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Financial Crises
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
1
Information inefficiencies
• Market participants can have insufficient
information about their counterparts
(asymmetric information). It leads to
– Adverse selection. This is an information
problem occurring before the transaction:
Potential bad credit risks are those who
seek loans most actively.
– Moral hazard. This occurs after the transaction: Borrowers may take on big risks.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Elimination of asymmetric information (1)
• A first solution to the problem is the
private production and sale of information.
• There are professional rating agencies (Standard and
Poor’s, Moody’s, Value Line), and you can set up
costly monitoring and auditing (state verification) of
the firm.
• But there is s ‘free-rider problem’ to this. If you buy a
security, people my simply copy your behavior without
paying for the information.
• This erodes potential extra profits, and you may not
have bought the information in the first place.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Elimination of asymmetric information (2)
• A second possibility could be to involve the
government in regulating the market.
• The objective is to make firms reveal honest
information by adhering to standard accounting
practices and to disclose pertinent information.
• Government can also impose stiff criminal penalties to
contain fraud.
• Government regulation may ease the asymmetric
information problems, but it is difficult to eliminate
them totally.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Elimination of asymmetric information (3)
• A third solution is to involve financial
intermediaries as experts in the production of
information.
• A private loan is not traded, so others cannot
watch and imitate (no free rider).
• This explains why indirect finance is more
important than direct finance.
• Larger firms (because they are better known)
obtain easier access to capital markets than
smaller firms.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Systemic instability and financial crises
• Financial crises are characterized by abrupt
declines in asset prices and by insolvencies of
financial and non-financial firms.
• Such crises are reoccurring in many countries.
They are caused by a sharp increase in adverse
selection and moral hazard problems.
• Four categories of factors trigger crises:
–
–
–
–
Increases in interest rates;
Increases in uncertainty;
Asset market effects on balance sheets; and
(Multiple) bank failures.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Asset market effects on balance sheets
• Balance sheets have important repercussions
on the financial system:
– A deterioration (fall in stock or housing prices) of
the balance sheet reduces the ‘net worth’ of a firm.
– Lenders are less willing to lend because of
reduced collateral.
– This induces moral hazard because borrowers take
higher risks.
– The increase in moral hazard makes lending less
attractive … this reduces economic activity.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Systemic instability and financial crises
• Financial crises are characterized by abrupt
declines in asset prices and by insolvencies of
financial and non-financial firms.
• Such crises are reoccurring in many countries.
They are caused by a sharp increase in adverse
selection and moral hazard problems.
• Four categories of factors trigger crises:
–
–
–
–
Increases in interest rates;
Increases in uncertainty;
Asset market effects on balance sheets; and
(Multiple) bank failures.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Typical financial crises
Deterioration of
a bank’s balance sheet
Increase in
interest rates
Stock market
decline
Increase in
uncertainty
Adverse selection and
moral hazard problems worsen
Economic activity declines
Bank panic
Adverse selection and
moral hazard problems worsen
Economic activity declines
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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How do financial bubbles affect activity?
The NY stock market
crashed on Friday,
October 1929, initiating
a persistent and long
downturn of the
economy
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Development of Stock Market Index
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Repercussions on the real economy
US Unemployment rate, 1929-1942
25
official series
20
Quelle: M.R. Darby,
Three-and-a-half
Million Employees
Have been mislaid,
Journal of political
Economy,
1976
15
10
Adjusted series
5
1930
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
1935
1940
12
Impact on people’s lives
Top CEOs had a especially hard time !
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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What dragged the economy down?
