Topic 3

Comparative Financial Systems

Source of picture: http://www.financialregulationforum.com

Outline of Topic 3
1. Financial systems can be
(a) bank-based (e.g. Germany, France, Japan)
(b) market-based systems (e.g. US, UK)

2. Evolution of Financial Systems:

– 1st phrase (millennium BC to first century AD)-Ancient practice
– 2nd phrase (1200 -1300s) - Italian Bankers
– 3rd phrase (early 1600s) - Dutch Finance
– 4thphrase (1719-1720)-Emergence of Market-based & bank-based
system

3. The financial systems in UK, US, Germany, France, Japan

T3-pg1
 Outline of Topic 3
4. The emergence of Market-based Vs Bank-based Financial Systems
4.1 Market based vs Bank-based financial system
4.2 Implications of the market-based & bank-based financial systems:
a) households’ asset allocation
b) firms’ financing
c) role of indirect intermediation

5. Causes of financial crises:

1) Banking problem (e.g. bank panic, bank runs)
2) Increase in interest rates
3) Decline in stock market
4) Increase in uncertainty
4

Outline of Topic 3
6. Financial Crises In The USA
6.1 Great Depression (1929)
6.2 Subprime mortgage crisis 2007, Global Financial Crisis 2007–09
Key Causes of GFC 2007-2009
1) the growth of global macro-imbalances
2) financial market innovations (securitization, RMBS, CDO)
6.3 Timeline of Global Financial Crisis
• 2006–07: House prices fell (US)
• Late 2007- subprime mortgage crisis
• Sept 2008 -Lehman Brothers investment bank failed

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 Outline of Topic 3
7. Financial Crises In Emerging Market Countries
7.1 Financial crises in emerging market countries
7.2 Causes of financial crises in emerging countries:
a) Deterioration in banks’ balance sheets
b) Increase in interest rates abroad and internally
c) Stock market decline and increase in uncertainty
d) Fiscal problems of the government
e) Rise of interest rates abroad

8. Financial Bubbles
– Dutch Tulip Mania (1636–37)
– Internet Bubble (late 1990s)
6

Learning Outcomes

• explain the importance of banks & financial markets around the world
• discuss how the historical evolution of financial systems helps
to explain the existence of bank-based & market-based financial systems
• outline the similarities & differences between the financial systems
of industrialised countries
• discuss the implications of the bank-based & market-based financial systems
(in terms of households’ asset allocation, role of indirect intermediation
and firms’ financing)
• explain the economic factors causing financial crises & its sequence
of events.
• discuss the historical financial crises and financial bubbles.
7

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 Introduction
• Financial systems (financial market & financial intermediaries)
can be divided into (i) bank-based d (ii) market-based systems.

(ii) bank-based systems

• banks are more important than banks (e.g. Japan & Germany)
• Bank claims on the private sector to GDP ratio for Germany was 127%
(i.e. 2.5 times of the USA, 48%)

(i) market-based financial system

• markets are more important than banks (e.g. UK & the USA)
• Equity market capitalisation to GDP ratio in 2009 for US was 107%
(i.e. 3 times of Germany, 39%)

• Banks and market are equally important in France

• other European countries (e.g. Italy, Spain) banks are
important than markets.
8
• However, there are differences in the irrespective relevance

International Comparison of Banks and Markets

9
Source: M. Buckle (2011) Principle of Banking and Finance, ch3

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 Introduction
• The importance of financial institution are different across countries
• Gross financial assets are held differently (e.g. by households,
by pension funds, by insurance companies, by mutual funds)
• Most assets are owned directly by households (except for the UK).
• Pension funds are important in USA & UK but
relatively unimportant in Germany & Japan
• Allocation of assets in the portfolio are different across countries.
• Equity (share) constitutes
high proportion of household portfolio assets in the UK (52%),USA (45%)
low proportion in Germany (13%) and Japan (12%)
• Bond, cash & cash equivalents (include bank accounts) constitute
high proportion of household portfolio assets in Japan (52%) & Germany (36%)
low proportion in USA (19% cash, 28% bond) (Allen & Gale, 2001)
12

Introduction
Firms’ fund raising
• Retained earnings are the most important source of finance
in all countries (except Japan)
• External finance is simply not very important.
• Loans is the most important external sources of finance
• Loan is the 2nd source of finance in the USA, UK,
Germany, Japan, France & Italy (Mayer, 1990; Corbett and Jenkinson, 1997).
• USA & UK have the highest financial market capitalisation to GDP,
loans are important for corporate finance than are securities markets
(bonds & stocks).
• Germany & Japan have the lowest financial market capitalisation to GDP
loan is almost 10 times greater than that from securities markets.
15

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 Summary for Introduction
• UK & USA are eg of market-based financial systems, where:

Financial markets (i.e. organised markets for securities,
e.g. stocks/ bonds/ futures/ options) are more important than banks

The proportion of gross financial assets owned by pension funds
is higher.

The proportion of equity in the total portfolio allocation of assets
by householders is higher.

Loans from financial intermediaries are more important for
corporate finance than marketable securities,
but at a lower extent than in other financial systems.
• Germany and Japan are examples of bank-based financial systems.

16

Evolution of Financial Systems

• The historical development of financial systems
explain the existence of market-based and bank-based financial system.

1st phrase –Ancient practice (millennium BC to first century AD)

• From Mesopotanian financial system (third millennium BC) to
Roman empire (first century AD)
2nd phrase (1200 -1300s)
• After the Romans, monetary systems did not develop in Europe until the next
period of progress, starting in 1200 until Renaissance in the 1300s
3rd phrase (early 1600s)
took place in Amsterdam in the early 1600s.
4th phrase (1719-1720)
17

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 1st phrase- Ancient Practices
• From the Mesopotanian financial system (third millennium BC)
To the Roman empire (first century AD)

Characteristics
• Financial instruments were initially limited to precious metals or metallic
(gold & silver) coins.
• Then extended to loans and mortgages.
• Loans were made to individuals for consumption needs and for
agricultural financing (from landlords to tenants).
• Mortgages combine loan & insurance, and were used for
foreign trade financing to finance a voyager.
• When catastrophe, repayment was not required
(i.e. similar to equity instruments).
• Financial intermediaries were limited to banks & money changers
(as many different types of coins exists)
• Banks began to operate (accept deposits & make loans) in Athens 18
• in the late 5th century BC.

