LBSIM

PGDM - FIN
Financial Institutions & Markets

Trimester I
Lecture I
 Study Plan
• Text Book
Financial Markets & Institutions
Eighth Edition 2017; Pearson Education
by Fredric S Mishkin, Stanley G Eakins, Tulsi Jayakumar & R K Pattnaik
Highly Recommended Readings
• Krugman, Paul,” The return of depression
economics and the crisis of 2008”, W.W. Norton
1st Edition 2008
• Stiglitz, Joseph, “Free Fall – Free markets and
the sinking of the global economy”, W. W.
Norton and company First Edition 2010
• McKinsey Global Institute Research: Debt and
(not much) deleveraging, Feb 2015
• Goldman Sachs Global Economics Paper No
99: Dreaming with Brics, October 2003
• Financial crisis Inquiry Commission report, USA
– January 2011
 One more suggested reading
• For those desirous of better understanding
of how certain instruments like MBS/CDOs
are/were created, go through chapter 8
titled ‘Securitization and the credit crisis of
2007’ of the 8th edition of ‘Options,
Futures and other Derivatives’ by Hull and
Basu
 If you like thrillers, go ahead and read

The Big Short

Inside The Doomsday Machine
Penguin Books, 2010

By Michael Lewis
Or
You can watch the movie, based on the
book, which was released in 2015
5
 Current Issues/happenings
• During the course of the lectures, we will be
discussing various current events in the
financial sector
• You are also strongly encouraged to
contribute in this regard
• Let us talk about some of these issues
 The US Social Security System
• Is the kitty growing?
• What happens when the inflows are less
than the outflows over an extended period
of time?
 The Three Pillars in India

• Tax Financed: not really there!

• Mandatory-Fully Funded: Old style
PFs/Contributory PFs and/or Pensions -
think about EPF! These are a combo of
Defined Benefit and Defined Contribution
schemes
• Voluntary: The Do it yourself way – PPF,
NPS for general subscribers and so on!
 From 3 Pillars to 5 Pillars
• The world bank recommended a 3 pillar
approach in the 90s
• In the first decade of the 21st century it
moved on a 5 pillar approach
 National Pension System (NPS)

• At first, the National Pension System (NPS), PFRDA’s

pension scheme, was extended to central government
employees who joined services from 2004. The central
government moved its employees to NPS to lower the burden
on its coffers from the earlier defined benefit pension
programme.
• The big bang launch of the new pension system in May 2009
for all Indians has had only limited success.
• There are good reasons to use the vehicle. Under the NPS,
the Indian citizen has a highly cost-effective option to use the
funds saved over a lifetime of work to target a corpus and
provide for income for old age.
• NPS is still a very low cost (besides being portable) product.
You pay as you go into a fund of your choice out of a universe
of fund managers, offering a choice of three funds.
 ANOTHER TOPIC
2008 Crisis: Bankers and regulators admit failures

• The financial commission’s public hearings in the US had produced

a number of interesting admissions from bankers and regulators,
and theories as to why what happened, did happen.
• Among them:
 Blankfein, then the big boss of Goldman Sachs, defended
Goldman’s sale of bundles of sour mortgages by saying that the
buyers knew what they were getting into.
“These are professional investors who wanted this exposure,” said
Blankfein.

• Let us look at the 3 key admissions made

by the bankers and regulators
 2008 Crisis contd.
1. Everybody thought gravity had been suspended.

