Prepared by: Dr. Surya Rana, Asst. Professor, Butwal Multiple Campus, T. U.

FINANCIAL CRISES: THEORY,

EVIDENCE, AND REMEDIES

A financial crisis is a situation in which asset prices see a steep decline in value, businesses
and consumers are unable to pay their debts, and financial institutions experience liquidity
shortages. A financial crisis is often associated with a panic or a bank run during
which investors sell-off assets or withdraw money from savings accounts because they fear
that the value of those assets will drop if they remain in a financial institution. Other
situations that may be labeled a financial crisis include the bursting of a speculative
financial bubble, a stock market crash, a sovereign default, or a currency crisis. A financial
crisis may be limited to banks or spread throughout a single economy, the economy of a
region, or economies worldwide.
A financial crisis may have multiple causes. Generally, a crisis can occur if institutions or
assets are overvalued, and can be intensified by irrational or herd-like investor behavior. For
example, a rapid string of selloffs can result in lower asset prices, prompting individuals to
dump assets or make huge savings withdrawals when a bank failure is rumored.
Contributing factors to a financial crisis include systemic failures, unanticipated or
uncontrollable human behavior, incentives to take too much risk, regulatory absence or
failures, or contagions that amount to a virus-like spread of problems from one institution or
country to the next. If left unchecked, a crisis can cause an economy to go into a recession or
depression. Even when measures are taken to avert a financial crisis, they can still happen,
accelerate, or deepen.

The increase in the number of crises and their impact on the economy has generated a large
amount of research into their causes. At theoretical level, the literature distinguished
between three main types (first, second, and third generation) models. The following
discussion examines each of these theories in turn.
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Many economists have intensive studies about currency crisis. The most important
contribution are Krugman and Obstfeld. Krugman (1979) has presented a crisis model which
is known as First-generation financial crisis theory. The main point of this model is that under
open economy, if government wants to maintain the fixed exchange rate, while there would
be a long time current account deficit because of the imbalance in economy that will lead
their currency devaluated. However, even government can use the foreign reserve to
maintain the balance of current account in the short time, but if the deficits continue
increasing, the result should be run out of foreign reserve and the fixed exchange rate
breakdown eventually. In Krugman’s paper, he presents a conception called ‘rational
expectations’, speculators are actively attempting to forecast the future in a ‘sophisticated
manner’. They expect that government would have to give up its fixed exchange rate sooner
or later, so they would change their domestic currency to foreign currency before the
government’s foreign reserve run out in order to avoid the loss from devaluation. However,
this kind of action would lead the foreign reserve exhausting earlier and financial crisis as
well, so this phenomenon can be seem as speculative attack. Krugman also figured out that
if government can get help from international institutions, then it can have more reserve
against speculative attack and maintain its exchange rate system temporarily. But if
government cannot solve the deficit of its current account, speculative attack would happen
again sooner or later.
In first-generation financial crisis model, currency crisis is an inevitable consequence with an
open economy with current account imbalance. However, in fact, the breakout of financial
crisis is random. Under a same economy, it is difficult to expect that whether currency crisis
would happen or not. Actually, in 1997 financial crisis, most of the affected countries gave
up maintaining their fixed exchange rate system before ran out of foreign reserve. But the
first-generation model cannot explain this phenomenon.

In order to explain when the government would give up the fixed exchange rate system and
would not give up under which situation, Obstfeld has presented another model in 1996,
which is known as Second-generation financial crisis theory. In his paper, Obstfeld points out
that the government may face cost like higher interest rate, deflation in economy when
maintaining fixed exchange rate.
In second generation models, crises are attributed either to some deterioration of domestic
conditions or to shifts in expectations. The monetary crisis starts either with the worsening
of economic fundamentals, or a shift from the expectations to consider endogenous
exchange rate policies with optimizing policy makers. These models introduce government
decision making and show the possibility of multiple equilibriums. Even if the
fundamentals are not bad, currency crises can still occur so long as speculative attacks on
currencies are able to drive market participants to believe that policy makers will devalue
the currencies; leading to a so called self-fulfilling currency crises. Some research shows that
prospective deficits account for currency crises. Esquivel & Larrain (1998) identified two key
characteristics of second generation models, namely: (i) the government is an active agent
 FINANC E AND ECONOMIC GROWTH: THEORY AND EVIDENCE Chapter 7 3

