The Financial System: Opportunities and Dangers Chapter 20 of Macroeconomics, 8 th edition, by N. Gregory MankiwMacroeconomics ECO62ECO62 Udayan RoyUdayan

The Financial System: Opportunities and Dangers

Chapter 20 of Macroeconomics, 8th edition, by N. Gregory Mankiw

ECO62 Udayan Roy

http://bcs.worthpublishers.com/mankiw7/

http://myweb.liu.edu/~uroy/eco62/index.html

http://myweb.liu.edu/~uroy/index.html

http://myweb.liu.edu/~uroy/index.html

The Financial System

• The financial system is the collection of institutions that facilitate the flow of funds between lenders and borrowers.

The Financial System: Saving

• When people earn income, they typically don’t want to consume their entire income all at once.

• But they may have no idea what to do with the unconsumed income.

• This unconsumed income is called saving

The Financial System: Investment

• On the other hand, there are people who may wish to spend money on various potentially valuable projects but either have no money of their own or may wish to spend their personal funds on projects other than their own

• The money that these people need for their spending plans is called investment

The Financial System Makes Saving Equal Investment

• The financial system makes it easier for lenders (those who have the saving funds) and borrowers (those who need funds for investment) to find each other

• Both groups benefit when the financial system does its job well

• When the financial system fails, both groups suffer

What does the financial system do?

• The financial system serves multiple purposes:– It helps entrepreneurs find the money needed to turn

business ideas into reality– It helps entrepreneurs pursue business projects without

having to personally carry too much of the risks associated with their projects

– It helps to protect lenders from irresponsible borrowers– It helps to foster economic growth by channeling

savings to the most valuable projects and cutting off funds for the less valuable projects

Financing Investment

• The financial system helps entrepreneurs find the money needed to turn business ideas into reality

• The money may take the form of– Debt finance (the entrepreneur sells bonds), and– Equity finance (the entrepreneur sells stocks)

Financing Investment

• The flow of funds takes place through– Financial markets• Stock market, bond market

– Financial intermediaries• Banks, mutual funds, pension funds, insurance

companies







Sharing Risk

• The financial system helps entrepreneurs pursue business projects without having to personally carry too much of the risks associated with their projects

• The financial system also enables savers to diversify—that is, lend their money to a variety of borrowers—thereby reducing the risks of lending

Sharing Risk

• Suppose it is your dream to start a restaurant. • Even if you have enough savings of your own

to pay for the restaurant, it might still be better to share the risks—and the rewards—of the restaurant venture with others

• And others may wish to share the risks of your restaurant venture if they believe that the returns would be good

Sharing Risk

• The financial system—that is, the financial markets and financial intermediaries—may put you in touch with other investors

• They would provide you money to get your restaurant started in return for part ownership– This is equity finance

• This way you would not have to carry the full risk of your restaurant on your own shoulders

Sharing Risk

• Even if you are not an entrepreneur, the financial system can help you use your savings to acquire ownership of a diversified portfolio of business enterprises

• This will help you keep your idiosyncratic risks low

• But systemic risks may remain







Dealing With Asymmetric Information

• The financial system helps to protect lenders from irresponsible borrowers


• Borrowers can hide crucial information—about their abilities and their plans—from potential lenders

• As a result, trusting lenders can get ripped off• If that happens often enough, all lending

would eventually end and the financial system would be unable to do what it is supposed to do


• The financial system—especially financial intermediaries, such as banks, and watchdogs, such as government regulators and the courts—can help lenders by– ensuring that lenders get adequate information

about potential borrowers– keeping a watchful eye on borrowers to ensure that

they do nothing stupid or reckless with borrowed money

– punishing dishonest treatment of lenders


• When entrepreneurs hide information about themselves or the projects for which they are seeking money, lenders face the problem of adverse selection

• When entrepreneurs hide information about how hard they would work to make their projects successful, lenders face the problem of moral hazard


• Why would an entrepreneur borrow money for his/her project?– has no personal funds– has enough personal funds, but wants to diversify

risks– knows something negative about the project that

he/she is hiding from lenders (adverse selection)– has no intention to work hard for the project

(moral hazard)


• A lender can partially avoid the problems of adverse selection and moral hazard by lending money to an intermediary, such as a bank, and letting the bank deal with the borrower

• The bank may have the resources to dig up hidden information about the borrower and the project