2nd phrase- Italian Bankers

• After the Romans, monetary systems did not develop in Europe until 1200
• From North of Rome in Tuscany & further North to the Renaissance
in the 1300s.
Characteristics
• Financial instruments became more varied (e.g. trade credit and mortgages,
bills of exchange, government & corporate securities, insurance contracts)
• The innovation of bills of exchange has been very important and
opened up the way to banks in a modern sense.
• Bills of exchange were debt instruments drawn on the buyer of goods,
which promised the payment of a specified amount in the
buyer’s hometown at some date in the future.
• Due to the prohibition on usury imposed by the Roman Catholic Church,
bills of exchange could not be discounted. To overcome this prohibition,
the exchange rate specified in the transaction was such that there was a
de facto discount.
• Note: Refer to Allen and Gale (2001) – look out for the role of the pre-Reformation Church;
the aristocracy, nation states and taxation; the rise of Islam; trade routes between Asia
19 and
Europe (via the Silk Road).

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 2nd phrase- Italian Bankers
Other new financial instruments appeared:
(i) Debt claims against amount borrowed by governments
(ii) Corporate claims (equity-like instruments) issued by partnerships
& companies.
(iii) Maritime insurance became important & life insurance was introduced.
• Financial intermediaries have early types of banks & insurance companies.
• After the Middle Ages Banks were first established in
Florence, Siena and Lucca, then spread to Venice and Genoa.
• In the 14th century Bardi and Peruzzi in Florence grew to a substantial size.
• In the 15th century, Medici banks in Florence achieved a sophistication
that remained unbeaten until the 19th century.
• The main activities of banks were:
– transferring money for international trade & the Roman Catholic Church
20
;
– establishing networks in Europe.

2nd phrase- Italian Bankers

• Informal markets appeared.
• Government & corporate securities were transferable & traded.
• Jewish people were more important than the Italians in northern Europe.
• Jewish plays important financial roles in Spain and Poland.
• The Church’s rules against usury gave the Jewish bankers
their competitive advantage.

21

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 3rd phrase- Dutch Finance (early 1600s)
• Took place in Amsterdam.
• The Netherlands independent from Spanish after a long, costly war.
• Trade and finance blossomed, Dutch called it’s as their ‘Golden Era’.
• The wealth that flowed down the River Rhine from Germany, France
and Switzerland led to new financial systems.
• Wealth increased - rise of Dutch painting, empire building & successful
wars against the English, culminating in a Dutch king of England in 1689.
• The Dutch gave the English a model for a ‘central bank’ and a new king.

22

3rd phrase- Dutch Finance (early 1600s)

• Financial markets became more formalised.
• The 1st formal stock exchange was established in 1608 as a market
for commodities & for securities (although these were less important).
• The market soon developed sophisticated trading practices.
• Tulip Mania (1636–37), the first financial bubble,
helped the development of the Amsterdam Bourse.
• Price of tulips rose quickly to very high levels then collapsed dramatically.
Caused many speculators bankcrupt.
• Options & futures contracts were traded on the Amsterdam Bourse;
• Government involved in the financial system through central banks
• The Bank of Amsterdam (established in 1609) became a model for public
banks set up by governments. Its main purpose was to facilitate payments.
• Commercial banks took deposits & made exchanges, but in general did not
provide credit.
23

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 4th Phrase- The Emergence Of
Market-based & Bank-based Systems (1719-20)
• South Sea Bubble occurred in England & the Mississippi Bubble in France.
• 2 distinctly different types of financial systems developed:
(i) stock market oriented US/UK model &
(ii) bank-oriented continental European model.
• UK repealed the heavy regulation of the stock market (called Bubble Act,
reacted to the South Sea Bubble) at the beginning of the 19th century.
• France only ease restriction on the stock market in 1980s.
• The French experience has substantially affected the development of
financial systems in continental Europe (especially the German system)

24

USA
• The National Bank Acts (1863 & 1864) set up a national banking system to
react to the chaos of the US Civil War.
• Fears of excessive centralisation led to the banks in each state being granted
limited powers: each bank was confined to a single state; and banks were
prohibited from holding equity or paying interest on demand deposits.
• After a series of panics in the system (1873, 1884, 1893, 1907),
the Federal Reserve System was established with a regional structure in 1913.
• In 1933 another major banking panic led to the closing of banks for an
extended period.
• This led to the Glass-Steagall Act of 1933, which introduced deposit
insurance & required the separation of commercial & investment banking
operations
• Prohibited universal banking & prevented banks from underwriting securities.
• So, throughout the 19th century, the US banking system was highly
fragmented, without a nationwide system with extensive branch networks. 25

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 USA
• Capital markets are more important than banks in the USA because:
1) The Civil War helped to develop New York’s financial market and the First
World War helped the New York market to supplant London markets
(as New York’s markets were financing all parties).
2) The prohibition on banks’ holding equity & the fragmentation of the banking
system (particularly to provide services to the corporate sector).
3) After the Great Crash 1929, Securities & Exchange Commission (SEC)
was created. SEC is the financial regulator to ensure the integrity of the
markets & the regulation of financial markets in US.
4) Financial innovation, introduced new financial instruments such as
derivatives (swap & options). At the same time, new exchanges for options
and financial appeared and become major markets.

27

USA –Regulation Relaxation

Relaxed 3 restrictions on the banking system
1) Erode the Glass-Steagall Act prohibitions
In 1987 the Fed allowed affiliates of approved commercial banks to engage
in underwriting activities. As long as the revenue did not exceed a specified
amount (10% initially but was raised to 25%) of the affiliates’ total revenues.
• In 1988 the Fed allowed 3 commercial banks (Bankers’ Trust, Citicorp & J.P.
Morgan) to underwrite corporate debt securities & to underwrite stocks.
• 2 competitive reasons determined this legislative change:
– Brokerage firms began to engage in the traditional banking business of
issuing deposits.
– Foreign banks’ activities in the USA eroded the position of national US
banks.