and maximizes an objective function and (ii) a circular process exists, leading to multiple
equilibriums.
The second generation models of currency crisis is a bit more complex to explain. Crises
may come even if economic fundamentals are good. In other words, good policy does not
necessarily protect from crises. These models capture the inherent instability of the private
currency market. Technically, the model is based on some kind of nonlinearity in the policy
reaction function. If the policy is linear (roughly speaking, the policy is the same before and
after the attack), there is usually only one solution to the model. But if it is not linear (the
policy changes before and after the crises), there is a possibility of multiple equilibria-an
equilibrium with crises and an equilibrium without crises are both possible.
For example, this can occur when the government is pursuing two goals. It wants to have a
fixed exchange rate on the other hand, but it also wants to keep unemployment down (or
alternatively, keep interest rates low, protect banks' balance sheets, contain external debt
burden, etc) on the other. Tight money supports the fixed exchange rate but worsens the
other situation. While the government is able to maintain exchange rate stability by tight
macro policy, it may choose to do so. But when a big crises comes, maintaining the exchange
rate becomes too costly, and the government will switch to the other regime of floating the
currency and achieving the domestic goal. In other words, the policy of fixing the exchange
rate under some domestic strain and the policy of giving up currency stability and achieving
domestic goals are both possible. Which one will be realized depends on whether the market
crises or not. The first solution is chosen if the market does not crises, but the second
solution is chosen if the crisis comes. It is the market, not the government, who decides.
The above explanation is just one example. There are many other ways to model policy
nonlinearity and have similar indeterminate results. Another point: the second generation
models can show the possibility of multiple equilibria but cannot tell us which outcome
(crises solution or non-crises solution) is more likely to emerge empirically. In other words,
the theory takes the market psychology as externally given, instead of explaining it.
The following phenomena, which are mutually related, are associated with the second
generation models:
Self-fulfilling crises: If the market decides to attack, a currency crisis will occur. If the
market chooses not to attack, a crisis will not happen. Any news or rumor (whether true or
false) that affects the market sentiment may start a crisis. Whether the country's policy is
good or bad, in this sense, is irrelevant.
Herding: currency traders and international investors may behave like a herd of buffalos. If
the leader goes in one direction, all others will follow without thinking. As a result, all of
them may go over a cliff. Their behavior is not rational or based on solid facts. Investors
invest in fashionable assets, but they do not really know very much about these assets.
Information cascade: If one person (say, a market analyst) says that country A has a trouble,
some people begin to believe it. Because some believe it, more and more people come to
believe it, until everyone is pessimistic about this country--but in reality, the first analyst
may be wrong, and there may be no problem with country A ! Once started, information
spreads like avalanche and no one can stop it.
4 FINANCIAL ECONOMICS

The first and second generation models have very different policy implications. In the first
generation models, the crisis is caused by problems in fundamentals. Bad policy invites
attacks, so correct the policy. But the second generation model points to inherent instability
in private sector behavior. If financial markets are inherently unstable and damaging, a free
economy may not be such a good thing. The government should regulate markets rather
than let them work freely.

