Financial Bubbles, Crises and Crashes

What was the role of subprime mortgages in the 2008 financial crisis?

- The banks had loose lending standards, and it was relatively easy to get a mortgage which led to an increase in subprime mortgages (mortgages given to those with low credit score). - Through securitization, the subprime loans were pooled into marketable securities. When these subprime borrowers defaulted on their loans, banks faced liquidity shortages. In addition to banks not receiving loan payments, the securities that were backed by subprime mortgages declined rapidly.

Why is the financial industry so heavily regulated? Opacity

2. Opacity a. Fraud Prevention:Opacity in financial transactions can facilitate fraudulent activities. Regulations are designed to increase transparency, making it harder for fraudulent activities to go unnoticed and ensuring the integrity of financial systems. b. Behave: Regulations are meant to guide the behavior of financial institutions and prevent them from engaging in unethical or irresponsible practices. Increased transparency helps ensure that institutions behave responsibly.

Why is the financial industry so heavily regulated? Centrality

3. Centrality a. Affect the economy: The financial industry plays a central role in the economy. Its stability is crucial for overall economic health. Regulations are in place to prevent disruptions in the financial sector from negatively affecting the broader economy. b. Trust is fundamental to the functioning of financial markets. Regulations are implemented to build and maintain trust among market participants, investors, and the public. This trust is essential for the smooth operation of financial systems.

What is a financial bubble?

A financial bubble has different definitions, from "an upward price movement over an extended range, than then implodes" or "The rise of asset prices above their fundamental economic value". Asset price bubbles are often defined as "persistent and cumulative deviations of the market price from the fundamental or intrinsic price" or "a bubble is a steep increase in the price of an asset such a share over a period of time, followed by a steep decrease in its price".

How did central banking develop historically?

The first central banks were private and deposit taking banks. They were government banks and helped to issue bonds to finance wars. They issued bank notes, and any bank could issue their own banknotes. When note issuing was restricted to one national bank and tied to gold reserves, these banks took on central bank status. - The first central bank in 1668 and was the Sweden Riksbank. - Bank of England 1694 - The bank of the United States (1791-1811) o The second bank of US 1816-136 o The federal reserve system 1913 - Banque de France 1800 - Norges Bank 1816

What are the main functions of the central bank?

The government's bank: checking account, sell/buy government securities. - Issue notes and coins and ensure faith in the monetary system. - The banks bank: lending and clearing functions. - Operate as lender of last resort. - Conduct monetary policy. o Conventional o Unconventional - Regulations, surveillance, and support -Economic research

Theories of Market Imperfections

heterogeneous expectations: Heterogeneous expectations involve investors having different beliefs about asset prices, and this can be due to different access to information. When the information the investors possess varies, there will be investors who are not acting rational and selling/buying pressure may cause the price to deviate from fundamental value. Short sale constraints: market imperfections that limit short-sale can prevent price correlations when assets are mispriced. There are several risks connected to short-sale constraints; fundamental risk, noise trader risk and synchronization risk. Asymmetric information: When one part of a transaction has information the other part lacks, only they can make an informed decision. The bondholders or the holder of other debt securities wont correctly determine the risks the banks face or rising defaults due to asymmetric information, and this may lead to a bank run. Extrinsic bubble: ​​Some factors may indirectly affect or correlate to economic variables. These extrinsic factors can influence prices and cause volatility, although they are not directly connected to the fundamentals, and they are called sunspots.

credit risk

risk that the borrower will default their loan. The banks that have lended out the money risk not receiving principal or interest if the borrower defaults their loan. Moral hazard: lenders engaging in risky activities after receiving the loan. Can be avoided by collateral requirements to increase borrowers' incentives to repay the loan (potential loss for borrower increases) Adverse selection: those who are more likely to default their loans are also more likely to get picked for loans. Can be managed by collecting information such as loan records, salaries and other assets about the borrower, and this process is called screening. Also normal to verify the information given with third parties

Liquidity risk

the risk of not being able to fulfill short-term obligations. Liquidity risk can for example be caused by banks' lending out long-term loans, while getting funding on short-term terms. To minimize liquidity risk it is important for the banks to make sure they have sufficient funds and are liquid enough to meet its financial obligations

interest rate risk

the risk that the value of a bond or another asset will decline in value due to fluctuations in the interest rates. Some measures that can be taken involve monitoring the changes in the interest rates and performing a duration analysis. A duration analysis measures a securities sensitivity to fluctuations in interest rates

Does regulation and supervision work?

