The Financial System: Opportunities and Dangers - PowerPoint Presentation

Slide1

The Financial System: Opportunities and Dangers

Chapter

20 of

Macroeconomics

,

9

th

edition, by N. Gregory

Mankiw

ECO62

Udayan

RoySlide2

Chapter Outline

The Financial System: What is it?

Financial Crises: Six common features

Case Study: Great Recession of 2008-9

Policies to recover from a crisis

Policies to

prevent

a

crisisSlide3

The Financial SystemSlide4

The Financial System

The

financial system

is

the

collection of institutions that

facilitate the

flow of funds between lenders and borrowers.Slide5

The Financial System: Saving

When people earn income, they typically don’t want to consume their entire income all at once.

But they may have no idea what to do with the unconsumed income.

This unconsumed income is called

savingSlide6

The Financial System: Investment

On the other hand, there are people who may wish to spend money on various potentially valuable projects but either have no money of their own or may wish to spend their personal funds on projects other than their own

The money that these people need for their spending plans is called

investmentSlide7

The Financial System Makes Saving Equal Investment

The financial system makes it easier for lenders (those who have the saving funds) and borrowers (those who need

funds

for investment) to find each other

Both groups benefit when the financial system does its job well

When the financial system fails, both groups sufferSlide8

What does the financial system do?

The financial system serves multiple purposes:

It helps

entrepreneurs find

the money needed to turn business ideas into reality

It helps entrepreneurs pursue business projects without having to personally carry too much of the risks associated with their projects

It helps to protect lenders from irresponsible borrowers

It helps to foster economic growth by channeling savings to the most valuable projects and cutting off funds for the less valuable projectsSlide9

Financing Investment

The financial system

helps entrepreneurs find the money needed to turn business ideas into

reality

The money may take the form of

Debt

finance (the entrepreneur sells

bonds to raise money),

and

Equity

finance (the entrepreneur sells stocks to raise money)Slide10

Financing Investment

The flow of funds takes place through

Financial markets

Stock market, bond market

Financial intermediaries

Banks, mutual funds, pension funds, insurance companiesSlide11

What does the financial system do?

The financial system serves multiple purposes:

It helps

entrepreneurs find

the money needed to turn business ideas into reality

It helps entrepreneurs pursue business projects without having to personally carry too much of the risks associated with their projects

It helps to protect lenders from irresponsible borrowers

It helps to foster economic growth by channeling savings to the most valuable projects and cutting off funds for the less valuable projectsSlide12

Sharing Risk

The financial system

helps entrepreneurs pursue business projects without having to personally carry too much of the risks associated with

their projects

The financial system also enables savers to

diversify

—that is, lend their money to a variety of borrowers—thereby reducing the risks of lendingSlide13

Sharing Risk

Suppose it is your dream to start a restaurant.

Even

if you have enough savings of your own to pay for the restaurant, it might still be better to share the risks—and the rewards—of the restaurant venture with

others

And others may wish to share the

risks

of your restaurant venture if they believe that the

returns

would be goodSlide14

Sharing Risk

The financial system—that is, the financial markets and financial intermediaries—may put you in touch with other investors

They would provide you money to get your restaurant started in return for part ownership

This is

equity finance

This way you would not have to carry the full risk of your restaurant on your own shouldersSlide15

Sharing Risk

Even if you are not an entrepreneur, the financial system can help you use your savings to acquire ownership of a diversified portfolio of business enterprises

This will help you keep your

idiosyncratic risks

low

But

systemic risks

may remainSlide16

What does the financial system do?