28

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 USA –Regulation Relaxation
2) Eliminate the Glass-Steagall Act
The Gramm-Leach-Bliley Financial Services Modernization Act of 1999
allows securities firms & insurance companies to purchase banks &
allows banks to underwrite insurance and securities and engage in real
estate activities.

3) Relax the restriction on banks crossing state boundaries

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
stated that after 1997 banks would be essentially unrestricted to interstate
banking, except in states that opted out or imposed other restrictions.
Nationwide banks beginning to emerge.

29

UK – Bubble Act (1720)

• South Sea Company was established in 1711 to fund the government debt in
exchange for a payment to the company.
• Speculation on South Sea Company stock caused a dramatic rise in its price.
This led to a large number of other stock issues by promoters who hoped to
profit from price appreciation.
• The Bubble Act (1720) was passed to prevent stocks from diverting
resources away from the South Sea Company. However, the Bubble Act did
not prevent a dramatic fall in the price of the South Sea Company, and many
speculators went bankrupt (note similar to the Tulip Mania in Amsterdam
Bourse).
• The Bubble Act was repealed in 1824 to create barriers to company formation.
Required a royal charter to form a joint stock company. As a result, the
London capital market did not become a source of funds for companies.
• However, London capital market did become important for government
financing in 19th century.
31

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 UK – London Stock Exchange (LSE)
• The London Stock Exchange (LSE) was established in 1802.
• LSE become more important as a source of funds for firms because of:
a. the repeal of the Bubble Act in 1824
b. the freedom to form companies without specific parliamentary approval,
introduced in 1856
c. the development of railways in Britain and abroad,
which resulted in a large demand for capital.
• New York replaced London as the world’s major financial centre after 1918.
To this day the UK remains a stock market-based financial system.

32

UK – Development of Banking System

The UK banking system developed strongly in the 19th century because:
1) Establishment of the Bank of England (1694)
• Bank of England was established as a private institution
to help government market debt to finance the 9 Years’ War with France.
• 1742 Bank of England was granted a monopoly over note issues
in England except for private banks.
• [Note that the growth of central banking activities in England laid the
foundation for the development of central banks in other countries]

2) Banks consolidated into nationwide networks

• Country banks needed to have London branches because of the Bank of
England’s role.
• London banks needed to have branches outside London. 33

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 UK – Development of Banking System
3) Concentration of commercial banking
• Commercial banking was traditionally dominated by 4 clearing banks
(Barclays, National Westminster, Midland & Lloyds)
(now Barclays, Royal Bank of Scotland, HSBC & Lloyds).
• Although there is no equivalent to the Glass- Steagall Act & universal
banking is allowed,
commercial and investment banking (merchant banking or securities firms
in UK terminology) were traditionally separate because of restrictive
practices.
• In 1986, the ‘Big Bang’ brought important structural changes in the LSE.
• All the securities firms became part of integrated financial institutions.

34

UK – Development of Banking System

4) Large Foreign Presence
• The foreign & domestic sectors banks are roughly equal in size.
• This large foreign presence may in part explain the high ratio of bank claims
on the private sector to GDP.
• However foreign banks are not involved with the domestic sector
(with a few exceptions)
• Traditionally, banks did not engage in long-term lending to industry.
• This explains why firms rely greatly on internal finance and markets for
raising funds.

35

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 Germany
• Banks play a far more important role and markets are less relevant
• Prior to 1850, German financial markets were undeveloped
relative to those in the UK, joint stock companies were rare.
• The markets (Frankfurt & Berlin) were mostly for
government debt and loans to princes, towns and foreign estate.
• Banks provided the initial finance for industrialisation &
managed the issue of shares & bonds to repay the loans.
• Links between banks and industry grew substantially during this period.
Banks were represented on the boards of companies, and
industrialists held seats on the boards of banks.
• Formed the Hausbank system where firms have a
long-term relationship with bank and use it for most of their financing needs.

36

Germany
• This qualifies as a universal banking system.
• Universal banks offer a full range of services to commercial customers &
are formally linked to their commercial customers through equity holdings.
• 3 major universal banks (Deutsche, Dresdner & Commerzbank)
dominate the allocation of resources in the corporate sector.
• This explains why the most important sources of funds for firms
were bank financing and internal finance.

37

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 Germany
Financial markets in Germany is relatively undeveloped because:
1) Rely on bank finance & the close relationship between banks & firms.
So bank loans are very important, although retained profit
is the most important source of finance.
2) Few households participate directly in the speculative financial market.
No prohibition for insider trading.
3) Limited availability of mutual funds.
German investors have a limited range of equity instruments to invest in.
The allocation across assets is mostly in cash & cash equivalents (36%) &
bonds (36%), while equity is fairly unimportant (13%).

39

Germany
• Recent developments – to create a single market in banking in the
European Union (EU) countries. This is to remove trade barriers across
European banking systems, by harmonising regulation in the EU countries.
• The Second Banking directive (1993) created the EU passport. It allows a
bank in 1 member country to provide core banking services throughout the EU.
• Complementary directives (Basel Capital Requirements Directives) aim to
harmonize solvency regulation across the EU.
• Basel 1 (1988) helped to strengthen the soundness & stability of the
international banking system by requiring higher capital ratios.
• Basel 2 (2006) revised Basel I by making the framework more risk sensitive &
representative of modern banks’ risk management practices.
• Note: Basel Committee on Banking Supervision

40

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 Japan
• Bank-based financial system is Japan (similar to German)
• Japan the government was active in the development of the banking system
(whereas the Germany Hausbank system developed in the private not public
sector)
• The Ministry of Finance & the Bank of Japan (BOJ) supervise extensively
over areas (e.g. opening of new branches, opening hours, credit volumes,
interest rates & accounting rules)

41

Japan
• In 19th century, feudalism and the Meiji Restoration were abolished.
• Japanese authorities played a leading role in the growth of the modern
industrial economy & the establishment of a financial system.
• During wartime (1937 to 1941), Japanese government introduced central
control of financial resources system (namely credit allocation system).
It determined a close relationship between banks & companies in the keiretsu
(i.e. a group of industrial firms with a core group of banks)
Characteristics of Japanese banking system:
1. Long-term relationships between a bank & firm.
2. Bank hold both debt & equity of non-financial firms.
3. Bank intervene actively in firm with financial problems.

