IBA, Main Campus

Financial Institutions & Markets

Why Do Financial Crises Occur &

why are they so damaging

lecture 7

By
ysaudagar@iba.edu.pk
M. Yousuf Saudagar
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 Preview
• Financial crises are major disruptions in financial markets characterized by
sharp declines in asset prices and firm failures.
• Beginning in August of 2007, defaults in the mortgage market for subprime
borrowers sent a shudder through the financial markets, leading to the
worst U.S. financial crisis since the Great Depression.
• Alan Greenspan, former Chairman of the Fed, described the 2007–2009
financial crisis as a “once-in-a-century credit tsunami.”
• Wall Street firms and commercial banks suffered losses amounting to
hundreds of billions of dollars. Households and businesses found they had
to pay higher rates on their borrowings—and it was much harder to get
credit.
• World stock markets crashed, with U.S shares falling by as much as half
from their peak in October 2007. Many financial firms, including
commercial banks, investment banks, and insurance companies, went belly
up.
• A recession began in December 2007. By the fall of 2008, the economy2was
in a tailspin.
What Is a Financial Crisis?

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 What is Financial Crisis
• A financial crisis is a situation where the value of assets drop rapidly and
is often triggered by a panic or a run on banks.
• When financial instruments and assets decrease significantly in value,
businesses have trouble meeting their financial obligations, and
financial institutions lack sufficient cash or convertible assets to fund
projects and meet immediate needs.
• Types of Financial crisis:
a) Currency crisis is the situation where doubts exist if the central
bank of a country has enough foreign exchange for maintaining the
country's fixed exchange rate.
b) Banking crisis occurs when many banks in a country are in serious
solvency or liquidity problems at the same time because there are
all hit 
c) Speculative Bubbles is a sharp, steep rise in prices that is fueled by
market sentiment and momentum, more than underlying 4
 Great depression

The crash was a result of an unsustainable boom in share

prices in the preceding years, which was caused by the
irrational exuberance of investors, buying shares on the margin
& over-confidence in the sustainability of economic growth
Overvalued Stocks, Low Margin Requirements; Poor Banking
Structures; Few federal restrictions
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 Black monday

Heightened hostilities in the Persian Gulf, a fear of higher interest rates, a five-year bull
market without a significant correction, and the introduction of computerized
trading have all been named as potential causes of the crash.
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 dotcom bubble

The 2000 stock market crash was a direct result of the bursting of the dotcom bubble.
It popped when a majority of the technology startups that raised money and went public
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 Sub prime mortgage crisis

The seeds of the financial crisis were planted during years of rock-bottom interest
rates and loose lending standards that fueled a housing price bubble in the U.S &
elsewhere. The collapse was fueled by low interest rates, easy credit, insufficient
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 Learning outcomes
• Why do these financial crises occur?

• Why have financial crises been so prevalent throughout U.S. history, as well
as in so many other countries, and what insights do they provide on the
current crisis?
• Why are financial crises almost always followed by severe contractions in
economic activity?

• We will examine these questions by developing a framework to understand

the dynamics of financial crises.

• We will make use of agency theory, the economic analysis of the effects of
asymmetric information (adverse selection and moral hazard) on financial
markets and the economy, to see why financial crises occur and why they
have such devastating effects on the economy.

• We will then apply the analysis to explain the course of events in a number
of past financial crises throughout the world, including the most recent
subprime crisis. 9
 Agency Theory & Definition of a Financial Crisis
• Academic finance literature calls the analysis of how asymmetric
information problems can generate adverse selection and moral
hazard problems called agency theory. Agency theory provides the
basis for our definition of a financial crisis.
• Asymmetric information problems act as barrier to financial
markets channeling funds efficiently from savers to households and
firms with productive investment opportunities and are often
described by economists as financial frictions .
• When financial frictions increase, it is harder for lenders to
ascertain the creditworthiness of borrowers. They need to charge a
higher interest rate to protect themselves against the possibility
default, which leads to a higher credit spread .
• When the credit spreads increase sharply and information flows
experience a particularly large disruption, financial markets stop
functioning, the economic activity collapses and financial crisis10
 Dynamics of Financial Crises

Financial crises have progressed in two

and sometimes three stages.

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 stage One: Initial Phase
• Now that we understand what a financial crisis is, we’ll first explore
the dynamics of financial crises in advanced and emerging
economies, that is, how these financial crises unfold over time.
• As earth-shaking and headline-grabbing as the most recent financial
crisis of 2007-08 was, it was only one of a number of financial crises
that have hit industrialized countries like US over the years.
• These experiences have helped economists uncover insights on
present day economic turmoil.
• Financial crises can begin in several ways: Credit and asset-price
booms and busts or a general increase in uncertainty caused by
failures of major financial institutions.
• To understand how these crises have unfolded, refer to figure below,
a diagram that traces out the stages and sequence of events in
advanced economies.
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 Why Do Financial Crises Occur and Why Are They So Damaging to the Economy?

