EC1008: Chapter 12 questions and answers
What causes bank panics to occur?
Bank panics occur because deteriorating balance sheets and tougher business conditions lead some banks into insolvency. Depositors then fear for the safety of their deposits and not knowing the quality of bank's loan portfolios, they run to banks and withdraw their deposits to the point that banks fail. The contagion can spread further if the runs lead to fire sales of banks' assets, causing the assets to decline in value. The resulting fall in banks' net worth can then lead to further bank failures and a full-fledged bank panic, in which many banks fail together.
Why do bank panics worsen asymmetric information problems in credit markets?
Because banks are special in that they solve asymmetric information problems and make loans to firms and households that cannot get loans from other sources. When banks go out of business, they no longer can solve these asymmetric information problems and so these asymmetric information problems increase in credit markets, causing a contraction in lending and a collapse of spending.
Why is the originate-to-distribute business model subject to the principal-agent problem?
Because the agent for the investor, the mortgage originator, has little incentive to make sure that the mortgage is a good credit risk.
What is a credit spread? Why do credit spreads rise significantly during a financial crisis?
Credit spreads measure the difference between interest rates on corporate bonds and Treasury bonds of similar maturity that have no default risk. The rise of credit spreads during a financial crisis (as occurred during the Great Depression and again during 2007-2009) reflects the escalation of asymmetric information problems that make it harder to judge the riskiness of corporate borrowers and weaken the ability of financial markets to channel funds to borrowers with productive investment opportunities.
"Financial engineering always leads to a more efficient financial system." Is this statement true, false, or uncertain?
False. Financial engineering may create financial products that are so complex that it can be hard to value the cash flows of the underlying assets for a security or to determine who actually owns these assets. In other words, the increased complexity of structured products can actually destroy information, thereby making asymmetric information worse in the financial system and increasing the severity of adverse selection and moral hazard problems.
What technological innovations led to the development of the subprime mortgage market?
The use of data mining to give households numerical credit scores that can be used to predict defaults and the use of computer technology to bundle together many small mortgage loans and cheaply package them into securities. Together both enable the origination of subprime mortgages, which then can be sold off as securities.
How can a decline in real estate prices cause deleveraging and a decline in lending?
A decline in real estate prices lowers the net worth of households or firms that are holding real estate assets. The resulting decline in net worth means that businesses have less at risk and so have more incentives to take on risk at the lender's expense. In addition, lower net worth means there is less collateral and so adverse selection increases. The decline in real estate prices can thus make borrowers less credit-worthy and cause a contraction in lending and spending. The real estate decline can also lead to a deterioration in financial institutions' balance sheets, which causes them to deleverage, further contributing to the decline in lending and economic activity.
How does the concept of asymmetric information help to define a financial crisis?
Asymmetric information problems (adverse selection and moral hazard) are always present in financial transactions but normally do not prevent the financial system from efficiently channeling funds from lender-savers to borrowers. During a financial crisis, however, asymmetric information problems intensify to such a degree that the resulting financial frictions lead to flows of funds being halted or severely disrupted, with harmful consequences for economic activity.
What were the various measures taken by different European countries to tackle the financial crisis of 2007-2009?
Different measures were taken by different countries to handle the financial crises of 2007 - 2009. These measures included expansionary monetary policy where a government stepped into the shoes of the investors and a huge amount of money was invested in infrastructure projects, creating a congenial environment for investment to take place. Bailout plans were implemented and stimulus packages were provided to various sectors in the economy. Tax and government spending were restructured to boost the investment sentiment. Global actions were taken by governments across the world to fight this financial contagion.
What impact do declining price levels have on lending by financial institutions?
Due to steep decline in economic activities, prices decline. Decline in price levels have an adverse effect on the net worth of firms, increasing the debt burden of the firm. Typically, a decline in price levels raises the value of the borrowing firms and household liabilities because of an increase in burden of indebtedness even though the real value of their assets do not increase. The increasing gap between the assets and liabilities leads the financial institution to reduce or stop lending to firms that have investment opportunities.