• Japan loans (not retained profit) are the most important source of financing.
42

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 Japan
• Japanese banks are highly segmented & specialized along functional lines.
• Financial Reform (1992) reduced the amount of segmentation
(i.e. different types of financial firms are allowed to enter new financial
activities through separate subsidiaries).
• Japan experienced a major banking system crisis in 1997 & 1998,
7 large financial institutions went bankrupt.
Private financial institutions still have not fully recovered from this crisis:
in July 2007 only 1 Japanese bank (Mitsubishi UFJ Financial Group)
still maintains a global presence & occupies the 7th position in
The Banker’s ranking of the top 1,000 banks.
In 1994, six of the 10 top banks were occupied by Japanese banks.

44

Japan
• In the past 50 years, Japanese securities market has been weak.
• Japanese banking system experienced an abundance of funds due to
the large financial surplus of the personal sector caused by
– Japanese households are heavy savers
– limited investment opportunities in housing.
• Japanese households’ asset allocation is mainly cash & cash equivalents
(52% including bank accounts).
• The equity market is volatile & speculative as companies reply on banks’
financing, thus high leverage ratios.

45

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 Japan
• In recent years, financial markets have steadily become more important.
– The Japanese government relaxed several regulatory restrictions
(e.g. restriction on issuing bonds) to gain international recognition.
– Large firms are increasingly rely on financial markets to raise funds.
– Resulted in fairly sophisticated financial markets.
• The development of the Japanese financial market has determined
the relative unimportance of equity (13%) & bonds (12%) in
the asset allocation of Japanese households.
• Note that in the 1990s the fall in individual ownerships has mainly been
offset by an increase in the holdings of banks, insurance companies and
business corporations.

46

France
• The Mississippi Bubble profoundly affected the development of the stock
market and banks in France.
• Official Bourse was set up after the collapse.
• Markets for company securities did not develop significantly during the 19th
and 20th centuries.
• The Mississippi Bubble retarded the development of banks for many years.
2 main institutions (1938–62) aim to provide long-term loans for the industry.
But they ended up providing short-term commercial loans & speculating in
foreign bonds.
(This suggests that the system of banks lending to industry developed in a
deeper way only in Germany).

47

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 France
• bank-based financial and markets are less relevant.
• In the 1980s, French government reformed the financial system and the
financial markets developed greatly because:
1) Two main reforms.
(i) the creation of a single national market, so that stocks from any of the 7
exchanges could be traded at any exchange.
(ii) the completion of a computerised trading system (i.e. Cotation Assistée
et Continu(CAC).
2) The immediate success of derivatives markets (e.g.MATIF) in mid-1980s.
3) The substantial presence of collective investment scheme (e.g. mutual funds),
holding 19% of financial assets (much higher than other country).
• Note, a high proportion of assets (62%) are held directly by households, and
hold mainly cash and cash equivalents (38%) & bonds (33%).

48

Market-based Vs Bank-based Financial Systems

• market-based & bank-based financial systems are different due to the
national banking structure:
1) Integration of banking and commerce
can operate either by
(i) banks’ ownership of commercial firms or
(ii) commercial firms’ ownership of banks.
– USA & UK - no integration of banking & commerce.
– Germany & Japan - close relationship between banks & firms, with
higher amount of information available to banks. Reduce moral hazard
problem through monitoring firms.
Moral hazard is one of the problems intermediaries face in lending.
It represents the risk (hazard) that the borrower engages in
undesirable activities (immoral) after lending. 49

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 Market-based Vs Bank-based Financial Systems
2) Integration of the provision of bank & non-bank financial services
• Bank financial services: deposit-based lending
Non-bank financial services: investment, underwriting, insurance, trust &
property services.
• UK & USA - low integration bank services (Note: now, more integration are
now possible after financial reform)
• Germany - high integration of bank services (characterizes universal banks).
• France & Italy - limited universal banking.

51

Market-based Vs Bank-based Financial Systems

Some peculiarities
• USA (unlike UK & EC) – no nationwide banking system with few banks.
• Germany & France – Equity markets only develop in recent years.
Banks are the primary source funds to firms.
Germany – strong links between banks & firms
France - banking relationship is less successful developed
• Japan - government is important in the development of the banking system,
Germany (Hausbank system) - no government intervention in the
development of banking system

52

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 Market-based Vs Bank-based Financial Systems
Qns: What is the economic reason for the existence of market-based & bank-
based system?
Ans: different reactions to the instability of financial markets.
• South Sea Bubble (UK) & Mississippi Bubble (France)
resulted the existence of market-based and bank-based financial system.
• UK repealed the heavy stock market regulation (Bubble Act) in the 19th century
France relaxed the stock market restriction only in 1980s.
• Many financial crises & speculative bubbles (Tulip Mania, Great Crash,1929)
affected the development of financial systems.
• Financial systems are fragile and crises are endemic.

53

Market-based Vs Bank-based Financial Systems

• Financial markets did not develop spontaneously.
• Various kinds of financial institutions were responsible for the first financial
transactions in loans & transfers.
• Amsterdam Bourse was established in 17th century
• Market imperfections (e.g. transaction costs & asymmetric information)
cause the financial systems have been much closer to the extreme
where no financial markets exist.
• Financial intermediaries are needed to overcome market imperfections,
and allows firms & investors to exploit the market effectively.

