CHAPTER 12
What is a financial crisis
A well-functioning financial system solves asymmetric info problems, so K allocated to most productive users
Asymmetric info problems are a barrier to efficient allocation of capital -> FINANCIAL FRICTIONS
When financial frictions ↑, financial markets less capable channeling funds efficiently therefore leading to decline in economic
activity
Financial crisis occurs when information flows in financial markets experience particularly large disruption, resulting in financial
frictions increasing sharply and financial markets stop functioning, and economic activity collapses.
Stages of a financial crisis
1) Initial phase
Financial crisis can begin in two ways: Credit boom and bust, or general increase in uncertainty caused by failure of major fin.
Institution
Credit boom and bust
o Financial crisis often start when economy introduces new types of loans or financial products (innovation), or when country
engages in financial liberalization (FL) (elimination of restrictions on financial markets & institutions)
o LR financial liberalization promotes = financial development & encourages well run financial system that allocates K efficiently
o SR = prompt financial institutions to go on a lending spree, called a credit boom
- Lenders may not have expertise/incentive to manage risk appropriately leads to over risky lending
- Gov. safety nets (deposit insurance), weaken market discipline & increase moral hazard incentive for banks to take on greater
risk
- lender/saver know that gov. insurance protects them from losses
- losses on loans begin to build up and value of loans decreases (asset side of BS) ↓ relative to liabilities ↓ net worth of
banks and other financial institutions
- Less capital means banks cut back on lending to borrowers (deleveraging)
this means bank become riskier causing lender/savers to pull funds
fewer funds mean fewer loans to fund productive investments and a credit freeze: lending boom → lending
crash
as loans become scarce, borrower-spenders decrease spending, causing economic activity to contract
Asset-price boom and bust
o Prices of asset such as equity shares driven by investor phycology > fundamental economic values
o Rise of asset prices > fundamental economic values = asset-price bubble (tech stock market bubble late 1990)
o Often driven by credit booms → large increase in credit is used to fund purchase of asset driving up their price
o When bubble bursts (asset prices realign with FEV), stock & real estate prices ↓, companies net worth declines & value of their
collateral ↓
o companies have less at stake more likely to make risky investments because they have less to lose financial institutions
tighten lending standards for borrower-spenders
o Asset-price bust = ↓ in value of financial institutions assets causing ↓ in institutions net worth and deterioration In balance
sheet (DELEVERAGE) -> Steeper decline in economic activity
Increase in uncertainty
Ex. Just after start of recession, crash in stock market or failure in major financial institution (2008 global financial crisis)
2) Banking crisis
↓ in balance sheet + tougher business conditions -> insolvency for some financial institutions
Unable to pay off depositors/ other creditors -> go out business
Bank panic: multiple banks go out of business at same time (asymmetric information)
o Depositors = panicked withdraw their deposits from banks -> banks fall
o Uncertainty about health of banking system in general runs on banks forces banks to sell off assets quickly to raise
funds (Fire sales)
Causes prices ↓ so much that more banks become insolvent & lead to multiple bank failures & fully-
fledged bank panic
Fewer banks operating -> creditworthiness of borrower-spenders disappears (adverse selection lead decline in economic activity)
Eventually public and private authorities shut down insolvent firms and sell them/liquidate them
Uncertainty declines, stock market recovers, balance sheets improve
Financial frictions decrease and financial crisis subsidies ready for economic recovery
3) Debt deflation
Substantial unanticipated decline in PL -> further decline in firms net worth bc. of increased burden of indebtedness
Unanticipated decline in PL raises value of borrowing firms/households liabilities in real terms (↑ burden debt) but does not ↑
real value of asset borrowers real net worth declines
Example: firm has asset of $100 million in 2019 and $90 million of LT liabilities ( $10 million net worth), PL fall 10% in 2020 the
real value of liabilities is now $99 million in 2019 terms. Real value of assets remains unchanged, real net worth falls $10 -> $1
Substantial decrease in real net worth of borrowers caused by sharp decline in PL creates increase adverse selection and moral
hazard problems for lenders (people will loan with less collateral)
lending & economic activity decrease for long time (great depression = worst economic contraction in history of most advanced
countries
What is a financial crisis
A well-functioning financial system solves asymmetric info problems, so K allocated to most productive users
Asymmetric info problems are a barrier to efficient allocation of capital -> FINANCIAL FRICTIONS
When financial frictions ↑, financial markets less capable channeling funds efficiently therefore leading to decline in economic
activity
Financial crisis occurs when information flows in financial markets experience particularly large disruption, resulting in financial
frictions increasing sharply and financial markets stop functioning, and economic activity collapses.
