Financial Crisis
Financial Crisis
Lecture 11
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FINC5090 Finance in The Global Economy
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Lecture 11 Financial Crisis
International capital markets
International banking
The challenge of regulating international banking
Financial crisis
International regulatory cooperation
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1. International capital markets: gains from trade
When a buyer and a seller engage in a voluntary transaction, both receive something that they want and both can be made better off.
A buyer and seller can trade
goods or services for other goods or services
goods or services for assets
assets for assets
All three types of exchange lead to gains from trade.
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1. International capital markets: comparative advantage
The theory of comparative advantage describes the gains from trade of goods and services for other goods and services:
With a finite amount of resources and time, use those resources and time to produce what you are most productive at (compared to alternatives), then trade those products for goods and services that you want.
Be a specialist in production, while enjoying many goods and services as a consumer through trade.
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1. International capital markets: intertemporal trade
The theory of intertemporal trade describes the gains from trade of goods and services for assets, of goods and services today for claims to goods and services in the future (today’s assets).
Savers want to buy assets (claims to future goods and services) and borrowers want to use assets to consume or invest in more goods and services than they can buy with current income.
Savers earn a rate of return on their assets, while borrowers are able to use goods and services when they want to use them: they both can be made better off.
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1. International capital markets: portfolio diversification
The theory of portfolio diversification describes the gains from trade of assets for assets, of assets with one type of risk for assets with another type of risk.
Investing in a diverse set, or portfolio, of assets is a way for investors to avoid or reduce risk.
Most people most of the time want to avoid risk: they would rather have a sure gain of wealth than invest in risky assets when other factors are constant.
People usually display risk aversion: they are usually averse to risk so they require a reward for taking extra risk
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Portfolio Diversification (1 of 2)
Suppose that 2 countries have an asset of farmland that yields a crop, depending on the weather.
The yield (return) of the asset is uncertain, but with bad weather the land can produce 20 tons of potatoes, while with good weather the land can produce 100 tons of potatoes.
On average, the land will produce: 0.5*20+0.5*100=60
if bad weather and good weather are equally likely (both with a probability of 1/2).
The expected value of the yield is 60 tons.
Suppose that historical records show that when the domestic country has good weather (high yields), the foreign country has bad weather (low yields).
and that we can assume that the future will be like the past.
What could the two countries do to avoid suffering from a bad potato crop?
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Portfolio Diversification (2 of 2)
Sell 50% of one’s assets to the other party and buy 50% of the other party’s assets:
diversify the portfolios of assets so that both countries always achieve the portfolio’s expected (average) values.
With portfolio diversification, both countries could always enjoy a moderate potato yield and not experience the vicissitudes of feast and famine.
If the domestic country’s yield is 20 and the foreign country’s yield is 100, then both countries receive
50% × 20 + 50% × 100 = 60.
If the domestic country′ s yield is 100 and the foreign country′ s yield is 20, then both countries receive
50% × 100 + 50% × 20 = 60.
If both countries are risk averse, then both countries could be made better off through portfolio diversification.
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1. International capital markets: global overview
In the U.S., capital markets provided 73% of funding for economic activity, in terms of equity and debt financing of non-financial corporations.
The use of debt capital markets to fuel economic growth is more prevalent in the U.S, at 80% of the total, whereas bank lending is more dominant in other regions, around 80% on average.
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1. International capital markets: global overview
The U.S. capital markets are largest in the world and continue to be among the deepest, most liquid, and most efficient.
Equities: U.S. equity markets represent 38.5% of the $105.8 trillion in global equity market cap, or $40.7 trillion; this is 3.7x the next largest market, the EU.
Fixed Income: U.S. fixed income markets comprise 38.3% of the $123.5 trillion securities outstanding across the globe, or $47.2 trillion; this is 1.9x the next largest market, the EU.
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1. International capital markets: global overview
Global flows remain below their pre-GFC trend
The post-GFC drop-off in flows was especially pronounced for bank loans, which are considered “other” investment flows. Portfolio debt and equity flows were also lower over the 2009–19 period. Foreign direct investment (FDI) held up better.
Inflows to EMEs held up reasonably well after the GFC (Graph 1.1, right-hand panel). They slowed sharply in some years; for instance, in 2015 when commodity prices fell and the economic outlook for China deteriorated. However, such slowdowns tended to be short lived.
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1. International capital markets: global overview
The post-GFC withdrawal of AE banks from international lending has been offset by the growing importance of market-based flows, particularly for capital inflows to EMEs
The growing role of asset managers, investment funds and other non-bank financial intermediaries was the second structural shift most frequently cited by survey respondents.
The relative decline in bank lending was driven in large part by the deleveraging of AE banks, particularly those headquartered in the euro area.
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1. International capital markets: driver of capital flow dynamics
Drivers of capital flows can be classified into push factors, pull factors and pipes.
Push factors motivate investors to seek opportunities away from their home economy.
Pull factors reflect country characteristics that can attract international capital to the recipient economy.
Pipes represent the institutional infrastructure of the global financial system through which capital flows ultimately move.