→ Trade-off between growth and stability: - Allowing too much risk-taking and speculation can drive economic growth by stimulating investment and innovation. - Excessive risk-taking can also lead to financial instability and systematic risk, which can have severe economic and social consequences. - Limit risk taking by financial institutions: Excessive risk taking can lead to financial instability and systematic risk, which can have severe economic and social consequences. → Ensure safety and stability: - Excessive risk taking - Monopolistic practices - Fraudulent operations - Supervision and regulation - Oversight and enforcement - Crisis management and resolution

How was the Norwegian banking crisis solved?

- After significant losses were found at the two biggest banks, kredittkassen and fokus bank, they established The State Bank Insurance Fund (SBF) in January 1991, and The State Bank Investment Fund (SBIF) in November 1991. value of share capital in the two banks was written down to zero, and SBF became the sole owner of these banks. - Facing crises at DnB in 1992, the government initiated gradual capital injections through SBF, SBIF, and private companies, but in March 1993 the value of ordinary share was written down to zero and SBF/SBIF became the majority owner of DnB. All the board of directors was replaced and even some managers. - The government implemented reforms to prevent the emergence of "Bad banks." A tax reform in 1992 imposed a 28% tax on net business and personal income. In 1993, monetary policy decoupled from a fixed exchange rate. Kredittilsynet introduced minimum capital requirements, and hybrid capital was allowed only with over seven percent core capital. The goal was to stabilize the financial sector and ensure responsible management.

The great depression

- Commonly known as the worst economic downturn in history of advanced industrial countries. It originated in the US in 1929. It began as an ordinary recession in the middle of 1929, but the downturn became worse until 1933. Key elements in the great depression were monetary contraction and the gold standard. Currencies were tied to the gold standard, and many countries abandoned this to recover from the depression, such as the UK in 1931. the stock markets crashed in 1929. It is also characterized by high deflation caused by the decline in money supply. In early 1930, people feared that wages would lower in the future, and stopped spending and borrowing. - The decline in asset prices, together with bank failures and panics, fed massive economic contraction, which worsened adverse selection and moral hazard problems in the financial markets, further aggravating the economic downturn. - Value of imports in the 75 largest economies dropped from $2998 million (1929) to $992 million (1932). At this point, the debt deflation started. Massive unemployment appeared in the US, UK, France and Germany in which 6 million were unemployed (25% of workforce).

Norwegian banking crisis: Bad policy

- In the 1950 to 1970s the credit market was heavily regulated. DnC, Bergen Bank and CBK, who were the three biggest banks in Norway competed to become the biggest bank. - 1983 credit-markets were deregulated. This made it possible for banks to lend freely and establish branches freely. This wasn't a well-prepared action; both the interest rate policy and tax policy stayed the same.When the tax policy, interest policy, and inflation was combined it turned into negative real interest rates after tax, in easier words it was "free" to borrow money. - Credit boom, and it was further fueled by fiscal expansion in 1985 (tax reductions). - The banks were expanding quickly and were still competing to be the biggest bank. The banks got problems funding their expansion, leading to the capital requirements to be relaxed and subordinated loans were accepted as equity. - When the banks got into solvency problems, they couldn't use this form of «equity» to cover running losses. - In 1986 when growth in lending was at peak, the financial supervision was reorganized. The Insurance Council and the Bank Inspectorate were combined into Kredittilsynet. Much time was spent on administrative work, and at the same time there was a boom in the stock market that led to that the security market had priority.

What caused The Great Depression in the United States?

- Monetary policy: huge decline in money supply by the federal reserve, believed to be a measure to preserve the gold standard since each currency was set in terms of gold prices. As money became a shortage in the economy. This led to a bank run as people were in need of money, and as people withdrew their money, banks were faced with a liquidity crisis. - U.S. Stock market crash: From 1928 to 1928, the stock price doubled. The federal reserve viewed the stock market boom as excessive speculation, and tightened monetary policy to limit the rise in stock prices.

How did losses in the US subprime mortgage market spread to the global financial system?