The financial system serves multiple purposes:

It helps

entrepreneurs find

the money needed to turn business ideas into reality

It helps entrepreneurs pursue business projects without having to personally carry too much of the risks associated with their projects

It helps to protect lenders from irresponsible borrowers

It helps to foster economic growth by channeling savings to the most valuable projects and cutting off funds for the less valuable projectsSlide17

Dealing With Asymmetric Information

Borrowers

can hide crucial information—about

their abilities and their plans—from

potential lenders

As a result,

unsuspecting

lenders can get ripped

off

If that happens often enough, all lending would eventually end and the financial system would be unable to do what it is supposed to doSlide18

Dealing With Asymmetric Information

The financial system—especially financial

intermediaries,

such as

banks,

and

watchdogs, such as government regulators and the courts—can help lenders by

ensuring that lenders get adequate information about potential borrowers

keeping a watchful eye on borrowers to ensure that they do nothing stupid or reckless with borrowed money

punishing dishonest treatment of lendersSlide19

Dealing With Asymmetric Information

When entrepreneurs hide information about themselves or the projects for which they are seeking money, lenders face the problem of

adverse selection

When

entrepreneurs

hide information about how hard they

intend to work

to make their projects successful, lenders face the problem of

moral hazardSlide20

Dealing With Asymmetric Information

Why would an entrepreneur borrow money for his/her project?

has no personal funds

has enough personal funds, but wants to diversify risks

knows something negative about the project that he/she is hiding from lenders (adverse selection)

has no intention to work hard for the project (moral hazard)Slide21

Dealing With Asymmetric Information

A lender can partially avoid the problems of adverse selection and moral hazard by lending money to an intermediary, such as a bank, and letting the bank deal with the borrower

The bank may have the resources to dig up hidden information about the borrower and the project

The bank may be able to ensure that the borrower will work hard to make the project a successSlide22

Dealing With Asymmetric Information

In some cases, asymmetric information may hurt an honest

borrower

An entrepreneur may be honest and hard working, but may be unable to convince potential lenders that she is

honest and hard

working

Here too, bank finance may be the solution

A bank may be willing to lend money to this borrower because the bank has resources to monitor the borrower, who in this case happens to be genuinely hard workingSlide23

Dealing With Asymmetric Information

Government regulators and the law enforcement system have obviously important roles to play in dealing with adverse selection and moral hazardSlide24

What does the financial system do?

The financial system serves multiple purposes:

It helps

entrepreneurs find

the money needed to turn business ideas into reality

It helps entrepreneurs pursue business projects without having to personally carry too much of the risks associated with their projects

It helps to protect lenders from irresponsible borrowers

It helps to foster economic growth by channeling savings to the most valuable projects and cutting off funds for the less valuable projectsSlide25

Fostering Economic Growth

The financial system

helps to foster economic growth by channeling savings to the most valuable projects and cutting off funds for the less valuable

projects

When asymmetric information is not a problem, a market for loanable funds in which people are free to lend and borrow should ensure the success of economically valuable projects and the failure of economically wasteful projectsSlide26

Fostering Economic Growth

For example, if in a well-functioning loanable funds market the equilibrium interest rate is 4%, then

the projects that can earn profits higher than 4% will succeed, and

the projects that cannot do so will

fail

It cannot be that a less profitable project gets funded and a more profitable project does not

In this way, a free market will

automatically

allocate funds so as to foster economic growthSlide27

Case Study: Microfinance

In poor countries, financial markets are undeveloped, primarily because of asymmetric information problems and weak or nonexistent government efforts to deal with

asymmetric information

In 1976, Muhammad

Yunus

,

an

economics professor in Bangladesh, started

Grameen

Bank to remedy the situationSlide28

Case Study: Microfinance

The Bank was successful in

funding

entrepreneurs

to

build small-scale businesses and improve their lives

Grameen

Bank and Prof. Yunus were awarded the Nobel Peace Prize in 2006

How did

Grameen

Bank succeed in solving the problem of asymmetric information?Slide29

Case Study: Microfinance

Loans were given to

groups

rather than

individuals

All members of the group that took a loan would be responsible for timely repayment

So, a

group would only admit members that the other members knew to be soundIn this way, the

group-lending

idea helped solve the asymmetric information problemSlide30

Case Study: Microfinance

Moreover,

Grameen

Bank gives loans in

small

amounts that are repaid—and renewed—after

short

intervalsTherefore, a continuing relationship develops between the bank’s loan officers and the borrowers

Moreover, as small amounts are loaned out at any given time, losses are lowSlide31

Financial crisis: six common features

Somehow the pipes get cloggedSlide32

Financial Crisis

A financial crisis is a major disruption of the

financial system’s ability

to make money flow between lenders and borrowers

Examples:

