Global Financial

Crisis
Dr. Nisful Laila, SE., M.Com.
In this section, you will learn:

a) Common features of financial crises

b) How financial crises can be self-perpetuating
c) Various policy responses to crises
d) About historical and contemporary crises, including the
U.S. financial crisis of 2007-2009
e) How capital flight often plays a role in financial crises
affecting emerging economies
Common features of financial crises (1)

 Asset price declines

• involving stocks, real estate, or other assets
• may trigger the crisis
• often interpreted as the ends of bubbles

 Financial institution insolvencies

• a wave of loan defaults may cause bank failures
• hedge funds may fail when assets bought with borrowed funds
lose value
• financial institutions interconnected,
so insolvencies can spread from one to another
Common features of financial crises (2)

 Liquidity crises
• if its depositors lose confidence, a bank run depletes the
bank’s liquid assets
• if its creditors have lost confidence, an investment bank may
have trouble selling commercial paper to pay off maturing
debts
• in such cases, the institution must sell illiquid assets at “fire
sale” prices, bringing it closer to insolvency
Financial crises and aggregate demand (1)

 Falling asset prices reduce aggregate demand

• consumers’ wealth falls
• uncertainty makes consumers and firms postpone
spending
• the value of collateral falls, making it harder for firms and
consumers to borrow
 Financial institution failures reduce lending
• banks become more conservative since more uncertainty
over borrowers’ ability to repay
Financial crises and aggregate demand (2)

 Credit crunch: a sharp decrease in bank lending

• may occur when asset prices fall and financial institutions
fail
• forces consumers and firms to reduce spending
 The fall in agg. demand worsens the financial crisis
• falling output lower firms’ expected future earnings,
reducing asset prices further
• falling demand for real estate reduces prices more
• bankruptcies and defaults increase, bank panics more
likely

Once a crisis starts, it can sustain itself for a long time

Financial rescues: Emergency loans

 The self-perpetuating nature of crises gives policymakers a

strong incentive to intervene to try to break the cycle of crisis
and recession.
 During a liquidity crisis, a central bank may act as a lender of
last resort, providing emergency loans to institutions to
prevent them from failing.
 Discount loan: A loan from the Federal Reserve to a bank,
approved if Fed judges bank solvent and with sufficient
collateral
Financial rescues: “bailouts”

 Govt may give funds to prevent an institution from

failing, or may give funds to those hurt by the failure
 Purpose: to prevent the problems of an insolvent
institution from spreading
 Costs of “bailouts”
 direct: use of taxpayer funds
 indirect: increases moral hazard, increasing likelihood
of future failures and need for future bailouts
“Too big to fail”

 The larger the institution, the greater its links to other

institutions
• Links include liabilities, such as deposits or borrowings
 Institutions deemed too big to fail (TBTF)
if they are so interconnected that their failure would
threaten the financial system
 TBTF institutions are candidates for bailouts. Example:
Continental Illinois Bank (1984)
Risky Rescues

 Risky loans: govt loans to institutions that may not be repaid

• institutions bordering on insolvency
• institutions with no collateral
• Example: Fed loaned $85 billion to AIG (2008)
 Equity injections: purchases of a company’s stock by the
govt to increase a nearly insolvent company’s capital when
no one else is willing to buy the company’s stock
• Controversy: govt ownership not consistent with free
market principles; political influence
The U.S. financial crisis of 2007-2009

 Context: the 1990s and early 2000s were a time of

stability, called “The Great Moderation”
 2007-2009:
• stock prices dropped 55%
• unemployment doubled to 10%
• failures of large, prestigious institutions like Lehman
Brothers
The subprime mortgage crisis

 2006-2007: house prices fell, defaults on subprime

mortgages, huge losses for institutions holding subprime
mortgages or the securities they backed
• Huge lenders Ameriquest and New Century Financial
declared bankruptcy in 2007
 Liquidity crisis in August 2007 as banks reduced lending
to other banks, uncertain about their ability to repay
• Fed funds rate increased above Fed’s target
Disaster in September 2008 (1)

