The Financial System Makes Saving

Equal Investment
• The financial system makes it easier for
lenders (those who have the saving funds) and
borrowers (those who need funds for
investment) to find each other
• Both groups benefit when the financial system
does its job well
• When the financial system fails, both groups
suffer
 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
 Sharing Risk
• 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
 Sharing Risk
• 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, a risk associated with a particular/individual
business
• But systemic risks may remain, which relates to
overall risk like recession/inflation in economy
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
Dealing With Asymmetric Information
• 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
Dealing With Asymmetric Information
• 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, borrowers face the
problem of moral hazard
Dealing With Asymmetric Information
• 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 repay for the project (moral
hazard)
Dealing With Asymmetric Information
• Government regulators and the law
enforcement system have obviously important
roles to play in dealing with adverse selection
and moral hazard
 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
 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
 Case Study: Microfinance
• 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?
 Case Study: Microfinance
• Loans were given to groups rather than
individuals
• All members of the group that took a loan
would be responsible for timely repayment
• So, a group would only admit members that
the other members knew to be sound
• In this way, the group-lending idea helped
solve the asymmetric information problem
Somehow the pipes get clogged

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
• Although each financial crisis is unique, most
financial crises share certain common
elements
1. Asset-price booms and busts
2. Insolvencies in financial institutions
3. Falling confidence
4. Credit crunch
5. Recession
6. A vicious circle
 Asset-price booms and busts
• Financial crises are often preceded by a period
of euphoria, called a speculative bubble,
during which the prices of assets rise above
their fundamental values
– The fundamental value of an asset is the price that
would prevail if people relied only on objective
analyses of the cash flows the asset is expected to
generate
 Asset-price booms and busts
• If people start buying assets not for the
expected cash flows from the asset but
because they hope to sell the asset later at a
higher price, for speculative purposes, an
asset’s price can rise above its fundamental
value
• However, such speculative bubbles inevitably
crash when euphoria ends and doubts set in
 Asset-price booms and busts
• Banks fueled the boom because they failed to do
their job of identifying irresponsible borrowers
and gave loan to sub-prime category, risky
borrowers.
• Why?
– Banks assumed that home prices would keep rising.
– Under that assumption, it would not matter if a
borrower defaulted.
– The bank would simply take the house the defaulter
had bought and sell it off at a now higher price,
thereby making a profit.
Insolvencies in financial institutions
• Eventually, home prices stopped rising and
then started to fall
• Borrowers then owed more money than the
value of the house they’d bought with the
loan, the value of houses declined as there
was no buyer for pricey houses
• Such borrowers stopped repaying their loans,
defaults started
Insolvencies in financial institutions
• 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
Insolvencies in financial institutions
• 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 under FDIC
• 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
 Falling confidence
• 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
 Falling confidence
• 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 contagious
disease
 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
 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
 Recession
• GDP fell
• Unemployment rose
• Officially the economy began to recover in
June 2009
• But in reality, that recovery has been very
weak
 A vicious circle
• A recession sets off a vicious circle
• Businesses fail and borrowers 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
Six Common Features
CASE STUDY: WHO IS TO BLAME
FOR THE CRISIS OF 2008-2009?
Case Study: Who should be blamed for
the financial 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
Case Study: Who should be blamed for
the financial crisis of 2008-2009?
– 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’
business and did not want to make them angry.
Case Study: Who should be blamed for
the financial crisis of 2008-2009?
– 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 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
 Policy Responses to a Crisis
• 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
 Policy Responses to a Crisis
• Conventional monetary policy
– Short-term nominal interest rates were cut till
they reached zero
– But nominal interest rates cannot be reduced
below zero
 Policy Responses to a Crisis
• 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
 Policy Responses to a Crisis
• Central bank’s lender-of-last-resort role
– 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
 Policy Responses to a Crisis
• 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
 Policy Responses to a Crisis
• 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
 Policy Responses to a Crisis
• 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
 Policy Responses to a Crisis
• 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
 Policy Responses to a Crisis
• Injections of government funds
– 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
 Policy Responses to a Crisis
• Injections of government funds
– The use of government funds to bail out the
financial sector is obviously risky because the
government may not get its money back
– 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
 Policy Responses to a Crisis
• 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
– 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
 Prevention: Shadow Banks
• 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.
 Prevention: Shadow Banks
• 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
 Prevention: Smaller Wall Street
• 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
 Prevention: Smaller Wall Street
• 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 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
Prevention: Macroprudential Regs
• 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
• But things changed in Greece in 2010
 Case Study: Europe’s Sovereign Debt
Crisis
• 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.
 Case Study: Europe’s Sovereign Debt
Crisis
• 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
 Case Study: Europe’s Sovereign Debt
Crisis
• 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
 Case Study: Europe’s Sovereign Debt
Crisis
• 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
 Case Study: Europe’s Sovereign Debt
Crisis
• 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
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