Note: Solid arrows in Stages 1 & 2 trace the sequence of events in a typical financial crisis; the dotted 14
arrows
show the additional set of events that occur if the crisis develops into a debt deflation.
 Stage One: Initial Phase

Financial crises can begin in several ways:

a) Credit booms and busts
b) Asset-price booms and busts
c) A general increase in uncertainty caused by
failures of major financial institutions.
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 Credit Boom and Bust
• The seeds of a financial crisis are often sown when an economy
introduces new types of loans or other financial products, known as
financial innovation, or when countries engage in financial
liberalization, the elimination of restrictions on financial markets and
institutions.
• In the long run, financial liberalization promotes financial
development and encourages a well-run financial system that
allocates capital efficiently.
• Financial liberalization also has a dark side: in the short run, it can
prompt FIs to go on a lending spree, called a credit boom.
• Unfortunately, lenders may not have the expertise, or incentives, to
manage risk appropriately in these new lines of business.
• Even with proper management, credit booms eventually outstrip the
ability of institutions—and government regulators—to screen and
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monitor credit risks, leading to overly risky lending.
 Credit Boom and Bust
• Government safety nets such as deposit insurance weaken market
discipline & increase the moral hazard incentive for banks to take on
greater risk than they otherwise would.
• Since depositors know that government insurance protects them
from losses, they will supply even undisciplined banks with funds.
• Banks can make risky, high-interest loans, knowing that they’ll walk
away with nice profits if the loans are repaid, and leave the bill to
the taxpayer if the loans go bad and the bank goes under.
• Eventually, this risk taking comes home to roost. Losses on loans
begin to mount and the drop in the value of the loans falls relative to
liabilities, thereby driving down the net worth of banks. With less
capital, these financial institutions cut back on their lending, a
process called deleveraging.
• Furthermore, with less capital, banks & other financial institutions
become riskier, causing depositors & other potential lenders to these
institutions to pull out their funds. 17
 Credit Boom and Bust
• Fewer funds mean fewer loans and a credit freeze. The lending boom
turns into a lending crash.
• When FIs’ balance sheets deteriorate and they deleverage and cut
back on their lending, no one else can step in to collect this
information and make these loans.
• The ability of the financial system to cope with the asymmetric
information problems of adverse selection and moral hazard is
therefore severely hampered (Deterioration in Fis’ Balance Sheet).
• As loans become scarce, firms are no longer able to fund their
attractive investment opportunities; they decrease their spending
and economic activity contracts.

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 Asset Price Boom and Bust
• Prices of assets such as shares and real estate can be driven well
above their fundamental economic values by investor psychology
(dubbed “irrational enthusiasm”).
• The rise of asset prices above their fundamental economic values is
an asset-price bubble.
• Asset-price bubbles are often also driven by credit booms, in which
the large increase in credit is used to fund purchases of assets,
thereby driving up their price.
• When the bubble bursts & asset prices realign with fundamentals,
stock prices tumble and companies see their net worth drop.
• Lenders look suspiciously at firms because those firms are more
likely to make risky investments, a problem of moral hazard.

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 Asset Price Boom and Bust
• Lending contracts, as borrowers become less creditworthy from the
fall in net worth (Second factor, Asset Price Decline, in the top row.
• As seen earlier, asset price bust can also deteriorate FI’s balance
sheets, which causes them to deleverage, steepening the decline in
economic activity.

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 Increase in Uncertainty
• US financial crises in the past have usually begun in periods of high
uncertainty, such as just after the start of a recession, a crash in the
stock market, or the failure of a major financial institutions.
• Crises began after the failure of Ohio Life Insurance and Trust in 1857;
Jay Cooke in 1873; Grant and Ward in 1884; the Knickerbocker Trust
in 1907; the Bank of the United States in 1930; Bear Stearns, Lehman
Brothers & AIG in 2008.
• With information hard to come by in a period of high uncertainty,
adverse selection and moral hazard problems increase, reducing
lending and economic activity (as shown by the arrow pointing from
the last factor, Increase in Uncertainty, in the top row).

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Stage two: Initial Phase

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 Stage Two: Banking Crisis
• Deteriorating balance sheets & tougher business conditions lead to
insolvency of some FIs, when net worth becomes negative.

