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36 Cards in this Set
- Front
- Back
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5 Key Functions of Financial System
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1. Mobilizing and pooling savings-reallocation of resources has positive impacts on growth (market based and intermediary based financial systems)
2. Producing information about investments-EOS 3. Monitoring investments and exerting corporate governance 4. Facilitating trading, diversification, and management of risk 5. Facilitating exchange of goods and services Overall banks are more efficient at these activities than individuals |
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2 Channels by which Financial Sector Development Reduces Poverty
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Indirect channel-via economic growth (leads to higher tax revenues, more jobs, higher wages
Direct Channel-poor entrepreneurs don't have access to markets or credit so development increases financing |
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Shadow Banking System
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Collection of financial institutions (non depository banks, hedge funds) that serve as intermediaries involved in facilitating creation of credit across markets
Not regulated because they are not banks Use short term funds (repo market, commercial paper) to make long term investments like securitized mortgages |
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Repo Market
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Sell security to one party for short period of time and than agree to buy it back for set price at later date
Used for funding short term investments since security holder gets paid principal plus interest Creates off balance sheet items Risks include security losing value and seller not being able to buy back security |
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History of Financial Crises
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Stock market became an important source of financing in 16th century
Crisis always involve the banking sector and capital markets because of the relationship between the two When capital markets are hit government intervenes and lowers rates creating an asset bubble that will eventually burst |
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Commons causes of current financial crisis
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1. Excessive risk taking by financial institutions
2. Complex financial products that regulators did not understand 3. Credit rating agencies 4. Failure of regulators to rapidly respond as events unfolded 5. Increasing number of institutions deemed too big to fail 6. Culmination of a long process of financialization |
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Financialization
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Increasing importance of financial markets, financial institutions in the operation of the economy
Lead to: shadow banking, increased risk taking by individuals, transformed illiquid assets into marketable securities, creates major income disparity between rich and poor |
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Causes of Financialization
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Fast expansion of banking system outside traditional banking instruments
Expansion of financial system relative to real sector Deregulation-Gramm Leach Bliley Lack of supervision and enforcement |
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Recoupling and Decoupling Hypothesis
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Recoupling-Any event in US effects rest of world because of reduction of exports
Decoupling-Emerging markets are less vulnerable to contagion because they are able to stimulate growth in own country and gain markets in developing countries |
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Consequences of Financialization
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Increased dominance of financial sector relative to real sector of economy
Tepid economic growth of real economy Speculation Increased bankruptcies Uncertainty Income disparity |
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Third World Debt Crisis
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Third World debt grew rapidly
Notion that countries could not go bankrupt Two debt crisises-one for poor countries (official debt) and one for middle income countries caused by commercial debt from international banks 1982 Mexico could not service its debt Expands to other countries because credit is reduced |
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Causes of Third World Debt Crisis
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Exogenous Factors-protectionism, trade reduction, slow economic growth, high interest rates on debt
Country Policy Shortfalls-monetary, fiscal, and exchange rate policies, regulation |
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Responses to Third World Debt Crisis
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Response 1-Countries encouraged to start IMF Program that would reduce budget deficits and urge economic reforms
Countries would than reschedule their debt but countries did not follow through with rescheduling Response II-Menu approach (debt-equity swaps, debt securitization) |
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Debt-Equity Swaps
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Brady Plan
External debt swapped for equity Leads to external debt decreasing but domestic debt increasing To work debt must be available for sale on exchange and at a discount and country must have assets that are attractive to investors Investors must be willing to take hair cut |
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Benefits and Drawbacks of Debt-Equity Swaps
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Benefit to country-size of external debt down,encourages investment that would not normally occur, stimulate repatriation of flight capital
Drawbacks for country-equity swapped at cheap price, inflation, |
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Third World Debt Crisis and Lessons for Euro
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Bank debt and public debt likely to have same effect
Is issue liquidity or solvency? Need for fiscal adjustment Need for structural adjustments-institutions, markets Debt relief and need to restore economic growth High public debt reduces options of policymakers and ties hands Political support and fairness |
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Brady Bonds
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Emerging market debt markets are small and illiquid
Brady Bonds allow Latin American countries to get loans from commercial banks in return for bonds backed with guarantees Banks exchange debt for securities and are able to get loans off balance sheets but at a 30-50% loss Creditors given "menu" of options to either exit markets at a loss or accept new bonds |
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Types of Financial Crisis
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Banking Crisis-bad loans, non payment
Exchange Rate crisis-loss of confidence Government external debt crisis Negative current account crisis Sovereign debt crisis Crisis of panic |
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What Greece must do to Transform itself
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Hire Young People
Low wage competition Slash government pensions and wages Increase economic output |
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If one Eurozone nation defaults why it spreads
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Crisis of confidence/panic
Each eurozone nations owns each others debt Banks in each country own substantial sovereign debt |
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US Economic Collapse
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Lehman goes under
Real estate bubble pops, house prices drop, defaults increase CDOs lose all value and many hedge funds collapse and or can't get funding Run on money markets caused by Lehman panic prevents commercial paper from being funded Contagion spreads because markets are so integrated Commercial banks restrict lending Commodity prices drop and global trade comes to standstill |
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Hypothesis for Collapse
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Hypothesis 1: Export centered economic polices of East Asian nations and accumulation of savings leads to lower interest rates, housing bubble,and growth of the financial sector
Hypothesis II: Policies pursued by US (low interest rates, easy mortgages, fiscal policy caused by war and Bush tax cuts, and lax financial regulation) leads to unsustainable consumption and creation of housing bubble |
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Eurozone Crisis
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Banking crisis, sovereign debt crisis, and slow economic growth
Need a strong political union since countries are so different Need real wage cuts and increased productivity Upcoming elections a big question |
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Is US out of the Woods?
