HO MB1e ch12 PDF

R.
GLENN
HUBBARD ANTHONY PATRICK
O’BRIEN
Money,
Banking, and
the Financial
System
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
CHAPTER 12
Financial Crises and
Financial Regulation
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
12.1 Explain what financial crises are and what causes them
12.2 Understand the financial crisis that occurred during the Great Depression
12.3 Understand what caused the financial crisis of 2007-2009
12.4 Discuss the connection between financial crises and financial regulation

CHAPTER 12
Financial Crises and
Financial Regulation
A CLOUDY CRYSTAL BALL ON THE FINANCIAL CRISIS
• Problems with the U.S. housing market ultimately led to the worst
recession since the Great Depression, yet many policymakers, business
leaders, and economists failed to see the crisis approaching.
• Policymakers, managers of financial firms, investors, and households
were struggling to deal with unprecedented events.
• An Inside Look at Policy on page 374 discusses the issues Congress
grappled with in 2010 during the debate over the Dodd-Frank Act.

Key Issue and Question
Issue: The financial crisis of 2007–2009 was the most severe since the
Great Depression of the 1930s.
Question: Does the severity of the 2007–2009 financial crisis explain
the severity of the recession during those years?
© 2012 Pearson Education, Inc. Publishing as Prentice Hall 4 of 57

12.1 Learning Objective
Explain what financial crises are and what causes them.

Financial crisis A significant disruption in the flow of funds from lenders to
borrowers.
• Economic activity depends on the ability of households and firms to borrow.

• A financial crisis disrupts the flow of funds from lenders to borrowers.
• A financial crisis typically leads to an economic recession as households and
firms face difficulty in borrowing money.
• In the past, most of the financial crises in the United States involved the
commercial banking system.
The Origins of Financial Crises

The Underlying Fragility of Commercial Banking
• Banks have a maturity mismatch because they borrow short term from
depositors and lend long term to households and firms.
• This means that banks face a liquidity risk because they may be unable to
meet their depositors’ withdrawals.
• Banks can borrow or sell assets to raise funds.
Insolvent The situation for a bank or other firm whose assets have less value
than its liabilities, so its net worth is negative.
• An insolvent bank may be unable to meets its obligations to pay off its
depositors.

Bank Runs, Contagion, and Bank Panics
• Prior to 1933, the United States had no system of government deposit

insurance.
• Once the bank’s liquid assets were exhausted, the bank would have to shut
its doors, at least temporarily.
Bank run The process by which depositors who have lost confidence in a bank
simultaneously withdraw enough funds to force the bank to close.
• In the absence of deposit insurance, the stability of a bank depends on the

confidence of its depositors.

Contagion The process by which a run on one bank spreads to other banks
resulting in a bank panic.
• If multiple banks have to sell the same assets—for example, mortgage-

backed securities—the prices of these assets are likely to decline and
some banks may even be pushed to insolvency.
Bank panic The situation in which many banks simultaneously experience

runs.
• A bank panic feeds on a self-fulfilling perception: If depositors believe that

their banks are in trouble, the banks are in trouble.

Government Intervention to Stop Bank Panics
• Governments have two main ways they can attempt to avoid bank panics:
(1) A central bank can act as a lender of last resort.
(2) The government can insure deposits.
Lender of last resort A central bank that acts as the ultimate source of credit
to the banking system, making loans to solvent banks against their good, but
illiquid, loans.
Federal Deposit Insurance Corporation (FDIC) A federal government agency

established by Congress in 1934 to insure deposits in commercial banks.

Figure 12.1
Bank Runs and the Government Response
Bank runs can cause good banks, as well as bad banks, to fail. Bank failures are costly
because they reduce credit availability to households and firms.•
Solved Problem 12.1
Would Requiring Banks to Hold 100% Reserves Eliminate Bank Runs?
As we saw in Chapter 10, the Federal Reserve requires banks to hold reserves
equal to 10% of their holdings of checkable deposits above a certain level. In
the 1950s, Milton Friedman of the University of Chicago and winner of the
Nobel Prize in Economics proposed that banks be required to hold 100%
reserves.
In 2010, Laurence J. Kotlikoff of Boston University advocated a similar plan. If
required to hold 100% reserves, banks would make loans and buy securities
with their capital rather than with deposits.
Briefly discuss how this proposal would affect the likelihood of bank runs.