• Both bankers and regulators touched upon the

fact that the financial system as a whole did not
consider that it was possible that housing prices
could decline. Banks did not think about this
when weighing the risk of housing-related
investments, for instance.
• “Somehow, we just missed, you know, that
home prices don’t go up forever,” said Jamie
Dimon, then chief executive of J.P. Morgan
Chase.
 2008 Crisis contd.
2. The deal was the thing.
• Two regulators Sheila Bair, then head of the
Federal Deposit Insurance Corporation, and
Mary Schapiro, then chief of the Securities and
Exchange Commission, testified that financial
firms had become too used to self-regulation,
and that they increasingly saw the generation of
financial transactions as their economic role in
life.
 2008 Crisis contd.
3. Nobody knew anything.
• The SEC and other regulators, have long seen the
protection of average individual investors from avaricious
professionals as one of their primary missions.
• The exchange between chairman of the committee,
Angelides, and Goldman’s Blankfein seemed however to
indicate that even the savvy big guys were clueless about
the risks they were taking.
• Let us discuss as to whether the actions of the
investment banks like Goldman, raters like
Moody’s, and others were taken knowing what they
were doing or they simply didn’t know
 2008 Crisis contd.
Emails: Goldman shorting the housing market and so on
• Among the documents released post
examination by the US Senate’s Permanent
Subcommittee on Investigations after
completion of its work on the financial crisis in
2010 were various Wall Street e-mail messages
which made headlines.
• Among these were emails wherein the Goldman
Sachs employees bragged about the money
they had made by shorting the housing market.
• it was ugly but you might say that it didn’t
amount to wrongdoing. May be you are right,
legally speaking!
 2008 Crisis contd.
Goldman CEO faces withering attack over ethics
• The masters of the universe were forced down to earth during the
hearings that took place last year.
• Goldman Sachs Chief Executive Lloyd Blankfein, the head of the
most powerful investment bank in the world, faced a blistering
cross-examination from U.S. lawmakers about the company's
ethics and behaviour towards its clients.
• Blankfein, who had said earlier that he was "doing God's work,"
was asked time and again whether he felt it was morally correct for
the bank to sell its clients securities when at the same time the firm
was betting against them.
• In an interrogation by Senator Carl Levin, Blankfein was constantly
interrupted, told to answer the question and stick to the point.
• "You're going short against the very security many of which are
described as crap by your own sales force internally." said Levin,
chairman of the Senate Permanent Subcommittee on
Investigations.
• "How do you expect to deserve the trust of your clients, and is
there not an inherent conflict here?"
 2008 Crisis contd.
What about the Rating Agencies?
• What some of their e-mails revealed was a deeply corrupt
system.
• The credit rating agencies had bestowed AAA ratings on
hundreds of billions of dollars’ worth of dubious assets, nearly
all of which subsequently turned out to be toxic waste. Of the
AAA rated subprime-mortgage-backed securities issued in
2006, 93% were downgraded in a few years time to junk status.
• The rating agencies began as market researchers, selling
assessments of corporate debt to people considering whether
to buy that debt. Eventually, however, they morphed into
something quite different: companies that were hired by the
people selling debt to give that debt a seal of approval.
• Those seals of approval came to play a central role in the whole
financial system, especially for institutional investors like
pension funds, which would buy the bonds if and only if they
received that coveted AAA rating.
 2008 Crisis contd: The system invited trouble!
• It was a system that looked dignified and respectable on the surface. Yet it
produced huge conflicts of interest. Issuers of debt — which increasingly
meant Wall Street firms selling securities they created by slicing and dicing
claims on things like subprime mortgages — could choose among several
rating agencies. So they could direct their business to whichever agency
was most likely to give a favorable verdict, and threaten to pull business
from an agency that tried too hard to do its job. It’s all too obvious, in
retrospect, how this could have corrupted the process.
• And it got what it deserved!
• The Senate subcommittee had focused its investigations on the two biggest
credit rating agencies, Moody’s and Standard & Poor’s; what it found
confirmed the very worst of practices. In one e-mail message, an S& P
employee explains that a meeting is necessary to “discuss adjusting
criteria” for assessing housing-backed securities “because of the ongoing
threat of losing deals.” Another message complains of having to use
resources “to massage the subprime and alt-A (a classification of
