FN1024 | Chapter 3

Four elements of sound risk management are assessed to arrive at the risk management:

(1) the quality of oversight provided by the board of directors and senior management, (2) the adequacy of policies and limits for all activities that present significant risks, (3) the quality of the risk measurement and monitoring systems, and (4) the adequacy of internal controls to prevent fraud or unauthorized activities on the part of employees.

two main reasons for the internet bubble of the late 1990s

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

A bank run and a bank panic are both events that can occur in the banking system, but they have different causes and consequences. A bank run occurs when a large number of depositors withdraw their funds from a bank at the same time due to concerns about the bank's solvency or ability to meet its obligations. Bank runs can be triggered by a variety of factors, such as rumors about the bank's financial stability or news of other banks in the same area experiencing financial difficulties. Bank runs can lead to liquidity problems for the bank and, in severe cases, may result in the bank becoming insolvent and being forced to close. A bank panic, on the other hand, is a more severe and widespread event than a bank run. A bank panic occurs when depositors lose confidence in the banking system as a whole and begin withdrawing their funds from all banks, regardless of their individual financial stability. Bank panics can be triggered by a major economic or financial crisis, such as a stock market crash or a banking crisis in another country. Bank panics can lead to a severe contraction in credit and a sharp decline in economic activity, as banks become unable to lend to businesses and consumers. In both cases, bank runs and bank panics can have significant consequences for the banking system and the broader economy. To prevent bank runs and panics, governments and central banks may take measures such as guaranteeing deposits, providing liquidity support to banks, or implementing regulatory reforms to improve the stability and resilience of the banking system.

Bank run vs bank panic

Camels approac

C: Capital adequacy A: Asset quality M: Management of the risk E: Earnings quality adequate and stability L: Liquidity S: Sensitivity

also known as the Banking Act of 1933, was a US law that separated commercial banking from investment banking activities. It was enacted in response to the Great Depression and aimed to prevent banks from engaging in risky investments that could threaten the stability of the financial system. The act established the Federal Deposit Insurance Corporation (FDIC) to insure bank deposits and created regulatory oversight for banks. It also prohibited commercial banks from underwriting or dealing in securities and restricted them from affiliating with companies that engaged in such activities. The Glass-Steagall Act remained in effect for over six decades until it was repealed in 1999 with the passage of the Gramm-Leach-Bliley Act. The repeal of Glass-Steagall has been criticized by some as contributing to the 2008 financial crisis by allowing banks to engage in riskier investment activities. However, others argue that the financial landscape had changed significantly since the enactment of Glass-Steagall and that its repeal was necessary to promote competitiveness and innovation in the financial industry. You will notice that one of the consequences of the repeal of Glass-Steagall has been greater consolidation of the industry through large mergers. This has created a problem called the 'too-big-to-fail problem.

The Glass-Steagall Act

indebtedness

The state of being obligated to another to repay something

Pillar 1 links capital requirements for large, internationally active banks more closely to actual risk of three types: market risk, credit risk, and operational risk. It does so by specifying many more categories of assets with different risk weights in its standardized approach. Alternatively, it allows sophisticated (typically the largest) banks to pursue an internal ratingsbased approach that permits these banks to use their own models of credit risk. 2. Pillar 2 focuses on strengthening the supervisory process, particularly in assessing the quality of risk management in banking institutions and evaluating whether these institutions have adequate procedures in place for determining how much capital they need. 3. Pillar 3 focuses on improving market discipline through increased disclosure of details about a bank's credit exposures, its amount of reserves and capital, the officials who control the bank, and the effectiveness of its internal rating system

These efforts culminated in what bank supervisors refer to as Basel 2, which is based on three pillars.

