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80 Cards in this Set
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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 |
Financial Crises |
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Two points for financial crisis |
Receive information If for some reason they can't, it increases financial firctions |
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Asymmetric information problems that act as a barrier to efficient allocation of capital |
financial frictions |
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Dynamics of Financial Crises (3) |
Stage One Stage Two: banking crises Stage Three: Debt Deflation |
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Three points for Stage One |
Credit Boom and Bust Asset-Price Boom and Bust Increase in Uncertainty |
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Two points for Credit Boom and Bust: |
Financial innovation or liberalization Credit Boom |
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In a credit boom and bust, what happens? |
Becomes extremely easy to get credit, use that credit to buy stuff, driving up prices. When everyone can't pay their loans, a bust happens |
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What is financial innovation? |
when an economy introduces brand new financial products |
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What is financial liberalization? |
When restrictions are lifted |
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In the long run, liberalization can lead to... |
more efficient asset allocation |
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In the short run, liberalization can lead to a lending spree thus leading to... |
a credit boom |
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One point for Financial innovation or liberatlization |
All of a sudden, its really easy to get credit because no one is checking. |
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Eventually, losses on the loans... |
mount (people default) |
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Institutions may not have ability (or incentives) to appropriately manage risk. Risk taking grows, eventually loosses on loans begin to mount leading to a... |
decline in bank capital and deleveraging |
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Bank capital = |
assets - liabilities |
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Why are loans assets? |
because they own interest on them |
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If people start to default on their loans, assets are... |
falling. Bank capital decreases. Decreased net worths lead to deleveraging, making lending/savers nervous |
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financial institutions cut back on their lending to borrower spending |
deleveraging |
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Banks have less capital, making them riskier, causing... |
lender-savers to pull out of the bank, and thus leading to a lending crash |
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prices of assets (such as equity shares and real estate) can be driven by irrational exuberance to prices well above their fundamental economic value |
asset-price boom and bust |
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Asset booms will.. |
always burst
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What happens in an asset boom? |
People become excited and drive the price of a stock beyond the actual worth of the good. |
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What can also cause a financial crises? |
increase and uncertainty |
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Three points for Stage Two: Banking Crises |
Tougher conditions may lead to insolvency. This leads to fire sales: banks sell off assets to raise funds quickly. This increases asymmetric information problems. |
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One point for Tougher conditions may lead to insolvency |
Assets quickly drop (net worth drops) |
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When supply goes up... |
price goes down |
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Fire sales (1 point) |
This drives the price of their assets down, Net Worth = Asset - Liabilities. Assets decline, net worth decreases, banks become even more insolvent. The banks fail. |
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What increases asymmetric information problems? |
With less banks operating, there is less information regarding the credit worthiness of borrowers |
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Eventually what happens? |
sell off insolvent firms, people become less uncertain, financial friction diminish recovery occurs or Debt Deflation |
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When a substantial unanticipated decline in the price level sets in, leading to a further deterioration in firms' net worth |
debt deflation |
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Debt deflation was a... |
big hallmark of the Great Depression |
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What is the fisher equation? |
r = i - pi |
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i = |
r + pi |
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What is deflation? |
prices are going down |
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What is debt deflation? |
prices drop unexpectedly |
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We... |
pay a fixed nominal interest rate on their liabilities |
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Substantial decline in the real net worth of borrowers caused by... |
a sharp drop in the price level creates an increase in adverse selection and moral hazard problems |
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Real interest rate = |
real cost of borrowing |
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With falling prices... |
r rises |
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Real interest rate has to go up to... |
offset the fall in prices |
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Real liabilities |
go up |
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Two causes of the crises |
Financial Innovation in the Mortgage Markets Agency Problems in the Mortgage Markets |
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One point for financial innovation in the mortgage market |
structured credit products |
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paid out income streams from a collection of underlying assets designed to have particular risk characteristics |