• Unable to pay off depositors or other creditors, some banks go out of

business. If severe enough, these factors can lead to a bank panic, in
which multiple banks fail simultaneously.

• To understand why bank panics occur, suppose that as a result of an

adverse shock to the economy, 5% of the banks have such large
losses on their loans that they become insolvent (have a negative net
worth and so are bankrupt). Because of asymmetric information,
depositors are unable to tell whether their bank is a good bank or
one of the 5% that are insolvent.

• Depositors at bad as well as good banks think that they may not get
back 100% of their deposits & will want to withdraw them (run to the
bank), because the bank may not have enough funds left later.
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 Stage Two: Banking Crisis…cont
• This will force the bank to sell off its assets to raise funds (fire sale).
Resultantly, their prices may decline so much that bank becomes
insolvent, although in normal circumstances it would have survived.
• Failure of one bank can lead to runs on other banks, which can
cause them to fail, and the resulting contagion can then lead to
multiple bank failures and a full-fledged bank panic.
• With fewer banks operating, adverse selection and moral hazard
problems become severe in the credit markets, and the economy
spirals down further.
• Bank panics have been a feature of all U.S. financial crises during the
19th and 20th centuries until World War II, occurring every twenty
years or so-1819, 1837, 1857, 1873, 1884, 1893, 1907, and 1930.
• Eventually, authorities sift through the wreckage of the banking
system, shutting down insolvent firms and selling them off or
liquidating them. 25
 Stage Two: Banking Crisis…cont

• Uncertainty in financial markets declines, the stock market recovers

& interest rates fall. Adverse selection & moral hazard problems
diminish, and the financial crisis subsides.
• With the financial markets able to operate well again, the stage is set
for an economic recovery.
• If not, then the economies go into stage three, which is Debt
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Deflation.
Stage three: Initial Phase

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 Stage Three: Debt Deflation
• If, however, economic downturn leads to a sharp decline in prices,
the recovery process can be short-circuited.
• In this situation, a process called debt deflation occurs, wherein
substantial decline in the price level sets in, leading to a further
deterioration in firms’ net worth because of the increased burden of
indebtedness.
• In economies with moderate inflation, which characterizes most
advanced countries, many debt contracts with fixed interest rates
are typically of fairly long maturity, ten years or more.
• Because debt payments are contractually fixed in nominal terms, an
unanticipated decline in the price level raises the value of borrowing
firms’ liabilities in real terms (increases the burden of the debt) but
does not raise the real value of borrowing firms’ assets.
• The borrowing firm’s net worth in real terms (the difference
between assets and liabilities in real terms) thus declines. 28
 Stage Three: Debt Deflation
• To better understand how this decline in net worth occurs, consider
what happens if a firm in 2018 has assets of $100 M & $90 M of
long-term liabilities, so that it has $10 M in net worth. If the price
level falls by 10% in 2019, the real value of the liabilities would rise
to $99 M in 2018 dollars, while the real value of the assets would
likely remain unchanged at $100 M. The result would be that real net
worth in 2018 dollars would fall from $10 M to $1 M.
• The substantial decline in real net worth of borrowers from a sharp
drop in the price level causes an increase in adverse selection and
moral hazard problems facing lenders. Lending and economic
activity decline for a long time.

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 The Global Financial Crisis of
2007–2009

• Most economists thought that financial crises of the type

experienced during the Great Depression were a thing of the
past for advanced countries like the United States.
• Unfortunately, the financial crisis that engulfed the world in
2007–2009 proved them wrong.

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 causes of the 2007–2009 Financial Crisis
• We begin our look at the 2007–2009 financial crisis by
examining three central factors:

1. Financial innovation in mortgage markets

2. Agency problems in mortgage markets, and

3. The role of asymmetric information in the credit-

rating process.

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 Financial Innovation in the Mortgage Markets- subprime mortgages
• Before 2000, only the most credit-worthy (prime) borrowers could
obtain residential mortgages.
• Advances in computer technology and new statistical techniques,
known as data mining, however, led to enhanced, quantitative
evaluation of the credit risk for a new class of risky residential
mortgages.
• Households with credit records could now be assigned a numerical
credit score, known as a FICO score (named after the Fair Isaac
Corporation, which developed it), that would predict how likely they
would be to default on their loan payments.
• In addition, by lowering transactions costs, computer technology
enabled the bundling of smaller loans (like mortgages) into
standard debt securities, a process known as securitization. These
factors made it possible for banks to offer subprime mortgages to
borrowers with less-than-stellar credit records. 32
 Financial Innovation in the Mortgage Markets- subprime mortgages
• The ability to cheaply quantify the default risk of the underlying high-
risk mortgages and bundle them in standardized debt securities called
mortgage backed securities provided a new source of financing for
these mortgages.
• Financial innovation didn’t stop there.
• Financial engineering, the development of new, sophisticated
financial instruments, led to structured credit products that pay out
income streams from a collection of underlying assets, designed to
have particular risk characteristics that appeal to investors with
differing preferences.
• The most notorious of these products were collateralized debt
obligations (CDOs).

