Financial Crisis - Banking - Lecture Slides, Slides of Banking and Finance

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Definition of Financial Crisis

 A situation in which the supply of money is outpaced by the demand for money. This means that liquidity is quickly evaporated because available money is withdrawn from banks (called a run), forcing banks either to sell other investments to make up for the shortfall or to collapse. –BusinessDictionary.com  Is “applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth; they do not directly result in changes in the real economy, may indirectly do so, notably if a recession or depression follows.” – Wikipedia  Many economists have offered theories about how financial crises develop and how they could be prevented. There is little consensus, however, and financial crises are still a regular occurrence around the world.

Asset Market effects on balance

sheets

 There are several factors which contribute to financial crises.  Increases in interest rates, increases in uncertainty, asset market effects on balance sheets and bank failures.

 The increase in moral hazard diminishes lendingless economic activity  Firm’s net worth can be reduced by an error on a balance sheet (stock prices going down)  This leads to a decrease in lending (less collateral), which lead to borrowers taking higher risks (moral hazard)

Deterioration of Financial

Institutions Balance Sheets

 Banks play a major role in financial markets because, of they are well positioned to engage in information- producing activities which produce productive investments for our economy.  The state of banks' balance sheet plays a very important part on lending.  If compromised, the banks' balance sheets would suffer substantial contractions in their capital.  Which would then lead to fewer resources to lend, and lending in all would decline.  Which then results in a decline in investment spending, slowing down economic activity.

Banking Crises and Increase in

Uncertainty Continued

 With a bank lending decrease, supplies of funds available to borrowers decrease as well. Which then leads into higher interest rates.  With an increase in adverse selection, bank panics cause the inability of lenders to solve this selection process in credit markets.  With the inability to solve the adverse selection makes banks' less likely to lend, and then a decline in lending, investment, and aggregate activity occurs.

History: Great Depression

 As the economic depression of the 1930s got worse and worse banks were failing at alarming rates. During the 1920s an average of 70 banks failed each year nationally. After the crash during the first 10 months of 1933, 744 banks failed.  In all, a total of 9000 banks failed during the 1930s. By, then depositors nation wide had lost $140 billion through bank failures...

Government Fiscal Imbalances

 Government imbalances may create fears of default on government debt.  These fears can spark a foreign exchange crisis in which the value of the domestic currency falls sharply because investors pull their money out of the country.  The decline then leads to destruction of the balance sheets of firms with large amounts of debt. These balance sheets once again lead to an increase in adverse selection and moral hazard problems.

Dynamics of a Financial Crises

 The Three stages  Stage One: Initiation  Stage Two: Bank Panics  Stage Three: Debt Deflation

Mismanagement of Financial

Liberalization/Innovation

 Elimination of restrictions on markets or institutions  New financial markets/institutions are created  Ex. Subprime residential mortgages  Good in the long run because it stimulates financial development  Bad when management begins taking on too much risk  Result: Credit boom where banks lend too much and they can’t keep enough information or they have no experience

Mismanagement of Financial

Liberalization/Innovation Cont’d

 Government creates a safety net which leads to Moral hazard  Banks will only win on high risk or the government loses  Too much risk-taking eventually leads to losses and banks net-worth (capital) falls  Leads to a cutback on lending or “deleveraging”

Spikes in interest rates

 1800’s most of U.S. crises were precipitated by increases in Interest Rates  This could be seen usually in London  Bank panics would lead to a need for liquidity  In turn interest rates would spike; sometimes 100 percentage points in a day  Leads to a decline in cash flows and lending, leads to adverse selection and moral hazard

Increase in Uncertainty

 Always a factor in financial crises  Rise once a recession has started  Failure of major institutions  Ohio Life Insurance and Trust Company 1857  Jay Cooke and Co. 1873  Grant and Ward 1884  Bank of the United States 1930  Again leads to drop in lending, increasing adverse selection and moral hazard

What Happens

 Because of worsening conditions in business and uncertainty, depositors begin to withdraw funds from banks’  With less banks, there is a loss in domestic currency, the debt burden of domestic firms increase  Asset Write-Downs, which the asset price declines which leads to a write-down value of the assets side of the balance sheet

Deterioration of Financial

Institutions’ balance sheets

 With financial Institutions’ balance sheets deteriorating, lending declines  Which leads to a decline in investment spending  Which slows economic activity