CHAPTER 2 Financial Crises
Banking crisis = significant part of country’s banking sector has become insolvent after heavy
losses or banking panics.
§ Systematic = a country’s corporate and financial sectors experience a large number of
defaults and great difficulties repaying contracts on time. Typically preceded by credit
booms and asset price bubbles. Afterwards contraction in economic activity and strains
on government’s financial position. Most important driver of worsening fiscal position
afterwards is the economic turndown, which is greater than cost of bank bailouts.
Sovereign debt crisis = government fails to meet interest or principal payments on its debt
obligations.
Currency crisis = value of a country’s currency falls precipitously.
Banks transform short-term deposit funding into long-term loans. In normal times, banks hold
more than sufficient reserves to handle withdrawals of deposits. As withdrawals increase,
banks are forced to liquidate assets against fire sale prices. Bank run is a self-fulfilling
prophecy, as banks often hold broadly similar portfolios of assets and the market can dry up
completely if they all try to sell at once.
This implies there are multiple equilibria, a good equilibrium and a bad one. If depositors
believe that other depositors will withdraw, then they all find it rational to redeem their claims
and a panic occurs, but when nobody believes a panic will occur. Depositors’ beliefs are self-
fulfilling and coordinated by “sun spots”.
The cause can also be on the asset side due to poor fundamentals arising from the business
cycle. Then crises are a response of depositors to the arrival of some negative news on
economic circumstances. Minsky’s financial-instability hypothesis links the business cycle to
financial crises. Events leading up to the crises start with a displacement (some exogenous,
outside shock to the macroeconomic system) an invention or abrupt change of economic policy
about which investors get excited. Five stages follow to the boom and eventual bust:
1. Credit expansion, characterised by rising asset prices
2. Euphoria, characterised by overtrading
3. Distress, characterised by unexpected failures
4. Discredit, characterised by liquidation
5. Panic, characterised by the desire for cash
The role of risk assessment is important, risks tend to be underestimated in good times and
overestimated in bad times. Risk may be endogenous. The amount of debt is a key factor
explaining the depth of the financial crisis. The economy may rely on informationally insensitive
debt, which makes it possible for firms with low quality collateral to borrow, generating a credit
boom. In a financial crisis uncertainty about the future increases, which widens the information
asymmetry between contracting parties (moral hazard and adverse selection).
Subprime mortgages are housing loans to high-risk borrowers with a weak or bad credit history
who do not qualify for a conventional mortgage. When housing prices dropped, many holders
could not refinance their mortgage and unable to continue payments.
The providers of subprime loans bundled the mortgage loans and sold them to investors via
CDOs. Mortgage providers tried to sell as many mortgages as possible, since they were only
interested in the upfront fee, and there was no incentive to perform a proper credit check as the
risks were transferred to third parties. The securitised instruments were high in demand for
investors searching for as much as possible spread above the risk-free rate, to offset at least
partially the declining risk-free rate. The credit risk agencies had non adequately assessed the
risks related to the subprime mortgages, which caused over-reliance. The activities to the
internal banking system were growing far more than end services to the real economy. This
,was accompanied by an increase in total system leverage. The SPVs were often funded with
short-term asset-back commercial paper, leading to a maturity transformation.
Credit derivatives increased as well; they allow an investor to take a position with respect to the
possibility that the so-called reference entity will default. Increased risk aversion and
deleveraging amplified the initial shock.
EFSM = EC can raise up to €60 billion on behalf of the EU for providing financial assistance to
EU member states experiencing financial difficulties.
EFSF = limited liability company authorised to issue debt securities, guaranteed up to a total of
€440 billion by euro-are countries on a pro rata basis, for lending to euro-area countries.
Causes
§ Lack of fiscal discipline à lack of budgetary discipline due to weak enforcement; risk
loving because they thought they would be bailed out anyway.
§ Diverging financial cycles: the financial cycle is driven by growth in credit and house
prices and has a much longer duration than business cycles and it has a wider
amplitude while the correction of the financial cycle is often accompanied by a financial
crisis. Turn of the financial cycle has effect on government revenues causing it to have
a larger impact on public finance than business cycles.
§ Diverging competitiveness: as countries in the euro area no longer have the possibility
to devaluate their currency, improving competitiveness can only restore external
imbalances.
§ Doom loop: during the financial crisis governments in several euro-area countries
engaged in large-scale financial sector bailouts. This requires immediate issuance of
additional debt by the sovereign causing an increase in its credit risk. This debt-
overhang might affect the private sector and households and corporations may
anticipate that this will require higher taxes diluting long-run returns on real-sector and
human-capital investments. This may result in under-investing. Furthermore, higher
sovereign risk reduces the value of collateral that financial institutions can use for
funding purposes. It can also cause lower ratings for the country’s banks. Finally, the
value of the explicit and implicit government guarantees to the financial sector decline,
which affects the credit quality. Funding problems on sovereign bond markets went
hand in hand with funding problems for banks in these countries.
§ Policy reactions: the reaction of European leaders led to initiation of ad hoc support
programmes and more structural measures being taken.
CHAPTER 3 (89-98) European Financial Integrations: Origins and History
In the 1970s the European Monetary System was introduced. The aim was to create a zone of
monetary stability in Europe. The core was the Exchange Rate Mechanism: currencies
fluctuating vis-à-vis one another within a bind of plus and minus 2.25 per cent around agreed-
upon central rates, which could be adjusted. However, countries didn’t really care about more
than there own, so a monetary union was a better idea. Next to an internal market, exchange
rate risks and transaction costs needed to be banned by introducing one common currency.
Convergence criteria EMU:
• Inflation may not exceed that of three-best-performing Member States by more than
1.5 percentage points.
