The Financial System: Opportunities

and Dangers
LET’S COVER:

• The functions of a healthy financial system

• The common features of financial crises
• Government policies to alleviate or prevent crises

1
LET'S THINK:
What the financial system does
• What functions does the financial system perform?
• Try to think of two or three, and write them down.
• Lets compile and compare later.

2
WHAT THE FINANCIAL SYSTEM DOES

1. Financing Investment
The financial system helps channel funds from savers—
households with income they do not need to spend
immediately…
To the investors—firms that need funds to finance
investment projects
WHAT THE FINANCIAL SYSTEM DOES
1. Financing Investment

• Financial system: the institutions in the economy

that facilitate the flow of funds between savers and
investors
• The financial system includes
• financial markets, like the stock market, through which
households and businesses directly provide funds for
investment
• financial intermediaries, like banks or mutual funds,
through which households indirectly provide funds for
investment
WHAT THE FINANCIAL SYSTEM DOES
1. Financing Investment
• Debt finance: selling bonds to raise funds for
investment
• A bond represents a loan from the bondholder to the firm.
• Equity finance: selling stock to raise funds for
investment
• A share or stock represents an ownership claim by the
shareholder in the firm.
WHAT THE FINANCIAL SYSTEM DOES

1. Financing Investment
• Financial intermediaries accept funds from savers and
direct them to investors.
• For example, banks accept deposits from households and
make loans to firms.
• Other examples: mutual funds, pension funds, and
insurance companies
WHAT THE FINANCIAL SYSTEM DOES

2. Sharing Risk
• Many people are risk averse:
other things equal, they dislike uncertainty.
• The financial system allows people to share risks:
• Investors can share the risk that their projects will fail with
the savers who provide the funds.
• Savers may be willing to accept these risks for the prospect
of a higher return than they could earn otherwise.
 WHAT THE FINANCIAL SYSTEM DOES
2. Sharing Risk
• Many people are risk averse:
other things equal, they dislike uncertainty.
• The financial system allows people to share risks:
• Savers can reduce risk through diversification: providing
funds to many different investors with uncorrelated assets.
• Diversification can reduce idiosyncratic risks, risks that
differ across individual businesses.
• Diversification cannot reduce systematic risks, which
affect most/all businesses.
WHAT THE FINANCIAL SYSTEM DOES
3. Dealing with Asymmetric Information
• Asymmetric information:
When one party to a transaction has more
information about it than the other party
• Adverse selection:
When people with hidden knowledge about
attributes sort themselves in a way that
disadvantages people with less information
• Example: investors who know their projects are less
likely to succeed are more eager to finance the projects
with other people’s funds
WHAT THE FINANCIAL SYSTEM DOES
3. Dealing with Asymmetric Information
• Moral hazard: arises from hidden knowledge about
actions, occurs when imperfectly monitored agents
act in dishonest or inappropriate ways.
• Example: entrepreneurs investing other people’s money
are not as careful as if they were investing their own
funds
WHAT THE FINANCIAL SYSTEM DOES
3. Dealing with Asymmetric Information
• The financial system helps mitigate the effects of
asymmetric information.
• Example: banks
• Banks address adverse selection by screening borrowers
for adverse hidden attributes that savers might be
unable to detect.
• Banks address moral hazard by restricting how loan
proceeds are spent or by monitoring the borrowers.
WHAT THE FINANCIAL SYSTEM DOES

4. Fostering Economic Growth

• There are many types of capital in the real world.
• Firms with lucrative investment projects are willing
to pay higher interest rates to attract funds than
firms with less desirable projects.
• The financial system helps channel funds to
projects with the highest expected returns relative
to their risk.
WHAT THE FINANCIAL SYSTEM DOES

4. Fostering Economic Growth

• Govt helps facilitate this function by providing
quality legal institutions, e.g.
• prosecuting fraud to reduce moral hazard
• enforcing disclosure requirements to reduce adverse
selection
LET’S BRAINSTORM

What if the Financial System Fails

• Suppose the financial system becomes unable to
perform the function of channeling funds from savers
to borrowers.
• Think two or three specific consequences,
• Then, we’ll compare.

14
COMMON FEATURES OF FINANCIAL CRISES
1. Asset-Price Booms and Busts
• Financial crises often follow a period of optimism and
a speculative asset-price bubble.
• Eventually, optimism turns to pessimism and the
bubble bursts, causing asset prices to drop.