1. Problems in the banking sector. Banks play a major role in the financing of productive investments because of their ability to produce information. Because banks have a mismatch between the maturities of liquid liabilities and illiquid assets (as explained in the next chapter), they are vulnerable to liquidity shocks. Deterioration in their balance sheets implies that fewer resources are available to lend. This leads to 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. A panic at one bank can very quickly spread to other banks as depositors rush to withdraw their deposits simultaneously. In the absence of deposit insurance and being ignorant of the quality of each bank's loan portfolios, depositors at both good and bad banks attempt to withdraw their funds simultaneously. However, the banks will have insufficient funds to meet all these requests. Because banks operate on a sequential service constraint (a first come, first served basis), depositors have a strong incentive to run on the bank first. Uncertainty about the health of the banking system can lead to runs on banks both good and bad, and the failure of one bank can provoke the failure of others (known as the contagion effect or systemic risk). These multiple bank failures are known as bank panics. There are two consequences of a bank panic. First, a loss of information in financial markets and a loss of financial intermediation by the banking sector. Second, a decrease in the supply of funds to borrowers (because of the absence of lending), which leads to higher interest rates. 2. An increase in interest rates. A sharp increase in interest rates, caused by either a decrease in the money supply or an increase in the demand (you do not have to know this process to study this unit), means that individuals and firms with the riskiest investment projects are the only ones willing to pay the higher interest. Bad credit risks are the only ones still willing to borrow (because of the adverse selection problem - see Chapter 4 for details). In other words, the only customers who still want to borrow when interest rates are high 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 and aggregate economic activity. Chapter 3: Comparative financial systems 55 3. Stock market decline. A sharp decline in the stock market is another possible reason for a serious deterioration in firms' balance sheets, which in turn can provoke a financial crisis. Given that share prices are the valuation of a firm's net worth, a stock market decline implies a reduction in the firm's net worth. The lower value of net worth implies a lower value of the collateral, which is property promised to the lender if the borrower defaults. The decline in the net worth makes banks less willing to lend because they are less protected by this collateral, and this causes a reduction in investments and aggregate economic activities. In addition, the decline in net worth induces firms to take on more risky investments, as they lose less if they have to default. As a consequence, lending is less attractive for banks, and thus there is a reduction in investments and aggregate economic activities. 4. An increase in uncertainty. The failure of prominent financial institutions, a recession or a stock market crash create increased uncertainty in the financial markets. Lenders become unable to screen good and bad credit risks (again due to the adverse selection problem). Once again, the decrease in lending results in a decline in investments and aggregate economic activity.

To understand why financial crises occur,

The Volcker Rule is a regulation that was implemented as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act in the United States. The rule prohibits banks from using customer deposits to make risky trades for their own profit. The aim of the rule is to prevent banks from taking excessive risks that could lead to another financial crisis, and to separate traditional banking activities from more speculative activities. The rule is named after former Federal Reserve Chairman Paul Volcker, who was an advocate for banking regulation. Proprietary trading is a type of trading in which a financial institution, such as a bank or investment firm, uses its own funds to buy and sell securities, commodities, or other financial instruments for the purpose of making a profit. The institution's own money is put at risk in the trades, rather than money from clients or customers. Proprietary trading can be highly profitable if successful, but it can also be risky if trades result in significant losses. In some cases, proprietary trading has been criticized for contributing to financial instability and systemic risk. Share Promptءذ

Volcker Rule

moral hazard problem

a problem that arises when people don't have to bear the negative consequences of their actions, like people who are more likely to crash a car are the ones who pay premiums for the insurance companies

debt deflation

a situation in which a substantial decline in the price level sets in, leading to a further deterioration in firms' net worth because of the increased burden of indebtedness

Subprime Residential Mortgages

a type of mortgage that is normally issued by a lending institution to borrowers with low credit ratings

Government-imposed capital requirements are another way of minimizing moral hazard at financial institutions. When a financial institution is forced to hold a large amount of equity capital, the institution has more to lose if it fails and is thus more likely to pursue less risky activities.capital functions as a cushion when bad shocks occur, making it less likely that the financial institution will fail, thereby directly adding to the safety and soundness of financial institutions

Capital Requirements

the amount of capital divided by the bank's total assets. To be classified as well capitalized, a bank's leverage ratio must exceed 5%; a lower leverage ratio, especially one below 3%, triggers increased regulatory restrictions on the bank. Through most of the 1980s, minimum bank capital in the United States was set solely by specifying a minimum leverage ratio.

Capital requirements for banks and investment banks take two forms. The first type is based on the leverage ratio

This legislation creates a new Consumer Financial Protection Bureau that is funded and housed within the Federal Reserve, although it is a completely independent agency. It has the authority to examine and enforce regulations for all businesses engaged in issuing residential mortgage products that have more than $10 billion in assets, as well as for issuers of other financial products marketed to poor people. It requires lenders to make sure there is an ability to repay residential mortgages by requiring verification of income, credit history, and job status. It also bans payments to brokers for pushing borrowers into higher-priced loans. It allows states to impose stricter consumer protection laws on national banks and gives state attorneys-general power to enforce certain rules issued by the new bureau. It also permanently increases the level of federal deposit insurance to $250,000.

