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MACROECONOMICS

ASSIGNMENT :
FINANCIAL CRISIS










MOHIT RAKYAN
B.A. (HONS) ECONOMICS
SEMESTER IV
ROLL NUMBER : 21215210




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FINANCIAL CRISIS

While nancial crises have common elements, they do come in many forms. A nancial crisis
is often associated with one or more of the following phenomena: substantial changes in
credit volume and asset prices; severe disruptions in nancial intermediation and the supply
of external nancing to various actors in the economy; large scale balance sheet problems (of
rms, households, nancial intermediaries and sovereigns); and large scale government
support (in the form of liquidity support and recapitalization). Financial crisis directly result
in a loss of paper wealth but do not necessarily result in changes in the real economy. As such,
nancial crises are typically multidimensional events and can be hard to characterise using a
single indicator.
Many theories have been developed over the years regarding the underlying causes of crises.
While fundamental factorsmacroeconomic imbalances, internal or external shocksare
often observed, many questions remain on the exact causes of crises. Financial crises
sometimes appear to be driven by irrational factors. These include sudden runs on banks,
contagion and spillovers among nancial markets, limits to arbitrage during times of stress,
emergence of asset busts, credit crunches, and re- sales, and other aspects related to nancial
turmoil.

TYPES OF FINANCIAL CRISIS
Banking crisis
When a bank suffers a sudden rush of withdrawals by depositors, this is called a bank run.
Since banks lend out most of the cash they receive in deposits, it is difcult for them to
quickly pay back all deposits if these are suddenly demanded, so a run renders the bank
insolvent, causing customers to lose their deposits, to the extent that they are not covered by
deposit insurance. An event in which bank runs are widespread is called a systemic banking
crisis or banking panic.
Examples of bank runs include the run on the Bank of the United States in 1931 and the run
on Northern Rock in 2007. Banking crises generally occur after periods of risky lending and
resulting loan defaults.

Speculative bubbles and crashes
A speculative bubble exists in the event of large, sustained overpricing of some class of assets.
One factor that frequently contributes to a bubble is the presence of buyers who purchase an
asset based solely on the expectation that they can later resell it at a higher price, rather than
calculating the income it will generate in the future. If there is a bubble, there is also a risk of
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a crash in asset prices: market participants will go on buying only as long as they expect others
to buy, and when many decide to sell the price will fall. However, it is difcult to predict
whether an asset's price actually equals its fundamental value, so it is hard to detect bubbles
reliably.
Well-known examples of bubbles (or purported bubbles) and crashes in stock prices and other
asset prices include the Dutch tulip mania, the Wall Street Crash of 1929, the Japanese
property bubble of the 1980s, the crash of the dot-com bubble in 20002001, and the now-
deating United States housing bubble. The 2000s sparked a real estate bubble where housing
prices were increasing signicantly as an asset good.

International nancial crises
When a country that maintains a xed exchange rate is suddenly forced to devalue its
currency because of a speculative attack, this is called a currency crisis or balance of
payments crisis. When a country fails to pay back its sovereign debt, this is called a sovereign
default. While devaluation and default could both be voluntary decisions of the government,
they are often perceived to be the involuntary results of a change in investor sentiment that
leads to a sudden stop in capital inows or a sudden increase in capital ight.
Several currencies that formed part of the European Exchange Rate Mechanism suffered
crises in 199293 and were forced to devalue or withdraw from the mechanism. Another
round of currency crises took place in Asia in 199798. Many Latin American countries
defaulted on their debt in the early 1980s. The 1998 Russian nancial crisis resulted in a
devaluation of the Ruble and default on Russian government bonds.

Wider economic crisis
Negative GDP growth lasting two or more quarters is called a recession. An especially
prolonged or severe recession may be called a depression, while a long period of slow but not
necessarily negative growth is sometimes called economic stagnation.

Declining consumer spendings
Some economists argue that many recessions have been caused in large part by nancial
crises. One important example is the Great Depression, which was preceded in many
countries by bank runs and stock market crashes. The subprime mortgage crisis and the
bursting of other real estate bubbles around the world also led to recession in the U.S. and a
number of other countries in late 2008 and 2009.
Some economists argue that nancial crises are caused by recessions instead of the other way
around, and that even where a nancial crisis is the initial shock that sets off a recession, other
factors may be more important in prolonging the recession.