Solved Problem 12.1
Would Requiring Banks to Hold 100% Reserves Eliminate Bank Runs?
Solving the Problem
Step 1 Review the chapter material.
Step 2 Answer the problem by discussing what causes bank runs and
whether requiring banks to hold 100% reserves would affect the
likelihood of runs.
We have seen that bank runs are caused by depositors’ knowledge that banks
keep only a fraction of deposits on reserve and loan out or invest the
remainder.
If banks held 100% reserves, rather than, say, 10%, depositors would no
longer have to fear that their money would not be available should they choose
to withdraw it. Depositors would also not be at risk of losing money if banks
made poor investments because the value of a bank’s loans and securities
would no longer be connected to the bank’s ability to refund depositors’ money.
We can conclude that whatever the other merits or drawbacks of a system of
100% reserve banking, such a system would not be subject to runs.
Bank Panics and Recessions

Exchange Rate Crises
Countries have attempted to keep the value of their currency fixed by pegging it
against another currency
Figure 12.2
An Exchange Rate Crisis
Resulted from the Pegging
of East Asian Currencies
The government of South
Korea pegged the value of
the won against the dollar.
The pegged exchange rate,
E2, was above the
equilibrium exchange rate,
E1.
To maintain the peg, the
Korean central bank had to
use dollars to buy surplus
won equal to Won3 – Won2.•
Sovereign Debt Crises
• Sovereign debt refers to bonds issued by a government.

• A sovereign debt crisis occurs when a country has difficulty making interest
or principal payments on its bonds.
• If the government defaults and is unable to issue bonds, it will have to
depend on tax revenues to pay for its spending.
• Even if the government avoids default, it will probably have to pay much
higher interest rates when it issues bonds.
• The resulting decreases in government spending or increases in taxes can
push the economy into recession.

• Sovereign debt crises result from either of two circumstances:
(1) chronic government budget deficits and interest payments taking up an
unsustainably large fraction of government spending, or
(2) a severe recession that increases government spending and reduces
tax revenues, resulting in soaring budget deficits.
• Following the 2007–2009 recession, several European governments, most

notably that of Greece, were pushed to the edge of debt crises, and imposed
sharp spending cuts and higher taxes.

Making the Connection
Why Was the Severity of the 2007–2009 Recession So Difficult to Predict?
• Recessions in the United States between 1933 and 2007 were not
accompanied by bank panics, but the recession of 2007–2009 did involve a
panic in the “shadow banking system.”
• Both the Great Depression and the recession of 2007–2009 were severe. Do
recessions accompanied by bank panics tend to be more severe?
• Research shows that recessions following bank crises have been more
severe with higher unemployment rates, sharper declines in real GDP and
prices, and longer durations.
• Government debt also soared from increased government spending and
higher budget deficits.

Why Was the Severity of the 2007–2009 Recession So Difficult to Predict?
The table below shows some key indicators for the 2007–2009 U.S. recession
compared with other U.S. recessions of the post-World War II period.
Because most people did not see the financial crisis coming, they also failed
to anticipate the severity of the 2007–2009 recession.
Understand the financial crisis that occurred during the Great Depression.