• The impact was then
– Increase of personal savings (and hence
a reduction of consumer spending) due to
a perceived reduction of personal wealth
– Change in consumer behavior
due to higher unemployment
– Credit implosion with an induced reduction
of demand, notably fixed investment
– Reduction of housing investment
due to prior over-investment
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The Great Depression: Further problems
• And :
– A general loss in consumers’ and investors’
confidence
– Change in spending behavior
due to insolvencies and bankruptcies
– Disintermediation due to a lack of liquidity
– Negative impact on public investment
due to a fall in tax revenue
– Policy failures, e.g. “strategic trade policies”
(Smoot-Hawley Act)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The Great Depression: US imports
Monthly data. Imports from 75 Countries (in bill. Gold $)
December
January
1929
February
1930
1931
November
March
1932
November
1933
April
October
May
September
August
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
July
June
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The central bank and systemic stability
• The health of the economy and the
effectiveness of monetary policy depend on a
sound financial system. Through supervising
and regulating financial institutions, the ECB
is better able to make policy decisions.
• But should it intervene?
• Rescue failing banks?
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Lecture 6
DETERMINANTS OF THE
MONEY SUPPLY, AND THE TOOLS
OF CENTRAL BANKS, Part One
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European System of Central Banks
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European System of Central Banks
• The European System of Central Banks
(ESCB) consists of the European Central
Bank (ECB) and the national central banks of
the EU Member States.
• The activities of the ESCB are carried out in
accordance with the Treaty establishing the
European Community (Treaty) and the Statute
of the European System of Central Banks and
of the European Central Bank (ESCB/ECB
Statute).
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Governance of the ECB
• The ESCB is governed by the decisionmaking bodies of the ECB.
– The Governing Council of the ECB is responsible
for the formulation of monetary policy,
– the Executive Board is empowered
to implement monetary policy.
• The ECB has recourse to the national central
banks to carry out her operations.
• The ESCB policy operations are executed on
uniform terms and conditions in all Member
States.
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ESCB: Basic tasks
• The basic tasks by the Eurosystem are:
– to define and implement the monetary policy of the
euro area;
– to conduct foreign exchange operations;
– to hold and manage the official foreign reserves of
the Member States; and
– to promote the smooth operation of payment
systems.
• In addition, the Eurosystem contributes to the
prudential supervision of credit institutions and
the stability of the financial system.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The US Federal Reserve System
• The formal structure of the Federal
Reserve System is characterized by
– a regional decentralization (there are 12
Federal Reserve Banks)
– each Federal Reserve Bank is quasi-public
(partly held by government, partly by
commercial banks in the district).
– all national banks chartered by the Office of
the Comptroller of the Currency have to be
members of the Federal Reserve System.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The Federal Reserve Bank of New York
• The Federal Reserve Bank of New York has
a special role (through its involvement in the
bond and foreign exchange markets and
through the presence of large commercial
banks).
• The FRBNY is the only US Reserve Bank to
be a member of the Bank for International
Settlements (BIS).
• Its president assumes a chief role in the
system.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Governance of the Federal Reserve System
• The Fed is headed by a seven-member Board
of Governors, with its influential Chairman
(Alan Greespan), headquartered in
Washington D.C.
• The Board of Governors is actively involved in
monetary policy making.
• All governors are (voting) members of the
Federal Open Market Committee (FOMC).
• In addition there are 12 (of whom 5 voting)
members from district banks in the FOMC.
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Should central banks be independent?
• A cornerstone of the monetary constitution of
the euro area is the independence of the ECB
and of the NCBs (Article 108).
• There are fears that a dependent ECB
– could succumb to financing large budget deficits of
the government.
– could be asked to monetize too much debt, which
would entails an inflationary bias.
• Central banking also requires expertise and
“should not be left to politicians”.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Should central banks be independent?
• Counterarguments:
– It is undemocratic to have monetary policy
controlled by a non-elected elite group.
– There is no accountability in central
banking, which is a precondition for, and
core element of, democratic legitimacy.
– There is need to coordinate monetary and
fiscal policies.
– The ECB could pursue a policy of selfinterest.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Principal-agent problem
• There is a typical principal-agent relation between the
Legislature and an independent institution bestowed
with a public function.
• In line with the requirements of Article 113 of the
Treaty, the President of the ECB presents the ECB’s
Annual Report to the European Parliament at its
plenary session.