Instead of fiscal imbalances or weakness in real activity, the most striking common feature
of recent crises in emerging markets was a sudden and large reversal in private capital
flows, which pushed many local banks and corporations into bankruptcy. This has led to a
“third generation” of crisis models, which assigns a key role to financial structure. The third
generation of theoretical models included financial sector indicators derived from aggregate
balance sheets of banks. After the failure of two generations of models, two approaches were
featured: herd behavior and the moral hazard problem. Under the herd behavior,
speculators follow behavior with the assumption that it reflects knowledge sets of others,
and that multiple equilibriums are likely to occur. According to moral hazard, implicit
guarantees granted to the financial institutions that are already ill-regulated and not
monitored closely led to over expansion of supply of financial instruments.
Third generation models focused on contagion effects as a cause of currency crises. In the
third generation model of currency crises, the problem is liquidity. The economy is working
well without large deficits and high inflation. However, it has accumulated substantial
amounts of foreign debt. Even worse, it has accumulated a lot of short-term foreign debt, i.e.
debt that matures in one year or less. If foreign creditors demand immediate repayment on
these credits, the country does not have enough foreign exchange to pay them off. Therefore,
the warning sign for this type of a currency crisis is having more short-term debt than
foreign exchange reserves. If the reserves are less than the short-term debt, then the country
would not be able to pay its obligations if creditors pull out.
We should point out, however, that the large short-term debt is not enough to trigger a
crisis. A crisis would unfold only if the lenders decide to pull out their investments. Why do
countries accumulate so much short-term foreign debt? For one, credit denominated in
dollars is cheaper compared to credit in the local currency. The local money is riskier and
lenders require a risk premium. Second, short-term debt is cheaper than long-term debt as
lenders do not commit their funds for a long time. So, at times when interest rates are low
and economies are growing, lenders and borrowers become tempted to lend and borrow,
perhaps too much when we look in retrospect.
Krugman (1999) argued that two factors had been omitted from formal models: the role of
companies’ balance sheets in determining their ability to invest, and capital flows in
affecting the real exchange rate. The empirical literature in these models uses the ratio of
domestic debts dominated foreign currency and the real exchange rate as key factors in
predicting crisis, specifically in emerging markets.
 FINANC E AND ECONOMIC GROWTH: THEORY AND EVIDENCE Chapter 7 5

Hyman Minsky was an American economist who lived from 1919 to 1996, living through the
Great Depression which undoubtedly moulded his heterodox post-Keynesian economics.
One of Minsky’s most significant contributions to the economic field was his Financial
Instability Hypothesis (FIH), which has seen a growth in relevance over recent years with
the Financial Crisis of 2008.
The conventional view is that a modern market economy is fundamentally stable, in the
sense that it is constantly equilibrium-seeking and sustaining, and that some exogenous
shock is necessary for some crisis to occur. However, Minsky challenged this perception
with the FIH. Essentially, Minsky argues that stability is destabilizing, and that the internal
dynamics of a system can be solely responsible for market failures. The FIH maintains that
the level of profits determines system behavior, as aggregate demand determines profit, and
so aggregate profits equal aggregate investment plus the government deficit. To Minsky,
banks act as profit-making institutions, with an incentive to increase lending, which
undermines the stability of the economy. Debt plays a crucial role in determining system
behavior, and so Minsky analyzes three distinct income-debt relations for economic units.
The three stages of lending which Minsky identifies are the Hedge, Speculative and Ponzi
stages. During the Hedge Stage, banks and borrowers are cautious and so loans are issued as
modest normal capital repayment loans, where the initial principles and the interest can be
repaid. Thus, the economy at this stage is likely to be equilibrium-seeking and containing.
Following this period, the Speculative Period emerges, where confidence in the banking
system grows. As banks are heavily incentivized to make profits, loans are issued where the
borrower can only afford to pay the interest, where the loan is against an asset which is
rising in value. As a result of the increase in speculation, the economy becomes a ‘deviation-
amplifying’ system. In continuation with the belief that asset prices will continue to rise, the
third stage in the cycle, the Ponzi Stage, emerges.
In the final stage of the FIH, the borrower can neither afford to pay the principal nor the
interest on the loans which are issued by banks. Therefore, the three stages of the FIH
suggest that, over periods of prolonged prosperity, economies tend towards economic
structures which increasingly rely on unstable loans, away from the financial structure of
stability in the initial stage. Minsky’s FIH proposes that the transition towards instability
will inevitably culminate in a financial crash.
Despite not coining the term himself, Minsky’s FIH predicts that capitalist economies in the
Ponzi stage will experience a ‘Minsky moment’. Crucially, the premise that asset prices will
continue to rise is what Minsky’s FIH seeks to unpick as a naive assumption, which has
critical implications in analysing the market - this premise underpins Ponzi finance.
However, the ‘Minsky moment’ emerges when these asset prices begin to decline
unexpectedly, and then the banks and the borrowers recognize the debt in the system.
This realization is fundamental to the FIH, as it is the moment where the loans issued in the
Ponzi stage, which the borrower has not the capacity to repay the principal nor the interest,
are recognized to be impossible to pay off. In sequence, confidence in the system plummets
to a stage where people rush to sell assets, which further results in a greater fall in prices.
6 FINANCIAL ECONOMICS

Minsky’s work on the FIH has become increasingly prevalent as of late, mostly due to the
Great Recession, which is a testament to the accuracy of Minsky’s predictions.