The Start of the Great Depression
• Several factors helped to increase the severity of the downturn during the
Great Depression.
• Stock prices plunged, thereby reducing household wealth, making it more
difficult for firms to raise funds, and increasing uncertainty. Higher
uncertainty leads to decreases in spending.
• In addition, Congress passed the Smoot-Hawley Tariff Act in June 1930,
which led to retaliatory increases in foreign tariffs, thereby reducing U.S.
exports.
• Following legislation that restricted immigration, population growth declined,
and spending on new houses fell.
The Financial Crisis of the Great Depression

Figure 12.3
The Great Depression
In panel (a), the data are expressed as index numbers relative to their values in 1929. Real
GDP declined by 27% between 1929 and 1933, while real consumption declined by 18%
and real investment fell by an astonishing 81%. These declines were by far the largest of the
twentieth century.
Panel (b) shows that the unemployment rate tripled from 1929 to 1930, was above 20% in
1932 and 1933, and was still above 10% in 1939, a decade after the Great Depression had
begun.•
Figure 12.4
The S&P 500, 1920–1939
The Federal Reserve raised interest rates after it became concerned by the rapid
increases in stock prices during 1928 and 1929.
The decline in stock prices from 1929 to 1932 was the largest in U.S. history.•

The Bank Panics of the Early 1930s
Figure 12.5
Bank Suspensions,
1920–1939
Bank suspensions, during
which banks are closed to
the public either temporarily
or permanently, soared
during the bank panics of the
early 1930s before falling to
low levels following the
establishment of the FDIC in
1934.•

Debt-deflation process The process first identified by Irving Fisher in which a
cycle of falling asset prices and falling prices of goods and services can
increase the severity of an economic downturn.
As the economic downturn worsened, the price level would fall, with two
negative effects:
• Real interest rates would rise, and the real value of debts would increase. As
the price index declined, fixed payments on loans and bonds had to be
made with dollars of greater purchasing power, increasing the burden on
borrowers and raising the likelihood of defaults.
• This process of falling asset prices, falling prices of goods and services, and
increasing bankruptcies and defaults can increase the severity of an
economic downturn.

The Failure of Federal Reserve Policy during the Great Depression
Why did the Fed not intervene to stabilize the banking system? Economists
have pointed to four possible explanations:
1. No one was in charge.
Power within the Federal Reserve System was divided. The Fed had less
independence from the executive branch, and important decisions required
forming a consensus that proved hard to come by, so taking decisive policy
actions was difficult.
2. The Fed was reluctant to rescue insolvent banks.
Fed officials believed that taking actions to save them might encourage risky
behavior by bank managers. In other words, the Fed was afraid of the
problem that economists now call moral hazard.

3. The Fed failed to understand the difference between nominal and real interest
rates.
With the price level falling, real interest rates were much higher in the early
1930s than policymakers at the Fed believed them to be.
4. The Fed wanted to “purge speculative excess.”
Many members of the Fed believed that the Depression was the result of
financial speculation during the late 1920s. So the Fed followed the
“liquidationist” policy, which held that allowing the price level to fall and weak
banks and weak firms to fail was necessary before a recovery could begin.

Did the Failure of the Bank of United States Cause the Great Depression?
• In the early 1960s, Milton Friedman and Anna Schwartz published an

influential discussion of the importance of bank panics in their book A
Monetary History of the United States, 1867–1960.
• Friedman and Schwartz singled out the failure in December 1930 of the
Bank of United States, a large private bank located in New York City.
• The Bank of United States ran into trouble from falling real estate prices
and mortgage defaults. It became the largest bank to have failed in the
United States up to that time. Economists continue to disagree as to
whether the Federal Reserve should have moved more forcefully to keep
the bank from closing.
• Some economists even argue that this episode was important in leading
the Fed to develop the “too-big-to-fail” doctrine, which holds that no large
financial institution can be allowed to fail because its failure may destabilize
the financial system.

Understand what caused the financial crisis of 2007–2009.