After 6 calm months, a financial crisis exploded:

 Fannie Mae, Freddie Mac
nearly failed due to a growing wave of mortgage defaults, U.S. Treasury
became their conservator and majority shareholder, promised to cover
losses on their bonds to prevent a larger catastrophe
 Lehman Brothers
declared bankruptcy, also due to losses on MBS
• Lehman’s failure meant defaults on all Lehman’s borrowings from
other institutions, shocked the entire financial system
Disaster in September 2008 (2)

 American International Group (AIG)

about to fail when the Fed made $85b emergency loan to prevent
losses throughout financial system
 The money market crisis
Money market funds no longer assumed safe, nervous depositors
pulled out (bank-run style) until Treasury Dept offered insurance
on MM deposits
 Flight to safety
People sold many different kinds of assets, causing price drops,
but bought Treasuries, causing their prices to rise and interest
rates to fall to near zero
An economy in freefall

 Falling stock and house prices reduced consumers’ wealth,

reducing their confidence and spending.
 Financial panic caused a credit crunch;
bank lending fell sharply because:
• banks could not resell loans to securitizers
• banks worried about insolvency from further losses
 Previously “safe” companies unable to sell commercial paper to
help bridge the gap between production costs and revenues
An economy in freefall

 Falling stock and house prices reduced consumers’ wealth,

reducing their confidence and spending.
 Financial panic caused a credit crunch;
bank lending fell sharply because:
• banks could not resell loans to securitizers
• banks worried about insolvency from further losses
 Previously “safe” companies unable to sell commercial paper to
help bridge the gap between production costs and revenues
The policy response (1)

 TARP – Troubled Asset Relief Program (10/3/2008)

• $700 billion to rescue financial institutions
• initially intended to purchase “troubled assets” like
subprime MBS
• later used for equity injections into troubled institutions
• result: U.S. Treasury became a major shareholder in
Citigroup, Goldman Sachs, AIG, and others
 Federal Reserve programs to repair commercial paper market,
restore securitization, reduce mortgage interest rates
The policy response (2)

 Monetary policy:
Fed funds rate reduced from 2% to near 0% and has remained
there
 The fiscal stimulus package (February 2009):
 Tax cuts and infrastructure spending costly nearly 5% of
GDP
 Congressional Budget Office estimates it boosted real GDP
by 1.5 – 3.5%
The aftermath (1)

 The financial crises eases

• Dow Jones stock price index rose 65% from 3/2009 to
3/2010
• Many major financial institutions profitable in 2009
• Some taxpayer funds used in rescues will probably never
be recovered, but these costs appear small relative to the
damage from the crisis
 percent of labor force 10

2
4
6
8
Dec-2007
Jan-2008
Feb-2008
Mar-2008
Apr-2008
May-2008
The aftermath (2)

Jun-2008
Jul-2008
Jul-2008
rate (left scale)
unemployment

Aug-2008
Sep-2008
Oct-2008
Nov-2008
Dec-2008
Jan-2009
Feb-2009
of

Mar-2009
(right scale)

Apr-2009
unemployment
average duration

May-2009
Jun-2009
Jul-2009
Aug-2009
15
18
21
24
27

weeks
The aftermath (3)

 Constraints on macroeconomic policy

• Huge deficits from the recession and stimulus constrain
fiscal policy
• Monetary policy constrained by the zero-bound problem:
even a zero interest rate not low enough to stimulate
aggregate demand and reduce unemployment
 Moral hazard
• The rescues of financial institutions will likely increase future
risk-taking and the need for future rescues
Reforming financial regulation: Regulating nonbank financial
institutions