Consumer Protection - Dodd frank

Financial instruments whose payoffs are linked to (i.e., derived from) previously issued securities are known as financial derivatives. As is discussed in Chapter 8, derivatives such as credit default ended up being "weapons of mass destruction" that helped lead to a financial meltdown when AIG had to be rescued after making overly extensive use of them. To prevent this from happening again, the Dodd-Frank bill requires many standardized derivative products to be traded on exchanges and cleared through clearinghouses to reduce the risk of losses if one counterparty in the derivative transaction goes bankrupt. More customized derivative products would be subject to higher capital requirements. Banks would be banned from some of their derivatives-dealing operations such as those involving riskier swaps. In addition, the bill imposes capital and margin requirements on firms dealing in derivatives and forces them to disclose more information about their activities عم، إنه شرح كامل للموضوع المذكور في السؤال. يتحدث النص عن المشتقات المالية (Derivatives) والتي هي أدوات مالية يتم ربط مخاطرها بأساسيات مالية أخرى. ومن المشتقات المالية المشهورة هي الائتمان الافتراضي (Credit default) والتي أسهمت في الأزمة المالية العالمية في 2008. ومن أجل منع تكرار هذه الأزمة مرة أخرى، أقرت الحكومة الأمريكية قانون دود-فرانك (Dodd-Frank) والذي يفرض بعض الشروط والتدابير الواجب اتخاذها من قبل المؤسسات المالية في مجال المشتقات المالية، بما في ذلك تداول بعض المشتقات المالية القياسية على المنصات المركزية، وتقييد بعض عمليات تداول المشتقات المالية المرتبطة بالمخاطر العالية، وفرض متطلبات رأس المال والهامش، والإفصاح عن مزيد من المعلومات حول الأنشطة المالية.

Derivatives

• Financial liberalisation results in an expansion in credit, which is accompanied by an increase in asset prices such as real estates and shares. They rise as the bubble inflates. • The bubble bursts and asset prices collapse (often within a short period of time) • Default of many firms and 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

Financial bubbles Financial bubbles

The following sequence of events characterizes many US financial crises: • The four factors causing financial crises (described above) lead to an increase in adverse selection and moral hazard problems. • Lending, investment spending and aggregate economic activity decline. • Depositors begin to withdraw their funds from banks, which can result in a full-scale bank panic. The determinants of the depositors' behavior are the economic slowdown and the uncertainty about the banking system. • Interest rates increase even further and financial intermediation by banks decreases because of the reduced number of banks. • Adverse selection and moral hazard problems worsen. • There is further economic contraction. • In case of a sharp decline in prices, the recovery process is short-circuited due to a further deterioration of firms' net worth. This phenomenon is known as debt deflation, or rather increased burden of indebtedness for firms.

Financial crises in the USA

do not appear on the bank balance sheet but nevertheless expose banks to risk involving trading financial instruments and generating income from fees.

Off-balance-sheet activities

Although before this legislation the FDIC had the ability to seize failing banks and wind them down, the government did not have such a resolution authority over the largest financial institutions—those structured as holding companies. Indeed, the U.S. Treasury and the Federal Reserve argued that one reason they were unable to rescue Lehman Brothers and instead had to let it go into bankruptcy was that they did not have the legal means to take Lehman over and break it up. The Dodd-Frank bill now provides the U.S. government with this authority for financial firms that are deemed systemic, that is, firms who pose a risk to the overall financial system because their failure would cause widespread damage. It also gives regulators the right to levy fees on financial institutions with more than $50 billion in assets to recoup any losses

Resolution Authority - Dodd Frank

Because banks are most prone to panics, they are subjected to strict regulations to restrict their holding of risky assets such as common stocks. Bank regulations also promote diversification, which reduces risk by limiting the dollar amount of loans in particular categories or to individual borrowers. With the extension of the government

Restrictions on Asset Holdings

asymmetric information problem

Situation in which one party to a transaction has relevant information that the other does not have and can take advantage of that fact to the first party's benefit and the other party's detriment.