- Problem originated in the US, extensive globalization of financial markets led to a global financial crisis. - In Spain, UK and Ireland there was a rapid increase in housing prices. In Spain there came a real estate boom which came people acquired loans to sustain their houses which led to an increase in demand which fueled the housing bubble. when loans exceeded the value, people defaulted on their loans. housing prices declined and house owners couldn't pay their loans. - There were multiple failures of financial institutions across Europe, for example Northern Rock in the UK. The housing prices peaked in 2008 and fell 31% between 2008 and 2014. Europe had a liquidity spiral.

What is securitization and what was the role of securitization in the Great Recession?

- Securitization is packaging assets into marketable securities. One of the main causes of the great recession was the securitization of subprime mortgages. - Subprime mortgages were being pooled together into securities such as MBS (mortgage-backed securities) and CDO (collateralized debt obligations). CDOs are designed to pay income streams from underlying assets, to assess certain risk factors the investors find attractive. Many of the mortgages were made to low-quality borrowers, and many were also wrongly rated, and therefore seemed safer to the investors. Another financial innovation made through securitization was the CDS (credit default swap), which some investors used to hedge their investments. - Securitization led banks and investors to engage in excessive risk taking. When borrowers started defaulting on their mortgages and the housing market crashed, all these mortgage-backed securities dropped significantly in value. As they were considered a safe investment, many banks and investors held large holdings of these securities, and this caused many banks to face financial problems.

What is shadow banking and what role did it play in the development of the Great Recession?

- Shadow banking is financial intermediaries such as hedge funds, investment banks and other nondepository financial firms who are not a part of the traditional regulated banking system. Shadow banks do not hold deposits, but They raise (that is, mostly borrow) short term funds in the money markets and use those funds to buy assets with longer term maturities. - As they don't face the same reserve requirements and regulations as commercial banks, they could take higher levels of credit risk and liquidity risk. Many of the securities that were traded were funded by Repos (repurchase agreements), which used mortgage-backed securities as collateral. As defaults on mortgages increased, lenders required larger amounts of collateral than before and financial institutions had to engage in fire sales. Since this required lowering the price, assets value declined even further.

Norwegian banking crisis: bad luck

- The first bad luck was the oil price collapse in 1986, with a decline of 67 per cent. This led to a sharp reduction in revenues from oil exports, this made problems for the Norwegian trade balance. The NOK was devalued, and the government shifted towards tighter fiscal policies to fight inflation and avoid new devaluations. They also implemented moderate tax changes, focusing on more taxes on gross income before deductions, this made the real interest rates positive after tax. - These policies were vital for macroeconomic stability but made severe challenges for households and businesses with high level of debt. Private consumption witnessed a four per cent drop from 1986 to 1989, the politicians plan was to have a reduction in nominal interest in 1990, but the Berlin-wall fell in 1989, this opens up to our second bad luck. - For the time being Norway had fixed exchange rates. Germany had an expansionary policy to finance the reunion, this led to high international interest rates in 1991-1992. Norway found itself unable to reduce its own interest rates, due to the fixed exchange rate. As a result of this interest rate policy that was influenced by the fall of the Berlin-wall prolonged the existing banking crisis in Norway, and further complicated the situation to stabilize the financial sector.

Describe the main features of The Great Recession

- The housing bubble: loose lending standards and excessive risk taking fueled the housing bubble. when borrowers defaulted their loans and housing prices declined, the bubble burst - Financial innovations: Subprime mortgages were offered to borrowers with low credit scores and marketable securities were developed through securitization (MBS, CDO, CDS) - Deregulated markets: repeal of the Glass-Steagall act in 1999: Allowed securities firms and insurance companies to purchase banks, and allowed banks to engage in real estate, insurance, and securities-activities . Various firms became so big that the government could not let them go bankrupt. Agency problems: mortgage brokers earned fees on the loans they gave out (the more volume the more money). they could walk away if prices went down, but there would be high profit if prices went up. Credit rating agencies also earned fees on giving AAA ratings.

Norwegian banking crisis: Bad banking

- They weren't used to analyse people or companies' ability to pay back the loans, therefore the credit assessments or internal controls weren't well enough adapted to a deregulated credit market - The visibility of credit losses appeared in 1990. Kredittilsynet reported that they needed to get more capital in order to maintain the minimum requirement. After some replacement in management, the 1991 final accounts show losses of 7 billion kroner. The government had to step in and spent 10 billion kroner to restore and rescue the bank (Aamo, 2017). This didn't only happen to CBK, there were also substantial losses found in DnC during the same time, this led to branch closures and down-staffing. Later, in 1990 both Bergen Bank and DnC had a merger into DnB, which is the biggest merger in Norway yet.