54

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Implications of Market-based & Bank-based Financial Systems
The implications of the market-based & bank-based financial systems:
i) firms’ financing
ii) households’ asset allocation
ii) role of indirect intermediation (pension funds, insurance companies, mutual funds)

Households’ asset allocation [see Figure 3.2]

• UK & USA equity is a much more important component of household
assets than in Japan, France and Germany.
• Equity holding in asset portfolio:
UK (52%), US (45%), Japan (12%), Germany (13%)
• Cash & cash equivalents (include bank accounts):
Japan (52%), Germany (36%), USA (19%)
Bond holding
Japan (13%), Germany (36%), USA (28%)
• Bonds are fairly unimportant in the UK & Japan.
• USA & UK households bear significant risk 55
Germany, France & Japan households bear relatively little risk.

Implications of Market-based & Bank-based Financial Systems

The implications of the market-based & bank-based financial systems:
a) households’ asset allocation
b) firms’ financing
c) role of indirect intermediation (pension funds, insurance companies, mutual funds)

(a) Households’ asset allocation [see Figure 3.2]

• In the UK & USA equity is a more important component of household
assets than in Japan, France and Germany.
• Bonds are fairly unimportant in the UK & Japan.
• USA & UK households bear significant risk
Germany, France & Japan households bear relatively little risk.
Households’ Asset Allocation US UK Germany Japan
Equity 45% 52% 13% 12%
Cash & cash equivalent (+bank a/c) 19% 36% 52%
Bond 28% 36% 13%56

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 57
Source: M. Buckle (2011) Principle of Banking and Finance, ch3

Market-based Vs Bank-based Financial Systems

• Gross financial assets are held directly by households, by pension funds,
by insurance companies, by mutual funds.
• Most assets are owned directly by households (except for the UK) see Fig3.3
• Germany, France & Japan – individuals invest indirectly through intermediaries
(e.g. pension funds & mutual funds)
• USA - individual direct participation in the stock market is high (but falling).
Different individual, different investment decisions.
• Individuals are becoming less involved in making transactions
directly in financial markets, whereas the market share of
pension funds & mutual funds are increasing.
• Pension funds & insurance: UK & USA (important);
Germany & Japan (unimportant)

58

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 60
Source: M. Buckle (2011) Principle of Banking and Finance, ch3

Market-based Vs Bank-based Financial Systems

b) firms’ financing
• distinction between market-based & bank-based systems is not clear.
• Differences in firms’ external financing.
• Germany & Japan (bank based system) –firms’ financing from financial
intermediaries is 10 times greater than that from securities markets,
due to low financial market capitalization to GDP
• In market-based systems- financial markets are also
unimportant source of finance.
.

61

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 Current Trend: Towards Market-based Financial Systems
Current trend is towards market-based systems.
Several government policies support this argument.
• European Union (EU) countries- towards a single financial market
through harmonising regulation throughout EU countries.
• France - financial markets are getting more important since mid-1980s.
• Japan – financial system reforms (i.e. ‘Big Bang’) in 1998-1999

2 reason for the growing importance of market-based systems:

i) Discredited government intervention.
ii) Effectiveness of financial markets in allocating resources
as emphasised by economic theory

Note: Market imperfections (e.g. transaction costs & asymmetric information)

limits the grow of financial markets. 62

Financial Crises
Definition of financial crises
~ major disruptions in financial markets that are characterised by sharp falls in
asset prices and the failure of many financial institutions (including banks).
• A financial crisis cause sharp decline in the economic activities.
• Financial crises have been common in Europe & USA and
its impacts on the development of financial systems are deep.
• Many emerging countries have had several banking problems in 1980-1996.
3/4 of IMF members suffered some form of financial crises
(Lindgren, Garcia, Saal, 1996).
• The causes & consequences of the various financial crises are important.

63

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 Financial Crises – Asymmetric Information
• Financial crises occur where there is a large increase in asymmetric
information in financial markets.
• Asymmetric information occurs when one party to a transaction has less
information than the other party, unable to make an accurate decision.
• Market become less efficient is information asymmetries increase.
• Channel for moving funds from savers to investors (market-based system)
becomes less attractive relative to the banking system.

64

Causes of Financial Crises

Causes of financial crises:
1) Banking problem (e.g. bank panic, bank runs)
2) Increase in interest rates
3) Decline in stock market
4) Increase in uncertainty

65

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 Causes of Financial Crises
(1) Bank Problem (bank panic, bank run)
• Banks play a major role in the financing investments as they are informative.
• Banks are vulnerable to liquidity shocks if they mismatch the maturities of
liquid liabilities and illiquid assets
• Deterioration in the banks’ balance sheets implies fewer resources for
lending. This causes a decline in investment spending which slows economic
activities.
• In the case of a severe crisis, the banks might fail.
• Fear can spread from one bank to another.
• One bank panic can spread very quickly to other banks
(as depositors rush to withdraw their deposits simultaneously).

66

Causes of Financial Crises

(1) Bank Problem (bank panic, bank run)
• Without deposit insurance and ignorant of the loan quality,
depositors withdraw their funds from both good & bad banks simultaneously.
• Banks will have insufficient funds to meet all these requests.
• Depositors have a strong incentive to run on the bank first because banks
operate on a sequential service constraint (i.e. first come, first served ).

67

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 Causes of Financial Crises
(1) Bank Problem (bank panic, bank run)

• Uncertainty about the health of the banking system can lead to bank runs
on both good & bad banks
• The failure of one bank can provoke the failure of others banks
(i.e. contagion effect or systemic risk).
• These multiple bank failures are known as bank panics.

Consequences of a bank panic:

(i) a loss of information in financial markets and a loss of financial
intermediation by the banking sector.
(ii) a decrease in the supply of funds to borrowers (because of the absence of
lending), which leads to higher interest rates.