structured credit products |
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Three points for agency problems in the mortgage markets |
principle agent problem commercial and investment banks rating agencies subject to conflict of interest |
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mortgage brokers (agent) quickly sold loans to investors (principle) in the form of mortgage back securities so the brokers often did not make a strong effort to determine credit worthiness |
Principle-agent problem |
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were earning large fees by underwriting mortgage-based securities and fees by underwriting mortgage-backed securities and structured credit products like CDO had weak incentives to ensure that the holders of the securities would be paid off. |
Commercial and Investment Banks |
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What is a CDO? |
Collareralized Debt Obligation |
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What do mortgage markets faced? |
weird incentive problems |
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Mortgage brokers don't care because... |
they will sell it |
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What is the adverse selection problem in this? |
investor coming in and buying the loan loaves risk |
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One point for Rating agencies subject to conflict of interest |
advised commercial and investment banks on how to structure their products and rated those products and banks leads to a conflict of interest |
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Investment banks lacked incentives to examine whether the investor could get paid because... |
the investment bank was paid a large fee whether or not the investor was paid |
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Six effects of the crisis |
1. Residential Housing Prices: boom & Bust 2. Deterioration of Financial Institutions' Balance sheets 3. Run on the Shadow Banking System 4. Global Financial Markets 5. Failure of High Profit Firms 6. Government Intervention and Recovery |
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One point for Residential housing boom and bust |
Price house increase, demand for houses decrease, prices decrease |
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One point for deterioration of financial institutions' balance sheets |
rise in defaults on mortgages, lower net worth |
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What is the shadow banking system? |
all of the investment banks |
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Two points for the run on the shadow banking system? |
as the bank's net worth decreases, more collateral was required Banks couldn't borrow as much |
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Run on the Shadow bank system leads to |
fire sales |
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Four countries in the global financial market? |
Greece Ireland Portugal France |
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Two failures of high profit firms |
Behr Sterns fell Had to sell themselves to JP Morgan for 1/10 of their worth |
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Three points for Government Intervention and Recovery |
Fed Monetary policy and liquidity provision Troubled Asset Relief Program Fiscal Policy |
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What is TARP |
government purchased 700b of subprime mortgages |
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Fiscal policy was done to... |
stimulate the economy |
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Three Points for Response of Financial Regulation |
Microprudential Supervision Macroprudential Supervision Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 |
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safety and soundness of individual financial institutions |
Microprudential supervision |
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safety and soundness of financial system in the aggregate |
Macroducential supervision |
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What was the problem? |
the whole system was pushing into riskier decisions |
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Five points for Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 |
1. Customer Protection 2. Resolution Authority 3. Systemic Risk Regulation 4. Volcker Rule 5. Derivatives |
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Three points for Consumer Protection: |
1. Bureau 2. Not part of the Fed, but is physically located inside the Fed. 3. Examine and enforce regulation in institutions with More than 10m in assets, issues, and mortgages |
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One point for resolution authority |
gave the government to regulate and take over larger banks |
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Two points for systematic risk regulation |
really big banks are subjected to higher bank capital requirements taking on risk means that you have more to lose |
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What does the Volcker Rule Say? |
banks cannot trade all of their funds |
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Two points for Volcker Rule |
Only allowed to own a small % of hedge funds limits the extent of trading |
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What is derivatives? |
need to be traded on exchanges, cleared through clearing house |
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Three points for Too-Big-To-Fail and Future Regulation |
Break Up Large Systematically Important Financial Institutions Higher Capital Requirements Leave It To Dodd Frank |
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One point for Break Up Large Systematically Important Financial Institutions |
Instead of one large bank providing services, split them up |
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Two points for Higher Capital Requirements |
Net worth needs to be even larger Can be countercyclical (lower for recession, higher for expansion) |
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Four Other Issues for future regulation |
Compensation in the financial services industry Government-Sponsored Enterprises Credit Rating Agencies Overregulation |
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One point for compensation in the financial services industry |
compensate as long as they haven't caused problems (doesn't address government industries or asymmetric information problems) |