The bill creates a Financial Stability Oversight Council, chaired by the Treasury secretary, which would monitor markets for asset-price bubbles and the buildup of systemic risk. In addition, it would designate which financial firms are systemically important and so would receive the official designation of systemically important financial institutions (SIFIs). These firms would be subject to additional regulation by the Federal Reserve, which would include higher capital standards and stricter liquidity requirements, as well as requirements that they draw up a "living will," that is, a plan for orderly liquidation if the firm gets into financial difficulties - القانون بينشئ مجلس للاستقرار المالي، رئيسه وزير الخزانة، اللي هيشيل مسؤولية متابعة حركة الأسواق عشان يتحرس من بقاء أسعار الأصول عالية جدًا وتجمع المخاطر النظامية. بالإضافة لكده، هيتحدد أي شركات مالية هي مهمة جدًا لنظام الاقتصاد ويتم إعطاؤها تصنيف رسمي كمؤسسات مالية مهمة جدًا (SIFIs). الشركات دي هتكون تحت تنظيم إضافي من جهاز الاحتياطي الفيدرالي، والتنظيم ده هيشمل متطلبات رأس مال أعلى ومتطلبات سيولة أكثر صرامة، وكمان متطلبات إعداد خطة تصفية مرتبة في حالة وقوع الشركة في صعوبات مالية.

Systemic Risk Regulation - Dodd Frank

1-Compensation in the Financial Services Industry (Regulators are studying ways to modify compensation in the financial industry to reduce risk-taking. One proposed solution is to issue claw backs for bonuses earned only if the firm remains healthy. 2-Government-Sponsored Enterprises (GSEs): The Dodd-Frank bill does not address privately owned government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac, which both experienced serious financial trouble and had to be taken over by the government. This leaves taxpayers on the hook for several hundred billion dollars. To prevent a similar situation in the future, the government has four options: fully privatize GSEs by removing their government sponsorship, nationalize them and make them government agencies, leave them as privately owned GSEs but strengthen regulations to restrict risk and impose higher capital standards, or leave them as privately owned GSEs but force them to shrink dramatically to reduce the risk they pose to the financial system. The decision on which route to take is crucial for safeguarding taxpayers and preventing another financial crisis. 3-Credit-Rating Agencies: After the global financial crisis, it became clear that credit-rating agencies had significant conflicts of interest and were providing inaccurate ratings, which led to investors making poor investment choices. Regulations were strengthened to reduce these conflicts of interest and provide greater incentives for credit-rating agencies to provide reliable ratings. However, more changes may be necessary, such as rethinking the reliance on credit ratings in the Basel 2 capital requirements, which are used by banks to determine their capital reserves. This is because the poor performance of credit-rating agencies in recent years has shown that relying on their ratings may not always be the best way to assess risk.

The Areas where regulations will be heading?

As a result of the global financial crisis, the world of financial regulation will never be the same. Although it is clear that more regulation is needed to prevent such a crisis from occurring again, the danger is substantial that too much or poorly designed regulation could hamper the efficiency of the financial system. If new regulations choke off financial innovation that can benefit both households and businesses, economic growth in the future will suffer

The Danger of Overregulation

1- Break Up Large, Systemically Important Financial Institutions One way to eliminate the too-big-to-fail problem is to make sure that no financial institutions are so large that they can bring down the financial system. Then regulators will no longer see the need to bail out these institutions, thereby subjecting them to market discipline. One way to shrink these institutions is to reimpose the restrictions in place before Glass-Steagall was repealed, thereby forcing these large SIFIs to break up their different activities into smaller, cohesive companies. Alternatively, regulations could specify that no financial institution can have assets over a specified maximum limit, forcing SIFIs to break up into smaller pieces Break Up Large, Systemically Important Financial Institutions One way to eliminate the too-big-to-fail problem is to make sure that no financial institutions are so large that they can bring down the financial system. Then regulators will no longer see the need to bail out these institutions, thereby subjecting them to market discipline. One way to shrink these institutions is to reimpose the restrictions in place before Glass-Steagall was repealed, thereby forcing these large SIFIs to break up their different activities into smaller, cohesive companies. Alternatively, regulations could specify that no financial institution can have assets over a specified maximum limit, forcing SIFIs to break up into smaller pieces 2-Higher Capital Requirements Because institutions that are too big to fail have incentives to take on excessive risk, another way to reduce their risk taking is to impose on them higher capital requirements. With higher capital, not only will these institutions have a larger buffer to withstand losses if they occur but they will have more to lose and hence have more "skin in the game," thereby reducing moral hazard and giving them less incentive to take on excessive risk. Another way of describing this approach is to say that higher capital requirements reduce the subsidy to risk taking for institutions that are too big to fail. In addition, because risk taking by SIFIs is far greater during booms, capital requirements could be increased when credit is expanding rapidly and reduced when credit is contracting. By so doing, capital requirements would become more countercyclical and could help restrain the boom-bust credit cycle. The Swiss central bank has been a leader in this kind of approach: It has the highest capital requirements among advanced countries for its largest banks and raises them when credit markets become particularly frothy. Legislation has been proposed in the U.S. Congress to double capital requirements for large financial institutions, again something that these institutions vigorously oppose. 3- Leave It to Dodd-Frank Another view is that Dodd-Frank has effectively eliminated the too-big-to-fail problem by making it harder for the Federal Reserve to bail out financial institutions, by increasing stricter regulations for SIFIs, and through the application of the Volcker rule. Indeed, the authors of the bill have declared that Dodd-Frank would "end too big to fail, as we know it." Although provisions in Dodd-Frank do take away some of the incentives for excessive risk-taking by large, systemically important financial institutions, there are doubts that this bill completely removes the too-big-to-fail problem.