Why would haircuts on collateral increase sharply during a financial crisis? How would this lead to fire sales on assets?
During a financial crisis, asset prices fall, oftentimes very rapidly and unexpectedly. This leads to the expectation that asset prices may fall further in the future, and increases the uncertainty over the value of assets put up as collateral. As a result, firms accepting collateral assets require larger and larger haircuts, or discounts on the value of collateral in expectation of future lower values. This requires firms to put up increasingly more collateral for the same loans over time. Due to the falling asset prices and rising haircuts, it becomes a "buyers market" for these rapidly falling assets; any firms needing to raise funds quickly would then be forced to sell assets at a fraction of their original worth.
How can collective and coordinated efforts by governments across the globe prevent future financial crises?
Globalization has connected the world making it a global village, where every country is trading with another country. The free trade has advantages as well as attached disadvantages. One of the major disadvantages is that any incident that occurs in any one part of globe will affect the other parts. This contagious effect has given rise to a situation where financial crises in one country can adversely affect other countries as well. Thus, to fight a financial crisis it is necessary that countries act together to reduce the adverse effects of global financial crises. Sharing information, transparency, harmonizing financial regulations among national regulators and international financial institutions are some of the common areas of concern. It is important that there is a mutual understanding among countries across the globe to ensure ethical banking.
How does a deterioration in balance sheets of financial institutions and the simultaneous failures of these institutions cause a decline in economic activity?
If financial institutions suffer a deterioration in their balance sheets and they have a substantial contraction in their capital, they will have fewer resources to lend, and lending will decline. The contraction in lending then leads to a decline in investment spending, which slows economic activity. When there are simultaneous failures of financial institutions, there is a loss of information production in financial markets and a direct loss of banks' financial intermediation. In addition, a decrease in bank lending during a banking crisis decreases the supply of funds available to borrowers, which leads to higher interest rates, which increases asymmetric information problems and leads to a further contraction in lending and economic activity.
The Great Depression of 1930 and the financial crises of 2007-2009 have some similarities and some differences. Compare and contrast the two economic crises.
In both cases, one common denominator was the uncertainty and weak appetite of investors. According to many, in 1930 one of the main causes of the Great Depression was the bank run faced by the Bank of the United States, and in 2007-09 it was again due to irresponsible activities on the part of investment banks like Bear Stearns, Lehman Brothers, and American International Group, Inc. (AIG.) The information flow during both time periods wasn't smooth and transparent enough. In 1930 the crisis was caused due to a default in farm mortgage and in 2007-09 it was due to a default in house mortgage. Adverse selection and moral hazard problems were common in both crises. Stock markets tumbled, and investment spending reduced in 1930 by 90% from its 1929 level. In contrast, during 2007 - 2009 the problem was accentuated due to the greed of investment bankers and the prevalent cut-throat competition among the banks to lend to sub-prime borrowers. It was also due to conflict of interest of rating agencies, which was not the case in the Great Depression of 1930.
What do you think prevented the financial crisis of 2007-2009 from becoming a depression?
In general, it is believed that the country as a whole probably learned from the experience of the Great Depression, and have put in place more sophisticated policy frameworks to help deal with severe economic downturns more effectively. For instance, bank panics, which were widespread during the Great Depression, were virtually nonexistent during the 2007-2009 crisis; this is probably due to bank accounts now being insured by the FDIC, when they were not during the Great Depression. Another factor seems to be the resolve by policymakers not to make the same mistakes made during the Great Depression by instituting more aggressive, swifter policies to avoid any contagion effects that would unnecessarily deepen or lengthen the crisis.
Why would macroprudential regulations not be sufficient enough to handle systemic discrepancies in an economy?
