government could use its funds to directly lend
money for such projects
• Injections of government funds
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 – Governments may also use their funds to invest money into a bank
to enable it to keep lending even when depositors have withdrawn
their deposits
– The hope is that the crisis is temporary and that the government
would get its money back when the crisis ends and depositors
return
• Injections of government funds
o The use of government funds to bail out the financial sector is
obviously risky because the government may not get its money
back
o Moreover, if financial institutions know that the government
would always rescue too-big-to-fail firms, they would have
incentives
• to take huge risks (moral hazard) and
• to become large just to become TBTF
• Injections of government funds
– However, despite the downside of using taxpayer funds to prop up
the financial industry, it may be necessary to do so in order to
avoid a huge financial catastrophe
POLICIES TO PREVENT A CRISIS
Policies to Prevent a Crisis
• There are no easy ways to prevent financial crises. They will definitely
happen again and again.
• However, here are a few ideas on prevention:
– Pay more attention to shadow banks
– Try to make financial institutions smaller
– Force banks to reduce risky lending
– Toughen up the enforcement of regulations
– Take a macro view of regulation
Prevention: Shadow Banks
• Commercial banks’ deposits are insured by the FDIC
• This could induce these banks to take huge risks
Opportunities and Dangers
Chapter 20 of Macroeconomics, 9th edition, by N. Gregory Mankiw
– If the risks succeed, the bank keeps the gains
– If the risks fail, the taxpayer takes the losses
• To avoid this, commercial banking is heavily regulated
• As a result, the commercial banking sector behaved very well during the
crisis of 2008-09
• The bulk of bad behavior came from the shadow banking sector, which is
only lightly regulated
– Investment banks, hedge funds, insurance companies, private equity
funds, etc.
• The obvious lesson is to treat the shadow banks just like regular banks:
insure the depositors, but regulate the shadow bankers
• One way to regulate these financial institutions is to require them to hold
more capital (owners’ equity) and less leverage
– When more of the owners’ money is at stake, these institutions
may take more sensible risks
Prevention: Smaller Wall Street
• No financial institution should be so vital to the financial system that it
becomes too big to fail
• Such an institution would be tempted to take big risks because
– If the risk succeeds, the managers make money
– If the risk fails, the taxpayer will come to the rescue
• If the financial system is dominated by just a few firms, they are likely to
be deeply interconnected
• In such a situation, the failure of even one firm may lead to big losses in
all firms, thus making each firm TBTF
• So, the financial system needs moderately sized firms, and lots of them
• So, mergers and acquisitions among financial firms need to be discouraged
• Bigger firms should be required to have more capital (owners’ equity) so
that they take sensible risks only
• On the other hand, bigness has the advantage of economies of scale
Prevention: Safer Wall Street
• Apart from higher capital requirements, the financial system could be
made safer by requiring commercial banks—whose deposits are
8
 guaranteed by the FDIC—from trading in complex assets such as
derivatives (Volcker Rule)
• Derivatives should be traded in exchanges, so that regulators can have
better information
Prevention: Tougher Regulators
• The government’s regulators clearly failed in
• doing their job
• The numerous regulatory agencies could be consolidated into a smaller
number
• New regulatory agencies have been set up in the US to watch the credit
rating agencies, the treatment of consumers of financial products, and
coordination of regulators
Prevention: Macroprudential Regs
• Traditionally, the government’s regulation of the financial sector has been
microprudential – Focused on what an individual financial institution
• needed to do to reduce the risk of its collapse
• Today, financial regulation is also
• macroprudential
– Focused on what the economy as a whole needed to do to reduce
the risk of financial crisis
• Example of a macroprudential policy that could reduce the risk of bubbles
in the housing market:
– require homebuyers to pay a higher down payment when home
prices rise
– this would make it harder for people to buy homes when home
prices rise, which would keep home prices from rising too quickly
Case Study: Europe’s Sovereign Debt Crisis
• The debts incurred by European governments had been widely considered
safe
• Consequently, lenders had charged very low interest rates when lending to
those governments
Opportunities and Dangers
Chapter 20 of Macroeconomics, 9th edition, by N. Gregory Mankiw
• But things changed in Greece in 2010
• In 2010, the Greek government’s debt had risen to 116 percent of GDP,
which was twice the European average
• It was revealed that the Greek government had been misreporting its
finances to keep lenders happy
• Fears of default caused the price of Greece’s government bonds to fall.
Lenders began asking for 100 percent in interest.
• Banks in other European countries such as Germany and France had
loaned money to the Greek government in the past by buying
• Greece’s government bonds
• With the fall in the price of those bonds, the banks faced the threat of
insolvency
– Remember what you learned in Ch. 4
• This could cause a financial crisis outside Greece
• So, other European countries got together and arranged a bailout for the
Greek government
• The idea was that the Greek government would use the money provided by
other countries to repay its debts
• This would stabilize the price of Greek government bonds and prevent
European banks outside Greece from failing
• Case Study: Europe’s Sovereign Debt
• Crisis
• As a condition for the bailout, the Greek government was forced to cut
spending and raise taxes
• The idea was that this would reduce the Greek government’s borrowing
and gradually return Greece to normality
• Greece is a member of the European Monetary Union
• Had Greece defaulted on its government debt, it would have been forced to
leave the Eurozone and return to using its old currency, the Drachma
• So far, the bailout has worked and Greece is still in the Eurozone
• However, the European countries that bailed out Greece resent having had
to pay to keep Greece in the Eurozone
• It is still not clear whether Greece’s budgetary
9
• problems have been solved

Conclusion
• The financial system is fragile and crisis prone
• But it is a big help when it works well
• So it needs to be kept in working condition
• This requires regulators to watch it carefully all the time for signs of
trouble
• At times, bailouts may be needed even though people may hate bailing out
the financial sector

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Opportunities and Dangers
Chapter 20 of Macroeconomics, 9th edition, by N. Gregory Mankiw