The transmission channels of financial shocks
Bank-based channel
E.g. during crisis times, global banks stop lending in many countries at once.
local internationally-funded banks can transmit global cycles and shocks, not just foreign owned banks.
Market-based channel
E.g. when an index provider increases a country’s weight in the index, the country typically experiences a surge in capital inflows.
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1. International capital markets: driver of capital flow dynamics
Impact of index inclusion: Chinese A-shares in MSCI Emerging Markets Index
In June 2017, the American financial index company MSCI announced the addition of domestic Chinese equities, denominated in renminbi (A-shares), to its Emerging Market Index starting in June 2018. MSCI started with an inclusion factor (IF) of up to 5%, followed by a revision in February 2019 that increased the total IF to 20% in three steps.
Graph C1.1, shows that there has been a generalised upward trend in average exposure to Chinese assets, pervasive across all fund categories.
The increasing weight of Chinese equities had significant effects on the relative importance of other EMEs.
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2. International banking: offshore banking
Offshore banking refers to banking outside of the boundaries of a country.
There are at least 3 types of offshore banking institutions, which are regulated differently:
An agency office in a foreign country makes loans and transfers, but does not accept deposits, and is therefore not subject to depository regulations in either the domestic or foreign country.
A subsidiary bank in a foreign country follows the regulations of the foreign country, not the domestic regulations of the domestic parent.
A foreign branch of a domestic bank is often subject to both domestic and foreign regulations, but sometimes may choose the more lenient regulations of the two.
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2. International banking: offshore currency trading
An offshore currency deposit is a bank deposit denominated in a currency other than the currency that circulates where the bank resides.
An offshore currency deposit may be deposited in a subsidiary bank, a foreign branch, a foreign bank, or another depository institution located in a foreign country.
Offshore currency deposits are sometimes (confusingly) referred to as eurocurrency deposits, because these deposits were historically made in European banks.
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2. International banking: offshore currency trading
Offshore currency trading has grown for three reasons:
growth in international trade and international business
political factors (ex., to avoid confiscation by a government because of political events)
avoidance of domestic regulations and taxes
Reserve requirements are the primary example of a domestic regulation that banks have tried to avoid through offshore currency trading.
Depository institutions in the U.S. and other countries are required to hold a fraction of domestic currency deposits on reserve at the central bank.
These reserves cannot be lent to customers and do not earn interest in many countries, Therefore the reserve requirement reduces income for banks.
But offshore currency deposits in many countries are not subject to this requirement, and thus can earn interest on the full amount of the deposit.
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2. International banking: the shadow banking system
Shadow banking system: financial institutions providing unregulated payment and credit services similar to those that banks provide. For example:
Money market mutual funds in the US provide check-writing services to customers and credit to firms (through commercial paper markets).
Investment banks provide credit to other entities while offering payment services (e.g. securitization)
Shadow banks have usually been minimally regulated compared to banks
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2. International banking: banking and financial fragility
Banks fail because they do not have enough or the right kind of assets to pay for their liabilities.
The principal liability for commercial banks and other depository institutions is the value of deposits, and banks fail when they cannot pay their depositors.
If the value of assets decline, say because many loans go into default, then liabilities could become greater than the value of assets and bankruptcy could result.
Bank run: creditors (i.e. depositors) lose confidence in the value of the bank’s assets and the massive withdrawals will cause a large and sudden loss of deposits.
When banks are highly interconnected through mutual loans and derivative contracts, bank runs therefore can be highly contagious.
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2. International banking: banking and financial fragility
Banks must invest in long-term assets (e.g. loans) in order to make profits but have to rely on short-term deposits as the major funding resources (maturity mismatch).
In a financial panic, banks might simultaneously be trying to unload marketable securities, causing a drawdown in the security market.
Bank balance sheet
Assets Liabilities
Loans $1,950 Demand deposits $1,000
Marketable securities $1,950 Time deposits $1,400
Reserves at central bank $75 Wholesale liab. $1,400
Cash $75 Capital $200
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2. International banking: banking and financial fragility
Banking panics in 1930-1931
https://www.federalreservehistory.org/essays/banking-panics-1930-31
“The US appeared to be poised for economic recovery following the stock market crash of 1929, until a series of bank panics in the fall of 1930 turned the recovery into the beginning of the Great Depression.”
According to Friedman and Schwartz (1963), the crisis began when “a contagion of fear spread among depositors (Friedman and Schwartz 1963, p. 308).” The contagion began in agricultural areas and accelerated after the failure of the Bank of the United States, which was the largest commercial bank ever to have failed up to that time in U.S. history, and whose distinctive name “led many at home and abroad to regard it somehow as an official bank (Friedman and Schwartz 1963, pp. 309-11).”
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2. International banking: banking and financial fragility
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2. International banking: government safeguards
In many countries there are several types of regulations to avoid bank failure or its effects.
Deposit insurance
Insures depositors against losses up to $100,000 in the U.S. when banks fail.
Prevents bank panics due to a lack of information: because depositors cannot determine the financial health of a bank, they may quickly withdraw their funds if they are not sure that a bank is financially healthy enough to pay for them.