What are the main forms of financial regulation and supervision?

1. Asset holdning 2. Capital Requirements 3. Prompt Corrective Action 4. Chartering 5. Discloure requirements 6. General consumer protection 7. Regulative competition 8. Financial supervision

What are the main features of the Minsky - Kindleberger model of financial crisis?

1. Displacement 2. Boom 3. Euphoria 4. Mania 5. Distress 6. Panic, crash and crisis

Why is the financial industry so heavily regulated? Fragility

1. Fragility a. Crisis: Financial markets and institutions can be prone to crises, such as the 2008 financial crisis. Regulations are put in place to mitigate the impact of such crises and prevent them from spiraling out of control. b. Asymmetric information imbalances between different market participants can lead to unfair advantages and market distortions. Regulations aim to ensure transparency and reduce information asymmetry, promoting fair competition. c. ST/LT business model: Short-term focus and excessive risk-taking by financial institutions can contribute to fragility. Regulations help enforce a balance between short-term and long-term considerations to foster stability.

What is a financial crisis?

A financial crisis is a disruption to financial markers so that financial markets are unable to efficiently channel funds to those who have the most productive investment opportunities. Can be characterized by asset prices facing a steep decline in value, people becoming unable to pay their debts, and banks and other institutions experiencing liquidity shortages - Banking crisis that happens when there is failure of some banking institutions or systemic banking crisis. They are defined as "significant signs of financial distress in the banking system (as indicated by significant bank runs, losses in the banking system, and or/bank liquidations). - private security market crisis: also known as the stock market crash. - Currency crisis that happens when a nominal deprecation of the currency vis-à-vis the U.S. dollar of at least 30% that is also at least 10 percentage points higher than the rate of depreciation in the year before. - Sovereign debt crisis: when a country is unable to pay its bills and is called the

What is a bank liquidity crisis and how can it be solved?

A liquidity crisis occurs when an otherwise solvent bank does not have liquid assets (i.e., reserves) necessary to meet short-term obligations, such as the sudden withdrawal of funds, repayment of loans, the payment of bills or paying its employees. The fractional reserve system makes banks especially vulnerable to liquidity crises.

How was Norway affected by the 2008 financial crisis?

After the Norwegian banking crisis, there was a well developed risk management procedure and skepticism towards new and complicated financial instruments, such as MBS AND CDOs. Norwegian banks had higher levels of own funds, than banks in other countries, meaning they had more of their own money at risk. While several banks had liquidity issues, there weren't concerns about bankruptcies, as in many other countries.

What are the main features of the Financial Instability Hypothesis (FIH)

Basic foundations of the FIH: 1 - Minsky has the objective of describing an endogenous process that potentially created crisis out of long periods of stability - Exogenous shocks are not required for systemic financial crisis to develop - Crisis can and will arise out of standard, internal cyclical behavior of the capitalist economy. Basic foundations of the FIH: 2 The financial instability hypothesis is a model of a capitalist economy which does not rely u The internal dynamics Premise 1: - The core decision-makers in the economy are profit seeking businessmen and bankers, not a "collection of hypothetical consumers" Premise 2: - Financial relations/financial regimes = the relationship between lenders and borrowers is the core mechanism through which the stability of the economy is decided - To understand the financial crisis we need to understand how financial relations are established and change over time. Premise 3: - The economy can be in stable or unstable financial regimes. Over periods of prolonged pros

What are the different types of banks?

Commercial Bank: Main business is financial intermediation (accepting deposits and making loans) Investment Banks: Corporate and government assistance, and market activity. Underwriting, stock market flotation, consultancy services, trading in financial markets, asset management etc. Universal Banks: Does both Commercial and Investment banking, like DNB for example. Glass Steagall: Federal law passed in 1933 that separated commercial banks from investment banking activities to protect depositors from potential losses through stock speculation. The act forced commercial banks to specialize in commercial or investment banking. Only 10% of commercial banks income could stem from securities.