What Can Be Done About the Too-Big-to-Fail Problem?

Stage one: Initial phase (Credit boom and bust - Asset Boom and Bust - increase in uncertainty)

What are the dynamics of a financial crisis? what is the first stage?

Stage Two: Banking Crisis

What are the dynamics of a financial crisis? what is the second stage?

Stage Three: Debt Deflation

What are the dynamics of a financial crisis? what is the third stage?

Information asymmetry occurs when one party in a transaction has more or better information than the other party. This can create an imbalance of power, with the party that has more information being able to exploit the other party's lack of knowledge to their advantage. In the context of financial markets, information asymmetry can lead to adverse selection and moral hazard problems. Adverse selection occurs when the party with less information ends up making decisions that are not in their best interest because they lack the necessary information. Moral hazard occurs when the party with more information engages in risky behavior because they know that the other party will bear the costs of any negative outcomes. To address information asymmetry in financial markets, various measures have been taken, such as mandatory disclosure requirements for companies, credit rating agencies to assess the creditworthiness of issuers, and insider trading laws to prevent individuals from using privileged information to gain an unfair advantage in the market. information asymmetries vs adverse selection Information asymmetry and adverse selection are related concepts that often go hand in hand in financial markets. Information asymmetry refers to a situation in which one party in a transaction has more or better information than the other party. This imbalance of information can lead to adverse selection, which occurs when the party with less information ends up making decisions that are not in their best interest because they lack the necessary information. In the context of financial markets, adverse selection can occur in various scenarios. For example, in the market for insurance, those who are at higher risk of making a claim may be more likely to purchase insurance, while those at lower risk may choose not to purchase insurance, leading to an adverse selection problem. Similarly, in the market for used cars, sellers may have more information about the condition of the car than buyers, leading to a situation where buyers may end up purchasing a car that is of lower quality than expected. To address adverse selection in financial markets, various measures have been taken, such as risk-based pricing for insurance policies, warranties for used cars, and credit screening for loan applicants. These measures aim to ensure that those who are at higher risk of defaulting on their payments or making a claim pay a higher premium or interest rate, thus incentivizing them to self-select out of the market.

information asymmetries vs adverse selection

To short-circuit this leverage cycle, macroprudential policies would make capital requirements countercyclical; that is, they would be adjusted upward during a boom and downward during a bust. In addition, during the upward swing in the leverage cycle, macroprudential policies might involve forcing financial institutions to tighten credit standards or even direct limits on the growth of credit. In the downward swing, macroprudential supervision might be needed to force the banking system as a whole to raise an aggregate amount of new capital so that banks would not curtail lending in order to reduce the level of their assets and raise capital ratios. To ensure that financial institutions have enough liquidity, macroprudential policies could require that financial institutions have a sufficiently low net stable funding ratio (NSFR), which is the percentage of the institution's short-term funding in relation to total funding. Macroprudential policies of the type discussed here are being considered as part of the Basel 3 framework but have not yet been completely worked out The term "leverage cycle" refers to the cyclical pattern of borrowing and lending that occurs in the banking and finance industry. The leverage cycle can be described as a feedback loop, where increased lending leads to increased borrowing, which in turn leads to further lending and so on. During a leverage cycle, financial institutions tend to increase their leverage, or the amount of debt they take on, in order to fund their investments. This can lead to increased risk-taking and speculation, as institutions seek higher returns on their investments in order to meet their debt obligations. As the cycle progresses, asset prices may become overinflated, leading to a bubble. Eventually, the bubble may burst, causing a financial crisis and a period of deleveraging, where institutions reduce their debt levels and liquidate their assets. The leverage cycle is often viewed as a key driver of financial instability, as it can lead to excessive risk-taking and contribute to systemic risk in the financial system. As a result, regulators and policymakers often monitor the leverage cycle and may take actions to try to mitigate its effects.