• The bank may be able to ensure that the borrower will work hard to make the project a success


• In some cases, asymmetric information may hurt an honest borrower

• An entrepreneur may be honest and hard working, but may be unable to convince potential lenders that she is hard working

• Here too, bank finance may be the solution• A bank may be willing to lend money to this

borrower because the bank has resources to monitor the borrower, who in this case happens to be genuinely hard working


• Government regulators and the law enforcement system have obviously important roles to play in dealing with adverse selection and moral hazard







Fostering Economic Growth

• The financial system helps to foster economic growth by channeling savings to the most valuable projects and cutting off funds for the less valuable projects

• When asymmetric information is not a problem, a market for loanable funds in which people are free to lend and borrow should ensure the success of economically valuable projects and the failure of economically wasteful projects

Fostering Economic Growth

• For example, if in a well-functioning loanable funds market the equilibrium interest rate is 4%, then – the projects that can earn profits higher than 4%

will succeed, and– the projects that cannot do so will fail

• In this way, a free market will automatically allocate funds so as to foster economic growth

Case Study: Microfinance

• In poor countries, financial markets are undeveloped, primarily because of asymmetric information problems and weak or nonexistent government efforts to deal with asymmetric information

• In 1976, Muhammad Yunus, and economics professor in Bangladesh, started Grameen Bank to remedy the situation


• The Bank was successful in enabling entrepreneurs get the money to build small-scale businesses and improve their lives

• Grameen Bank and Prof. Yunus were awarded the Nobel Peace Prize in 2006

• How did Grameen Bank succeed in solving the problem of asymmetric information?


• Loans were given to groups rather than individuals

• All members of the group that took a loan would be responsible for timely repayment

• A group would only admit members that the other members knew to be sound

• In this way, the group lending idea helped solve the asymmetric information problem


• Moreover, Grameen Bank gives loans in small amounts that are repaid—and renewed—after short intervals

• Therefore, a continuing relationship develops between the bank’s loan officers and the borrowers

• Moreover, as small amounts are loaned out at any given time, losses are low

FINANCIAL CRISISSomehow the pipes get clogged

Financial Crisis

• A financial crisis is a major disruption of the economy’s ability to make money flow between lenders and borrowers

• Examples:– Great Depression 1930s– Great Recession 2008-09

Six Common Features

• Although each financial crisis is unique, most financial crises share certain common elements1. Asset-price booms and busts2. Insolvencies in financial institutions3. Falling confidence4. Credit crunch5. Recession6. A vicious circle

Asset-price booms and busts

• Financial crises are often preceded by a period of euphoria, called a speculative bubble, during which the prices of assets rise above their fundamental values– The fundamental value of an asset is the price that

would prevail if people relied only on objective analyses of the cash flows the asset will generate


• If people start buying assets not for the expected cash flows from the asset but because they hope to sell the asset later at a higher price, an asset’s price can rise above its fundamental value

• However, such speculative bubbles inevitably crash when euphoria ends and doubts set in


• In the Great Recession of 2008-09, a speculative bubble developed in home prices


• Banks fueled the boom because they failed to do their job of identifying irresponsible borrowers and not giving them loans.

• Why?– Banks assumed that home prices would keep rising. – Under that assumption, it would not matter if a

borrower defaulted. – The bank would simply take the house the defaulter

had bought and sell it off at a higher price, thereby making a profit.

Recap: Six Common Features


Insolvencies in financial institutions

• Eventually, home prices stopped rising and then started to fall

• Borrowers then owed more money than the value of the house they’d bought with the loan

• Such borrowers stopped repaying their loans– Mortgage loans are “non-recourse”– Better to just return the house keys to the bank


• Of course, banks could take the homes (collateral) and sell them

• But then banks would lose money because home prices had fallen

• When banks’ assets (the homes) lose value, their Capital (owners’ equity) turns negative– See Ch. 4

• At that point, the bank is insolvent


• Many financial institutions turned insolvent– Financial institutions have assets and liabilities• Assets are what others owe them• Liabilities are what they owe others

– When the value of assets falls below the value of liabilities, the financial institution is insolvent

– When a financial institution becomes insolvent, it is forced to stop operations

