M&C Chapter 12

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 occur red 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.

Some countries do not advertise that a system of deposit insurance like the FDIC in the United States exists in their banking system. Explain why some countries would want to do that.

-Not advertising deposit insurance may reduce the problem of moral​ hazard, which is created by a system of deposit insurance.-The information about the presence of a system of deposit insurance makes depositors and bank clients less likely to monitor a​ bank's activities.

Describe the process of "securitization" in your own words. Was this process solely responsible for the Great Recession financial crisis of 2007-2009?

Securitization allows a provider to pool a number of economic assets into one instrument. After that, it sells the repackaged items to a buyer. Securitization gives buyers options, and originators are free to sell liquid securities. No, securitization was not the only process responsible for the great recession of 2007-2009. Financial innovation, securitization (mortgage markets), and agency problems in the market were the causes of the financial crisis. Because of securitization, efforts were not made to evaluate the risk of default by borrowers. Emphasis was put on the selling loans instead of evaluating borrowers. This contributed to huge defaults by borrowers which was one of the reasons for financial crisis.

How does a deterioration in balance sheets of financial institutions cause a decline in economic activity?

There's less resources to lend out, so less loans are made and less investment, less economic activity.

How can a decline in real estate prices cause deleveraging and a decline in lending?

This causes a decline in the financial institution's assets, which affects their balance sheet due to a lower net worth. This causes them to deleverage which means they cut back on the loans they give out.

How can the Dodd-Frank eliminate the too-big-to-fail problem?

Three ways in which the D-F can alienate the too-big-to-fail problem include increasing regulations on financial institutions, as well as implementing the Volcker rule, which will make it more difficult for the Fed to intervene in the financial system.

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 do financial crises start in advanced economies?

credit 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, which leads 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.

Why is it important for the U.S. government to have resolution authority?

Resolution authority allows the government to quickly takeover a failing firm.

How did a decline in housing prices help trigger the subprime financial crisis starting in 2007?

-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.

Why might financial liberalization and globalization lead to a financial crisis in emerging market economies?

Emerging economies are more dependent on external capital flows. A credit boom can end abruptly by external shocks being propagated due to financial globalization.

What do you think prevented the financial crisis of 2007-2009 from becoming a depression?

A combination of competent monetary and fiscal policy. The Federal Reserve Board saw to it that interest rates were kept very low which made it easy for business and consumers to borrow money. Congress passed a huge stimulus designed to put money in the hands of consumers. Even payroll taxes were temporarily reduced. All of this gradually created the conditions for economic recovery. The use of nonconventional policy by FED to create term auction facilities. The creation of new programs such as lending to investment banks & purchasing commercial paper, and the FED use of monetary policy to reduce Fed Funds rate

How does the concept of asymmetric information help to define a financial crisis?

A financial crisis occurs when there's a large disruption to information flows in markets, resulting in financial frictions and credit spreads sharply increasing - asymmetric problems lead to less lending and a decline in economic activity.

Why were consumer protection provisions included in the Dodd-Frank bill, a bill designed to strengthen the financial system? What are some of the problems with these regulations?

Because in order to pass, Dodd-Frank (as with any Congressional legislation) had to have political support, including the support of congressmen and Senators who had long wanted more "consumer protection" laws. They exacted the "price" of having consumer protection provisions added to Dodd-Frank, in exchange for their voting for the bill.

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.

How can higher capital requirements eliminate the too-big-to-fail problem?

Another method is to require the largest institutions to maintain higher capital ratios. The larger capital of these institutions will allow them to not only withstand losses if they happen, but also give them more to lose and give them a larger stake in the game. By increasing capital requirements, too-big-to-fail institutions lose their subsidy for risk-taking. Due to heightened risk-taking during boom times, capital requirements could also increase during periods of rapid credit expansion, while they would decrease during periods of credit contraction. Capital requirements under these measures could become more countercyclical, thereby reducing the boom-bust cycle.

How can a bursting of an asset-price bubble in the stock market help trigger a financial crisis?

Assets will realign with fundamental economic values, so stock prices fall and companies see their net worth decline. Reduction in asset prices causes a serious deterioration in borrowing​ firms' balance sheets. The value of collateral they can pledge then drops, so they now have "less skin in the game," leading to riskier investments. Adverse selection increases and they become less credit worthy. Financial institutions tighten lending standards and reduce the amount of loans they make.

What technological innovations led to the development of the subprime mortage market?

Data Mining - quantitative evaluation of the credit risk for a new class of riskier reidential mortgages.

Describe two similarities and two differences between the United States' experiences during the Great Depression and the Great Recession financial crisis of 2007-2009.

Differences: No bank panic occurred in 2007-2009, as opposed to the Depression and the source of asset-price increases was different for both. Similarities: Both episodes were preceded by sharp increases in asset prices (bubble) and credit spreads widened and the availability of credit declined during both

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.