The Housing Bubble Bursts
• When housing prices rise faster than housing rents, the likelihood that the
housing market is experiencing a bubble is increased. Between January
2000 and May 2006, house prices more than doubled, while rents increased
by less than 25%, providing evidence of a bubble.
• Home prices began to decline in 2006 after some homebuyers had trouble
making mortgage payments. When lenders foreclosed on some of these
loans, the lenders sold the homes, causing housing prices to decline further.
Mortgage lenders that made subprime loans suffered heavy losses.
• Most banks and other lenders tightened their requirements for borrowers.
This credit crunch made it more difficult for potential homebuyers to obtain
mortgages, which further depressed the housing market.
The Financial Crisis of 2007–2009

Bank Runs at Bear Stearns and Lehman Brothers
• August 2007: French bank BNP Paribas announces that it would not allow
investors to redeem their shares in three funds that had held large amounts
of mortgage-backed securities. Credit conditions worsen.
• March 2008: Lenders become concerned about the decline in mortgage-
backed securities at Bear Stearns. With aid from the Federal Reserve, Bear
is saved from bankruptcy.
• August 2008: The crisis deepens as nearly 25% of subprime mortgages are
at least 30 days past due.

• September 2008: Lehman Brothers files for bankruptcy protection after the
Treasury and the Fed decline to help. Merrill Lynch agrees to sell itself to
Bank of America. The failure of Lehman marks a turning point in the crisis.
• Reserve Primary Fund announces that it would “break the buck” by allowing
the value of shares in the fund to fall to $0.97.
• Many parts of the financial system become frozen as trading in securitized
loans largely stops.

The Federal Government’s Extraordinary Response to the Financial Crisis
• Having focused on the commercial banking system, the government was

poorly equipped to deal with a crisis in the shadow banking system.
• Most policymakers did not realize until well into 2007 that the subprime crisis
might evolve into a full-blown financial crisis.
• The Fed began aggressively driving down short-term interest rates; the
federal government effectively nationalized Fannie Mae and Freddie Mac;
and the Treasury moved to stop the runs on money market mutual funds.

• In September 2008, the Fed and the Treasury also unveiled a plan for
Congress to authorize $700 billion to be used to purchase mortgages and
mortgage-backed securities from financial firms and other investors.
• The objective of the Troubled Asset Relief Program (TARP) was to restore a
market in these securities. Ultimately, TARP funds were used to make direct
preferred stock purchases in banks to increase their capital.
• Also, a stress test administered by the Treasury to 19 large financial firms
during early 2009 helped to reassure investors that the firms had sufficient
capital to deal with a severe economic downturn.

Discuss the connection between financial crises and financial regulation.

• New government financial regulations typically occur in response to a crisis.
There is a regular pattern: (1) crisis, (2) regulation, (3) response to new
regulations by financial firms, and (4) response by regulators.
Lender of Last Resort

• Congress created the Federal Reserve System as the lender of last resort to
provide liquidity to banks during bank panics.
• The Fed failed its first crucial test when it stood by while the banking system
collapsed in the early 1930s.
• Congress responded to this failure by establishing the FDIC and by
reorganizing the Fed to make the Federal Open Market Committee (FOMC)
to centralize decision making.
Financial Crises and Financial Regulation

Success in the Postwar Years and the Development of the “Too-Big-to-
Fail” Policy
• The Fed has performed its role well during most of the post-World War II
period.
• In 1970, when the quality of commercial paper issued by large corporations
came into question, the Fed helped to avoid a crisis by providing commercial
banks with loans.
• Again in 1974, when banks feared a run by depositors holding negotiable
CDs, the Fed avoided what could have been a significant blow to the
financial system.
• During the stock market crash of October 19, 1987, many securities firms
were hurt by falling stock prices. Before the stock market opened the
following day, Federal Reserve Chairman Alan Greenspan announced in the
media the Fed’s readiness to provide liquidity to support the economic and
financial systems.

Too-big-to-fail policy A policy under which the federal government does not
allow large financial firms to fail for fear of damaging the financial system.
• In 1984, the comptroller of the currency provided Congress with a list of

banks that were considered too big to fail. A failure by any of these banks
was thought to pose systemic risk to the financial system.
• Banks that were not allow to fail had, in effect, unlimited deposit insurance.
So, depositors had much less incentive to monitor the behavior of bank
managers and to withdraw their deposits or demand higher interest rates if
the managers made reckless investments.
• The too-big-to-fail policy also was criticized for being unfair because it
treated small and large banks differently.