– When financial institutions stop operations, the economy suffers


• Suppose you and your friends decide to start a bank• You and your friends put $1,000 of your own money

in the business. – This is called capital

• You borrow $39,000. – These are your liabilities

• You lend $40,000. – That is, you buy $40,000 in assets

• Your leverage ratio = assets/capital = 40


• Suppose your assets then increase in value by $400 – a mere +1%

• The return on your capital is +40%!!!• This is the magic of leverage


• But the magic of leverage cuts both ways• If your assets decrease in value by $1,000 (or,

a mere -2.5%), you will lose all your capital (or, a loss of -100%)


• The heavy reliance on leverage by financial institutions at the time of the Great Recession meant that many such institutions became insolvent when home prices began to fall



Falling confidence

• Some bank deposits are insured by the government

• But not all• As banks and other financial institutions faced

the threat of insolvency, many lenders withdrew their deposits (a run)

• This reduced the ability of businesses to get loans for business projects

Falling confidence

• Troubled financial institutions also had to sell their assets (loans) at fire sale prices to increase their cash reserves– Banks use short-term deposits to give long-term

loans– When short-term deposits dry up for troubled

banks, they are forced to sell their long-term loans (to less troubled financial institutions) at fire sale prices

Falling confidence

• But the fire sale of assets reduces asset prices• And, as we saw before, this fall in asset prices

can make many financial institutions, that are otherwise healthy, insolvent

• In this way, trouble spreads like infectious disease

Falling confidence

• Moreover, if the number of financial institutions is small, each will have lots of financial dealings with the others

• In that case, if one institution becomes insolvent, the others would also be hurt and may themselves become insolvent



Credit crunch

• With spreading insolvency shutting down financial institutions, and falling confidence leading depositors to take money out of financial institutions, would-be borrowers—even those with profitable investment projects—have trouble getting loans

Credit crunch

• During the Great Recession, loans for home buyers dried up almost completely, as it became clear that home prices do not always go up



Recession

• Many households were unable to borrow money to buy homes or to even buy simple things

• Many businesses were unable to borrow money to build new factories or buy machines, furniture, etc.

• So, aggregate planned expenditure fell• A recession began

Recession

• GDP fell• Unemployment rose• Officially the economy began to recover in

June 2009• But in reality, that recovery has been very

weak



A vicious circle

• A recession sets off a vicious circle• Businesses fail and can’t repay their loans• This further intensifies the insolvency of

financial institutions, which had helped cause the recession in the first place

• As people lose their jobs, they default on their debts, again adding to the vicious circle

Six Common Features

Case Study: Who should be blamed for the financial crisis of 2008-2009?

• Possible culprits include:– The Federal Reserve: it may have kept interest rates

too low for too long after the 2001 recession, thereby fueling the housing bubble

– Home buyers: they were too stupid to realize that home prices could fall at some point and that they’d be better off renting

– Mortgage brokers: knowing that they could sell the loans to investment banks—and being greedy and unprincipled—they paid no attention to loan quality


– Investment banks: they were greedy and unprincipled enough to package the mortgage loans and sell them to gullible buyers (such as pension funds) who believed what the rating agencies said about the mortgage loan packages

– Rating agencies: they gave high grades to mortgage assets that later turned out to be highly risky. • Maybe they were just stupid. • Others say they were greedy for the investment banks’

business and did not want to make them angry.


– Regulators: government regulators were not paying any attention to the rampant misbehavior of the private sector. • These regulatory bodies were often underfunded. • There was a general ideology that hated regulation.

– Government policy makers: for decades, politicians in both the Republican and Democratic parties sought to use government policies to encourage home ownership over renting. • This may have partially fed the home price bubble

Policy Responses to a Crisis

• Policy makers used many tools to fight the crisis:– Conventional fiscal policy– Conventional monetary policy– Central bank’s lender-of-last-resort role– Injections of government funds


• Conventional fiscal policy– Taxes were cut– Government spending was increased– But this meant increased budget deficits, which

would make already high government debt even higher and, therefore, raise the possibility of a government debt crisis


• Conventional monetary policy– Short-term nominal interest rates were cut– But nominal interest rates cannot be reduced

below zero


• Central bank’s lender-of-last-resort role– Banks take short-term deposits from savers and

lend money for long-term business projects– So, if falling confidence leads to a sudden

withdrawal of deposits, even a solvent bank would face a liquidity crisis

– The bank may have to sell its assets at fire sale prices, which could crash asset prices, and turn the liquidity crisis into an insolvency crisis


