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CHAPTER 12Financial Crises in Advanced Economies
Global: The European Sovereign Debt Crisis
-The increase in budget deficits that followed the financial crash of 2007-2009 led to fears of
government defaults and a surge in interest rates.
-The sovereign debt crisis, which began in Greece, moved on to Ireland, Portugal, Spain and Italy
-The stresses created by this and related events continue to threaten the viability of the euro.
What is a 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
-Financial crises (Ch1): major disruptions in financial markets that are characterized by sharp
declines in asset prices and the failures of many financial and non financial firms
Crisis Episodes by type. Incident of single, twin and triple crises
-all three types of crises, not just banking crises, come in waves
-incident of currency and sovereign debt crises predominately low- and middle-income countries
Dynamics of Financial Crises
-Stage One: Initiation of a Financial Crisis
-Credit Boom and Bust: Mismanagement of financial liberalization/innovation drives down
the net worth of banks and triggers the deleveraging process (debt to equity leverage factor
becomes larger in financial crisis if it was predominately debt and needs to fund that with
equity(retained earnings))-to improve debt equity ratio is to sell asssets
-Deleveraging process is where you sell assets to decrease your debt to equity ration by
using Retained Earnings**
*-VIX is good example of short term interest rates movements-
- Asset-price Boom and Bust
-As the asset-price bubble burst, the net worth of companies declines, encouraging
firms to make riksier investment
-Increase in Uncertainty
-Stage Two: Banking Crisis
, - Deteriorating balance sheets may lead financial institutions into insolvency*
- Savers withdraw teir deposits and the Banks sell off assets to raise necessary funds
- the fire sales cause asset prices to drop again and more banks to fail
-Stage Three: Debt deflation
-As debt payments are fixed in nominal terms, an unanticipated decline in price level will
raise the burden of the debt in real terms
** Types of insolvency include cash-flow insolvency (illiquidity) and balance-sheet insolvency. i.e. a
firm or an individual can default due to the liquidity and/or negative net worth on balance sheet.
The Mother of all financial Crises: the Great Depression
-How did a financial crisis unfold druing the Great Depression and how it led to the worst economic
downturn in the history of the US and other advanced economies?
-This event was “bought on” by:
- Stock market cash
-Bank panics
- Continuing decline in stock prices
- Debt deflation
The Global Financial Crisis of 2007-2009
-Causes of the 2007-2009 Financial crisis:
- Financial innovations emerge in the mortgage markets
-Subprime mortgage
- Mortgage-backed securities
- Collateralized debt obligations (CDO’s)
-Housing price bubble forms
-Increase in liquidity from cash flow surging to the US
-Development of subprime mortgage market fueled hosuing demand and housing
housing prices
-Agency problems arise
-“originate-to-distribute” model is subject to principal-(investor) agent (mortgage
broker) problem
-Borrowers had little incentive banks (as well as rating agencies) had weak incentive
to access the quality of securities
-Information problem surface
-Housing price bubble bursts
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