Financial System
Financial System
and Dangers
LET’S COVER:
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
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
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.
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
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.
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?
25
POLICY RESPONSES TO A CRISIS
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