• Average long-term interest rate that doesn’t exceed that of the three-best-performing
Member States by more than 2 percentage point.
, • Normal fluctuation margins provided for by the ERM for at least two years, without
devaluing against the currency of any other Member State.
• Planned or actual government deficit to GDP ratio must not exceed 3 per cent.
• Government debt to GDP ratio must not exceed 60 per cent.
With this currency union the monetary policy was delegated to the ECB. The governing council
(executive board and governor) of the ECB is responsible for taking monetary policy decisions.
National central banks play a role in implementing monetary policy. ECB’s primary objective is
price stability = maintaining inflation in the euro area below but close to 2 per cent in the
medium term.
Well-functioning monetary unions require the maintenance of fiscal discipline among its
member countries. There is a preventive arm that prescribes the path for sound fiscal policies,
while the corrective arm is intended to prevent ‘gross policy errors’ by deterring excessive
deficits and requiring their prompt correction should they occur.
The six-pack covers fiscal policy surveillance, as well as macroeconomic surveillance. Next to
that, it introduces reverse qualified majority voting: a recommendation or proposal of the
Commission is considered adopted by the Council unless a qualified majority of member states
votes against it, thereby bringing some automaticity in the procedure.
The two-pack added a contribution to the preventive arm of the SGP: it obliges government to
submit their budgetary plan for the coming year to the EC.
Fiscal Compact: balanced budget rule (including an automatic correction mechanism) and a
strengthening of the excessive deficit procedure.
European policy makers have also enhanced the possibilities to monitor and prevent large
macroeconomic and financial imbalances within the euro area à Macroeconomic Imbalance
Procedure: based on a continuous monitoring of a scoreboard consisting of a set of 11
indicators covering the major sources of macroeconomic imbalances.
CHAPTER 4 Monetary Policy of the European Central Bank
The European Central Bank (ECB) is responsible for the monetary policy in the European
Union. The NCB’s of the member states in the euro area play a role in implementing monetary
policy through open market operations. The Eurosystem is also responsible for:
• Conduct of foreign exchange operations
• Holding and management of the official foreign reserves of the EU member states
• Promotion of smooth operation of payment systems.
Governing Council is the most important decision-making body of the ECB.
• Six members of Executive boars and governors of euro-area NCBs (no national
representatives, but independent personal capacity).
• Formulating monetary policy, including decisions about interest rates, every six weeks.
Executive Board is another decision-making body of the ECB.
• President, VP and up to 4 other members (appointed by European Council via QMV,
with eight years term office).
• Prepares meetings of the Governing Council and may give instructions to NCBs
General council plays a role as decision-making body as long as not all Member States use the
euro as their currency.
• President and VP of ECB and governors of NCBs
, • NCBs without adoption of euro can’t participate in decisions related to the single
monetary policy for the EU. Here they have the opportunity to discuss monetary policy
issues and exchange rate relations with the euro.
Price stability is primary objective of the ECB: inflation below, but close to 2 per cent in the euro
area in the medium-term. Inflation is measured with HICP, which is a comprehensive measure
for prices of consumption goods. Price decreases (deflation) are also not consistent with price
stability. Prices may be temporarily distorted by short-term factors. Euro-area wide
developments are the only determinants of decisions regarding the monetary policy.
The ECB is also responsible for supervision of banks and plays an important role in the ESRB
responsible for the macro prudential oversight of the financial system within the EU.
The monetary policy of the ECB is based on a ‘two-pillar’ strategy that explicitly pairs the
discussion of monetary factors (monetary analysis) with a broad-based non-monetary analysis
of the risks to price stability in the short to medium run (economic analyses). This strategy
provides a cross-check of the indications that stem from the shorter-term economic analysis
with those from the longer-term monetary analyses, so no important information relevant for
assessing future inflation trends is overlooked.
The economics analyses focuses on the assessment of current economic and financial
developments and the implied short- to medium-term risks to price stability. Due attention is
paid to the need to identify the nature of shocks hitting the economy, their effects on cost and
pricing behaviour, and the short- to medium-term prospects for their propagation in the
economy.
The monetary analysis focuses on a medium- to long-term horizon. The focus is on money
growth (M3), since the inflation in the long run is considered to be a mostly monetary
phenomenon. Nowadays the analysis goes well beyond M3 growth. Now it is mainly to serve
as a means of cross-checking from a medium- to long-term perspective, the short- to medium-
term indications from the economic analysis.
The ECB has several instruments at its disposal to affect inflation and output.
• Policy rates: banks can use the marginal lending facility and the deposit facility if they
need liquidity or if they want to stall liquidity. They have an overnight maturity and are
available to banks on their own initiative. The interest rates are normally substantially
higher (for borrowing) or lower (for depositing) than the corresponding money market
rate, so banks usually only use this facilities in the absence of other alternatives. There
are no limits to the access of these facilities, so the rates provide a ceiling and a floor.
EUNIA represents the average rate on unsecured overnight euro lending transactions
in the interbank market and is a weighted average rate on transactions reported to the
ECB.
• Open market operations: the Eurosystem affects money market interest rates by
providing more (or less) liquidity to banks if it wants to decrease (increase) interest
rates. To manage liquidity in the money market and steer short-term interest rates, it
uses open market operations à it buys (or sells) financial assets. If assets are bought
from (sold to) a bank, the reserves of that bank at the central bank increase
(decrease).
o Main refinancing operations
o Longer-term refinancing operations
o Fine tune operations à on ad hoc basis. Managing the liquidity situation in the
money market and steering interest rates in order to smooth the effects on
interest rates of unexpected liquidity fluctuations in the market.
