Transcript Slides

FINANCIAL CRISES
Chap 12 & 13
International Financial Crises
• Banking Crisis – Sudden collapse of the domestic
banking system.
• Currency Crises – Loss of credibility of fixed exchange
rate system.
• Systemic Financial Crisis/Sudden Stops – Breakdown of
system of international capital flows.
• Sovereign Debt Crisis – Gov’t unable to pay-off debts
IMF World Economic Outlook, 1998
Prototypical Banking Crises
• Event, often deregulation or advance in financial
technology, leads to rapid expansion in credit to
speculative borrowers. Borrowers drive up asset prices
(usually real estate). Rising asset prices increases the
value of collateral which can support further expansion of
credit creating a cycle of asset price acceleration and
credit extension.
• Eventually, asset prices rise too far above fundamental
values and begin to fall. The cycle turns vicious. Asset
prices fall, collateral values fall, restrictive covenants bind,
speculative borrowers default, banks capital takes a hit,
lending is cut back, asset prices fall further.
Sweden
Japan
01-Mar-97
01-Mar-96
01-Mar-95
01-Mar-94
01-Mar-93
01-Mar-92
80.0
01-Mar-91
90.0
01-Mar-90
100.0
01-Mar-89
110.0
01-Mar-88
130.0
01-Mar-87
120.0
Index 1981=100
Credit to Private nonfinancial sector from Banks,
total - Market value Percentage of GDP
01-Mar-86
01.03.1975
01.06.1977
01.09.1979
01.12.1981
01.03.1984
01.06.1986
01.09.1988
01.12.1990
01.03.1993
01.06.1995
01.09.1997
01.12.1999
01.03.2002
01.06.2004
01.09.2006
01.12.2008
01.03.2011
01.06.2013
Axis Title
Sweden & Japan in the 1980s
Real Estate Prices
350
300
140.0
250
200
150
Tokyo
Stockholm
100
70.0
60.0
50
0
5
The cost of cleaning up after financial crises is very high.
Link
Challenges to Monetary Policy Effectiveness
Government Intervention
Bank failure can be contagious
1. Interbank Lending
2. Panic conditions
Link
Swedish Model of Crisis Resolution
Peter Englund The Swedish 1990s banking crisis
1.
2.
3.
4.
5.
Broad political support. Agreement with the main
opposition party….
Broad coverage. The guarantee covered all kinds of bank
obligations except equity capital and included all banks
with subsidiaries, but no other financial institutions.
Minimizing the subsidy to the banks and their owners.
Support payments should be recovered as far as
possible.
Only banks deemed to be profitable in the long run should
be supported.
Bad Bank – Government capitalized institution, Securum,
to buy bad loans from major banks
Japanese Model
• Implicit Deposit Guarantees
• Weak Governance: Banks were allowed to under
provision in order to avoid reporting losses and pay
dividends
• Regulatory Forbearance: Japanese banks were allowed
to under-report non-performing loans.
• Banks stumbled forward, evergreening loans, but could
not make new loans.
Kanaya & Woo Japanese Banking Crisis of the 1990s
9
1. Bank Risk Taking Channel
• Economic studies suggest that banks respond to
persistent periods of low interest rates by taking
more risk.
• Yield chasing – Banks may implicitly promise
yields to investors, need to earn yields that match
those promises. Only by taking on more risk can
they do so.
• Evidence suggests that yield chasing is less
prevalent in well-regulated banking markets.
10
IT and Bank Risk Taking
BIS View (Borio and Wheelock, 2004;
Borio and White, 2004)
• Inflation targeting monetary policy passively
allows bank credit to expand to fuel the asset
price boom general price inflation
• Unless policymakers act to defuse a boom, a
crash will follow.
10
Currency Crises
• Market believes that exchange rate will be devalued in the
near future.
• Lenders demand higher interest rates to lend in domestic
dollars to compensate for loss of value after devaluation.
• Central bank must use its foreign reserves to buy domestic
currency and prop up exchange rate.
• If pain of interest rates is too painful or loss of reserves too
severe, central bank may be forced to devalue.
Market Expects Devaluation
η>0
iHIBOR
iFF +η
S´
⓪
iFF
ΔR
S
D
Clearing Balances
Go for the Jugular
ERM Crisis
• In 1980’s, European economies constructed a system of
linked currencies called the Exchange Rate Mechanism.
• Inflationary German fiscal policy following re-unification
led to high DM interest rates.
• To maintain link, other Euro currencies needed to have
interest rates too high for their own situation.
• In Sept. 1992, markets expected a delinking/devaluation
of currencies.
Currency Crisis
• Speculation against
the pound forced Bank
of England to raise
interest rates and buy
pounds in forex
markets.
• Pain of interest rates
was viewed as too
severe and B of E was
forced to abandon the
peg.
Pounds/DM
0.42
0.41
0.4
0.39
0.38
0.37
0.36
0.35
0.34
0.33
0.32
1992 1992 1992 1992 1992 1992 1992 1992 1992 1992 1992 1992
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Principal Global Indicators Database
Fragile banking system makes high interest rates untenable
and can lead to fears of devaluation (especially if central
bank funds used to bailout banking system)
Banking
Crisis
Currency
Crisis
Exchange rate devaluation can damage balance sheets if
balance sheets (deposits or borrowings) are dollarized.
Sudden Stops
• International hot money (short-term lending) is subject to
herding behavior from international financial market.
• Rapid inflows and rapid outflows.
• When capital inflows stop, either those canLink
be replaced with
forex reserves, or domestic borrowers will face bankruptcy.
• Domestic firms can no longer finance investment
• Demand, GDP, and employment fall.
• Devaluation of currency.
Balance of Payments Equation
Current
Account
+
Net
Capital Inflows
=
Overall Balance
(increase in
reserves)
Sudden Stop
• What if capital flows out?
Current
Account
=
+
Overall Balance
(increase in
reserves)
Net
Capital Inflows
Money going out of the economy drive foreign exchange payments out of
balance.
Sudden Stop
Increase demand for domestic
currency causes depreciation.
Current
Account
Current
Account
+
=
Net
Capital Inflows
Overall Balance
(increase in
reserves) = 0
Depreciation leads to
currency account
reversal.
Current Account % of GDP
20
15
10
5
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
-5
-10
-15
Indonesia
Malaysia
Thailand
Korea
1999
2000
2001
2002
Foreign Reserves
Measures of Adequate Reserves
• Import Coverage: Reserves > Imports for 2-3 Months
• Greenspan-Guidotti Rule: Reserves exceed 100% of debt
due within one year.
Link
Buildup Foreign Reserve Assets
350000.000
Reserves (excluding gold)
300000.000
Millions of US$
250000.000
200000.000
150000.000
100000.000
50000.000
0.000
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Indonesia
Korea, Republic of
IMF Financial Statistics
Malaysia
Thailand
Korea
Short-term External Foreign Currency Debt Korea
180
160
140
Billion US$
120
100
80
60
40
20
0
Dealing with Sudden Stops
• Modern Approach
Swap lines
Link
Link
Final Exam
• Monday, December 14th, 08:30AM - 11:30AM. LG5
•
•
•
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Multifunction Room.
Cumulative. Similar to mid-term and practice exams.
Bring writing instruments and a calculator.
Semi-open book – Bring 1 A4 size paper with handwritten
notes on both sides.
Office Hours: Standard.