What are the main pros and cons of financial regulation and supervision

Cons: - If regulation prohibits something, than breaking rules without being caught can be profitable - Regulation provides a (potentially) monopolistic adantage to the successful rule-breaker Pros: - Limits excessive risk taking, fraudulent operations and monopolistic exercises - Investors having the same information Consequences: 1. Unregulated entitets will benefit 2. Regulated entities will try to escape regulation 3. The more effective regulation is, the more efforts will be spent on avoiding it 4.Regulators can be easily be hijacked by the industry: If you are an expert in modern finance - why on earth would you become an regulator

What is a bank solvency crisis and how can it be solved?

Definition: Ability of a business to have enough assets to cover its liabilities. Example: When Lehman Brothers went under, its debts (liabilities) were much greater than its assets. Therefore, even though it had access to temporary funds from the Federal Reserve, this access to liquidity couldn't solve the underlying problem that it couldn't meet its liabilities The FDIC uses two primary methods to handle a failed bank: 1. Payoff-method FDIC allows the bank to fail and pays of depositors up to the insurance limit. After the bank has liquidated the FDIC lines up with other creditors of the bank and is paid its share of the proceeds from the liquidated assets 2. Purchase and assumption method The FDIC reorganizes the bank, typically finding a willing merger partner who assumes all the failed bank liabilities so that no depositor or other creditor loses a penny.

The Efficient Market Hypothesis

EMH states that asset prices fully reflect all available information, leaving it nearly impossible to consistently make abnormal returns. According to the EMH we can divide market efficiency into 3 forms: Weak form, Semi-strong form, and strong form. Weak form efficiency is when prices reflect all historical information (such as trading history). With semi-strong form efficiency, the prices reflect all publicly available information and strong form efficiency is when prices reflect both publicly and private information. EMH also assume that investors are rational and that prices follow a "random walk" which means that the new information and changes that hits the market has to be unpredictable Rational bubble: agent belief in the role of non-fundamentals in determining asset prices is self-reinforcing. If agents believe the prices will rise, and act accordingly, the price will rise. The burst of a bubble or a steep decrease in prices may therefore be a rational reaction to new information.

1. What are the main components and functions of the financial system?

Financial Markets Debt Market & Equity Market Primary and Secondary Market - Primary markets: Markets in which corporations raise funds through new issues of securities. IPOs - Secondary markets: Markets that trade financial instruments once they are raised. Money and Capital Markets - Money market: Markets that trade debt securities or instruments with maturities of less than a year - Capital markets: Markets that trade debt and equity instruments with maturities of more than one year. o Capital stock (common + preferred) o Debt securities o Hybrid securities Financial Institutions: The role of financial institutions is to provide a range of financial services, including deposit taking, lending, investment and managing risk. They make sure that the businesses and firms can get funds for financing. Financial institutions provide financial transactions and play as a mediator in economic activities. Financial Infrastructure: involves clearing and payment systems Institutional Framework: laws & regulation, enforcement institutions (Finanstilsynet) The financial system has three main functions: Value exchange: A way of making payments Risk Transfer: A means for pricing and allocating certain risks Intermediation: A way of transferring resources between savers (surplus units) and borrowers (deficit units)

Describe the basic business model of banking

From the asset side: Banks use the acquired funds to buy income earning assets. - Reserves (cash and deposits at central bank) - Loans - Securities - Other assets (physical capital, i.e., buildings, computers etc.) From the liability side: Banks issue liabilities to acquire funds. - Deposits - Borrowing (from the CB, other banks, or corporations) -Bank capital (share capital and retained earnings (net worth))

Discuss the inherent dilemmas of the LoLR-function

If the banks are confident that the central bank will help them out of financial distress, they may be willing to take on greater risk (moral hazard). Especially "too big to fail" firms may feel confident in this. It can also reduce incentive to thoroughly assess risk

What is the relationship between financial bubbles, financial crises and economic crises; Stage 3

In economic downturns, deflation occurs when prices begin to fall. This leads to a further decline in the company's net worth because of the debt they hold. Deflation becomes an issue when consumers expect prices to continue falling, resulting in consumers becoming reluctant to borrow and purchase. Companies have to sell more to cover their obligations because existing debt becomes more expensive, while their revenues drop. When the debtholders start to default on their loans, banks fail, sustaining the credit freeze.

What are the differences between indirect and direct finance?

Indirect finance is where borrowers borrow funds from the financial market through indirect means, such as through a financial intermediary. This is different from direct financing where there is a direct connection to the financial markets as indicated by the borrower issuing securities directly on the market.