Great Depression 1930s

Great Recession 2008-09 Slide33

Six Common Features

Although each financial crisis is unique, most financial crises share certain common elements

Asset-price booms and busts

Insolvencies in financial institutions

Falling confidence

Credit crunch

Recession

A vicious circleSlide34

Asset-price booms and busts

Financial crises are often preceded by a period of euphoria, called a

speculative bubble

, during which the prices of assets rise above their

fundamental values

The

fundamental value

of an asset is the price that would prevail if people relied only on objective analyses of the cash flows the asset

can be expected to generateSlide35

Asset-price booms and busts

If people start buying assets not for the expected cash flows from the asset but because they hope to sell the asset later at a higher price, an asset’s price can rise above its fundamental value

However, such speculative bubbles inevitably crash when euphoria ends and doubts set inSlide36

Asset-price booms and busts

In the Great Recession of 2008-09, a speculative bubble developed in home pricesSlide37

Asset-price booms and busts

Banks fueled the boom because they failed to do their job of identifying irresponsible borrowers and

refusing their loan requests

.

Why?

Banks

assumed that home prices would keep rising

.

Under that assumption, it would not matter if a borrower defaulted.

The bank would simply take the house the defaulter had bought and sell it off at a

now higher price, thereby making a profit.Slide38

Recap: Six Common Features

Although each financial crisis is unique, most financial crises share certain common elements

Asset-price booms and busts

Insolvencies in financial institutions

Falling confidence

Credit crunch

Recession

A vicious circleSlide39

Insolvencies in financial institutions

Eventually, home prices stopped rising and then started to fall

Borrowers then owed more money than the value of the house they’d bought with the loan

Such borrowers stopped repaying their loans

Mortgage loans are “non-recourse”

Better to just return the house keys to the bankSlide40

Insolvencies in financial institutions

Of course, banks could take the homes (collateral) and sell them

But then banks would lose money because home prices had fallen

When banks’ assets (the homes) lose value, their

capital

(owners’ equity) turns negative

See Ch. 4

At that point, the bank is

insolventSlide41

Insolvencies in financial institutions

Many financial institutions turned

insolvent

Financial institutions have

assets

and

liabilities

Assets are what others owe them

Liabilities are what they owe others

When the value of assets falls below the value of liabilities, the financial institution is

insolventWhen a financial institution becomes insolvent, it is forced to

shut down

When financial institutions

shut down,

the economy suffersSlide42

Insolvencies in financial institutions

Suppose you and your friends decide to start a bank

You and your friends put $1,000 of your own money in the business.

This is called

capital

You borrow $39,000.

These are your

liabilities

You lend $40,000.

That is, you buy $40,000 in assetsYour

leverage ratio

= assets/capital = 40Slide43

Insolvencies in financial institutions

Suppose your assets then increase in value by $400

a mere +1%

The return on your capital is +40%!!!

This is the magic of

leverageSlide44

Insolvencies in financial institutions

But the magic of leverage cuts both ways

If your assets decrease in value by $1,000 (or, a mere -2.5

%) to $39,000, you have just enough money to repay the $39,000 you’d borrowed

So, after repaying your debts, you’ll have nothing left. You

will lose all your capital (or, a loss of -100%)Slide45

Insolvencies in financial institutions

The heavy reliance on leverage by financial institutions at the time of the Great Recession meant that many such institutions became insolvent when home prices began to fallSlide46

Recap: Six Common Features

Although each financial crisis is unique, most financial crises share certain common elements

Asset-price booms and busts

Insolvencies in financial institutions

Falling confidence

Credit crunch

Recession

A vicious circleSlide47

Falling confidence

Some bank deposits are insured by the government

But not all

As banks and other financial institutions faced the threat of insolvency, many lenders withdrew their deposits (a

run

)

This reduced the ability of businesses to get loans for business projectsSlide48

Falling confidence

Troubled financial

institutions also had to sell their assets (loans) at

fire sale

prices to

get cash to repay fleeing lenders

Banks use short-term deposits to give long-term loans

When short-term deposits dry up for troubled banks, they are forced to sell their long-term loans (to less troubled financial institutions) at fire sale pricesSlide49