mortgages where the risk-profile falls between prime and subprime)
numbers to preserve market share.”
• Clearly, the rating agencies skewed their assessments to please their
clients.
 Another topic
The BRICS
• There was a time when the BRIC
countries were seen as the hottest story in
the investment world
• What do you think is the current view?
Why Do Financial Crises
Occur and Why Are They
So
Damaging to the
Economy?
 A Credit Tsunami
• Financial crises are major disruptions in
financial markets characterized by sharp
declines in asset prices and firm failures.
• Beginning in August 2007, the U.S.
entered into a crisis that was described as
a “once-in-a-century credit tsunami.”
 Why did it happen?
• Why did this financial crisis occur?
• Why have financial crises been so prevalent
throughout U.S. history, as well as in so many other
countries, and what insights do they provide on the
last decade’s crisis?
• Why are financial crises almost always followed by
severe contractions in economic activity?
• We will be able to answer these questions pretty
well by the time this course comes to a close
• Before going further, let us understand 2 terms:
1. Moral Hazard
2. Adverse Selection
 Moral Hazard
• Moral hazard is the risk that a party to a
transaction has not entered into the
contract in good faith, has provided
misleading information about its assets,
liabilities or credit capacity, or has an
incentive to take unusual risks in a
desperate attempt to earn a profit before
the contract settles.
 Adverse Selection
• Adverse selection is a concept in economics, insurance, and risk
management, which captures the idea of a "rigged" trade. When buyers
and sellers have access to different information (asymmetric information),
traders with better private information about the quality of a product will
selectively participate in trades which benefit them the most (at the
expense of the other trader). A textbook example is Akerlof's market for
lemons.
• "The Market for Lemons: Quality Uncertainty and the Market
Mechanism" is a 1970 paper by the economist George Akerlof which
examines how the quality of goods traded in a market can degrade in the
presence of information asymmetry between buyers and sellers, leaving
only "lemons" behind. A lemon is an American slang term for a car that is
found to be defective only after it has been bought.
• Suppose buyers can't distinguish between a high-quality car (a "peach")
and a "lemon". Then they are only willing to pay a fixed price for a car that
averages the value of a "peach" and "lemon" together. But sellers know
whether they hold a peach or a lemon. Given the fixed price at which
buyers will buy, sellers will sell only when they hold "lemons"
 Financial Crisis:
Moral Hazard and Adverse Selection
• A functioning financial system is critical to
a robust economy.
• However, both moral hazard and adverse
selection are present.
• The study of these problems (agency
theory) is the basis for understanding and
defining a financial crisis.
 What Is a Financial Crisis?
• Asymmetric information creates barriers
between savers and firms with productive
investment opportunities.
• A financial crisis occurs when information
flows in financial markets experience a
particularly large disruption. Financial
markets may stop functioning completely.
Dynamics of Financial Crises in
Advanced Economies
• Financial crises hit countries like United
States every so often, and each event
helps economists gain insights into the last
decade’s turmoil.
• These crises usually proceed in 2 or 3
stages, as the next two slides outline:
Sequence of Events in Financial Crises
in Advanced Economies
Sequence of Events in Financial Crises
in Advanced Economies, contd.
 Stage One: Initiation
Financial crisis can begin in several ways:
• Credit Boom and Bust
• Asset-Price Boom and bust
• Increase in Uncertainty
 Stage One: Initiation contd.
A credit Boom
• The seeds of a financial crisis can begin
with mismanagement of financial
liberalization or innovation:
─elimination of restrictions
─introduction of new types of loans or other
financial products
• Either can lead to a credit boom, where
risk management is lacking.
 Stage One: Initiation contd.
• Government safety nets weaken
incentives for risk management.
Depositors ignore bank risk-taking.
• Eventually, loan losses accrue, and asset
values fall, leading to a reduction in
capital.
• Financial institutions cut back in lending, a
process called deleveraging. Banking
funding falls as well.
 Stage One: Initiation contd.
• As FIs cut back on lending, no one is left
to evaluate firms. The financial system
losses its primary institution to address
adverse selection and moral hazard.
• Economic spending contracts as loans
become scarce.
 Stage One: Initiation contd.
A financial crisis can also begin with an
asset- price boom and bust:
• A pricing bubble starts, where asset values exceed their
fundamental values.
• When the bubble bursts and prices fall, corporate net