• In 1991, Congress passed the Federal Deposit Insurance Corporation
Improvement Act of 1991 (FDICIA). The act required the FDIC to deal with
failed banks using the method that would be least costly to the taxpayer,
which typically means closing the bank, reimbursing the bank’s insured
depositors, and using whatever funds can be raised from selling the bank’s
assets to reimburse uninsured depositors.
• The act did contain an exception, however, for cases in which a bank’s
failure would cause “serious adverse effects on economic conditions or
financial stability.” During the financial crisis of 2007–2009, this exception
proved to be important.

The Financial Crisis and a Broader Fed Role as Lender of Last Resort
• In March 2008, the Fed and the Treasury intervened to keep Bear Stearns
from failing.
• Some economists and policymakers criticized this action, saying that it
increased moral hazard in the financial system. This criticism may have
played a role in the Fed’s decision not to attempt to save Lehman Brothers
in September 2008.
• A few days later, though, the Fed made a large loan to the American
International Group (AIG) insurance company in exchange for 80%
ownership of the firm, which effectively nationalized the company.
• With the exception of Lehman Brothers, the Fed, FDIC, and the Treasury
combined to take actions that resulted in no large financial firms failing with
losses to investors. The too-big-to-fail policy appeared to be back.

The 2010 Financial Overhaul: The End of the Too-Big-to-Fail Policy?
• Congress criticized the “Wall Street bailout” that they believed resulted from
TARP and the actions taken to keep large financial firms from failing.
• The Wall Street Reform and Consumer Protection Act (known as the Dodd-
Frank Act) passed in July 2010 contained provisions intended to end the too-
big-to-fail policy.
• The act allows the Fed, FDIC, and Treasury to seize and “wind down” large
financial firms. Previously, only the FDIC had this power, and it could only
use it to close commercial banks. The intent was to give policymakers a third
option besides allowing a large firm to go bankrupt or taking action to save it.
• The FDIC predicted that the act would lead investors to shift funds toward
smaller firms, where the information costs of determining the riskiness of
investments would be lower. Larger firms would have to provide investors
with higher expected returns to compensate them for the ending of the too-
big-to-fail policy.

Figure 12.6
Lender of Last
Resort: Crisis,
Regulation, Financial
System Response,
and Regulatory
Response

Was Long-Term Capital Management the Pebble That Caused the Landslide?
• It is clear that many financial firms underestimated the risk involved with
mortgage-backed securities, but could it be that they made those risky
investments because they expected the Federal Reserve to save them
from bankruptcy?
• In 1998, the Fed intervened in the failure of the hedge fund Long-Term
Capital Management (LTCM). The Fed gathered 16 financial firms that
agreed to invest in LTCM to stabilize the firm so that its positions could be
“unwound,” or slowly sold off without destabilizing financial markets.
• The seeds of the 2007–2009 financial crisis may lie in the Fed’s actions
with respect to LTCM in 1998. Confident that the Fed would intervene on
their behalf, financial firms may have taken on risky investments. However,
no hedge funds received aid from the Fed during the crisis.

Reducing Bank Instability
• One argument for limiting competition among banks is that it increases a
bank’s value, thereby reducing bankers’ willingness to make excessively
risky investments.
• However, in the long run, anticompetitive regulations may create incentives
for unregulated financial institutions and markets to compete with banks.
• The Banking Act of 1933, which authorized Regulation Q, was an attempt to
maintain profitability by limiting competition for funds among banks.
Regulation Q placed ceilings on the interest rates banks could pay on time
and savings deposits and prohibited banks from paying interest on demand
deposits. In practice, however, the regulation forced banks to innovate to
survive.
• As rising inflation rates drove interest rates above the Regulation Q ceilings,
corporations and wealthy households substituted short-term investments in
Treasury bills, commercial paper, and repurchase agreements for short-term
deposits in banks. The introduction of money market mutual funds in 1971
also gave savers another alternative to bank deposits.
Firms sold a substantial fraction of their commercial paper to money market
mutual funds. Banks suffered because, as our analysis of adverse selection
predicts, only high-quality borrowers can successfully sell commercial paper,
leaving banks with low-quality borrowers.
Disintermediation The exit of savers and borrowers from banks to financial