 Nonbank financial institutions (NBFIs) do not enjoy federal

deposit insurance, so were less regulated than banks
 Since the crisis, many argue for bank-like regulation of NBFIs,
including:
• greater capital requirements
• restrictions on risky asset holdings
• greater scrutiny by regulators
 Controversy: more regulation will reduce profitability and
maybe financial innovation
Reforming financial regulation: Addressing “too big to fail”

 Policymakers have been rescuing TBTF institutions since

Continental Illinois in 1984.
 Since the crisis, proposals to
• limit size of institutions to prevent them from becoming TBTF
• limit scope by restricting the range of different businesses
that any one firm can operate
 Such proposals would reverse the trend toward mergers and
conglomeration of financial firms, would reduce benefits from
economics of scale & scope
Reforming financial regulation: Discouraging excessive risk-
taking

 Most economists believe excessive risk-taking is a key cause of

financial crises.
 Proposals to discourage it include:
• requiring “skin in the game” – firms that arrange risky
transactions must take on some of the risk
• reforming ratings agencies, since they underestimated the
riskiness of subprime MBS
• reforming executive compensation to reduce incentive for
executives to take risky gambles in hopes of high short-run
gains
Reforming financial regulation: Changing regulatory
structure

 There are many different regulators, though not by any

logical design.
 Many economists believe inconsistencies and gaps in
regulation contributed to the 2007-2009 financial
crisis.
 Proposals to consolidate regulators or add an agency
that oversees and coordinates regulators.
Financial crises in emerging economies

 Emerging economies: middle-income countries

 Financial crises more common in emerging economies than
high-income countries, and often accompanied by capital flight.
 Capital flight: a sharp increase in net capital outflow that
occurs when asset holders lose confidence in the economy,
caused by
• rising govt debt & fears of default
• political instability
• banking problems
Capital flight

 Interest rates rise sharply when people sell bonds

 Exchange rates depreciate sharply when people sell the
country’s currency
 Contagion: the spread of capital flight from one country to
another
• occurs when problems in Country A make people worry that
Country B might be next,
so they sell Country B’s assets and currency, causing the
same problems there
• like a bank panic
Capital flight and financial crises

 Banking problems can trigger capital flight

 Capital flight causes asset price declines, which worsens
a financial crisis
 High interest rates from capital flight and loss in
confidence cause aggregate demand, output, and
employment to fall, which worsens a financial crisis
 Rapid exchange rate depreciation increases the burden
of dollar-denominated debt in these countries
The International Monetary Fund

 International Monetary Fund (IMF):

an international institution that lends to countries experiencing
financial crises
• established 1944
• the “international lender of last resort”
 How countries use IMF loans:
• govt uses to make payments on its debt
• central bank uses to make loans to banks
• central bank uses to prop up its currency in foreign exchange
markets
Summary (1)

 Financial crises begin with asset price declines, financial

institution failures, or both. A financial crisis can produce a
credit crunch and reduce aggregate demand, causing a
recession, which reinforces the financial crisis.
 Policy responses include rescuing troubled institutions.
Rescues range from riskless loans to institutions with liquidity
crises, giveaways, risky loans, and equity injections.
Summary (2)

 Financial rescues are controversial because

of the cost to taxpayers and because they increase moral
hazard: firms may take on more risk, thinking the government
will bail them out if they get into trouble.
 Over 2007-2009, the subprime mortgage crisis evolved into a
broad financial and economic crisis in the U.S. Stock prices
fell, prestigious financial institutions failed, lending was
disrupted, and unemployment rose to near 10%.
Summary (3)

 Financial reform proposals include: increased regulation of

nonbank financial institutions; policies to prevent institutions from
becoming too big to fail; rules that discourage excessive risk-
taking; and new structures for regulatory agencies.
 Financial crises in emerging market economies typical include
capital flight and sharp decreases in exchange rates, which can be
caused by high government debt, political instability, and banking
problems. The International Monetary Fund can help with
emergency loans.
Q&A