In the 2008–2009 crisis, the crucial asset was housing:

house prices soared until 2006, then fell to the ground
2009.
COMMON FEATURES OF FINANCIAL CRISES
2. Insolvencies at financial institutions
• Falling asset prices cause defaults on bank loans.
• Since banks are highly leveraged, defaults greatly
reduce their capital, increasing the risk of
insolvencies.

In 2008–2009, many banks held mortgages and assets

backed by mortgages. Falling house prices sharply
increased mortgage defaults, pushing many financial
institutions toward bankruptcy.
COMMON FEATURES OF FINANCIAL CRISES

3. Falling confidence
• Insolvencies at some banks reduce confidence in
others, and individuals with uninsured deposits
withdraw their funds.
• To replace their shrinking reserves, banks must sell
assets. Selling by many banks causes steep price
declines—called a fire sale.
In 2008–2009, the collapse of Bear Stearns and
Lehman Brothers reduced confidence in other
large institutions, many of which were
interdependent.
FYI: The TED spread
• The TED spread measures the perceived credit risk of
banks.
• Definition: TED spread =
rate on three-month interbank loans
– rate on three-month T-bills
(expressed in basis points)
• The TED spread is usually between 10 and 50 basis
points.
• In a financial crisis, falling confidence in banks causes
the TED spread to rise…
The TED spread, 2003–2014
500

450

400

350
basis points

300

250

200

150

100

50

0
Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan.
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
COMMON FEATURES OF FINANCIAL CRISES

4. Credit crunch

• Frequent defaults and insolvencies make it hard for

investors to get loans—even those with good credit
and lucrative projects.

In 2008–2009, banks sharply reduced

lending to consumers for buying homes and
to businesses for expanding operations or
buying inventories.
COMMON FEATURES OF FINANCIAL CRISES
5. Recession
• With less credit available, consumer and business
spending declines, reducing aggregate demand.
• Result: output falls, unemployment rises.

In 2008–2009, unemployment rose above 10%

and remained very high for many months after
the financial crisis.
COMMON FEATURES OF FINANCIAL CRISES

6. A vicious circle
• The recession reduces profits, asset values, and
household incomes, which increases defaults,
bankruptcies, and stress on financial institutions.
• The financial system’s problems and the economy’s
downturn reinforce each other.

In 2008–2009, the vicious circle was

apparent, creating fears the economy
would spiral out of control.
 The Anatomy of a Financial Crisis
Insol- Falling Credit
Recession
Asset- vencies confidence crunch
(from falling
price at some in many (banks
aggregate
bust financial financial reduce
demand)
institutions institutions lending)

Vicious circle
(recession puts more
pressure on asset prices and
financial institutions)
Who should be blamed for the financial
crisis of 2008–2009?
Possible culprits include:
• The Federal Reserve
• Home buyers
• Mortgage brokers
• Investment banks
• Rating agencies
• Regulators
• Government policymakers
All of them likely deserve a share of the blame.
What should government policies do?

• What should the government do if a financial crisis

occurs?
• Can the government prevent financial crises?
• Try to think of a specific policy to alleviate a financial
crisis and another policy to prevent future crises.

25
POLICY RESPONSES TO A CRISIS

1. Conventional monetary policy

• The central bank can manage the money supply
to lower interest rates and encourage spending.

The Fed reduced the federal funds rate to

nearly zero by 12/2008, yet this was
insufficient.
POLICY RESPONSES TO A CRISIS
2. Conventional fiscal policy
• The government can increase spending and cut taxes.

Fiscal policymakers enacted stimulus of $168

billion in 2008 and $787 billion in 2009.

But the large and growing government debt

sharply limited further stimulus measures.
POLICY RESPONSES TO A CRISIS
3. Lender of last resort
• Runs on banks can create a
liquidity crisis,
in which solvent banks have
insufficient funds to satisfy
depositors’ withdrawals.
• The central bank can make
direct loans to these banks,
acting as a lender of last
resort.
In 2008–2009, the Fed acted as lender of last resort to
many banks and to shadow banks, which perform many
of the same functions as banks and were experiencing
similar problems.
POLICY RESPONSES TO A CRISIS
4. Injections of govt funds
• The govt can use public funds to prop
up the financial system:
• Give funds to those who
have experienced losses
(e.g., Federal Deposit
Insurance)
• Make risky loans (e.g., stake in AIG
in 2008)
• Inject capital into ailing
institutions, taking an
ownership stake (e.g., TARP)