leverage cycle - from macroprudential

A low net stable funding ratio (NSFR) suggests that a bank may be relying too much on short-term funding to support its long-term assets, increasing its liquidity risk and vulnerability to financial stress. The NSFR measures a bank's ability to fund its long-term assets with stable, longer-term sources of funding. Policymakers monitor NSFR levels to assess the stability and resilience of the banking system.

low net stable funding ratio

which focuses on the safety and soundness of the financial system in the aggregate. Rather than focus on the safety and soundness of individual institutions, macroprudential supervision seeks to mitigate systemwide fire sales and deleveraging by assessing the overall capacity of the financial system to avoid them. In addition, because many institutions that were well capitalized faced liquidity shortages and found that their access to short-term funding was cut off, macroprudential supervision focuses not only on capital adequacy as a whole but also on whether the financial system has sufficient liquidity

macroprudential supervision

Countercyclical capital requirements are part of macroprudential policies that regulate banks and financial institutions. These requirements adjust the level of capital that banks must hold based on the stage of the economic cycle, so they can build a buffer during good times and absorb losses during bad times. The goal is to promote financial stability and reduce systemic risks in the financial system.

macroprudential supervision and leverage cycle

in which assets are valued in the balance sheet at what they could sell for in the market

mark-to-market accounting, also called fair-value accounting,

which focuses on the safety and soundness of individual financial institutions. Microprudential supervision looks at each institution separately and assesses the riskiness of its activities and whether it complies with disclosure requirements. Most important, it checks whether that institution satisfies capital ratios and, if not, either it engages in prompt corrective action to force the institution to raise its capital ratios or the supervisor closes it down, along the lines we have discussed.

microprudential supervision

Adverse Selection

the situation in which one party to a transaction takes advantage of knowing more than the other party to the transaction

(1) restrictions on asset holdings, (2) capital requirements, (3) prompt corrective action, (4) chartering and examination, (5) assessment of risk management, (6) disclosure requirements, (7) consumer protection, (8) restrictions on competition, and (9) macroprudential regulation (1) القيود المفروضة على حيازات الأصول ، (2) متطلبات رأس المال ، (3) اتخاذ إجراءات تصحيحية فورية ، (4) الميثاق والفحص ، (5) تقييم إدارة المخاطر ، (6) الإفصاح المتطلبات ، (7) حماية المستهلك ، (8) قيود المنافسة ، و (9) التنظيم التحوطي الكلي

what are the nine basic types of financial regulation aimed at lessening asymmetric information problems and excessive risk taking in the financial system:

1. A financial crisis occurs when a particularly large disruption to information flows occurs in financial markets, with the result that financial frictions and credit spreads increase sharply, thereby rendering financial markets incapable of channeling funds to households and firms with productive investment opportunities, and causing a sharp contraction in economic activity. 2. Financial crises can start in advanced countries like the United States in several possible ways: credit and asset-price booms and busts or a general increase in uncertainty when major financial institutions fail. The result is a substantial increase in adverse selection and moral hazard problems that lead to a contraction of lending and a decline in economic activity. The worsening business conditions and deterioration in bank balance sheets then trigger the second stage of the crisis, the simultaneous failure of many banking institutions, a banking crisis. The resulting decrease in the number of banks causes a loss of their information capital, leading to a further decline of lending and a spiraling down of the economy. In some instances, the resulting economic downturn leads to a sharp slide in prices, which increases the real liabilities of firms and households and therefore lowers their net worth, leading to a debt deflation. The further decline in borrowers' net worth worsens adverse selection and moral hazard problems, so that lending, investment spending, and aggregate economic activity remain depressed for a long time. 3. The most significant financial crisis in U.S. history, that which led to the Great Depression, involved several stages: a stock market crash, bank panics, worsening of asymmetric information problems, and finally a debt deflation. 4. The global financial crisis of 2007-2009 was triggered by mismanagement of financial innovations involving subprime residential mortgages and the bursting of a housing price bubble. The crisis spread globally, with substantial deterioration in banks' and other financial institutions' balance sheets, a run on the shadow banking system, the failure of many highprofile firms, and sharp

what causes a financial crisis?

stress testing

which calculates losses under dire scenarios, and value-at-risk (VaR) calculations, which measure the size of the loss on a trading portfolio that might happen 1% of the time—say, over a two-week period. In addition to these guidelines, bank examiners will continue to consider interest-rate risk in deciding the bank's capital requirements