• This is followed by the adoption of a European
Parliament resolution, which provides a
comprehensive ex post assessment of the ECB’s
activities and policy conduct.
• The Chairman of the Fed reports to the US Congress.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The objectives of the ESCB
• The primary objective of the ESCB,
as defined in Article 105 of the Treaty,
is to maintain price stability.
• Without prejudice to the primary objective,
the ESCB has to support the general
economic policies in the EU.
• In pursuing its objectives, the ESCB has to act
in accordance with the principle of an open
market economy with free competition,
favoring an efficient allocation of resources.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The mandates of central banks
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Reporting requirements of central banks
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ESCB monetary policy instruments
• In order to achieve its objectives,
the ESCB has at its disposal a set
of monetary policy instruments.
• The ESCB
– conducts open market operations,
– offers standing facilities and
– requires credit institutions to hold minimum
reserves on accounts with the ESCB.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Money supply process
• In order to understand the money supply
process, we have to come back to the
ECB’s balance sheet and the monetary
base (or high-powered money).
• The assets of the CB constitute the
sources of the base.
• The liabilities of the CB constitute the
uses of the base.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Schematic central bank balance
Assets
Liabilities
Gold and SDR
Bank notes
Forex
Bank lending
Securities
Bank reserves
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Bundesbank, Balance sheet 2001
31st of December, in bill. €
Gold
35.0
Foreign exchange*)
71.8
Bank lending
Main ref inancing
80.5
Long-term lending
41.1
Marginal ref inancing
1.4
Loans to gov ernment
4.4
Other assets
5.8
TOTAL
240.0
*) Including claims on the ECB.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Banknotes
Bank reserv es
ECB claims
Rev aluation
Reserv e f und
Other liabilities
Capital
Prof its
TOTAL
76.5
57.5
30.9
41.7
5.4
11.7
5.1
11.2
240.0
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The control of the monetary base
• The quantity-oriented approach to
monetary policy purports that the central
bank can control the monetary base.
• It is basically effected via open market
operations with commercial banks.
• The ECB can control OMOs more
effectively than foreign reserves, but
she can also use interventions in forex
markets to change the monetary base.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Controlling the money supply
• Under fixed exchange rates controlling the
money supply is more difficult.
• In this case the central bank has to “sterilize”
inflows or outflows of foreign exchange.
• It renders interest rates endogenous,
i.e. they vary in response to sterilizing
interventions.
• Forex interventions will be discussed later.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Forex inflows with sterilization
Assets
Gold
Forex
Liabilities
Base money remains fixed
Securities
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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OMOs
• Among the OMOs, the main refinancing operations
(MROs) are the most important, playing a pivotal role in
steering liquidity and signaling the stance of monetary
policy.
• Roughly 75% of liquidity is provided by MROs.
• MROs were conducted as fixed rate and variable rate
tenders with a minimum bid rate.
• The MROs are regular, liquidity providing, reverse
transactions, conducted as standard tenders, with a
weekly frequency and normally a maturity of two weeks.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Longer-term refinancing (LTROs)
• Longer-term refinancing operations (LTROs)
are carried out through monthly standard
tenders and have a maturity of three months.
• LTROs are regular open market operations
executed by the Eurosystem also in the form
of a reverse transaction.
• On average over the year, LTROs provide
about 25% of the total refinancing of banks.
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Reserve requirements of banks
• The Eurosystem requires banks to hold minimum
reserves equal to 2% of certain short-term liabilities.
It is part of base money.
• The purpose is the stabilization of short-term interest
rates and the enlargement of the structural liquidity
deficit of banks.
• Reserve requirements bear interest, and must only be
fulfilled on average over a one-month reserve
maintenance period.
• It has a significant smoothing effect on the behavior of
short-term interest rates.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Short-term liquidity policy
• The monetary base is also affected when a central
bank makes a discount loan to a bank. The ECB does
not use this instrument however.
