EC102 WEEK 9

Origins of financial crises

Usually start at the end of periods when economic agents have extremely optimistic views
of their incomes, behaviour of asset prices or the economy’s performance, i.e. after periods
of irrational exuberance
 Lenders make excessive and risky loans; borrowers take on borrowing and debt for
excessive and risky purposes
 Financial intermediaries lever up to make very aggressive, risky loans to households
and firms
 Households and financial intermediaries invest heavily in the stock market, often
financed by borrowing
 Households borrow to buy larger and more expensive houses
 Households, financial intermediaries, and other firms become heavily indebted
 Risk and debt accumulate in the economy
 Asset bubbles: asset prices increase quarter after quarter due to
speculation/expectation; usually the price of a stock or a share is linked to future
profits, but sometimes people divorce their expectation of prices to expectations of
profit which leads to an intrinsic momentum in prices. It has the nature of a self-
fulfilling prophecy -> leads to losses in the prices of these assets
 Under this mechanism, after a while the price goes completely out of line with its
fundamental value (e.g. price of stocks should be fundamentally based on the future
profits)
 2008-2009 crisis; preceded by a massive housing market bubble; in some countries
the price of a house doubled in less than 10 years (the same family that received the
utility of 100, received the utility of 200 in less than 10 years- graph)
 Bubbles burst with price crashes; some people start speculating that prices will fall;
people realising the bubble problem when profits tend to be much less than the
asset prices justify. These people begin to sell these assets instead of having an
excessive demand -> people wake up from these beliefs and realise the lack of
alignment between asset prices and fundamental values -> asset prices collapse,
bubble bursts

Possible triggers of a financial crisis

 Loan defaults: some of the most reckless loans prove unpayable (losses on
loans); mild macroeconomic shocks may also cause loan defaults (super-levered
banks are affected by mild shocks- businesses that are perfectly viable can’t
repay loans any more-> decline in value of loans)
 Bursting of asset price bubbles: speculators awaken to unsustainability of the
bubble (decline in value of assets or securities)
 Loan defaults +asset price declines = losses (given that banks are highly
leveraged)
 Losses + high leverage = insolvencies
 The asset side of banks’ balance sheets shrinks; these banks were highly
leveraged to begin with, so coupled with asset losses leads to insolvencies
 Mortgage defaults: when house prices are steady- there is no problem for
banks; when house prices fall- there are balance sheet losses
Contagion:
 Spikes in insolvencies in some banks will lead to insolvencies in other banks. Banks
often lend to each other, so a bank which becomes insolvent, defaults on its debt to
the bank that lent to it, causing losses to the lending bank (bank A defaults, bank B
experiences losses).
 When lenders and depositors observe one bank becoming insolvent, they begin to
worry about other banks’ solvency; suppose I have a deposit with HSBC, and I see
that Lloyds is becoming insolvent -> how exposed is HSBC to Lloyds (how much
money did HSBC lend to Lloyds)? The more exposed my bank is to the insolvent
bank, the bigger the losses my bank experiences and so the more likely the losses on
my bank’s balance sheet -> How similar were HSBC’s lending practices to Lloyds’ (the
failing institution)?
 As a result, there may be withdrawal of deposits and other forms of short-term
lending (runs) even in solvent banks (e.g. in 2008-2009, the collapses of northern
rock, bear Stearns, Lehman brothers, etc. reduced confidence in other large
institutions, many of which were interdependent)
 A problem of information: hard to know all the loans and securities banks are
making; hard to judge whether our bank is safe or not, whether it is exposed to other
failing banks or not, or whether their lending strategies are safer than the other
failing banks’ strategies.