Macroprudential regulatory steps as a standalone measure may not be sufficient to handle systemic discrepancies; it has to be clubbed with microprudential measures which deal with individual institutions. Macroprudential measures envelop the entire system and its impact is more profound than microprudential measures. The reason for low focus on microprudential measure is that it does not cover the entire financial institutions as result of which some issues remain unattended causing concern at later stages.
What are the challenges a Central Bank would face when handling a financial crisis and how would they react to them?
Most Central Banks across the globe believe that the monetary policy tools that are at their disposal aren't sufficient enough to handle financial crises. They want more active intervention from the government in terms of backing up individual fiscal policies. They want the government to maintain a special reserve in order to handle such financial crises. This gives rise to levying additional taxes on the financial sector to raise this fund. This fund could be used for other purposes like injecting capital in banks and providing rescue packages at the time of such crises. In normal times this fund could be used as a deposit insurance guarantee.
How did the global financial crisis promote a sovereign debt crisis in Europe?
The contraction in economic activity reduced tax revenues at the same time that government bailouts of failed financial institutions required an increase in government outlays. The result was a surge in budget deficits that lead to fears that the governments of hard-hit countries would default on their debt. The result was a huge sell off in the sovereign bonds of these countries that led to a surge in interest rates on these bonds.
How did a decline in housing prices help trigger the subprime financial crisis that began in 2007?
The decline in housing prices led to many subprime borrowers finding that their mortgages were "underwater" because they owed more on them than their houses were worth. When this happened, struggling homeowners had tremendous incentives to walk away from their homes and just send the keys back to the lender. Defaults on mortgages shot up sharply, causing losses to financial institutions, which then deleveraged, causing a collapse in lending.
How does a general increase in uncertainty as a result of the failure of a major financial institution lead to an increase in adverse selection and moral hazard problems?
The failure of a major financial institution, which leads to a dramatic increase in uncertainty in financial markets, makes it hard for lenders to screen good from bad credit risks. The resulting inability of lenders to solve the adverse selection problem makes them less willing to lend, which leads to a decline in lending, investment, and aggregate economic activity.
What role did the shadow banking system play in the 2007-2009 financial crisis?
The shadow banking system is composed of hedge funds, investment banks, and other nondepository financial firms that are not subject to the tight regulatory frameworks of traditional banks. Due to the light regulation, they had lower capital requirements (if any at all) and were able to take on significantly more risk than other financial firms. They are important because a large amount of funds flowed through the shadow banking system to support low interest rates, which fueled some of the housing bubble. Because of their large presence in financial markets, when credit markets began tightening, funding from the shadow banking system decreased significantly, which further reduced access to needed credit.
What role does weak financial regulation and supervision play in causing financial crises?
Weak regulation and supervision mean that financial institutions will take on excessive risk, especially if market discipline is weakened by the existence of a government safety net. When the risky loans eventually go sour, this causes a deterioration in financial institution balance sheets, which then means that these institutions cut back lending and economic activity declines.
How can the bursting of an asset-price bubble in the stock market help trigger a financial crisis?
When an asset-price bubble bursts and asset prices realign with fundamental economic values, the resulting decline in net worth means that businesses have less skin in the game and so have incentives to take on more risk at the lender's expense, increasing the moral hazard problem. In addition, lower net worth means there is less collateral and so adverse selection increases. The bursting of an asset-price bubble therefore makes borrowers less credit-worthy and causes a contraction in lending and spending. The asset price bust can also lead to a deterioration in financial institutions' balance sheets, which causes them to deleverage, further contributing to the decline in lending and economic activity.
How can financial innovation lead to financial crises?
With restrictions lifted or the introduction of new financial products, financial institutions often go on a lending spree and expand their lending at a rapid pace. Unfortunately, the managers of these financial institutions may not have the expertise to manage risk appropriately in these new lines of business, leading to overly risky lending. In addition, regulation and government supervision may not keep up with the new activities, further leading to excessive risk taking. When loans eventually go sour, this causes a deterioration in financial institutions' balance sheets, a decrease in lending, and therefore a decrease in economic activity.