68

Causes of Financial Crises

(2) An increase in interest rates

• A sharp increase in interest rates (due to decrease in the money supply or

an increase in the demand) means that individuals & firms with the
riskiest investment projects are the only ones willing to pay the higher interest.
• Customer with bad credit risks are the only ones still willing to borrow
when interest rates are high.
• They are those who are likely to have weak, risky uses for the money.
• The consequence is that lenders no longer want to make loans.
• This decrease in lending leads to a decline in investment & aggregate
economic activity.

69

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 Causes of Financial Crises
(3) Stock Market Decline
• Stock market decline implies a lower value of the firm’s net worth &
lower collateral value (which is property promised to the lender
if the borrower defaults).
• Banks are less willing to lend as they are less protected by the
declining value of collateral.
Resulted a reduction in investments & aggregate economic activities.
• Decline in net worth induces firms to take on more risky investments,
as they lose less if they have to default.

70

Causes of Financial Crises

(4) An increase in uncertainty
Financial markets are more uncertain when:
i) failure of prominent financial institutions
ii) recession
iii) stock market crash

• Lenders become unable to screen good and bad credit risks

(due to the adverse selection problem).
• Decrease in lending causes decrease decline in investments &
aggregate economic activity.

71

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 Financial Crises In The USA
Sequence of events characterises many US financial crises:
a. 4 factors causing financial crises (mentioned earlier) lead to
an increase in adverse selection and moral hazard problems.
b. Decline in lending, investment spending & aggregate economic activity.
c. Bank panic happened as depositors to withdraw their funds from banks due
to economic slowdown and uncertainty about the banking system caused
d. Interest rates increase further and financial intermediation by banks
decreases as number of banks reduced
e. Adverse selection & moral hazard problems worsen.
f. Economic contracted further.
g. Debt deflation (i.e. prices declined sharply, firms’ net worth deteriorated
because of the increased burden of indebtedness borne by firms) happened.
The recovery process is short circuited.
73

Great Depression (1929)

• the worst ever experienced by the USA.
• 1928-1929: Stock market boomed which stock prices doubled.
The Fed pursued a tight monetary policy by increasing interest rates.
• 1929: Stock market crashed
• Middle-1930: >50% of the stock market decline had been reversed.
• After mid-1930: stock market continued to decline & the adverse shocks
extended to the agricultural industry. Uncertainty increased & economic
contracted, adverse selection & moral hazard worsen in credit markets.
• Oct 1930 to March 1933, a sequence of banks collapsed (over 1/3 of the US
banks went out of business).
– Decline in the amount of financial intermediation and the ability of financial
markets to channel funds to firms.
– Price fell by 25%. This triggered a debt deflation (i.e. net worth fell because
of the increased burden of indebtedness borne by firms).
– The decline in net worth and the resulting increase in adverse selection &
moral hazard problems in the credit market prolonged economic contraction 74
and unemployment rate rose to 25%.

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 Global Financial Crisis 2007–09
2 key Causes of GFC 2007-2009
1) the growth of global macro-imbalances
2) financial market innovations

1) the growth of global macro-imbalances

• Large current account deficits for the counterparties (e.g. US, UK, Europe)
• Large current account surpluses in Asian (e.g. China & Japan, oil exporting
countries).
• The surpluses had been used to buy large amounts of government debt in
the US & Europe and drove down interest rates in US & Europe.
• Low interest rates in the US & Europe resulted low inflation as low cost
imports coming from fast growing developing nations such as China.
• Low inflation has allowed central banks to keep interest rates low.
76

Global Financial Crisis 2007–09

• Low interest rates caused massive expansion of debt (esp. mortgage debt).
• A rapid expansion of mortgage lending by banks fuelled a
property price bubble as house prices grew at very fast rates.
• This in turn led lenders to relax credit standards leading to a
rapid expansion of sub-prime mortgage lending in the US (& EC).

Sub-prime borrowers:
~ borrowers who do not qualify for prime interest rates because they have
weakened credit histories, low credit scores,
high debt-burden ratios or high loan-to-value ratios.
• Investors desire to obtain higher yields to
offset the lower interest rates available in credit markets.
77

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 Global Financial Crisis 2007–09
2) Financial market innovation
• This desire for higher yields was satisfied by financial innovation,
in particular the process of securitization (i.e. debt is packaged then
transferred off the balance sheets of banks and new securities issued).
• See Figure 3.4 for the securitization process.
• Securitisation allows banks to diversify risk by transferring risk off their
balance sheet and transfer the debt to other parts of the financial system.
• Majority of investors in the securitised debt were other banks that held the
securities in their trading books.
• The ratings agencies also assigned high credit ratings to much of the
securitised debt products, thus creating the perception that the default risk
on these securities was very low.

78

79
Global Financial Crisis 2007–09
• The bank transfers the pool of mortgages
to a separate entity called a special purpose vehicle (SPV).
SPV should be independent of the bank and is normally set up as a trust.

79
Source: M. Buckle (2011) Principle of Banking and Finance, ch3

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 Global Financial Crisis 2007–09
Residential Mortgage Backed Securities (RMBS)
= securities created from packages of residential mortgages

Collateralised debt obligations (CDOs)

• additional securities
• combine multiple RMBSs (or parts of RMBSs) and then
selling portions of the income streams derived from the
mortgage pool or RMBSs to investors with different appetites for risk.

80

Global Financial Crisis 2007–09

2006–07: House prices fell (US)
• Many borrowers found that they owed more on their house than it was worth.
Many borrowers chose to default (particularly subprime borrowers who were
more sensitive to the fall in house prices).
• Rising loan defaults caused many RMBSs and CDOs (backed by residential
mortgages) experienced substantial losses.
Late 2007
• Banks (e.g. Northern Rock, UK) that depended heavily on securitisation to
fund expansion of its business, found that this source of funding dried up as
investors began to shun new issues of securitised mortgages.
• Banks holding securitised debt in their trading books began to experience
severe mark-to market losses.
• Liquidity problem arise as banks reduced lending to each other through the
inter-bank market as fears of insolvency increased. 81

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 Global Financial Crisis 2007–09
2008
• Large institutions (e.g. Fannie Mae & Freddie Mac) became reliant on
government support in the US.
Sept 2008 -Lehman Brothers investment bank failed
• A large drop in confidence occurred in Sept 2008
when Lehman Brothers investment bank failed,
so signalling that major institutions were not too big to fail.
• The collapse in confidence in the banking sector in the world
led central banks & governments to intervene
to provide exceptional liquidity support,
then recapitalisation of major banks, to prevent further failures.
• The severely impaired state of the banking system
led to a large reduction in credit extension by banks thus resulting in
82
a severe world economic recession.