Fire sales
Selling of large amounts of assets
 Once a bank is insolvent its assets get liquidated
 Other banks even solvent ones, begin to sell their own assets; as depositors and
lenders become concerned about the general wisdom of leaving their money with
banks, they withdraw their deposits. And so, banks become very worried about
illiquidity (even solvent ones) ->to replace their shrinking reserves, and stave off
illiquidity, even solvent banks must sell their assets, trying to turn illiquid assets into
reserves, so that they can face withdrawals
 steep price declines- the attempt of banks to create reserves to avoid illiquidity,
causes a big decline in asset prices

Credit Crunch
 Firms that relied on insolvent banks can no longer borrow
 Even solvent banks try to turn as much of their loans as possible into reserves
(whenever a loan is repaid, instead of the money being re-loaned, it is kept as a
reserve; plus, any cash injection from depositors or lenders are kept as reserves)
 Consumers could no longer borrow to buy houses, and firms could no longer borrow
to invest, to buy inventories and in some cases not even to pay their workers
 Collapse in credit flowing in the UK economy in the financial crisis: combination of
banks being bankrupt, but banks still in business refusing to lend

Recession
When banks stop lending, then spending by consumers and firms declines, reducing AD.
The credit crunch is the culmination of the financial side of the crisis and the beginning of
the macro-economic crisis.
Result: output falls, unemployment rises

A vicious cycle
 As the recession takes hold, profits are down, and thus assets values are down, and
household incomes (mortgage defaults), which increases defaults, bankruptcies and
stress on financial institutions
 The financial system’s problems and the economy’s downturn reinforce each other

 The Credit crunch transforms the crisis from a financial sector crisis to an overall
crisis for the whole economy. Once it has become a macro-economic crisis, all sorts
of feedback loops come back to the financial sector and make the original shock
even worse, as there are more defaults and more asset price declines

Policy responses to a crisis

A recession needs to be met with counter-cyclical macro-economic policy (conventional
response)
1. Central bank can lower interest rates
2. The fiscal authority can increase spending and cut taxes (big spike in the deficit
during the financial crisis)
Lending of last resort
1. Runs on banks can create a liquidity crisis, in which solvent banks have insufficient
funds to satisfy depositors’ withdrawals
2. The central bank can make direct loans to these banks, acting as a lender of last
resort
3. The fiscal authority can also pitch in with banks and other financial (and sometimes
non-financial) actors

Nationalisations and publicly-funded recapitalisations

it is believed that insolvency of banks is tremendously damaging for the macro-economic
system, because banks perform this critical role of lending to businesses; governments very
often put a very high premium in avoiding the shut-downs of banks
1. Government takes insolvent banks over, making up the difference between assets
and liabilities, plus some extra capital, and becomes the sole owner of the bank
2. For near-insolvent banks, the government increases the bank’s capital and becomes
co-owner of the bank (publicly-funded recapitalisation)
 The point is to keep the banks operating so firms have somewhere to go for
credit, otherwise the collapse of the economy will be even more severe
 These operations are often loosely referred to as bail-outs

Subsidised lending
1. Government offers subsidies to banks that lend to firms and households (e.g. central
bank lending to very low interest rates, if money is used to lend to businesses that
need help)

Financial system reform:

Goals:
 Modifying the behaviour of financial actors and intermediaries; one important
precondition to a financial crisis is the build-up of excessive leverage in the financial
system- so, try to limit risk-taking by financial intermediaries and contain leverage
 Make the financial system more resilient to losses
 Should do this without impairing the system’s function of providing credit: can we
strike the right balance between allowing banks to lend and take some risks and
protecting the economy from excessive risk and leverage
Regulation:
 Has to do with the rules that the financial institutions need to obey; regulators
make the rules which are designed to put limits on how much risk and leverage
banks may take
Supervision
 Has to do with the day-to-day monitoring of financial institutions’ behaviour;
enforcement of the regulation
 Important because banks are complicated and big, so monitoring that they stick to
the rules is hard
‘Regulators’ often refers to both those who design regulation and those who supervise it
 Many agencies in different countries share different roles in regulation and
supervision
 Central banks almost everywhere play an important role in regulation and
supervision (in the eurozone, ECB is the most important regulator)
 But other agencies contribute as well (e.g. in the US, the FED plays an important
role)
Micro vs. ‘macro-prudential’ supervision
 Traditionally, supervision meant the monitoring of individual banks; teams within the
regulating agency would follow the balance sheet, the lending practices etc. of a
particular bank, intervening only in the practices of that bank itself (micro-prudence)
 The financial crisis exposed that there may be behaviour by individual banks, which
the system can deal with if it’s only one bank that experiences difficulties because of
 that particular strategy. If the same strategy is followed by many banks
simultaneously, the systemic risk is much bigger -> could create panic, contagion, fire
sales etc.
 Macro-prudential supervision: supervisors don’t specialise specific banks but follow
the financial system as a whole and have the tools to intervene in the whole system
e.g. supervision in the UK: BoE divided into three: MPC (focuses on countercyclical
policy), FPC (designed on the model of the MPC but focuses on the safety and
solidity and resilience of the financial system as a whole), PRA (prudential regulation
authority-teams focusing on individual banks)

Tools of the FPC: countercyclical capital buffer, limits of loan-to-value or debt-to-income

ratios (a way to limit leverage in an economy) e.g. for mortgages, the loan-to-value ratio
is the size of the mortgage compared to the size of the loan; if the limit is 80%, the bank
can only lend up to 80% of the price of the house, limits to lending to certain sectors
 Capital requirements: a minimum on the capital that a firm has compared to the
total amount of assets of this firm (the capital is the cushion; the more capital the
bigger of a % loss on assets a firm can withstand before becoming insolvent); e.g. a
mandatory leverage ratio (a maximum amount of leverage a firm can have compared
to capital), or a capital ratio (compares capital to ‘risk adjusted’ assets; when
computing the ratio, more weight is put on riskier assets)
- Regulators’ limit to the disproportion between assets and capital, i.e. leverage,
penalising types of assets that are more risky
- Higher capital requirements reduce risk of insolvency and hence of financial
crises
- Higher capital requirements mean a lower mandatory leverage ratio (and/or a
lower mandatory capital ratio)
- Higher capital requirements limit the consequences of losses in the value of
banks’ assets. They prevent the failure of a financial institution which may
increase the risk for the whole financial system
- Capital requirements limit banks’ ability to use leverage and expand lending. If
capital requirements are too stringent, there will be less overall lending in the
economy. Although some projects are too risky or have too low of a return and
should not be financed in the first place, some projects with a solid return and/or
acceptable risk will not be financed either
- Counter-cyclical capital buffers: higher capital requirements in booms, to put a
break on lending and cool down the economy; lower capital requirements in a
recession when restrictions to credit could be damaging
 The bankers’ argument against higher capital requirements: the higher the capital
requirement, the less they can use their capital to lever up and increase their assets
and so the less they can lend (remember the model of banks: start with capital, lever
it up through leverage and then buy assets- so limiting the amount of assets
compared to capital, implicitly limits the amount of lending banks can make).
Leverage is also the way banks make profits; leverage is borrowing cheap and then
lending dear -> so, whenever banks argue against higher capital requirements, their
motives are unclear
 Striking a balance: a leverage ratio of 1 means that assets must equal capital, and
that would mean a perfectly safe bank but which would make very little lending;
 similarly a bank with a leverage ratio of 100, would be incredibly risky because all it
would need is a very small loss in asset values to go bankrupt. Many economists are
worried that the balance is not quite right yet, although the capital requirements
have risen after the financial crisis
 Stress tests: annual exercises to evaluate resilience to large adverse shocks; the best
way to assess whether a financial institution is resilient in the case of a crisis, is to
simulate the consequences on their balance sheet in case of a decline in asset prices
(e.g. a big recession). Central bankers and financial regulators send big banks a
scenario and ask them to see what happens to their balance sheets, and whether
they would survive it. In practice, banks don’t want to fail these tests because the
results are publicly known and may mean that lenders will want higher interest
rates, or they may need to be told to increase capital (i.e. limit leverage)
 Compensation reform: traditionally, the structural compensation for top
management of all large compensation was two-fold: base salary and bonus based
on performance; the bonus is asymmetric- a manager will only face an upside risk,
they benefit financially if things go well, but there is no downside financially if things
go badly.
- Incentives of managers not aligned with the interest of
shareholders/taxpayers/workers: if a bank gets in trouble, sometimes it is the
taxpayer who has to pick up the bill through nationalisation or recapitalisation.
- Management does not experience the downside of poor decision-making, and
losses arising from their decisions; this can create appetite for risk- it might
induce them more risk, if they can only gain and not lose from a risky choice, and
the cost will be borne by those who participate in both the upside and downside
(like taxpayers and shareholders)
- Compensation of top management was based on very short-term performance
indicators (e.g. what was the change in profits over the last few quarters, or the
change of the price of the shares in the last few quarters) -> incentives to engage
in excessive risk taking, e.g. when there is an asset bubble, a manager who is paid
on the profits realised on the last two quarters, they have an incentive to keep
buying in the bubble, whereas the shareholders might say let’s not buy in the
bubble, because the bubble will crush
- Guidelines for reform: less asymmetric, less based on short-term performance
(e.g. limits imposed on bonus sizes-changing the structure of compensation in
the EU, or claw-back clauses based on long-term performance, if a decision taken
in the past turns out to be excessively risky or unwise some of the pay can be
taken back)
- This is about the way managers are paid, but not about how much: there is a
parallel debate about the size of compensation of top management (inequality);
but this is irrelevant to excessive risk-taking