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ASYMMETRIC INFORMATION AND FINANCIAL
CRISIS
A nancial system performs the essential coordination function of channeling funds from
households and rms with surplus funds to those individuals and rms with both shortage of
funds and productive investment opportunities. A well functioning nancial system directs
funds to where they can do most good, promoting economic stability and growth. But this
smooth functioning of nancial markets can be impeded when one party lacks information to
make accurate decisions. This is called asymmetric information (access to different
information) and creates two kinds of problems :
1. Adverse Selection : It refers to a market process in which undesired results occur when
buyers and sellers have asymmetric information; the "bad" products or services are more
likely to be selected. For example, a bank that sets one price for all of its checking account
customers runs the risk of being adversely selected against by its low-balance, high-activity
(and hence least protable) customers.
2. Moral Hazard : It is a situation in which one party in a transaction has more
information than another. In particular, moral hazard may occur if a party that is
insulated from risk has more information about its actions and intentions than the party
paying for the negative consequences of the risk. More broadly, moral hazard occurs
when the party with more information about its actions or intentions has a tendency or
incentive to behave inappropriately from the perspective of the party with less
information.
The analysis of how asymmetric information problems can generate the problems of adverse
selection and moral hazard is called the agency theory. According to it, a nancial crisis
occurs when an increase in asymmetric information from a disruption in the nancial system
prevents it from channeling funds efciently from lenders-savers to borrowers-spenders, the
households and rms with productive investment opportunities.

FACTORS OF FINANCIAL CRISIS
1. Asset Market effects on Balance Sheets
2. Deterioration of Financial Institutions Balance Sheets : Banks play a major role
in nancial markets because they are well positioned to engage in information-producing
activities which produce productive investments for our economy. The state of banks
balance sheet plays a very important part on lending. If compromised, the banks balance
sheets would suffer substantial contractions in their capital. Which would then lead to
fewer resources to lend, and lending in all would decline. Which then results in a decline
in investment spending, slowing down economic activity.
3. Banking Crisis and Increases in Uncertainty : If nancial institutions balance
sheets are deteriorated severely enough, they will begin to fail. By denition a bank panic
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would occur in a situation when multiple banks fail simultaneously. In a panic, depositors
fearing for the safety of their money and without insurance or knowing a particular bank's
loan portfolio will withdraw as quickly as possible. When this happens in a large amount,
there is a loss of information production in nancial markets and a banks nancial
intermediation. With a bank lending decrease, supplies of funds available to borrowers
decrease as well. Which then leads into higher interest rates. With an increase in adverse
selection, bank panics cause the inability of lenders to solve this selection process in credit
markets. And with the inability to solve the adverse selection makes banks less likely to
lend, and then a decline in lending, investment, and aggregate activity occurs.
4. Increasing Interest Rates : Increases in interest rates also play a role in promoting a
nancial crisis through an effect on cash ow. With this negative increase in interest rates,
a rm would have fewer internal funds and must raise funds from an external source.
Banks might not lend out to rms even if they have a good risk, resulting in a drop in cash
ow, and again adverse selection and moral hazard problems become more severe.
Impacting lending, investment, and overall economic activity.
5. Government Fiscal Imbalances : Government imbalances may create fears of default
on government debt. These fears can spark a foreign exchange crisis in which the value of
the domestic currency falls sharply because investors pull their money out of the country.
The decline then leads to destruction of the balance sheets of rms with large amounts of
debt. These balance sheets once again lead to an increase in adverse selection and moral
hazard problems.

DYNAMICS OF FINANCIAL CRISIS
Financial crises in advanced economies usually progress in two sometimes three stages.