True, false, or uncertain: Deposit insurance always and everywhere prevents financial crises.

False. Deposit insurance is a very good system to prevent bank panics, but these events are just one potential element in a financial crisis. As the events that unfolded during the Great Recession illustrate, financial crisis have many aspects evolving at the same time. A system of deposit insurance might help to prevent bank panics, but it is unable to prevent the effects of the asset price decline in the housing market or the spreading of the crisis to international financial markets. Also, deposit insurance creates moral hazard incentives encouraging risk-taking on the part of banks that might make a financial crisis more likely.

Define "financial frictions"in your own terms and explain why an increase in financial frictions is a key element in financial crises.

Financial frictions are a set of conditions that prevent financial markets to effectively assign funds to the best investment opportunities. In general, they increase when information asymmetries worsen, preventing lenders from ascertaining the best potential borrowers. Financial frictions are a key element in financial crises because as the channeling of funds through the financial market is interrupted or limited, the economy slows down. This could trigger an asset price decline, increase in uncertainty, and the deterioration in financial institutions' balance sheets.

How has financial regulation changed in the wake of the global financial crisis of 2007-2009?

Financial regulation has undergone many changes in the wake of the global financial crisis. First is the shift from microprudential supervision, which focuses on the safety and soundness of individual institutions, to macroprudential supervision, which focuses on the safety and soundness of the financial system in the aggregate. Second is the Dodd-Frank Act of 2010, which is the most comprehensive financial reform legislation since the Great Depression. It makes provisions in seven areas: (1) consumer protection, (2) annual stress tests, (3) resolution authority, (4) limits on Federal Reserve lending, (5) systemic risk regulation, (6) the Volcker rule, and (7) derivatives trading.

What issues does future regulation need to address?

Future regulation needs to address several issues: (1) the too-big-to-fail problem, which can be at least partially addressed either by breaking up large financial institutions or by imposing higher capital requirements on them; (2) many of the provisions of the Dodd-Frank legislation; and (3) reform of the GSEs to make it less likely that they will require government bailouts in the future.

How can breaking up financial institutions prevent the too-big-to-fail problem?

In the event that a financial institution fails, after a sufficient time, there will be no need to bail it out. This is the first approach to avoiding the problem of two-big-to-fail. The largest financial institutions have opposed both of these approaches. One of them would be to reimpose the restrictions that existed before the G-S was annulled, while the other would be to specify a maximum limit over which no institution could have assets. A company can be broken up to eliminate the 'Too-Big-to-Fail' problem if there are synergies available that might provide the largest companies with better risk management capabilities or lower costs. It is possible that breaking up the financial system would actually detract from its efficiency rather than boost it.

Why is it a good idea for macroprudential policies to require countercyclical capital requirements?

Leverage cycles indicate that over business cycles, lending increases substantially in booms and decreases substantially in downturns. If countercyclical capital requirements were initiated, this would require more capital held at institutions during booms, which would reduce lending and help to mitigate credit bubbles that can be damaging later on. Likewise, when the economy goes into a downturn, capital requirements could be lowered, which would encourage more lending and facilitate faster economic growth.

Provide one argument in favor of and one against the idea that the Fed was responsible for the housing price bubble of the early 2000s.

Proponents of the idea that the Fed was responsible for 2007-09argue the Fed helped create the conditions for a housing bubble by setting the federal funds rate too low for too long. Since the federal funds rate is a critical benchmark for interest rates, this action made funds cheaper to financial intermediaries, and these intermediaries were, therefore, more willing to lend to homeowners. Additional arguments that blame the Fed argue that the Fed did not utilize its authority over financial institutions to combat questionable lending practices. Supporters of the Fed ́s policy leading up to 2007-09, suggest other factors were also responsible, like the inflow of a substantial amount of foreign capital. The debate is ongoing.

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.

What role did the shadow banking system play in the 2007-2009 financial crisis?

The shadow banking sector played a critical role in the financial crisis. Shadow banking was under the purview of fewer regulations and government protections than traditional banking. This made shadow banking highly fragile. Fewer regulations also meant it had a competitive advantage relative to traditional banks allowing it to grow in size and even surpass the traditional banking sector for a while. The shock caused by the bursting of the housing bubble and sub-prime mortgage crisis helped trigger a run on the shadow banking system. Shadow banks did not have the the traditional deposit insurance or lender of last resort measures to protect them from this run. The financial crisis showed how vulnerable shadow banking was to a liquidity shock and forced a major government response. 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 are "haircuts"?

the difference between current market value of an asset and the value ascribed to the asset falling in value in an immediate cash sale or liquidation

When does a financial crisis occur?

when a particularly large disruption to information flows occurs in financial markets, with the result that financial frictions 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.