The ‘too big to fail’ problem

 Governments very often, faced with the prospect of bankruptcy in the financial
system, end up bailing out.
 The prospect of a bank failure is terrifying because it leads to a lot of businesses and
households not being able to borrow, but more importantly because it triggers
contagion.
 Occasionally governments underestimate the risk of contagion, e.g. Lehman Brothers
went bankrupt and triggered a catastrophic contagion- failure to bail out this bank a
massive mistake? Those at the forefront of the financial crisis have claimed that they
tried to bail out, but there wasn’t enough time.
 when push comes to shove governments have to bail out large banks in trouble
(implicit bailout guarantee): this makes them safer compared to non-financial or
small firms, because they benefit from this implicit bailout guarantee -> the cost of
borrowing is lower for these systemically important banks (perceived as safer),
because they can borrow at lower rates than less systemically-important banks or
even other non-financial firms -> access to cheaper funding means higher leverage
(borrow more at lower rates), at the same time they know they will be bailed out, so
they take on more risk; and further grow (the bigger you get the more systemically
important you are, the more the government will have no choice but to bail you out
if you get in trouble -> incentives are aligned for big banks to borrow more, become
more leveraged, take more risks and become even bigger, and thus the government
cannot afford to let such banks to fail, because it will be too catastrophic
 problem is, the financial system has become even more concentrated now than it
was before; there are fewer and larger banks than before the crisis
- higher capital requirements for TBTF banks (more systemically-important banks
have higher capital requirements than smaller banks) and more stress tests
targeted at these banks
- bail-in rules: public recapitalisation conditional on losses imposed on bond
holders (yes recapitalise, but at the same time default on the debts towards the
lenders); part of the new eurozone bank resolution mechanism; problem is that
governments end up deferring needed recapitalisation to avoid inflicting losses
on bond holders (=voters)
 banks which are too big to fail are perceived as riskless by their creditors and
are more prone to making riskier investments through more leverage (as
they are expected to be bailed-out). Bail-in rules imply that the government
can only put new capital in a bank if the bank’s creditors suffer losses, hence
encouraging creditors to exert more monitoring and pressure on banks to
lend more sensibly.