• Using public funds to prop up

ailing institutions is controversial
and may increase moral hazard.
POLICIES TO PREVENT CRISES
1. Focusing on shadow banks
• Shadow banks engage in financial intermediation and include:
• Investment banks
• Hedge funds,
• Private equity firms, and
• Insurance companies.
• Their deposits are not federally insured, so they are not heavily regulated
like traditional banks and can take on much more risk.
• Their failures can hurt the broader economy, so many policymakers suggest
limiting the risk they can take, increasing their capital requirements, and
allowing more government oversight.
POLICIES TO PREVENT CRISES
2. Restricting size
• Institutions deemed “too big
to fail” have a moral hazard
problem.
• Some proposals would limit the
size of financial institutions to
reduce the harm their failures
would cause to the rest of the
financial system.
• Proposals include limiting
mergers and increasing
capital requirements for
larger banks.
POLICIES TO PREVENT CRISES
3. Reducing excessive risk taking
• To prevent financial firms
from failing, some propose
limits on excessive risk
taking.
• Problem: defining
“excessive”
• The Dodd-Frank Act of 2010
includes the
Volcker rule, which prohibits
commercial banks from
making certain types of
speculative investments.
POLICIES TO PREVENT CRISES
4. Making regulation work better
• The regulatory
apparatus
overseeing the
financial system
is highly
fragmented.
• Dodd-Frank and other
measures seek to
coordinate the various
regulatory agencies
and improve the
effectiveness of
financial industry
oversight.
 The European sovereign debt crisis
• Debt problems in Greece:
• Rising govt debt, revelations that Greece may have
misreported its finances in earlier years
• Greek bonds downgraded, prices fell, interest rates
shot up as markets worried that Greece might default
• Repercussions throughout Europe:
• Many European banks held Greek bonds, whose falling
values pushed them toward bankruptcy.
• Policymakers worried that banks would fail, causing a
credit crunch and economic downturn.
The European sovereign debt crisis
• Bailing out Greece:
• The ECB and healthier countries in Europe made loans
to Greece to prevent an immediate default. The loans
came with conditions that Greece enact austerity
measures to improve its finances.
• Taxpayers in countries providing the funds resented
the bailouts. Greek citizens resented the austerity
measures and rioting ensued.
• Other countries with problems:
• Many feared a Greek default would lead to a run on
bonds from Spain, Portugal, Ireland, and Italy.
 Government debt in 2006 and 2011
180
2006
160
2011
140
percent of GDP

120

100

80

60

40

20

0
Germany Spain Greece Ireland Italy Portugal
 percent
Ja

10
15
20
25
30

0
5
n-
06
Ju
l-0
Ja 6
n-
07
Ju
l-0
Ja 7
n-

Italy
08 Spain
Ju
Ireland
Greece

Portugal
l-0
Germany

Ja 8
n-
09
Ju
l-0
Ja 9
n-
10
Ju
l-1
Ja 0
n-
1
Ju 1
l-1
Ja 1
n-
Interest rates on ten-year bonds

12
Ju
l-1
Ja 2
n-
13
Ju
l-1
Ja 3
n-
14
Ju
l-1
4
 IN SUMMARY
• A healthy financial system serves several purposes,
including:
• channeling funds from saving to investment
• allocating risk
• mitigating problems arising from asymmetric
information
• fostering economic growth

38
 IN SUMMARY
• Financial crises begin with a sharp decline in asset
prices, often after a speculative bubble.
• The fall in asset prices leads to insolvencies, which
reduce confidence in the financial system and spur
depositors to withdraw their funds.
• As a result, banks reduce lending, causing a credit
crunch. Business and consumer spending fall, causing
an economic downturn.
• In a vicious circle, the downturn puts further pressure
on asset prices and financial institutions.

39
 IN SUMMARY
• Policymakers can respond to a crisis in several ways: they can
use conventional monetary and fiscal policy to expand
aggregate demand,
• The central bank can provide liquidity by acting as a lender of
last resort and
• The government can use public funds to prop up the financial
system.
• Policies that aim to prevent future crises include focusing
more on regulating shadow banks,
• Restricting the size of financial firms,
• Limiting excessive risk-taking, and
• Reforming the regulatory agencies that oversee the financial
system.
40
THANK YOU