1. MGT 470 Financial Crises (cs3ed) v1.0 Oct 15 1 The Need for Regulation  The Great Depression of the 1930’s  The 2007-2009 world-wide recession  Numerous other less severe financial crises  affect economies of large, well developed countries as well as that of small or less developed countries  since 1970, 119 countries have experienced 146 banking crises  see p. 360 in your text book  Most financial crises were the result of insufficient regulation What is a Financial Crisis?  A financial crisis occurs when information flows in financial markets experience a particularly large disruption  This results in financial frictions and credit spreads increase sharply and financial markets stop functioning  Economic activity then collapses Dynamics of Financial Crises in Advanced Economies Stage 1: Initiation of Financial Crisis  Credit Boom and Bust  often the seeds of a financial crisis is the introduction of new types of loans or financial products; called “financial innovation”  the cause can also be due to some countries engaging in “financial liberalization” which is the reduction or elimination of some restrictions on financial markets  in the short run, financial innovation & liberalization prompts financial institutions to go on a lending spree (a “credit boom”) to finance investors wishing to take advantage of new opportunities Understanding a Financial Crisis

2. MGT 470 Financial Crises (cs3ed) v1.0 Oct 15 2 Dynamics of Financial Crises in Advanced Economies (continued) Stage 1: Initiation of Financial Crisis (continued)  Credit Boom and Bust (continued)  lenders may not have the expertise or incentives to manage risk appropriately when lending to investors intending to benefit from these new opportunities  credit booms often outpace the ability of financial institutions and govt’ regulators to screen and monitor credit risks ( ref. Ch 11 Information Asymmetry – adverse selection); this leads to overly risky lending  financial liberalization weakens market discipline and increase moral hazard incentive for banks to take greater risk than they otherwise would  because lender-savers know that govt’ guaranteed insurance (i.e. FDIC) protect them from losses, they will supply even undisciplined banks with funds  banks and other financial institutions make even riskier investments to borrower-spenders; they will make hefty profits if the loans are repaid and rely on govt’ insurance programs (funded by taxpayers) if borrower-spenders default  at some point the higher-risk loans start to default  losses on loans begin to mount and the value of loans (on the asset side of the balance sheet) fall relative to the liabilities side; this drives down the net worth (assets minus liabilities) of banks & other financial institutions  with less capital, banks cut back on lending to borrower- spenders (a process called “deleveraging)  with less capital, banks are perceived as becoming riskier causing lender-savers and other potential lenders to the institutions to pull out their funds  fewer funds mean fewer loans  the lending boom turns into a lending crash

3. MGT 470 Financial Crises (cs3ed) v1.0 Oct 15 3 Dynamics of Financial Crises in Advanced Economies (continued) Stage 1: Initiation of Financial Crisis (continued)  Credit Boom and Bust (continued)  when financial institutions slow down making loans, financial frictions rise  financial frictions: the “stickiness involved in making transactions; the total process including time, effort, money and tax effects of gathering information and making transactions such as buying stock or borrowing money  this limits the ability of financial institutions to address asymmetric information problems of adverse selection and moral hazard  as loans become scarcer, borrower-spenders are no longer able to fund their productive investment opportunities causing economic activity to contract  Asset-Price Boom and Bust  prices of assets such as stocks and real estate can be driven by investor psychology well above the theoretical value  when this occurs, it’s called an “asset-price bubble” such as the stock bubble of the late 90’s and the housing bubble of the early 2000’s  asset-price bubbles are often driven by credit booms in which the large increase in credit is used to fund the purchase of assets, thereby driving up their price  at some point, investors become unwilling to buy assets at the inflated prices; the bubble bursts  when the bubble bursts asset prices tumble and realign to their theoretical values  companies who own these assets see their net worth drop and the value of the collateral they can pledge for new loans also drop

4. MGT 470 Financial Crises (cs3ed) v1.0 Oct 15 4 Dynamics of Financial Crises in Advanced Economies (continued) Stage 1: Initiation of Financial Crisis (continued)  Asset-Price Boom and Bust (continued)  these companies tend to make riskier investments because they have less to lose – moral hazard  financial institutions are forced to tighten lending standards to borrower-spenders  the asset-price bust also cause a decline in the value of financial institutions’ assets causing a decline in their net worth, causing them to “deleverage” which causes further decline in economic activity as previously discussed  Increase in Uncertainty  lender-savers less likely to lend or save  financial frictions increase which reduce lending and economic activity Stage 2: Banking Crisis  Deteriorating balance sheets and tougher business conditions cause the net worth of some financial institution to become negative, resulting in insolvency/ bankruptcy  Unable to pay off depositors or other creditors, some banks go out of business (Chapter 7 bankruptcy)  If the above activities are severe enough, there may be a “bank panic” in which multiple banks fail  the source of the contagion is asymmetric information  panicked depositors, not knowing the quality of their bank’s loan portfolios and without depositor sufficient insurance, withdraw their deposits (a “bank run”) to the point at which the bank fails  uncertainty about the health of the banking system in general can lead to runs on multiple banks, good and bad, which will force banks to sell of asset quickly to raise the necessary funds (a “fire sale”)

5. MGT 470 Financial Crises (cs3ed) v1.0 Oct 15 5 Dynamics of Financial Crises in Advanced Economies (continued) Stage 2: Banking Crisis (continued)  If the above activities are severe enough, there may be a “bank panic” in which multiple banks fail  the source of the contagion is asymmetric information  panicked depositors, not knowing the quality of their bank’s loan portfolios and without sufficient depositor insurance, withdraw their deposits (a “bank run”) to the point at which the bank fails  uncertainty about the health of the banking system in general can lead to runs on multiple banks, good and bad, which will force banks to sell of asset quickly to raise the necessary funds (a “fire sale”)  fire sales cause the prices of assets to fall so much that the bank becomes bankrupt  After a bank panic there is less faith in the financial system  fewer lenders-savings willing to fund banks  financial frictions increase further  investing and other economic activities decline further  possible domino effect which may cause firms in related and nonrelated industries to fail