In the years preceding the crash of 2007-08, regulation became more lax and new practices
(such as securitization and off-balance sheet leverage) spread about the system. Low interest
rates provided a strong incentive to take on debt, and from 1997 to 2007, mortgage stock
rose from $4.7 tn to $14.1tn, pushing up house prices by more than 90%. However, this
resulted in the financial sector building up a huge exposure to the housing market through
mortgages to subprime borrowers.
Minsky recognized this stage as the Speculative and Ponzi stage, or the inherently unstable
part of the market cycle. As subprime borrowers found themselves in negative equity,
unable to refinance their mortgage and facing the effects of the adjustable-rate mortgages,
subprime borrowers began to default. The Minsky moment occurred as house prices began
to fall, which resulted in huge damage to the financial system and collateral damage to the
rest of the economy. From 2005 to 2011, foreclosures skyrocketed from 800,000 to four
million. In essence, the Financial Crash of 2008 is a perfect illustration of Minsky’s FIH, as it
reveals how the economic system progressed through the three successive stages, and
eventually culminated in a Minsky moment which plummeted the economy into chaos.
Minsky’s FIH maintains that business cycles are compounded out of the internal dynamics
of the economy and the system of interventions and regulations.
To conclude, Minsky argues that periods of prolonged prosperity, the ‘tranquil period’,
incentivise financial institutions to invest in riskier assets. However, riskier assets result in
greater market exposure, making the system more vulnerable to defaults. As the lending
criteria are relaxed, the increase in supply of credit increases the leverage of the banking
system - the highly leveraged financial system is at risk of systemic collapse when asset
prices fall. Minsky’s work on the instability of financial markets is heavily supported by
evidence from the 2008 Financial Crisis, and thus holds significant weight as an economic
hypothesis

The financial crisis of 2007–08, also known as the global financial crisis and the 2008
financial crisis, was a severe worldwide economic crisis considered by many economists to
have been the most serious financial crisis since the Great Depression of the 1930s, to which
it is often compared.
It began in 2007 with a crisis in the subprime mortgage market in the United States, and
developed into a full-blown international banking crisis with the collapse of the investment
bank Lehman Brothers on September 15, 2008. Excessive risk-taking by banks such as
Lehman Brothers helped to magnify the financial impact globally. Massive bail-outs of
financial institutions and other palliative monetary and fiscal policies were employed to
prevent a possible collapse of the world financial system. The crisis was nonetheless
followed by a global economic downturn, the Great Recession. The Asian markets (China,
Hong Kong, Japan, India, etc.) were immediately impacted and volatilized after the U.S.
 FINANC E AND ECONOMIC GROWTH: THEORY AND EVIDENCE Chapter 7 7

sub-prime crisis. The European debt crisis, a crisis in the banking system of the European
countries using the euro, followed later.
In 2010, the Dodd–Frank Wall Street Reform and Consumer Protection Act was enacted in
the US following the crisis to promote the financial stability of the United States. The Basel
III capital and liquidity standards were adopted by countries around the world.
The main factor for the Financial Crisis of 2007–2008 was a high default rate in the United
States subprime home mortgage sector. This happened when many housing mortgage
debtors failed to make their regular payments, leading to a high rate of foreclosures. At that
time, low interest rates encouraged mortgage lending. Many mortgages were bundled
together and formed into new financial instruments called mortgage-backed securities, in a
process known as securitization. The accumulation and subsequent high default rate of
these subprime mortgages led to the financial crisis and the consequent damage to the
world economy.