worth falls as well. Moral hazard increases as firms have
little to lose.
• FIs also see a fall in their assets, leading again to
deleveraging.
 Stage One: Initiation contd.
Finally, a financial crisis can begin with an increase in
uncertainty.
• Periods of high uncertainty can lead to crises, such as
stock market crashes or the failure of a major financial
institution. Examples include:
– 2008, when AIG, Bear Sterns and Lehman Bros. failed
• With information hard to come by, moral hazard and
adverse selection problems increase, reducing lending
and economic activity
 Stage Two: Banking Crisis
Deteriorating balance sheets lead financial
institutions into insolvency. If severe
enough, these factors can lead to a bank
panic.
•Panics occur when depositors are unsure which banks are
insolvent, causing all depositors to withdraw all funds
immediately
•As cash balances fall, FIs must sell assets quickly, further
deteriorating their balance sheet
•Adverse selection and moral hazard become severe – it
takes years for a full recovery
 Stage Three
What is Debt Deflation?
• Consider a firm in 2015 with assets of
$100 million, $90 million of long-term
liabilities, and $10 million in net worth.
• Let us say that the price levels fall by 10%
in 2016.
• As a result, the real value of assets goes
down vis-à-vis the real value of liabilities,
as the latter is fixed in nominal terms, and
so the net worth gets wiped out!
 Stage Three: Debt Deflation
The crisis may or may not lead to a sharp fall in
prices.
If the crisis also leads to a sharp decline in
prices, debt deflation can occur, where asset
prices fall, but debt levels do not adjust,
increasing debt burdens.
• This leads to an increase in adverse
selection and moral hazard, which is followed
by decreased lending
• Economic activity remains depressed for a
long time
 Cases
We will now examine the most important cases
which highlight various financial crises,
focusing on how they started and the impact
they had:
• The Great Depression in the last century
• The Global Financial Crisis of 2007-2009
Later, we will look at some other important
recent cases outside the US:
• European Sovereign Debt crises
• Crises in Emerging market economies
• Banking crises in various countries
 Case: The Great Depression
• In 1928 and 1929, stock prices doubled in
the U.S. The Fed tried to curb this period
of excessive speculation with a tight
monetary policy. But this led to a stock
market collapse of more than 20% in
October of 1929, and losing an additional
20% by the end of 1929.
• As the next slide shows, the decline
continued for several years.
Stock Market Prices During
The Great Depression
 Case: The Great Depression contd.
• What might have been a normal recession
turned into something far worse, when
severe droughts in 1930 in the Midwest led
to a sharp decline in agricultural production.
• Between 1930 and 1933, one-third of U.S.
banks went out of business as these
agricultural shocks led to bank failures.
• For more than two years, the Fed sat idly by
through one bank panic after another.
 Case: The Great Depression
contd.
Adverse selection and moral hazard in credit
markets became severe. Firms with
productive uses of funds were unable to get
financing. As seen in the next slide, credit
spreads increased from 2% to nearly 8%
during the height of the Depression in 1932.
Credit Spreads During
The Great Depression
 Case: The Great Depression
contd.
• The deflation during the period led to a
25% decline in price levels.
• The prolonged economic contraction led to
an unemployment rate around 25%.
• The Depression was the worst financial
crisis ever in the U.S. It explains why the
economic contraction was also the most
severe ever experienced by the nation.
 Case: The Great Depression
contd.
• Bank panics in the U.S. spread to the rest
of the world, and the contraction of the
U.S. economy decreased demand for
foreign goods.
• The worldwide depression caused great
hardship, and the resulting discontent led
to the rise of fascism and WWII.
 Next Case: The Global
Financial Crisis of 2007-2009
We begin our look at the 2007–2009
financial crisis by examining three central
factors:
•financial innovation in mortgage markets
•agency problems in mortgage markets
•the role of asymmetric information in the
credit rating process
 Case: The Global Financial
Crisis of 2007-2009
Financial innovation in mortgage markets
developed along a few lines:
• Less-than-credit worthy borrowers found
the ability to purchase homes through
subprime lending, a practice almost
nonexistent until the 2000s
• Financial engineering developed new
financial products to further enhance and
distribute risk from mortgage lending
 Case: The Global Financial
Crisis of 2007-2009 contd.
Agency problems in mortgage markets also reached new
levels:
• Mortgage originators did not hold the actual mortgage, but
sold the note in the secondary market
• Mortgage originators earned fees from the volume of the
loans produced, not the quality
• In the extreme, unqualified borrowers bought houses they