markets.
To circumvent Regulation Q, banks developed new financial instruments for

savers.
Citibank introduced negotiable certificates of deposit that were not subject to
Regulation Q interest rate ceilings. In addition, they developed negotiable order
of withdrawal (NOW) accounts on which they paid interest.
Banks also developed automatic transfer system (ATS) accounts that
effectively pay interest on checking accounts.

• With the passage of the Depository Institutions Deregulation and Monetary
Control Act of 1980 (DIDMCA) and the Garn-St. Germain Act of 1982,
Congress eased the anticompetitive burden on banks by phasing out
Regulation Q.
• Congress passed the Garn-St. Germain Act to help reverse disintermediation
by allowing banks to offer money market deposit accounts (MMDAs), which
would be covered by FDIC insurance but against which banks were not
required to hold reserves.

Figure 12.7
Interest Rate Ceilings:
Crisis, Regulation,
Financial System
Response, and
Regulatory Response

Capital Requirements
• After an examination, a bank receives a grade in the form of a CAMELS

rating based on the following:
Capital adequacy
Asset quality
Management
Earnings
Liquidity
Sensitivity to market risk
• Regulating the minimum amount of capital that banks are required to hold
reduces the potential for moral hazard and the cost of bank failures.
• Regulators increased their focus on capital requirements following the
savings-and-loan (S&L) crisis of the 1980s.

Basel accord An international agreement about bank capital requirements.
• The fallout from the S&L crisis led a program by the Bank for International
Settlements (BIS), located in Basel, Switzerland.
• The Basel Committee on Banking Supervision developed the Basel accord
to regulate bank capital requirements.
• Under the Basel accord, bank assets are grouped into four categories based
on their degree of risk. These categories are used to calculate a measure of
a bank’s risk-adjusted assets by multiplying the dollar value of each asset by
a risk-adjustment factor.

A bank’s capital adequacy is calculated using two measures of the bank’s
capital relative to its risk-adjusted assets:
• Tier 1 capital consists mostly of bank capital, or shareholder’s equity.
• Tier 2 capital equals the bank’s loan loss reserves, its subordinated debt,
and several other bank balances sheet items.

• Implementation of these capital requirements meant that banks with low
capital ratios were forced to close or to raise additional capital, thereby
increasing the stability of the commercial banking system.
• Large commercial banks developed financial innovations that allowed these
banks to push some assets off their balance sheets.
• Some large banks, such as Citigroup, formed special investment vehicles
(SIVs) to hold risky assets.
• By the time of the financial crisis, there were about 30 SIVs, holding about
$320 billion in assets.
• As the assets held by the SIVs lost value, banks were forced to bring the
SIVs back into the bank’s balance sheet.

Figure 12.8
Capital Requirements:
Crisis, Regulation,
Financial System
Response, and
Regulatory Response

The 2007–2009 Financial Crisis and the Pattern of Crisis and Response
Key provisions of the Wall Street Reform and Consumer Protection Act, referred
to as the Dodd-Frank Act:
• Created the Consumer Financial Protection Bureau to protect consumers in
their borrowing and investing activities.
• Established the Financial Stability Oversight Council, to identify and act on
systemic risks to the financial system.
• Ended the too-big-to-fail policy for large financial firms.
• Made several changes to the Fed’s operations.
• Required certain derivatives to be traded on exchanges, not over the counter.
• Implemented the “Volcker Rule” by banning most proprietary trading at
commercial banks.
• Required hedge funds and private equity firms to register with the SEC.
• Required that firms selling mortgage-backed securities and similar assets
retain at least 5% of the credit risk.
Figure 12.9
The Financial Crisis of
2007–2009: Crisis,
Regulation, Financial
System Response, and
Regulatory Response