Stages of a financial crisis
1) Initial phase
Financial crisis can begin in two ways: Credit boom and bust, or general increase in uncertainty caused by failure of major fin.
Institution
Credit boom and bust
o Financial crisis often start when economy introduces new types of loans or financial products (innovation), or when country
engages in financial liberalization (FL) (elimination of restrictions on financial markets & institutions)
o LR financial liberalization promotes = financial development & encourages well run financial system that allocates K efficiently
o SR = prompt financial institutions to go on a lending spree, called a credit boom
- Lenders may not have expertise/incentive to manage risk appropriately leads to over risky lending
- Gov. safety nets (deposit insurance), weaken market discipline & increase moral hazard incentive for banks to take on greater
risk
- lender/saver know that gov. insurance protects them from losses
- losses on loans begin to build up and value of loans decreases (asset side of BS) ↓ relative to liabilities ↓ net worth of
banks and other financial institutions
- Less capital means banks cut back on lending to borrowers (deleveraging)
this means bank become riskier causing lender/savers to pull funds
fewer funds mean fewer loans to fund productive investments and a credit freeze: lending boom → lending
crash
as loans become scarce, borrower-spenders decrease spending, causing economic activity to contract
Asset-price boom and bust
o Prices of asset such as equity shares driven by investor phycology > fundamental economic values
o Rise of asset prices > fundamental economic values = asset-price bubble (tech stock market bubble late 1990)
o Often driven by credit booms → large increase in credit is used to fund purchase of asset driving up their price
o When bubble bursts (asset prices realign with FEV), stock & real estate prices ↓, companies net worth declines & value of their
collateral ↓
o companies have less at stake more likely to make risky investments because they have less to lose financial institutions
tighten lending standards for borrower-spenders
o Asset-price bust = ↓ in value of financial institutions assets causing ↓ in institutions net worth and deterioration In balance
sheet (DELEVERAGE) -> Steeper decline in economic activity
Increase in uncertainty
Ex. Just after start of recession, crash in stock market or failure in major financial institution (2008 global financial crisis)
2) Banking crisis
↓ in balance sheet + tougher business conditions -> insolvency for some financial institutions
Unable to pay off depositors/ other creditors -> go out business
Bank panic: multiple banks go out of business at same time (asymmetric information)
o Depositors = panicked withdraw their deposits from banks -> banks fall
o Uncertainty about health of banking system in general runs on banks forces banks to sell off assets quickly to raise
funds (Fire sales)
Causes prices ↓ so much that more banks become insolvent & lead to multiple bank failures & fully-
fledged bank panic
Fewer banks operating -> creditworthiness of borrower-spenders disappears (adverse selection lead decline in economic activity)
Eventually public and private authorities shut down insolvent firms and sell them/liquidate them
Uncertainty declines, stock market recovers, balance sheets improve
Financial frictions decrease and financial crisis subsidies ready for economic recovery
3) Debt deflation
Substantial unanticipated decline in PL -> further decline in firms net worth bc. of increased burden of indebtedness
Unanticipated decline in PL raises value of borrowing firms/households liabilities in real terms (↑ burden debt) but does not ↑
real value of asset borrowers real net worth declines
Example: firm has asset of $100 million in 2019 and $90 million of LT liabilities ( $10 million net worth), PL fall 10% in 2020 the
real value of liabilities is now $99 million in 2019 terms. Real value of assets remains unchanged, real net worth falls $10 -> $1
Substantial decrease in real net worth of borrowers caused by sharp decline in PL creates increase adverse selection and moral
hazard problems for lenders (people will loan with less collateral)
lending & economic activity decrease for long time (great depression = worst economic contraction in history of most advanced
countries