could not afford through either creative mortgage products
or outright fraud (such as inflated income)
 Case: The Global Financial
Crisis of 2007-2009 contd.
Finally, the rating agencies didn’t help:
•Agencies consulted with firms on structuring
products to achieve the highest rating, creating
a clear conflict
•Further, the rating system was hardly
designed to address the complex nature of the
structured debt designs
•The result was meaningless ratings that
investors had relied on to assess the quality of
their investments
 Mini-Case: CDOs
Before continuing with the crisis, let’s take a
detour and see how Collateralized Debt
Obligations (CDOs) played a role in the crisis.
•A special purpose vehicle (SPV) is created to buy assets,
create securities from those assets, and then sell those
securities to investors.
•In a CDO, the securities (or tranches) are created based on
default priorities. The first defaults go to the lowest rated
tranches. The highest rated tranches suffer defaults if most of
the assets default.
 Mini-Case: CDOs contd.
There are many, many tranches in a CDO,
each with different exposure to defaults:
•The highest rated tranches are called super senior tranches
•The next bucket is known as the senior tranche – it has a little
more risk and pays a higher interest rate
•The next tranche is the mezzanine tranche - it bears more
risk and has an even higher interest
•The lowest tranche is the equity tranche - this is the first
tranche that suffers losses from defaults
 Mini-Case: CDOs contd.
• If this sounds complicated, you are right. It can be difficult
to determine exactly what they are worth and who has the
rights to what cash flows.
• In a speech in the middle of the crisis, Ben Bernanke, the
chairman of the Federal Reserve, joked that he “would like
to know what those damn things are worth.”
• Bottom line - increased complexity of structured products
can actually reduce the amount of information in financial
markets. Makes you wonder who is willing to buy these in
the first place!
 Case contd: The Global
Financial Crisis of 2007-2009
Many suffered as a result of the 2007–2009
financial crisis. We will look at five areas:
•U.S. residential housing
•FIs balance sheets
•The “shadow” banking system
•Global financial markets
•The failure of major financial firms
 Case: The Global Financial
Crisis of 2007-2009 contd.
• Initially, the housing boom was lauded by
economics and politicians. The housing
boom helped stimulate growth in the
subprime market as well.
• However, underwriting standards fell.
People were clearly buying houses they
could not afford, except for the ability to
sell the house for a higher price.
 Case: The Global Financial
Crisis of 2007-2009 contd.
• Lending standards also allowed for near
100% financing, so owners had little to
lose by defaulting when the housing
bubble burst.
• The next slide shows the rise and fall of
housing prices in the U.S. The number of
defaults continued to plague the U.S.
banking system for many years.
Housing Prices: 2002–2010
 Was the Fed to Blame for the
Housing Price Bubble?
• Some argue that low interest rates from
2003 to 2006 fueled the housing bubble
• In early 2010, Mr. Bernanke rebutted this
argument. He argued that rates were
appropriate.
 Was the Fed to Blame for the
Housing Price Bubble contd?
• He also pointed to new mortgage
products, relaxed lending standards, and
capital inflows as more likely causes.
• Bernanke’s speech was very controversial,
and the debate over whether monetary
policy was to blame for the housing price
bubble continues to this day.
 Case: The Global Financial
Crisis of 2007-2009 contd.
• As mortgage defaults rose, banks and
other FIs saw the value of their assets fall.
This was further complicated by the
complexity of mortgages, CDOs, defaults
swaps, and other difficult-to-value assets.
• Banks began the deleveraging process,
selling assets and restricting credit, further
depressing the struggling economy.
 Case: The Global Financial
Crisis of 2007-2009 contd.
• The shadow banking system also
experienced a run. These are the hedge
funds, investment banks, and other
liquidity providers in the financial system.
When the short-term debt markets seized,
so did the availability of credit to this
system. This led to further “fire” sales of
assets to meet higher credit standards.
 Case: The Global Financial
Crisis of 2007-2009 contd.
• As seen in the next two slides, the fall in
the stock market and the rise in credit
spreads further weakened both firm and
household balance sheets.
• Both consumption and real investment fell,
causing a sharp contraction in the
economy.
Stock Prices: 2002–2009
Credit Spreads: 2002–2009
 Case: The Global Financial
Crisis of 2007-2009 contd.
• Europe was actually first to raise the alarm
in the crisis. With the downgrade of $10
billion in mortgage related products, short
term money markets froze, and in August
2007, a French investment house
suspended redemption of some of its
money market funds. Banks and firms
began to hoard cash.