Financial Crises In Emerging Market Countries

• Many emerging market countries have experienced financial crises in recent
years.
• Financial crises are different between the emerging market countries & USA
mainly due to the differences in the institutional features of debt markets
in emerging market countries.
• The sequence of events characterising these financial crises is different from
what occurred in the USA (19th & early 20th centuries) mainly due to
differences in the institutional features of debt markets in emerging market
countries.
Mexico Dec 1994
Venezuela 1994
Thailand, Indonesia South Korea July 1997
Ecuador 1998
Turkey 2000
Argentina Dec 2001
83

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 Financial Crises In Emerging Market Countries
Causes of financial crises in emerging countries:
1) Deterioration in banks’ balance sheets
due to the increase in loan losses caused by
(i) weak supervision by bank regulators &
(ii) lack of expertise in screening/monitoring borrowers at banks.
– This factor affected Mexican & East Asian crises and determined an
erosion of banks’ capital.
– Note: Argentina with well supervised banking system & no lending boom
occurred before the crisis;
in 1998 Argentina entered a recession that led to some loan losses.
2) Increase in interest rates abroad and internally
amplified adverse selection
(i.e. the parties willing to take on the most risk would seek loans). 84
Consistent with the US, affected Mexican & Argentine but not East Asian crises.

Financial Crises In Emerging Market Countries

3) Stock market decline and increase in uncertainty
• consistent with the US experience,
affected Mexico, Thailand, South Korea & Argentina.

4) Fiscal problems of the government

• As government budget deficits could not be financed by foreign borrowing,
the government forced banks to absorb large amounts of government debt.
• Investors lost confidence in the ability of the government to repay its debt.
The price of government debt decreased
• Big losses in banks’ balance sheets.
• This factor was typical of the Argentine crisis,
but not of the US, Mexican & East Asian crises.
85

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 Financial Crises In Emerging Market Countries
5) Rise of interest rates abroad
• The US Fed began to increase the government rate
to head off inflationary pressures.
• Although this monetary policy was successful in the USA,
it put upward pressures in foreign countries (esp in Mexico & Argentina).

86

Financial Crises In Emerging Market Countries

a. These factors worsened adverse selection & moral hazard problems.

b. Financial intermediaries experienced more difficulties
in screening out good & bad borrowers.
c. Decline in capital caused a decrease in the value of firms’ collateral &
an increase in firms’ incentives to make risky investments
(because of less equity to lose if the investments were unsuccessful).
d. speculative attacks developed in the foreign exchange markets,
plunging the economies into a full-scale crisis.
e. The interaction of the institutional structure of debt markets with the
currency devaluations played an important role.
Large proportions of firms’ debts were denominated in foreign currencies,
the depreciation of domestic currencies implied an increase in indebtedness.
90

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 Financial Crises In Emerging Market Countries
• Currencies collapse caused a rise in actual & expected inflation rates, &
interest rates.
• The increased interest payments caused
reductions in the cash flows of households & firms.
• The very short duration of debt contracts (of emerging market countries)
provoked a substantial effect on cash flows.
• The sharp decline in lending led to an economic activity decline and to a
deterioration in balance sheets, thus worsening banking crisis.
• Banks experienced substantial losses
because many firms & households were unable to pay off their debts.
• The deterioration of banks’ balance sheet worsen because of the large
amount of short-term liabilities denominated in foreign currencies,
which experienced a sharp increase in their value after the devaluation.
• The banking system would have collapsed in the 91
absence of a government safety net (e.g. the assistance of the IMF).

Financial Bubbles
• Financial crises often arise after asset prices bubbles.
• A bubble occurs when an asset or commodity becomes overinflated in
value.
3 distinct phases of bubbles:
1) Credit expansion due to financial liberalisation, & increase in asset prices
(e.g. real estates & shares). They rise as the bubble inflates.
2) bubble bursts & asset prices collapse (within a short period of time).
3) Default of many firms & other agents that have borrowed to buy assets at
inflated prices. A banking crisis may follow, causing problems in real
sectors of the economy such as industry.
Examples of Financial Bubbles
Dutch Tulip Mania Mexico (1994–95)
South Sea Bubble in England East Asia (1997– 98)
Mississippi Bubble in France Housing market bubbles (US, UK, Spain)
92
Bubbles in Japan (late 1980s) Internet bubble (late 1990s)

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 Dutch Tulip Mania (1636–37)
• The first serious financial bubble.
• Tulip bulbs prices rose quickly to very high levels,
before collapsing dramatically & causing many speculator bankrupt.

Sequence of events characterised the Dutch Tulip Mania

• The tulip experienced a strong growth in popularity in the Netherlands,
boosted by competition for possession of the rarest tulips.
• The competition escalated until prices reached very high levels.
• The flower rapidly became a luxury item and a status symbol.
• In 1623, a single bulb of a famous tulip variety could cost as much as a
thousand florins (vs. the average yearly income of 150 florins).
• Tulips were also exchanged for land & houses.
• By 1636, tulips were traded on the stock exchanges of numerous Dutch
towns and cities. 93

Dutch Tulip Mania

• People started to trade their other possessions in order to
speculate in the tulip market.
• Some traders sold tulip bulbs that had only just been planted or those they
intended to plant (i.e. tulip future contracts, a type of derivative instrument).
• Dutch government started to introduce regulation to control the tulip mania.
• A few informed speculators started liquidating their tulip bulbs & contracts.
• Supply of tulip bulbs increased as people harvesting new tulip bulbs.
• Suddenly tulip bulbs were not quite as rare as before.
• People began to suspect that the demand for tulips could not last.
• The tulip market began a slight downward trend.