Falling confidence

But the fire sale of assets reduces asset prices

And, as we saw before, this fall in asset prices can make many financial institutions, that are otherwise healthy, insolvent

In this way, trouble spreads like infectious diseaseSlide50

Falling confidence

Moreover, if the number of financial institutions is small, each will have lots of financial dealings with the others

In that case, if one institution becomes insolvent, the others would also be hurt and may themselves become insolventSlide51

Falling Confidence: Measuring it

The TED Spread is the interest rate on 3-month interbank loans

minus

the interest rate on 3-month

Treasury bills. Lenders will not lend to risky borrowers unless they get a high interest rate. So, the TED Spread rises when lending to banks is considered particularly risky.

See

https://

research.stlouisfed.org/fred2/series/TEDRATE

for current data.Slide52

Recap: Six Common Features

Although each financial crisis is unique, most financial crises share certain common elements

Asset-price booms and busts

Insolvencies in financial institutions

Falling confidence

Credit crunch

Recession

A vicious circleSlide53

Credit Crunch

With spreading insolvency shutting down

one financial institution after another,

and falling confidence

causing depositors

to take money out of financial institutions, would-be borrowers—even those with profitable investment

projects—would have

trouble getting loansSlide54

Credit Crunch

During the Great Recession, loans for home buyers dried up almost completely, as it became clear that home prices do not always go upSlide55

Recap: Six Common Features

Although each financial crisis is unique, most financial crises share certain common elements

Asset-price booms and busts

Insolvencies in financial institutions

Falling confidence

Credit crunch

Recession

A vicious circleSlide56

Recession

Many households were unable to borrow money to buy homes or to even buy simple things

Many businesses were unable to borrow money to build new factories or buy machines, furniture, etc.

So, aggregate planned expenditure fell

A recession beganSlide57

Recession

GDP fell

Unemployment rose

Officially the economy began to recover in June 2009

But in reality, that recovery has been very weakSlide58

Recap: Six Common Features

Although each financial crisis is unique, most financial crises share certain common elements

Asset-price booms and busts

Insolvencies in financial institutions

Falling confidence

Credit crunch

Recession

A vicious circleSlide59

A vicious circle

A recession sets off a vicious circle

Businesses fail and can’t repay their loans

This further intensifies the insolvency of financial institutions, which had helped cause the recession in the first place

As people lose their jobs, they default on their debts, again adding to the vicious circleSlide60

Six Common FeaturesSlide61

Case study: who is to blame for the crisis of 2008-2009? Slide62

Case Study: Who should be blamed for the financial crisis of 2008-2009?

Possible culprits include:

The Federal Reserve

: it may have kept interest rates too low for too long after the 2001 recession, thereby fueling the housing bubble

Home buyers

: they were too stupid to realize that home prices could fall at some point and that they’d be better off renting

Mortgage brokers

: knowing that they could sell

to investment

banks the loans they’d made—and

being greedy and unprincipled—they paid no attention to loan qualitySlide63

Case Study: Who should be blamed for the financial crisis of 2008-2009?

Investment banks

: they were greedy and unprincipled enough to package the mortgage loans and sell them to gullible buyers (such as pension funds) who believed what the rating agencies said about the mortgage loan packages

Rating agencies

: they gave high grades to mortgage assets that later turned out to be highly risky.

Maybe they were just stupid.

Others say they were greedy for the investment banks’ business and did not want to make them angry.Slide64

Case Study: Who should be blamed for the financial crisis of 2008-2009?

Regulators

: government regulators were not paying any attention to the rampant misbehavior of the private sector.

These regulatory bodies were often underfunded.

There was a general ideology that hated regulation.

Government policy makers

: for decades, politicians in both the Republican and Democratic parties sought to use government policies to encourage home ownership over renting.