• Central bank’s lender-of-last-resort role– A central bank could prevent such a dire outcome

by printing money and lending it to banks that face a liquidity crisis• When the central bank makes loans when nobody else

would, it is acting as a lender of last resort


• Central bank’s lender-of-last-resort role– During the Great Recession, the Fed made lots of

such loans, not only to banks, but to other financial institutions that faced liquidity crises• These institutions are called shadow banks because

they take short-term deposits and make long-term loans, just like banks• Example: money market mutual funds. Fed became a

lender of last resort to these funds, when depositors fled


• Injections of government funds– When borrowers default on their bank loans, a

bank may have to shut down, in which case its depositors would lose their money

– That could have ripple effects because the depositors would cut back on their spending plans

– The FDIC insures bank deposits up to a limit. • This limit was raised from $100k to $250k in 2008

– This reduces the adverse ripple effects of bank failure


• Injections of government funds– But the FDIC does not insure all deposits at a

failed bank. – Therefore, some adverse ripple effects could still

occur– When those ripple effects are likely to be large

enough, the bank is called too big to fail and the government uses its money to rescue it


• Injections of government funds– Moreover, if it becomes impossible for businesses

to borrow money to finance their projects—especially somewhat risky ones—business investment spending could crash, causing a recession

– In such a case, the government could use its funds to directly lend money for such projects


• Injections of government funds– Governments may also use their funds to invest

money into a bank to enable it to keep lending even when depositors have withdrawn their deposits

– The hope is that the crisis is temporary and that the government would get its money back when the crisis ends and depositors return


• Injections of government funds– The use of government funds to bail out the

financial sector is obviously risky because the government may not get its money back

– Moreover, if financial institutions know that the government would always rescue too-big-to-fail firms, they would have incentives • to take huge risks (moral hazard) and • to become large just to become TBTF


• Injections of government funds– However, despite the downside of using taxpayer

funds to prop up the financial industry, it may be necessary to do so in order to avoid a huge financial catastrophe

Policies to Prevent a Crisis

• There are no easy ways to prevent financial crises. They will definitely happen again and again.

• However, here are a few ideas on prevention:– Pay more attention to shadow banks– Try to make financial institutions smaller– Force banks to reduce risky lending– Toughen up the enforcement of regulations

Prevention: Shadow Banks

• Commercial banks’ deposits are insured by the FDIC

• This could induce these banks to take huge risks– If the risks succeed, the bank keeps the gains– If the risks fail, the taxpayer takes the losses

• To avoid this, commercial banking is heavily regulated


• As a result, the commercial banking sector behaved very well during the crisis of 2008-09

• The bulk of bad behavior came from the shadow banking sector, which is only lightly regulated– Investment banks, hedge funds, insurance

companies, private equity funds, etc.


• The obvious lesson is to treat the shadow banks just like regular banks: insure the depositors and leash the managers

• One way to leash these financial institutions is to require them to hold more capital (owners’ equity) and less leverage– When more of the owners’ money is at stake,

these institutions may take more sensible risks

Prevention: Smaller Wall Street

• No financial institution should be so vital to the financial system that it becomes too big to fail

• Such an institution would be tempted to take big risks because– If the risk succeeds, the managers make money– If the risk fails, the taxpayer will come to the

rescue


• If the financial system is dominated by just a few firms, they are likely to be deeply interconnected

• In such a situation, the failure of even one firm may lead to big losses in all firms, thus making each firm TBTF

• So, the financial system needs moderately sized firms, and lots of them


• Mergers and acquisitions among financial firms need to be discouraged

• Bigger firms should be required to have more capital (owners’ equity) so that they take only sensible risks

• On the other hand, bigness has the advantage of economies of scale

Prevention: Safer Wall Street

• Apart from higher capital requirements, the financial system could be made safer by requiring commercial banks—whose deposits are guaranteed by the FDIC—from trading in complex assets such as derivatives (Volcker Rule)

• Derivatives should be traded in exchanges, so that regulators can have better information

Prevention: Tougher Regulators

• The government’s regulators clearly failed in doing their job

• The numerous regulatory agencies could be consolidated into a smaller number

• New regulatory agencies have been set up in the US to watch the credit rating agencies, the treatment of consumers of financial products, and coordination of regulators

Documents

The Financial System: Opportunities and Dangers Chapter 20 of Macroeconomics, 8 th edition, by N. Gregory MankiwMacroeconomics ECO62ECO62 Udayan RoyUdayan