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 collateralized debt obligation
• Creation of a collateralized debt obligation involves a corporate
entity called special purpose vehicle (SPV), which buys a collection
of assets such as corporate bonds/loans, real estate bonds &
mortgage-backed securities. The SPV then separates the payment
streams (cash flows) from these assets into several buckets called
tranches.
• Highest-rated tranches, called super senior tranches are paid off
first, so have the least risk. This CDO is a bond that pays out cash
flows first to investors, it has the least risk & lowest interest rate.
• The next bucket of cash flows, called senior tranche, is paid out
next; the senior CDO has a little more risk and pays a higher interest
rate.
• The next tranche of payment streams, the mezzanine tranche of the
CDO, is paid out after the super senior and senior tranches and so it
bears more risk and has an even higher interest rate.
• Lowest tranche is the equity tranche; this set of cash flows are not
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 collateralized debt obligation
• If all of this sounds complicated, it is. There were even CDO2s and
CDO3s that sliced and diced risk even further, paying out the cash
flows from CDOs to CDO2s and from CDO2s to CDO3s.
• Although financial engineering has the potential benefit of
creating products and services that match investors’ risk appetites,
it too has a dark side.
• Structured products like CDOs, CDO2s, and CDO3s can get so
complicated that it can be hard to value cash flows of the
underlying assets for a security or to determine who actually owns
these assets.
• Indeed, at a speech given in October 2007, Ben Bernanke, the
chairman of the Federal Reserve, joked that he “would like to know
what those damn things are worth.” In other words, the increased
complexity of structured products can actually reduce the amount of
information in financial markets, thereby worsening asymmetric
information in the financial system and increasing the severity of35
 Agency Problems in the Mortgage Markets
• The mortgage brokers that originated the loans often did not make a
strong effort to evaluate whether the borrower could pay off the
loan, since they would quickly sell (distribute) the loans to investors
in the form of mortgage-backed securities.
• This originate-to-distribute business model was exposed to the
principal–agent problem of the type in which the mortgage brokers
acted as agents for investors (the principals) but did not have the
investors’ best interests at heart.
• Once the mortgage broker earns his or her fee, why should the
broker care if the borrower makes good on his or her payment?
• The more volume the broker originates, the more he or she makes.
• Not surprisingly, adverse selection became a major problem.
• Risk-loving investors lined up to obtain loans to acquire houses that
would be very profitable if housing prices went up, knowing they
could “walk away,” if housing prices went down. 36
 Agency Problems in the Mortgage Markets
• The principal–agent problem also created incentives for mortgage
brokers to encourage households to take on mortgages they could
not afford or to commit fraud by falsifying information on a
borrower’s mortgage applications in order to qualify them for
mortgages.
• Compounding this problem was lax regulation of originators, who
were not required to disclose information to borrowers that would
have helped them assess whether they could afford the loans.
• The agency problems went even deeper.
• Commercial and investment banks, which were earning large fees
by underwriting mortgage-backed securities and structured credit
products like CDOs, also had weak incentives to make sure that the
ultimate holders of the securities would be paid off.

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 Agency Problems in the Mortgage Markets
• Financial derivatives, financial instruments whose payoffs are linked
to (i.e., derived from) previously issued securities, also were an
important source of excessive risk taking.
• Large fees from writing financial insurance contracts called credit
default swaps, which provide payments to holders of bonds if they
default, also drove units of insurance companies like AIG to write
hundreds of billions of dollars’ worth of these risky contracts.

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 Asymmetric Information and Credit-Rating Services
• Credit-rating agencies, who rate the quality of debt securities in
terms of the probability of default, were another contributor to
asymmetric information in financial markets.
• The rating agencies advised clients on how to structure complex
financial instruments, like CDOs, at the same time they were rating
these identical products.
• The rating agencies were thus subject to conflicts of interest because
the large fees they earned from advising clients on how to structure
products they were rating meant that they did not have sufficient
incentives to make sure their ratings were accurate.
• The result was wildly inflated ratings that enabled the sale of
complex financial products that were far riskier than investors
recognized.

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