 Case: The Global Financial
Crisis of 2007-2009 contd.
• The end of credit led to several bank
failures.
• Northern Rock was one of the first, relying
on short–term credit markets for funding.
Others soon followed.
• By most standards, Europe experienced a
more severe downturn that the U.S.
 Case: The Global Financial
Crisis of 2007-2009 contd.
Finally, the collapse of several high-profile
U.S. investment firms only further
deteriorated confidence in the U.S.
• March 2008: Bear Sterns fails and is sold
to JP Morgan for 5% of its value only 1
year ago
• September 2008: both Freddie and Fannie
put into conservatorship after heaving
subprime losses.
 Case: The Global Financial
Crisis of 2007-2009 contd.
Finally, the collapse of several high–profile
U.S. investment firms only further
deteriorated confidence in the U.S.
•September 2008: Lehman Brothers files for
bankruptcy. Merrill Lynch sold to Bank of
America at “fire” sale prices. AIG also
experiences a liquidity crisis.
 Case: The Global Financial
Crisis of 2007-2009 contd.
The crisis and impaired credit markets
caused the worst economic contraction
since World War II.
• The crisis peaked in September of 2008.
• Congress passed a bailout package, but
the stock market continued to decline, and
credit spreads reached over 500 bps.
 Case: The Global Financial
Crisis of 2007-2009 contd.
• The fall in real GDP and increase in
unemployment to over 10% in 2009
impacted almost everyone.
• The recession that started in December
2007 became the worst economic
contraction in the United States since
World War II, and is now called the “Great
Recession.”
 Case: The Global Financial
Crisis of 2007-2009 contd.
• Starting in March 2009, a bull market in
stocks got under way and credit spreads
began to fall.
• Unfortunately, the pace of the recovery
was slow.
 Yet Another Case
European Sovereign Debt Crisis
• Up until 2007, all the countries that had
adopted the euro found their interest rates
converging to very low levels.
• At the same time, several of these countries
were hit very hard by:
─Lower tax revenue from economic contraction
─High outlays for FI bailouts
─Fears of government default cause rates to
surge
European Sovereign Debt Crisis
contd.
• Greece was the first domino to fall
─In September 2008, govt projected a 6%
deficit and debt-to-GDP of 100%
─In October, with newly elected officials,
numbers were shown to be far worse
─Fear of default caused rates on Greek debt to
peak near 40%
─Debt-to-GDP rose to 160% in 2012
European Sovereign Debt Crisis
contd.
• Greece was forced to write-down its debt
(partial default)
• Civil unrest broke out as unemployment
rates climbed
• The prime minister was eventually forced
to resign
European Sovereign Debt Crisis
contd.
• Ireland, Portugal, Spain, and Italy followed
─Governments forced to embrace austerity
measures to shore up their public finances
─Interest rates climbed to double-digit levels
─Severe recessions resulted, despite
assurances from the ECB to help
─Unemployment rates rose to double-digits
(25% in Spain)
 Financial Crises
in Emerging
Market Economies
Some emerging market economies
opened their markets and …..
• In the 1990s, some emerging market
economies opened their markets in the
hope of rapid expansion. But, many
experienced crises which were really bad.
 Some of the developing countries thus
ended up shifting from a path of high
growth to a sharp decline in economic
activity?
Dynamics of Financial Crises in
Emerging Market Economies
• The dynamics of financial crises in
emerging market economies have many of
the same elements as those found in
advanced countries like United States
• However, there are some important
differences.
• The next slide outlines the key stages.
Emerging Market Financial
Crisis: Sequence of Events
Emerging Market Financial Crisis:
Sequence of Events contd.
 Stage One: Initiation
Financial crises in emerging market
countries develop along two basic paths:
• Credit Boom and Bust
• Severe Fiscal Imbalances
 Stage One: Initiation contd.
Crisis initiation involving a credit boom and
bust usually proceeds as follows:
• The country often starts with a solid fiscal
policy
• A weak credit culture and capital inflows lead
to a furious credit boom that follows
liberalization, leading to risky lending
• High loan losses eventually materialize
 Stage One: Initiation contd.
Crisis initiation involving a credit boom and
bust usually proceeds as follows :
• As bank balance sheets deteriorate, lending
is cut back (more severe here as compared
to the developed countries, since the rest of
the economy is not as developed)
• A lending crash fully materializes
 Stage One: Initiation contd.
• Why does prudential regulation fail to stem
a banking crisis? Is this different than the
U.S. and other developed economies?
• The story is similar to the U.S., with
various interests trying to prevent
regulators from doing their jobs. However,
in developing economies, these interests
(business) probably have more power
 Stage One: Initiation contd.