94

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 Dutch Tulip Mania
• In February 1637 the market experienced a widespread panic: everyone
realised that tulips were not worth the prices people were paying for them,
and began to sell.
• The bubble burst: in less than 6 weeks, tulip prices crashed by over 90%.
• Attempts were made to resolve the situation, but these were unsuccessful.
• Individuals were stuck with the bulbs they held at the end of the crash.
• Note:
Lesser versions of the tulip mania also occurred in other parts of Europe
(e.g. UK), but never reached the state they had in the Netherlands.

95

Internet Bubble (late 1990s)

• Remarkable market values assigned to internet & related high-tech companies
seemed inconsistent with rational valuation.
• Equity valuations were based on uncertain future forecasts.
• Even if all market participants rationally priced common stocks as the present
value of all future cash flows expected, it was still possible for
inflated prices to develop.

2 main causes for the internet bubble

1) Outlandish & unsupportable claims were being made regarding the growth of
the internet (& the related telecommunications structure needed to support it);
2) Unsustainable projections for the rates & duration of growth of these ‘new
economy’ companies.

96

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 Internet Bubble (late 1990s)
Example:
• Amazon.com stock was trading for $130 a share, a prominent analyst issued
a buy stock recommendation, even though official projections led him to a
valuation of only $30.
• Admitting that he could justify any valuation between $1 and $200, the
analyst stated his recommendation was based on the company, its
opportunities & its management.
• During those years, professional investors argued that
the valuations of high-tech companies were proper, and
professional pension fund and mutual fund managers overweighted
their portfolios with high-tech stocks.
• Although it is now clear in retrospect that these professionals were wrong,
there were certainly no obvious arbitrage opportunities available.
97

Internet Bubble (late 1990s)

• While there were no profitable and predictable arbitrage opportunities
available during the internet bubble, and although stock prices eventually
did adjust to levels that more reasonably reflected the likely present value of
their cash flows, an argument can be maintained that
asset prices did remain ‘incorrect’ for a period of time.
• In the USA, the market index of the internet stock industry went above 1,000
in February 2000, and fell to 200 in October 2000.
• Internet firms represented 6% of the public equity market during Feb2000,
the pure internet sector represented 19% of the daily volume.
• The above stylised facts about returns and volumes provide evidence of the
irrationality of financial markets.
• The result was that too much new capital was allocated to internet and
related telecommunications companies.
• The stock market may well have temporarily failed in its role of 98
efficiently allocating equity capital.

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 Summary for Topic 3
• Differences reactions to the instability of financial markets explain the
existence of market-based financial systems (where financial markets are
more important than banks) and bank-based financial systems.
• A clear distinction between marketbased (USA & UK) & bank-based
systems (Germany, Japan & France), although the current trend is towards
market-based systems.

99

The two types of financial systems have different implications for:

 Households’ asset allocation: in the market-based systems, equity (in the
sense of stocks and shares) is a much more important component of
household assets than in the bank-based systems; the reverse is true for
cash, cash equivalents (which include bank accounts) and bonds.
 The role of indirect intermediation (pension funds, insurance companies,
mutual funds): individuals’ indirect investments through intermediaries are
dominant in the bank-based systems, whereas individuals’ direct participation
to the stock market is high in the market-based systems, especially the USA
(although even there it is in decline).
 Firms’ financing: in the market-based systems, loans from financial
intermediaries are more important for corporate finance than marketable
securities, but at a lesser extent than in the bank-based financial systems.
• financial crises, a major disruptions caused by a marked increase in the
asymmetric information problem in financial markets. The four types of
factors that lead to financial crises are bank panics, increase in interest rates,
stock market decline and increase in uncertainty. 100

T3-pg42
 Sample Examination Questions
Q1. Analyse the historical evolution of financial systems in order to explain the
reasons for the existence of market-based and bank-based systems.

Q2. a. Compare and contrast the German and Japanese banking systems.
b. Explain the main implications of the presence of market-based versus
bank-based financial systems.

Q3. a. How did competitive forces lead to the repeal of the Glass-Steagall Act’s
separation of the banking and securities industries? What are the recent
changes in US regulation on the separation of the banking and securities
industries?
b. In the light of the global financial crisis of 2007–09 discuss the case for a
new Glass-Steagall Act. 101

Sample Examination Questions

Q4. a. How can a stock market crash provoke a financial crisis?
b. Analyse the main events of financial bubbles. Refer to the internet bubble
of the late 1990s as a case study.

Q5. a. Analyse the causes of the global financial crisis of 2007–09.

b. What lessons can regulators learn from this crisis?

102

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 References
• M. Burkle (2011) Principle of Banking and Finance, chapter 3

Essential reading
• Allen, F. and D. Gale Comparing Financial Systems. (Cambridge, Mass.:
MIT Press, 2001) Chapters 1, 2 and 3.
• Mishkin, F. and S. Eakins Financial Markets and Institutions.
(Boston, London: Addison Wesley, 2009) Chapter 18.

Further reading
• Heffernan, S. Modern Banking. (Chichester: John Wiley and Sons,2005)
Chapter 2.

103

extra
Appendix – Bank Run vs Bank Panic
• A bank run (also known as a run on the bank) occurs in a fractional
reserve banking system when a large number of customers withdraw their
deposits from a financial institution at the same time and either demand cash
or transfer those funds into government bonds or precious metals or a safer
institution because they believe that financial institution is, or might become,
insolvent.
• A banking panic or bank panic is a financial crisis that occurs when
many banks suffer runs at the same time, as people suddenly try to convert
their threatened deposits into cash or try to get out of their domestic banking
system altogether.
• A systemic banking crisis is one where all or almost all of the banking
capital in a country is wiped out. The resulting chain of bankruptcies can
cause a long economic recession as domestic businesses and consumers
are starved of capital as the domestic banking system shuts down.

105

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