This may have partially fed the home price bubbleSlide65

Policy Responses to a CrisisSlide66

Policy Responses to a Crisis

Policy makers used many tools to fight the crisis:

Conventional fiscal policy

Conventional monetary policy

Central bank’s lender-of-last-resort role

Injections of government fundsSlide67

Policy Responses to a Crisis

Conventional fiscal policy

Taxes were cut

Government spending was increased

But this meant increased budget deficits, which would make already high government debt even higher and, therefore, raise the possibility of a government debt crisis Slide68

Policy Responses to a Crisis

Conventional monetary

policy

Short-term nominal interest rates were

cut till they reached zero

But nominal interest rates cannot be reduced below zeroSlide69

Policy Responses to a Crisis

Central bank’s lender-of-last-resort

role

Banks take short-term deposits from savers and lend money for long-term business projects

So, if falling confidence leads to a sudden withdrawal of deposits, even a solvent bank would face a

liquidity crisis

The bank may have to sell its assets at fire sale prices, which could crash asset prices, and turn the liquidity crisis into an

insolvency crisisSlide70

Policy Responses to a Crisis

Central bank’s lender-of-last-resort

role

A central bank could prevent such a dire outcome by printing money and lending it to banks that face a liquidity crisis

When the central bank makes loans when nobody else would, it is acting as a

lender of last resortSlide71

Policy Responses to a Crisis

Central bank’s lender-of-last-resort

role

During the Great Recession, the Fed made lots of such loans, not only to banks, but to other financial institutions that faced liquidity crises

These institutions are called

shadow banks

because they take short-term deposits and make long-term loans, just like banks

Example: money market mutual funds. Fed became a lender of last resort to these funds, when depositors fledSlide72

Policy Responses to a Crisis

Injections of government funds

When borrowers default on their bank loans, a bank may have to shut down, in which case its depositors would lose their money

That could have ripple effects because the depositors would cut back on their spending plans

The FDIC insures bank deposits up to a limit.

This limit was raised from $100k to $250k in 2008

This reduces the adverse ripple effects of bank failureSlide73

Policy Responses to a Crisis

Injections of government funds

But the FDIC does not insure

all

deposits at a failed bank.

Therefore, some adverse ripple effects could still occur

When

those ripple effects are likely to be large enough, the bank is called

too big to fail

and the government uses its money to rescue it Slide74

Policy Responses to a Crisis

Injections of government funds

Moreover, if it becomes impossible for businesses to borrow money to finance their projects—especially somewhat risky ones—business investment spending could crash, causing a recession

In such a case, the government could use its funds to directly lend money for such projectsSlide75

Policy Responses to a Crisis

Injections of government funds

Governments may also use their funds to invest money into a bank to enable it to keep lending even when depositors have withdrawn their deposits

The hope is that the crisis is temporary and that the government would get its money back when the crisis ends and depositors returnSlide76

Policy Responses to a Crisis

Injections of government funds

The use of government funds to bail out the financial sector is obviously risky because the government may not get its money back

Moreover, if financial institutions know that the government would always rescue too-big-to-fail firms, they would have incentives

to take huge risks (moral hazard) and

to become large just to become TBTFSlide77

Policy Responses to a Crisis

Injections of government funds

However, despite the downside of using taxpayer funds to prop up the financial industry, it may be necessary to do so in order to avoid a huge financial catastropheSlide78

Policies to Prevent a CrisisSlide79

Policies to Prevent a Crisis

There are no easy ways to prevent financial crises. They will definitely happen again and again.

However, here are a few ideas on prevention:

Pay more attention to

shadow banks

Try to make financial institutions smaller

Force banks to reduce risky lending

Toughen up the enforcement of

regulations

Take a macro view of regulationSlide80

Prevention: Shadow Banks

Commercial banks’ deposits are insured by the FDIC

This could induce these banks to take huge risks

If the risks succeed, the bank keeps the gains

If the risks fail, the taxpayer takes the losses

To avoid this, commercial banking is heavily regulatedSlide81

Prevention: Shadow Banks

As a result, the commercial banking sector behaved very well during the crisis of 2008-09

The bulk of bad behavior came from the shadow banking sector, which is only lightly regulated

Investment banks, hedge funds, insurance companies, private equity funds, etc.Slide82

Prevention: Shadow Banks

The obvious lesson is to treat the shadow banks just like regular banks: insure the

depositors, but regulate the shadow bankers

One way to

regulate these

financial institutions is to require them to hold more capital (owners’ equity) and less leverage