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Need more growth and jobs
Economy has not returned to long term growth rate Big recessions are followed by big recoveries and that has not happened yet Huge national debt caused by Fed buying up Treasurary securities which lowers rates Demand for national debt is not infinite |
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What Financial Reforms Should Address
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Excessive risk taking and leverage
Reducing systematic risk Opacity Credit rating and conflicts of interest Enforcement of regulations Restore confidence |
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Positive arguments for Dodd-Frank
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Consumer protection bureau-gives americans information on mortgages and acts as watchdog for unfair practices
Ends too big to fail Bailouts-safe way to liquidate failed firms, new capital and leverage requirement Advance warning system-Creates council to address systematic risks caused by big firms Transparency-regulation on OTC derivatives Protects investors-new rules on credit rating agencies |
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Negative arguments for Dodd-Frank
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Too confusing, long, and bureacratic-a lot still not sorted out
New government agencies that serve cross purposes Volcker rule implementation Encourages people to find new loopholes |
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The Chicago Plan
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Irving Fischer Creates in 1933 in response to Depression
Government has full monoply in creating money preventing banks from creating and destroying it Banks required to have 100% reserves on checking accounts Removes risk taking ability of banks and thus booms and busts of financial sector |
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Limited Purpose Banking
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Have banks only do what "Main Street" needs which is connect lenders and borrowers and savers to investors
Removes risk taking ability of banks |
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Islamic Finance
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Prevents financing of harmful activities
Financial system that embraces risk sharing as an investor must share risk of economic activity with those who came up with it Leads to 100% reserve banking and no need for FDIC insurance Islamic finance does not allow debt but requires equity |
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Positives of Islamic Finance
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No debt or leverage
Investors exercise transparent ownership of assets so if project fails they fail too No Too Big to Fail institutions Finance performs basic function of channeling savings to investors Investors and entrepreneurs work as partners No need for deposit insurance or lender of last resort Financial stability since bankruptcy of one project does not have effect on rest of institution and banks do not lend to each other so they are not interconnected |
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Informational and Agency Problems
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Informational Problems
1. People take it as a negative when firms issue more equity 2. Adverse incentive effect-once an entrep. issues equity his incentive to perform well goes down because he no longer reaps all the rewards Agency Problem 1. Entrepreneurs (agent) more interested in high risk/high return but lender (principal) is interested in the safer route |
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Equity or debt Financing?
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Equity
1. Because entrep. shares risk with capital provider 2. When downturn firm will not cut production as much 3. In crisis, debt financed firm may face short term debt withdrawal while this is not the case with equity 4. In bad times, banks stop issuing debt but people want to buy equity because it is underpriced |
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Reasons for Forming Euro
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Economic union and no trade barriers
More trade and capital mobility Federalism to deal with lender of last resort Eliminates FX transaction costs for members Better resource allocation By having common market reduces possibility of conflict |
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Problems with Forming of Euro
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Economic Union, not political union
No lender of last resort Each country could pursue own economic policies without repercussion Big countries do not have more power than smaller ones No flexibility in dealing with asymmetric shocks |
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How Eurozone differs from US
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US is a political and economic union
US has a lender of last resort US has one head of government |