Answering the Key Question
At the beginning of this chapter, we asked the question:

“Does the severity of the 2007–2009 financial crisis explain the severity of the
recession during those years?”
We have seen that the recession of 2007–2009 was the most severe since the
Great Depression of the 1930s. It was also the first to be accompanied by a
financial crisis.
We discussed research showing that recessions involving financial crises have
been longer and deeper than recessions that do not involve financial crises.
We noted that because financial crises disrupt the flow of funds from savers to
households and firms, they cause substantial reductions in spending, which is
the key reason they make recessions worse. So, it is likely that the severity of
the 2007–2009 financial crisis explains the severity of the recession.

AN INSIDE LOOK AT POLICY
Congress Struggles to Reform
Financial Markets, Prevent Future Crisis
WALL STREET JOURNAL, Regulating a Moving Target
Key Points in the Article
• How much should Congress write strict rules to reduce risks of another global
financial crisis? And how much should it leave to regulators who failed to
prevent the crisis in the first place? Pending legislation would give less
discretion to regulators.
• Two countervailing forces were evident during the Congressional deliberations:
(1) Because markets are constantly evolving, when Congress writes too many
rigid rules, it often fails to get them right.
(2) Congress doesn’t revisit the rules of finance frequently enough to avoid
future crises.

AN INSIDE LOOK AT POLICY

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R.

HUBBARD ANTHONY PATRICK

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 4 of 57

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 of 57

• Economic activity depends on the ability of households and firms to borrow.

The Origins of Financial Crises

The Origins of Financial Crises

• Prior to 1933, the United States had no system of government deposit

• In the absence of deposit insurance, the stability of a bank depends on the

The Origins of Financial Crises

• If multiple banks have to sell the same assets—for example, mortgage-

Bank panic The situation in which many banks simultaneously experience

• A bank panic feeds on a self-fulfilling perception: If depositors believe that

The Origins of Financial Crises

Federal Deposit Insurance Corporation (FDIC) A federal government agency

The Origins of Financial Crises

The Origins of Financial Crises

The Origins of Financial Crises

• Sovereign debt refers to bonds issued by a government.

The Origins of Financial Crises

• Following the 2007–2009 recession, several European governments, most

The Origins of Financial Crises

The Origins of Financial Crises

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 20 of 57

The Financial Crisis of the Great Depression

The Financial Crisis of the Great Depression

The Financial Crisis of the Great Depression

The Financial Crisis of the Great Depression

1. No one was in charge.

2. The Fed was reluctant to rescue insolvent banks.

The Financial Crisis of the Great Depression

4. The Fed wanted to “purge speculative excess.”

The Financial Crisis of the Great Depression

• In the early 1960s, Milton Friedman and Anna Schwartz published an

The Financial Crisis of the Great Depression

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 29 of 57

The Financial Crisis of 2007–2009

The Financial Crisis of 2007–2009

The Financial Crisis of 2007–2009

• Having focused on the commercial banking system, the government was

The Financial Crisis of 2007–2009

The Financial Crisis of 2007–2009

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 35 of 57

Lender of Last Resort

Financial Crises and Financial Regulation

Financial Crises and Financial Regulation

• In 1984, the comptroller of the currency provided Congress with a list of

Financial Crises and Financial Regulation

Financial Crises and Financial Regulation

Financial Crises and Financial Regulation

Financial Crises and Financial Regulation

Financial Crises and Financial Regulation

Financial Crises and Financial Regulation

Disintermediation The exit of savers and borrowers from banks to financial

To circumvent Regulation Q, banks developed new financial instruments for

Financial Crises and Financial Regulation

Financial Crises and Financial Regulation

Financial Crises and Financial Regulation

• After an examination, a bank receives a grade in the form of a CAMELS

Financial Crises and Financial Regulation

Financial Crises and Financial Regulation