• There are two standing facilities offered
by the Eurosystem
– the marginal lending facility and
– the deposit facility,
• These instruments provide and absorb overnight
liquidity, signal the stance of monetary policy and set
an upper and lower limit for the overnight market
interest rate.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The use of the standing facility
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Key ECB interest rates
• The key ECB interest rates are
at present
– the minimum bid rate on the main
refinancing operations,
– the interest rate on the marginal lending
facility
– and the interest rate on the deposit
facility.
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What assets are eligible for credit operations?
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ECB interest rates
EONIA (euro overnight index average):
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Interest rate policy in Europe and the US
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The notion: quantity of money
• In addition to the central bank, commercial
banks do also supply credit money.
• We assume that there is a fixed relationship
between central bank money (base money)
and credit money.
• Then the quantity of money M equals
M = m  B = multiplier  base money.
• We assume the ECB controls B,
then she also controls M.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Money creation through bank credit
• Credit money is created (destroyed) if
the sum of demand deposits of nonbanks at commercial banks increases
(declines)
• In the case of a credit to a customer by
a bank, the bank creates „book money“.
• As this credit is redeemed, money is
destroyed.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Money creation by a commercial bank
Example: A commercial bank receives a cash
deposit of € 1 Mill. and uses it for a loan
to a firm of € 1 Mill..
A
Bank
Loan + € 1 mill.
Loan + € 1 mill.
A
Outlays + € 1 mill.
Outlays etc.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Firm
Cash deposit + € 1 mill.
Demand deposit + €1 mill.
Demand deposit etc.
L
L
Liability + € 1 mill.
Liability + € 1 mill.
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Money creation by banks: is it limited?
Yes, money creation by banks is not infinite!
• Central banks require commercial banks to
maintain minimum reserves to be held on
accounts of the central bank.
• These reserve requirements are calculated
as a percentage of demand, savings and time
deposits.
• Demand deposits represent a claim on central
bank money, which commercial banks cannot
create themselves.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Multiple money creation: An example
• Mr. K. puts € 10,000 into his acount at
A-Bank.
• The central bank requires minimum reserves
of 20% of the deposit (=1/5).
• There remains an excess reserve of € 8,000.
• A-Bank grants a loan to Mr. L. for the
purchase of a car. The amount of the loan
can only be € 8,000.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Example, continued
• Mr. L. transfers this amount to an account
of the car dealer at B-Bank.
• At B-Bank it creates excess reserves of
€8,000 minus €1,600 minimum reserves
required (= € 6,400).
• These excess reserves can be used for a
loan, etc.....
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Example, continued
• It is best to imagine this process in
terms of “rounds” of credit creation:
Round
Deposit Minimum reserve Excess reserve=
credit creation
1
10000
(primary impulse)
2000
8000
2
8000
1600
6400
3
6400
1280
5120
4
5120
1024
4096
etc.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The money creation multiplier
• The money creation multiplier is obtained
as a result of an infinite geometric series.
• In the example:
10,000 + 8,000 + 6,400+..... = 50,000
• From an initial excess reserves
of € 10,000 an an additional credit
volume of 40000 € can be derived.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The credit multiplier
By subtracting
R2 from R1
it is obtained:
[1 - (1-) ]  Cr =
[{1-}1 - {1-}+1] ER
  Cr = {1-} ER
=
 Cr=ER ({1-} /  )
or in this case: ({1-.2} / .2 ) = 4
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Critique of the simple model
• Supply of credit must meet a demand!
• Banks do not extend their lending to the
maximum because of insolvency risks.
• Lending is limited by capital adequacy
ratios (Basel I and II).
• But there are refinancing possibilities
– through the ESCB, and
– through the interbank market.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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An example: The Eurodollar market
• The Eurodollar market (better: xeno
market) is an off-shore market for the
US dollar (more generally: any hard
currency).
• It is characterized by the absence of
mandatory reserve requirements for
commercial banks.
• The experience has shown that this
market had avoided “credit explosion”.
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