Crisis initiation can also involve severe fiscal
imbalances:
•The government faces a large deficit and
either cajoles or forces banks to buy gov’t
bonds
•If confidence falls, the gov’t bonds are sold by
investors, leading to a price decline
•As a result, bank balance sheets deteriorate,
and the usual lending freeze follows
 Stage One: Initiation contd.
Crisis initiation can also involve other
factors:
• A rise in rates in developed economies
can spill over into risk taking in developing
countries (e.g., the Mexican crisis)
• Asset price declines are less severe, but
certainly increase problems
• Unstable political systems create high
levels of uncertainty, increasing agency
conflicts
 Stage Two: Currency Crisis
• The FX markets soon start taking bets on
the depreciation of the currency of the
emerging market, in what is called a
speculative attack. Over supply begins,
the value of the currency falls, and a
currency crisis ensues.
 Stage Two: Currency Crisis
contd.
• The government can attempt to defend the
home currency by raising interest rates.
That should encourage capital inflows.
However, banks must pay more to obtain
funds, decreasing bank profitability, which
may lead to insolvency.
• Speculators in the FX market know this.
Mass sell-offs of the currency continue.
 Stage Two: Currency Crisis
contd.
• The currency crisis can also result from a
large fiscal imbalance.
─Investors suspect inability to repay the loans
─Sell-offs of debt
─Sell-off of the domestic currency follows
─A speculative attack on the currency ensues
 Stage Three:
Full Financial Crisis
• Many emerging market firms denominate
their debt in U.S. dollars or yen. An
unexpected currency devaluation
increases their debt burden, leading to a
decline in their net worth.
• This crisis, along with the currency crisis,
leads the country into a full–fledged
financial crisis.
 Stage Three:
Full Financial Crisis contd.
• The currency collapse can also lead to
higher inflation. The increase in interest
rates again leads to lower firm cash flows
and increased agency problems.
• Bank losses are inevitable as debtors are
no longer able to meet interest obligations.
Banks likely fail as well.
An Actual Financial Crisis in an
Emerging economy
With this framework in mind, we now turn to
an actual financial crisis in an emerging
economy:
•Argentina, 2001-02
 Argentina
• Argentina had a well-supervised banking
system.
• Govt fiscal problems weakened the
banking system - banks forced to take on
gov’t debt.
• Provinces had incentives to spend beyond
receipts and call on federal gov’t to fund
the deficit. Recession in 1998 didn’t help.
Inflation, Argentina, 1998–2004
 Real GDP Growth,
Argentina, 1998–2004
Unemployment Rate,
Argentina, 1998–2004
 Argentina contd.
• In October 2001, bank panic began as
default on gov’t debt becomes inevitable.
• Depositors restricted to withdrawing only
$250 in cash per week.
• Confidence falls, riots ensue.
 Argentina contd.
• Full–blown speculative attacks developed in
the foreign exchange for the Argentine Peso
• Raising interest rates no longer possible
• December 2001 – gov’t suspends debt
payments
Argentine Peso, 1998–2004
 Argentina contd.
• By June 2002, peso fell to less than $0.30
• Dollar denominated debt tripled in value,
many firms insolvent
• Huge bank outflows, financial flows halted
• Inflation rose, nearing 40%.
Interest Rates, Argentina,
1998–2004
 Argentina contd.
• Recovery began by the end of 2003
─Unemployment fell below 15%
─Inflation dropped to 5%
• Crisis took a huge toll on the economy as a
whole
 Preventing Emerging Market
Financial Crises
• Increase bank regulation
─Adequate Capital requirements
─Risk measurement / monitoring systems
─Policies to limit risk-taking
─Fraud prevention
• Independent (from political pressure)
regulation.
 Preventing Emerging Market
Financial Crises contd.
• Disclosure and Market-based discipline
• Limit currency mismatch – limit foreign
borrowing
• Liberalization only after correct policies and
procedures in place
Some Banking Crises
Throughout the World
 Banking Crises
Scandinavia
• Norway, Sweden, Finland
─Highly restrictive banking environments
• Only high quality loans
• No expertise in screening and monitoring
─Liberalization leads to lending boom
─Real estate collapses in late 1980s
─Bailout through early 1990s, large in scale
 Banking Crises
East Asia
• Thailand, Malaysia, Indonesia, Philippines,
and South Korea
─Lending booms lead to loan losses
─Currency collapse follows (1997)
─15% to 35% of banks fail
─Cost of bailout over 15% of GDP, as high as
50% for Indonesia
 Banking Crises
India
• Banks in India particularly the Public
Sector Banks are sitting on a huge pile of
NPAs
 Banking Crises
India contd.
• The challenge is not only to keep the
banks continue to perform their main
function of lending but also provide for
adequate capital to meet the BASEL III
norms
 Banking Crises
India contd.
• The problem is not just about resolving the
present mess but also to make sure that
the banks are managed well in future