Creates a moral hazard for banks to take excessive risk because they are no longer fully responsible for failure.
Reserve requirements
Banks required to maintain some deposits on reserve at the central bank in case they need cash.
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2. International banking: government safeguards
3. Capital requirements and asset restrictions
Higher bank capital (net worth) means banks have more funds available to cover the cost of failed assets.
Asset restrictions reduce risky investments by preventing a bank from holding too many risky assets and encourage diversification by preventing a bank from holding too much of one asset.
4. Bank examination
Regular examination prevents banks from engaging in risky activities.
5. Lender of last resort
In the U.S., the Federal Reserve System may lend to banks with inadequate reserves (cash).
6. Government-organized bailouts
Failing all else, the central bank or fiscal authorities may organize the purchase of a failing bank by healthier institutions, sometimes throwing their own money into the deal as a sweetener.
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Figure 20.2 Frequency of Systemic Banking Crises, 1970-2011
Generalized banking crises have been plentiful around the world since the mid-1970s, but in recent years they have been concentrated in richer countries.
Source: Laeven and Valencia, op. cit.
Copyright © 2018 , Ltd. All rights reserved.
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3. Difficulties in regulating international banking
Government safeguards and banking regulations become less effective in an international environment where banks can shift business among different jurisdictions.
1. Deposit insurance in the U.S. covers losses up to $100,000, but since the size of deposits in international banking is often much larger, the amount of insurance is often minimal.
2. Reserve requirements also act as a form of insurance for depositors, but countries cannot impose reserve requirements on foreign currency deposits in agency offices, foreign branches, or subsidiary banks of domestic banks.
3. Bank examination, capital requirements, and asset restrictions are more difficult internationally.
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3. Difficulties in regulating international banking
4. No international lender of last resort for banks exists.
The IMF sometimes acts a “lender of last resort” for governments with balance of payments problems.
5. The activities of nonbank financial institutions are growing in international banking, but they lack the regulation and supervision that banks have.
6. Derivatives and securitized assets make it harder to assess financial stability and risk because these assets are not accounted for on the traditional balance sheet.
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3. Difficulties in regulating international banking: the financial trilemma
A financial trilemma constrains what policymakers in an open economy can achieve. At most two goals from the following list of three are simultaneously feasible:
Financial stability.
National control over financial safeguard policy.
Freedom of international capital movements
For example, a country that closes itself financially from the outside world can regulate its banks strictly, thereby promoting domestic financial stability.
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4. Financial crisis
A financial crisis occurs when there is a particularly large disruption to information flows in financial markets, with the result that financial frictions increase sharply and financial markets stop functioning.
Dynamics of financial crisis
Stage One: Initiation of a Financial Crisis
Credit Boom and Bust: Mismanagement of financial liberalization/innovation leading to asset price boom and bust
Asset-price Boom and Bust
Increase in Uncertainty
Stage two: Banking Crisis
Stage three: Debt Deflation
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4. Financial crisis
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4. Financial crisis: causes of the GFC
Causes of the 2007–2009 Financial Crisis:
Financial innovations emerge in the mortgage markets
Subprime mortgage
Mortgage-backed securities
Collateralized debt obligations (CDOs)
Housing price bubble forms
Increase in liquidity from cash flows surging to the United States
Development of subprime mortgage market fueled housing demand and housing prices
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4. Financial crisis: causes of the GFC
Causes (cont’d):
Agency problems arise
“Originate-to-distribute” model is subject to principal-(investor) agent (mortgage broker) problem
Borrowers had little incentive to disclose information about their ability to pay
Commercial and investment banks (as well as rating agencies) had weak incentives to assess the quality of securities
Information problems surface
Housing price bubble bursts
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4. Financial crisis: effects of the GFC
Effects of the 2007–2009 Financial Crisis
After a sustained boom, housing prices in the U.S. and other countries (such as Ireland or Spain) began a long decline, starting in 2006.
The decline in housing prices contributed to a rise in defaults on mortgages and a deterioration in the balance sheet of financial institutions.
This development in turn caused a run on the shadow banking system.
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4. Financial crisis: effects of the GFC
Height of the 2007–2009 Financial Crisis
The stock market crash gathered pace in the fall of 2008, with the week beginning October 6, 2008, showing the worst weekly decline in U.S. history.
Surging interest rates faced by borrowers led to sharp declines in consumer spending and investment.
The unemployment rate shot up, going over the 10% level in late 2009 in the midst of the “Great Recession, the worst economic contraction in the United States since World War II.
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Credit Spreads and the 2007–2009 Financial Crisis
Source: Dow-Jones Industrial Average (DJIA). Global Financial Data: http://www.globalfinancialdata.com/index_tabs.php?action=detailedinfo&id=1165.
A credit spread is the difference in yield between a U.S. Treasury bond and another debt security of the same maturity but different credit quality.
In deteriorating market conditions, investors tend to purchase U.S. Treasuries (decrease government bond yield) and sell their holdings in corporate bonds (increase the yield of corporate bonds).
During the financial crisis, credit spreads remained significantly higher than pre-crisis levels for several months.
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4. Financial cri
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