When more of the owners’ money is at stake, these institutions may take more sensible risksSlide83

Prevention: Smaller Wall Street

No financial institution should be so vital to the financial system that it becomes too big to fail

Such an institution would be tempted to take big risks because

If the risk succeeds, the managers make money

If the risk fails, the taxpayer will come to the rescueSlide84

Prevention: Smaller Wall Street

If the financial system is dominated by just a few firms, they are likely to be deeply interconnected

In such a situation, the failure of even

one

firm may lead to big losses in

all

firms, thus making each firm TBTF

So, the financial system needs moderately sized firms, and lots of themSlide85

Prevention: Smaller Wall Street

So, m

ergers

and acquisitions among financial firms need to be discouraged

Bigger firms should be required to have more capital (owners’ equity) so that they take

sensible risks

only

On the other hand, bigness has the advantage of economies of scaleSlide86

Prevention: Safer

Wall Street

Apart from higher capital requirements, the financial system could be made safer by requiring commercial banks—whose deposits are guaranteed by the FDIC—from trading in complex assets such as derivatives (Volcker Rule)

Derivatives should be traded in exchanges, so that regulators can have better informationSlide87

Prevention: Tougher Regulators

The government’s regulators clearly failed in doing their job

The numerous regulatory agencies could be consolidated into a smaller number

New regulatory agencies have been set up in the US to watch the credit rating agencies, the treatment of consumers of financial products, and coordination of regulatorsSlide88

Prevention: Macroprudential

Regs

Traditionally, the government’s regulation of the financial sector has been

microprudential

Focused on what an individual financial institution needed to do to reduce the risk of its collapse

Today, financial regulation is also

macroprudential

Focused on what the economy as a whole needed to do to reduce the risk of financial crisisSlide89

Prevention: Macroprudential

Regs

Example of a

macroprudential

policy that could reduce the risk of bubbles in the housing market:

require homebuyers to pay a higher down payment when home prices rise

this would make it harder for people to buy homes when home prices rise, which would keep home prices from rising too quicklySlide90

Case Study: Europe’s Sovereign Debt Crisis

The debts incurred by European governments had been widely considered safe

Consequently, lenders had charged very low interest rates when lending to those governments

But things changed in Greece in 2010Slide91

Case Study: Europe’s Sovereign Debt Crisis

In 2010, the Greek government’s debt had risen to 116 percent of GDP, which was twice the European average

It was revealed that the Greek government had been misreporting its finances to keep lenders happy

Fears of default caused the price of Greece’s government bonds to fall. Lenders began asking for 100 percent in interest.Slide92

Case Study: Europe’s Sovereign Debt Crisis

Banks in other European countries such as Germany and France had loaned money to the Greek government in

the past

by buying Greece’s government bonds

With the fall in the price of those bonds, the banks faced the threat of insolvency

Remember what you learned in Ch. 4

This could cause a financial crisis outside GreeceSlide93

Case Study: Europe’s Sovereign Debt Crisis

So, other European countries got together and arranged a bailout for the Greek government

The idea was that the Greek government would use the money provided by other countries to repay its debts

This would stabilize the price of Greek government bonds and prevent European banks outside Greece from failingSlide94

Case Study: Europe’s Sovereign Debt Crisis

As a condition for the bailout, the Greek government was forced to cut spending and raise taxes

The idea was that this would reduce the Greek government’s borrowing and gradually return Greece to normalitySlide95

Case Study: Europe’s Sovereign Debt Crisis

Greece is a member of the European Monetary Union

Had Greece defaulted on its government debt, it would have been forced to leave the Eurozone and return to using its old currency, the Drachma

So far, the bailout has worked and Greece is still in the EurozoneSlide96

Case Study: Europe’s Sovereign Debt Crisis

However, the European countries that bailed out Greece resent having had to pay to keep Greece in the Eurozone

It is still not clear whether Greece’s budgetary problems have been solvedSlide97

Conclusion

The financial system is fragile and crisis prone

But it is a big help when it works well

So it needs to be kept

in working condition

This requires regulators to watch it carefully all the time for signs of trouble

At times, bailouts may be needed even though people may hate bailing out the financial sector