What are the main differences and similarities between Minsky's and Kindleberger's theories of financial crises?

Kindleberger defined a bubble as an upward price movement over an extended range that then implodes. Minsky states that during a bubble, asset prices typically increase above fundamental value, and eventually the bubble bursts. Difference: Minsky's definition uses the fundamental value of the asset. A possible disadvantage of this is that the bubble can only be identified after the event Similar: price increase, followed by a burst

Describe different bank management.

Liquidity Management: Focuses on the importance of having sufficient cash on-hand in case of deposits outflows. Asset Management: The bank must buy assets that have low default risk, and keep a diversified portfolio of assets. Liability Management: Involves acquiring funds at a low cost to keep their earnings high. Adequacy Management: They must decide how much of the capital they should maintain, and then acquire the needed capital.

What is the meaning of "exogenous" and "endogenous" in the context of financial crises?

Meaning: "Exogenous" refers to factors that are external to the financial system or market under consideration. Context in Financial Crises: Exogenous factors are typically events or developments that originate outside the financial system but have significant impacts on it. Examples of exogenous factors in the context of financial crises could include geopolitical events, natural disasters, sudden changes in global economic conditions, or other unexpected shocks. These events are not directly caused by the internal dynamics of the financial system but can have profound effects on its stability and functioning. Endogenous: Meaning: "Endogenous" refers to factors that arise from within the financial system or market itself. Context in Financial Crises: Endogenous factors are internal to the financial system and are often related to the system's inherent vulnerabilities, structural issues, or the behavior of market participants. For example, excessive risk-taking, speculative bubbles, overleveraging, inadequate risk management practices, or flaws in financial regulations could be considered endogenous factors. Financial crises driven by endogenous factors are essentially a result of problems and imbalances that build up within the financial system over time

How is money created and destroyed?

Money is created within the banking system when banks issue loans; it is destroyed when the loans are repaid. An increase (decrease) in reserves in the banking system can increase (decrease) the money supply.

What is money?

Money today is a type of IOU, but one that is special because everyone trusts that it will be accepted by other people in exchange for goods and services. There are three main types of money: currency, bank deposits and central bank reserves. Each represents an IOU from one sector of the economy to another. Money has different roles; the first role is to be a store of value. Something that Is expected to retain its value in a reasonably predictable way over time. Money's second role is to be a unit of account, the thing that goods and services are priced in terms of. For example menus, contracts, and price labels. Thirdly, money must be a medium of exchange.

What are the main functions of banks?

One of the main functions of the banks is what we call Core banking. This involves holding deposits, making loans, and payment mechanisms.

What is the relationship between financial bubbles, financial crises and economic crises; Stage 1

Stage One: Initial Phase Financial crises often start with a financial innovation and/or financial liberalization, this can lead to financial institutions going on a lending spree, in the short horizon. This results in a credit boom, creating a self-reinforcing spiral. The self-reinforcing spiral is a situation where the net worth of bank customers increases, which leads to banks loosening their lending standards, further leading to an increase of the net worth in the bank and resulting in further loosened lending standard. The credit bubble will bust, banks start to lose their money and they are forced to restrict lending, also called deleverage. Furthermore, with less capital, the banks get riskier, causing depositors and lenders to pull out their funds. This will further result in the need for more deleveraging which eventually leads to a credit freeze. Moreover, Asset-Price booms are driven by investor psychology where asset prices are well above their fundamental value. The fundamental value is the value based on realistic expectations of the assets future cash flows. Asset-price booms are often driven by credit booms because there are more funds available to drive up the price. When the bubble bursts, the asset price starts to realign with the fundamental value, causing a negative spiral. The net worth of the bank`s customers declines, the bank needs to tighten the lending standards, causing the net worth of the bank to diminish and the bank need to deleverage further.

What is the relationship between financial bubbles, financial crises and economic crises; Stage 2

Stage Two: Banking Crisis Financial institutions become insolvent if they are unable to meet their debt obligations. This solvency issue occurs when the bank's customers are unable to repay their loans, causing the value of assets to drop below the value of liabilities. If severe enough, it can lead to a bank panic where multiple banks fall simultaneously. Often in panic, depositors start to worry about the safety of their deposits. This uncertainty can lead to bank runs, where depositors withdraw their funds, creating a liquidity crisis. Eventually, authorities will shut down these financial intuitions and liquidate them or sell them. Later the uncertainty in financial markets declines, the stock market starts to recover, and we will see improvements in the balance sheet.