Stage One : Initiation of Financial Crisis
Financial Crisis can begin in several ways, some of which are as follows :
1. Mismanagement of Financial Innovation/Liberalisation : This can be in the form
of either elimination of restrictions on markets or institutions or creation of new nancial
markets/institutions such as introduction of subprime residential mortgages. They are
good in the long run because they stimulate nancial development, but can be bad when
management begins taking on too much risk. For example a credit boom where banks
lend too much and they cant keep enough information or they have no experience. The
government could create a safety net which can lead to moral hazard. Banks will thus only
win on high risk or the government loses. Too much risk-taking eventually leads to losses
and banks net-worth (capital) falls which ultimately leads to a cutback on lending or
deleveraging
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2. Asset Price Boom and Bust : Assets, stocks and real estate prices get driven up by what
investors incorrectly think they are worth. The result is an asset price bubble. A price
bubble can be driven up by credit booms if credit is used to purchase assets. The bubble
eventually bursts and prices fall to correct levels causing everyone to lose, forcing banks to
deleverage again.
3. Increase in Uncertainty : Always a factor in nancial crises. There is a rise in
uncertainty once a recession has started. This can further lead to failure of major
institutions such as Ohio Life Insurance and Trust Company 1857, Jay Cooke and Co.
1873, Grant and Ward 1884, Bank of the United States 1930. This again leads to drop in
lending, increasing adverse selection and moral hazard

Stage Two : Banking Crisis
Because of worsening conditions in business and uncertainty, depositors begin to withdraw
funds from banks. With less banks, there is a loss in domestic currency, the debt burden of
domestic rms increase. We thus have Asset Write-Downs, in which the asset price declines
which leads to a write-down value of the assets side of the balance sheet. With nancial
Institutions balance sheets deteriorating, lending declines. This leads to a decline in
investment spending which slows economic activity. Eventually institutions, even healthy ones,
begin to fail. Depositors, because of fear and uncertainty, start to remove their deposits until
the point that the bank fails. A Bank Panic thus occurs.
After a certain point the uncertainty in nancial markets declines, the stock market recovers
and balance sheets improve. Adverse selection and moral hazard problems diminish and the
nancial crisis subsides. With the nancial markets able to operate well again, the stage is et
for an economic recovery.

Stage Three : Debt Deation
If the economic downturn leads to a sharp decline in price level, the recovery process can be
short circuited. A debt deation might occur when a substantial unanticipated decline in price
level sets in, leading to further deterioration in rms net worth due to the increased burden of
indebtedness.

POLICY RESPONSE TO ASSET PRICE BUBBLES
There are two types of asset price bubbles, which are as follows :
1. Credit Driven Bubbles : When a credit boom begins, it can lead to an asset price
bubble because individuals and rms can use true widely available credit to purchase
particular assets and thereby raise their prices. The rise in asset values in turn encourages
further lending to purchase these assets, either because it increases the value of the
collateral or raises the value of capital at nancial institutions, which improves their
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balance sheet positions and gives them more capacity to lend. The lending for these assets
can increase demand for them further and hence raises prices even more, creating a
feedback loop. When the bubble bursts, the collapse in asset prices then leads to a reversal
of the feedback loop : loans go sour, lenders cut back on credit supply, demand for assets
decline further, and prices drop even more.
2. Optimistic Expectations Driven Bubbles : Bubbles that are driven solely by overly
optimistic expectations pose much less risk to the nancial system than credit driven
bubbles. The bursting of these bubbles does not deteriorate nancial institutions balance
sheets and thus does not have a severe impact on the economy and the recession that
follows is usually mild.

Policy and Practice
The central banks in order to ensure the smooth working of the economy need to respond
and take action especially against credit driven bubbles. Regulatory policy to affect what is
happening in credit markets in the aggregate referred to as macro-prudential regulation, is a
widely agreed upon policy for addressing these bubbles.
Financial regulation and supervision on an ongoing basis by central banks can prevent
excessive risk taking that can directly trigger a credit boom, which in turn leads to a bubble.
When a rapid rise in asset prices accompanied by a credit boom provides a signal that a
bubble might be forming, central banks could then consider implementing policies to reign
credit growth directly or implement measures to make sure credit standards are sufciently
high. Appropriate macro-prudential regulation can then help limit credit driven bubbles and
improve the performance of both the nancial system and the economy





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