While the collapse of large financial institutions was prevented by the bailout of banks by
national governments, stock markets still dropped worldwide. In many areas, the housing
market also suffered, resulting in evictions, foreclosures, and prolonged unemployment. The
crisis played a significant role in the failure of key businesses, declines in consumer wealth
estimated in trillions of US dollars, and a downturn in economic activity leading to the Great
Recession of 2008–2012 and contributing to the European sovereign-debt crisis.
The bursting of the US housing bubble, which peaked at the end of 2006, caused the values
of securities tied to US real estate pricing to plummet, damaging financial institutions
globally. The financial crisis was triggered by a complex interplay of policies that
encouraged home ownership, providing easier access to loans for subprime borrowers;
overvaluation of bundled subprime mortgages based on the theory that housing prices
would continue to escalate; questionable trading practices on behalf of both buyers and
sellers; compensation structures that prioritize short-term deal flow over long-term value
creation; and a lack of adequate capital holdings from banks and insurance companies to
back the financial commitments they were making. Questions regarding bank solvency,
declines in credit availability, and damaged investor confidence affected global stock
markets, where securities suffered large losses during 2008 and early 2009. Economies
worldwide slowed during this period, as credit tightened and international trade
declined. Governments and central banks responded with unprecedented fiscal
stimulus, monetary policy expansion and institutional bailouts. In the US, Congress passed
the American Recovery and Reinvestment Act of 2009.

There is no need for a new global financial system or for creating new international
institutions to maintain financial stability. Rather, there is a need for strengthening the
existing institutional framework by enhancing those general principles that ensure a smooth
functioning of market economies. They include:
 Stability-oriented macroeconomic policies;
8 FINANCIAL ECONOMICS

 High competition on all markets;

 The protection of property rights;
 Freedom of contract; and
 Unlimited liability.
As regards macroeconomic policies, they have to be medium term oriented and geared
towards price stability and sound public finances. The commitment to price stability and
sound public finances is the best contribution of monetary and fiscal policies to maintain
financial stability. However, there is no trade-off between price stability and financial
stability and there is also no trade-off between sound public finances and financial stability.
As regards the institutional framework for the financial sector, we have to accept that even
the tightest regulation cannot prevent a financial crisis. However, it is clear that the benefits
of tighter regulation are generally larger. Hence, there is a need for a realistic assessment of
the costs and benefits of tighter regulation. New regulation should set general principles
rather than drawing up long lists of discretionary measures, which are necessarily
incomplete and invite renewed regulatory arbitrage.
New regulations should
1) Not cover all possible states of nature but rather provide automatic stabilizers for
the financial system in general terms.
2) Strengthen incentives that improve the disciplining forces of competition.
3) Discourage “short-termism” and promote a medium to long-term attitude of
financial agents towards success and stability.
4) Not prevent financial innovation as it is important for growth and employment,
5) Strengthen at the same time the concept of liability and responsibility.
There are, in particular, five areas of concern that should be addressed to strengthen the
institutional framework for the financial sector:
Risk management of banks: Both bank management and supervisors will have to play a
more active role in scrutinizing risk management practices (internal checks and balances,
clear lines of responsibilities, etc.), especially with regard to off-balance sheet entities and
structured products. This should hold true not only in times of crisis but maybe even more
important in good times when risks are less obvious.
Management of liquidity risk: Bank management should enhance their liquidity
management practices to address the liquidity risks in their day-to-day business along the
line of the “Principles for Sound Liquidity Risk Management and Supervision” provided by
the Basel Committee.
Credit rating agencies: Rating methodologies failed to capture risks embodied in structured
products and investors relied too heavily on those external ratings. Rating agencies should
enhance their transparency and should comply with relevant codes of conduct. More
differentiated rating systems for structured products should be adopted. Conflicts of interest
are to be avoided which are in particular acute when a rating agency also offers consulting
services.
 FINANC E AND ECONOMIC GROWTH: THEORY AND EVIDENCE Chapter 7 9

Valuation, disclosure and accounting: Weaknesses in accounting standards and gaps with
regard to valuation of structured products contributed to the current crisis. Banks will have
to develop robust pricing, risk management and stress testing models and improve
disclosure practices. Supervisors and accounting standard setters should advance the
transparency and the disclosure standards for off-balance sheet vehicles. They should
further reassess the valuation of assets, with a special focus on the mark-to-market approach
given its potentially pro-cyclical effects.
Strengthen capital adequacy: Supervisors did not adequately account for the risks
associated with new complex financial instruments. Some financial engineering in recent
years focused on repackaging weak credits into high-rated securities, receiving a favorable
risk weighing for capital adequacy standards. The respective prudential norms and rating
schemes should be reassessed also with a view to make the financial instruments less
complex. In order to increase the capital buffers that banks need to hold with regard to
illiquid structured products and off-balance sheet activities, the capital adequacy provisions
within the Basel II framework should be also enhanced in these areas.