Define and explain the LoLR function.

The LoLR function is the lender of last resort function of a central bank. To resolve a crisis they act as lender of last resort to other banks to avoid the severe consequences of bankruptcy. If the bank is unable to meet the demands of customers and creditors in the short term, customers may fear for the safety of their money and this could lead to a bank run. The bank could then go bankrupt. This can also be a preventing act as banks are connected and the fallout could spread, meaning that other banks can be affected by one bank's bankruptcy. The LoLR function is only available for solvent banks, and is given to those in danger of liquidity failure.

What is the bubble triangle?

The bubble triangle starts off as a metaphor to think of a financial bubble as a fire. A fire relies on oxygen, fuel, and heat, whereas a financial bubble relies on marketability, money and credit, as well as speculation to form and sustain itself. -Marketability (oxygen) explains the ease with which assets can be traded and includes factors like divisibility, transportability, and the capacity to find buyers and sellers. - Like fuel for a fire, money and credit serves as the reason behind a bubble's expansion. - Speculation is the heat of the fire. Speculation is purchasing or selling an asset with the sole purpose of selling it later for capital gains. Over to how bubbles burst, the obvious answer is that they will eventually, "run out of fuel". This could happen following an increase in interest rates, bank tightening, or a narrowing credit market.

The Monetarism - The government did it

The monetarism theory says that financial crises and bubbles are caused by flaws in monetary policy, and emphasizes the role of money supply in affecting markets. Monetarists state that high inflation comes from central banks pouring too much money into the economy. This further leads to a systematic allocation in assets, and asymmetric information for the consumer. This is because the consumer may not know if prices rise because of inflation or because of an increase in demand for that particular product. there is also a problem with too little inflation, because it leads to a decrease in demand in the economy This theory does among others criticize the federal reserve for increasing interest rates during the great recession when they should have lowered them. the rate of growth in money needs to be stable or constant.

What is monetary policy and what are the main goals of monetary policy?

The state has two ways to affect the operations of the economy. 1. Fiscal Policy: Government spending. Tax level and Keynes 2. Monetary policy: The action a central bank or a government can take to influence how much money is in a country's economy and how much it costs to borrow. The goal of monetary policy is to secure a stable and low rate for inflation, typically around 2%. They also want to secure moderate long-term interest rates, maximum employment, and economic growth, and to manage the financial crisis.

The Austrian Theory

The theory claims that the reasons for the financial crisis lay in the interference of monetary authorities in setting interest rates (Oppers, 2002). The components in the model are interest rates, money, and credit. By changing one of these components, a mismatch in investing and consumers preferences will be created. It suggests that the government should not change these components, but let the market run its natural course instead. The theory begins with the idea that interest rates are determined by the relationship between saving and investing in the economy. In this view, there are two kinds of goods produced in an economy, final-consumption goods, and capital goods (Bilginsoy, 2014). When the interest rate is low more capital goods, and less consumption goods are produced. This outcome is perfectly consistent with the consumers' changing preferences.

What are the main tools of monetary policy?

There are two types of monetary policy. 1. Expansionary - Increase monetary base, reduce interest rate. a. Increase money supply and thus stimulate economic activity. 2. Contractive - Decrease monetary base, increase interest rate. a.Decrease monetary supply and dampen economic activity (reduce inflation)

Behaviorist approach

This theory argues that the movement of asset prices is highly affected by irrational human factors and focuses on how non-optimizing investors contribute to crises. Investors interact and influence each other. understanding the decision making of investors is a key element in the behaviorist approach, and the theory takes on several factors that contribute to crises, among others: human overconfidence quantitative and qualitative moral anchors cognitive dissonance

What is the role of money in financial crises?

Traditional view of money creation and financial crisis: - The CB controls the money supply by controlling the quantity of reserves - Money supply will expand according to the money multiplier - Failure by the central bank to control the money supply can create financial crisis New view: - The central bank does not manage the quantiy of reserves, it manges the price of reserves - Private banks create most of the money in the economy, on demand - The CB can not fully control this lending - Failure to control credit expansion, by private banks fuels booms and eventually lead to crisis