1. FINANCIAL CRISES Chap 12 & 13

2. International Financial Crises Banking Crisis – Sudden collapse of the domestic banking system. Currency Crises – Loss of credibility of fixed exchange rate system. Systemic Financial Crisis/Sudden Stops – Breakdown of system of international capital flows. Sovereign Debt Crisis – Gov’t unable to pay-off debts IMF World Economic Outlook, 1998

3. Prototypical Banking Crises Event, often deregulation or advance in financial technology, leads to rapid expansion in credit to speculative borrowers. Borrowers drive up asset prices (usually real estate). Rising asset prices increases the value of collateral which can support further expansion of credit creating a cycle of asset price acceleration and credit extension. Eventually, asset prices rise too far above fundamental values and begin to fall. The cycle turns vicious. Asset prices fall, collateral values fall, restrictive covenants bind, speculative borrowers default, banks capital takes a hit, lending is cut back, asset prices fall further.

4. Sweden & Japan in the 1980s

5. The cost of cleaning up after financial crises is very high. Challenges to Monetary Policy Effectiveness 5 Link

6. Government Intervention Bank failure can be contagious 1. Interbank Lending 2. Panic conditions Link

7. Swedish Model of Crisis Resolution 1. Broad political support. Agreement with the main opposition party…. 2. Broad coverage. The guarantee covered all kinds of bank obligations except equity capital and included all banks with subsidiaries, but no other financial institutions. 3. Minimizing the subsidy to the banks and their owners. Support payments should be recovered as far as possible. 4. Only banks deemed to be profitable in the long run should be supported. 5. Bad Bank – Government capitalized institution, Securum, to buy bad loans from major banks Peter Englund The Swedish 1990s banking crisis

8. Japanese Model Implicit Deposit Guarantees Weak Governance: Banks were allowed to under provision in order to avoid reporting losses and pay dividends Regulatory Forbearance: Japanese banks were allowed to under-report non-performing loans. Banks stumbled forward, evergreening loans, but could not make new loans. Kanaya & Woo Japanese Banking Crisis of the 1990s

9. 1. Bank Risk Taking Channel Economic studies suggest that banks respond to persistent periods of low interest rates by taking more risk. Yield chasing – Banks may implicitly promise yields to investors, need to earn yields that match those promises. Only by taking on more risk can they do so. Evidence suggests that yield chasing is less prevalent in well-regulated banking markets. 9

10. 10 IT and Bank Risk Taking BIS View (Borio and Wheelock, 2004; Borio and White, 2004) Inflation targeting monetary policy passively allows bank credit to expand to fuel the asset price boom  general price inflation Unless policymakers act to defuse a boom, a crash will follow. 10

11. Currency Crises Market believes that exchange rate will be devalued in the near future. Lenders demand higher interest rates to lend in domestic dollars to compensate for loss of value after devaluation. Central bank must use its foreign reserves to buy domestic currency and prop up exchange rate. If pain of interest rates is too painful or loss of reserves too severe, central bank may be forced to devalue.

12. Market Expects Devaluation S D i HIBOR Clearing Balances i FF S´S´ ΔRΔR i FF +η η > 0 ⓪ 

13. ERM Crisis In 1980’s, European economies constructed a system of linked currencies called the Exchange Rate Mechanism. Inflationary German fiscal policy following re-unification led to high DM interest rates. To maintain link, other Euro currencies needed to have interest rates too high for their own situation. In Sept. 1992, markets expected a delinking/devaluation of currencies. Go for the Jugular

14. Currency Crisis Speculation against the pound forced Bank of England to raise interest rates and buy pounds in forex markets. Pain of interest rates was viewed as too severe and B of E was forced to abandon the peg. Principal Global Indicators Database

15. Banking Crisis Currency Crisis Fragile banking system makes high interest rates untenable and can lead to fears of devaluation (especially if central bank funds used to bailout banking system) Exchange rate devaluation can damage balance sheets if balance sheets (deposits or borrowings) are dollarized.

16. Sudden Stops International hot money (short-term lending) is subject to herding behavior from international financial market. Rapid inflows and rapid outflows. When capital inflows stop, either those can be replaced with forex reserves, or domestic borrowers will face bankruptcy. Domestic firms can no longer finance investment Demand, GDP, and employment fall. Devaluation of currency. Link

17. Balance of Payments Equation Current Account Net Capital Inflows += Current Account Overall Balance (increase in reserves)

18. Sudden Stop What if capital flows out? Current Account Net Capital Inflows + Current Account Overall Balance (increase in reserves) Money going out of the economy drive foreign exchange payments out of balance. =

19. Current Account Sudden Stop Increase demand for domestic currency causes depreciation. Net Capital Inflows + = Current Account Overall Balance (increase in reserves) = 0 Depreciation leads to currency account reversal.

21. Foreign Reserves Measures of Adequate Reserves Import Coverage: Reserves > Imports for 2-3 Months Greenspan-Guidotti Rule: Reserves exceed 100% of debt due within one year. Link

22. Buildup Foreign Reserve Assets IMF Financial Statistics

23. Korea

24. Dealing with Sudden Stops Modern Approach Swap lines Link Link

25. Final Exam Monday, December 14 th, 08:30AM - 11:30AM. LG5 Multifunction Room. Cumulative. Similar to mid-term and practice exams. Bring writing instruments and a calculator. Semi-open book – Bring 1 A4 size paper with handwritten notes on both sides. Office Hours: Standard.