Econ 2035 Chapter 16 Book Notes

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major disruptions in financial markets characterized by sharp declines in asset prices and firm failures

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Financial crises

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A well-functioning financial system solves asymmetric information problems so that capital is...

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allocated to its most productive uses

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these asymmetric information problems, which act as a barrier to efficient allocation of capital

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financial frictions

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occurs when information flows in financial markets experience a particularly large disruption, with the result that financial frictions increase sharply and financial markets stop functioning

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financial crises

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Financial Crisis can begin in two ways

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credit boom or bust

general increase in uncertainty caused by failures of major financial institutions

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when an economy introduces new types of loans or other financial products

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financial innovation

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The seeds of a financial crisis are often sown when an economy participates in...

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financial innovation or financial liberalization

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the elimination of restrictions on financial market and institutions

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financial liberalization

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financial institutions go on a lending spree

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credit boom

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Financial liberalizations can lead to...

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credit booms

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Credit booms eventually outstrip the ability of institutions to...

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screen and monitor credit risks, leading to overly risky lending

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Government safety nets weaken...

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market discipline

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Government safety nets increase...

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the moral hazard incentive for banks to take on greater risk than they otherwise would

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financial institutions cut back on their lending to borrower spender

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deleveraging

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When financial institutions stop collecting information and making loans, financial frictions...

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rise, limiting the financial system's ability to address the asymmetric information problems of adverse selection and moral hazard

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As loans become scarce, borrower-spenders are no longer able...

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to fund their productive investment opportunities and they decrease their spending, causing economic activity to contract

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their values based on realistic expectations of the assets' future income stream

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fundamental economic values

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The rise of asset prices about their fundamental economic values

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asset-price bubble

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When the bubble bursts and asset prices realign with fundamental economic values...(3)

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real estate prices tumble

companies see their net worth decline

the value of collateral these companies can pledge drops

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the difference between assets and liabilities

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net worth

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U.S. financial crises have usually begin in...

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periods of high uncertainty

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Deteriorating balance sheets and tougher business conditions lead some financial institutions to...

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insolvency

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What is insolvency?

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When net worth becomes negative

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Uncertainty about the health of the banking system in general can lead to..

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runs on banks, both good and bad

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banks sell off their assets quickly to raise the necessary funds

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fire sales

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Fire sales of assets may cause...

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prices to decline so much more that more banks become insolvent

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Public and private authorities shut down...

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insolvent firms and sell them off or liquidate them

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occurs when a substantial unanticipated decline in the price level sets in, leading to a further deterioration in firms' net worth because of the increased burden of indebtness

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debt deflation

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The substantial decline in real net worth of borrowers caused by a sharp drop in the price level creates...

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an increase in adverse selection and moral hazard problems for lenders.

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Three central factors caused the 2007-2009 Financial Crises:

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Financial innovation in mortgage markets

agency problems in mortgage markets

the role of asymmetric information in the credit-rating process

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paid out income streams from a collection of underlying assets, designed to have particular risk characteristics that appealed to investors with differing preferences

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structured credit problems

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financial instruments whose payoffs are link to previously issues securities, also were an important source of excessive risk taking

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financial derivatives

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a financial derivative that provides payments to holders of bonds if they default

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credit default swap

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rate the quality of debt securities in terms of the probability of default

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credit-rating agencies

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Credit rating agencies contributed to...

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asymmetric information

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The impact of the crisis was most evident in five key areas:

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1. the U.S. residential housing market

2. financial institutions' balance sheets

3. the shadow banking system

4. global financial markets

5. the headline grabbing failures of major firms in the financial industry

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short-term borrowing that, in effect, uses assets like mortgage backed securities

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repurchase agreements

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authorized the Treasury to spend $700 billion purchasing subprime mortgage assets from troubled financial institutions or to inject capital into these institutions

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Troubled Asset Relief Program

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focuses on the safety and soundness of individual financial institutions

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microprudential supervision

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A focus on micro prudential supervision is..

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not enough to prevent financial crises.

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focuses on the safety and soundness of the financial system in the aggregate

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macroprudential supervision

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a feedback loop resulted from a boom in issuing credit, which led to higher asset prices, which resulted in higher capital buffers at financial institutions, which supported further lending in the context of unchanging capital requirements, which then raised asset prices further, and so on

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leverage cycle

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these firms are subject to additional regulation by the Federal Reserve, which includes higher capital standards and stricter liquidity requirements

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systematically important financial institutions

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Three approaches to solving the too-big-to-fail problem:

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Break Up Large Systematically Important Financial Institutions

Higher Capital Requirements

Leave It To Dodd Frank

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One way to shrink overly large institutions is to reimpose...

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the restrictions that were in place before Glass-Stegall was repealed, and thereby forcing these large SIFIs to break up their different activities into smaller, cohesive companies

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With higher capital, not only will institutions have a larger buffer they will also have...

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more to lose, reducing moral hazard

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Regulators are adopting regulations aimed at modifying...

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compensation in the financial services industry to reduce risk taking.

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A major gap in the Dodd-Frank bill is that it does not...

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address privately owned, government-sponsorsd enterprises, such as Fannie Mae and Freddie Mac

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To prevent a crisis from happening again a government might: 4

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1. Fully privatize GSEs by taking away their government sponsorship, thereby removing the implicit backing for their debt.

2. Completely nationalize them by taking away their private status and making them government agencies.

3. Leave them as privately owned GSEs, but strengthen regulations to restrict the amount of risk they take and to impose higher capital standards.

4. Leave them as privately owned GSEs, but force them to shrink dramatically so that they no longer expose the taxpayer to huge losses or pose a systematic risk to the financial system when they fail.

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The inaccurate ratings provided by credit-rating agencies helped promote...

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risk taking throughout the financial system and led to investors not having the information they needed to make informed choices about their investments

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If new regulations choke off financial innovation that can benefit both households and businesses,...

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future economic growth will suffer