Transcript 4. Financial crises

Financial crises
Dr Katarzyna Sum
International monetary system
Financial crisis- definition
 Powerful shocks within the financial
system which trigger a decrease or a
deepening of the already ongoing
production decrease
Stock market crunches (1)
 Stock market crunches are relatively rare
but their occurrence affects seriously the
economy
 The source of a stock market crunch is
usually a speculative bubble
 The optimism of investors drives the
emergence of a speculative bubble
Stock market crunches (2)
 Speculative bubbles emerge on the base of
rational expectations
Initially investors expect that the positive trend
concerning e.g. a productivity increase will go on
 This happened for example during Dot Com
crisis
Stock market crunches (3)
 Behavioural finance can explain stock market crunches
 Small investors just follow the trend without qny rational
economic analysis
 Large investors can predict the burst of a speculative
bubble but they are usually unwilling ton withdraw their
funds due to competitory pressures
Stock market crunches (4)
 Once the speculative bubble burst it affects majorly
investor who purchased stock by borrowing money from
banks
 This was e.g. the source of the Japanese stock market
crisis in the 90-ties
 The Dot Com crisis was much softer since investors
financed their purchases via own capital
Banking crises (1)
 Banks play a prominent role in financing
economic activity
The willingness of banks to grant loan
depends largely on the economic cycle
and the net value of enterprises
 In times of economic recession banks
lack of objective information concerning
the situation of the enterprises
Banking crises (2)
 Banks know that enterprises in times of recessions need the funds
to maintain liquidity instead of financing production
 This situation creates moral hazard- enterprises will require loans
even if they can not pay them back
 Since banks know that they are forced to negative selection of
companies requiring loans
 Banks raise the risk premium and hence the interest on granted
loans
 As an effect liable companies limit their loan requirements, only
companies who want to support their liquidity require loans
Banking crises (3)
 Due to lending money to unreliable companies banks
have to face toxic debt
 This can seriously affect the solvency of the banks
 The risk of the occurrence of financial crisis is the
greater the larger the preceding credit expansion is
 Banking crises can also occur due to a disadvantageous
change of the economic situation e.g the Norwegian
banking crisis in the 80-ties was due to of an oil price
decrease
Currency crises (1)
 Currency crises occur if the financial
markets participants start to mistrust a
specific currency and subsequently
withdraw their funds and the central banks
are not able to counteract this tendency
Currency crises (2)
Currency crises can bbe grouped into
three generations
First generation- Krugman
Second generation- Obstfeld
 Third generation- eclectic model
The first generation of currency
crises (1)
 The Krugman model
 Internal reasons for the outbreak of the
crisis
The reason of the currency crisis is
inadequate economic policy especially
concerning the fiscal situation
The first generation of currency crises
crises (2)
Lax fiscal policy the budget deficit is financed
by the central bank  inflation the internal
unequilibrium can not be reconciled with the
fixed exchange rate
 Fiscla expansion increasing internal demand
for imports +inflation balance of payment
deficit devaulation pressure decrease of
reserves speculative attack currency crisis
The first generation of currency
crises crises (3)
 Currency crises in the 80-ties
 Latin American countries (Argentina,
Chile)
 This were usually emerging economies
who had to cope with high inflation, fiscal
deficit and fixed exchange rates
The first generation of currency
crises crises (4)
 Low level of foreign currency reserves
Capital flow liberalisation+ lack of banking
regulation  lack of control over excess
money supply
 Additional contsraint- high level of foreign
loans to latin Amertican Countries
insolvency
The second generation of currency
crises (1)
 The Obstfeld model
 The main reason for the crisis are
speculative attacks
 Especially fixed or intermediate exchange
rate regimes are prone to this type of
currency crises
The second generation of currency
crises (2)
 The crisis occurs in economies with good
economic policy
Countries with high levels of foreign
reserves
 External reasons for the crisis
The second generation of currency
crises (3)
 Second generation crises occurred in the 90-ties
 E.g. the ERM crisis
 Restructuring of the German economy  inflationary
pressure in Germany strict monetray policy
incraesed interest rates  overvaluation of the DM
 Other economies within the ERM system raised the
intsrest rates as well to maintain the exchange rate parity
The second generation of currency
crises (4)
 Speculative attack on the GBP- the only economy that
did not increase the interest rate devaluation of GBP
 This triggered speculative attacks on all the currencies
within the ERM which were related to the DM
 As a consequence all countries who participated in the
ERM were forced the devalue their currencies
The third generation of currency
crises (1)
 An eclectic model describes the third generation crises
 The theory was a reaction to the currency crises which
occurred in emerging economies at the end of the 90ties
 A characteristic feature was the fact that the economies
hit by the crisis had fixed exchange rates
 The crisis hit well performing, promising economies
(Malaysia, Indonesia, South Korea)
The third generation of currency
crises (2)
 Microeconomic reasons for the crisis- risky investments
undertaken by banks and companies
 Macroeconomic reasons- insufficient competiveness of the
economy, lack of financial supervision
 Underdeveloped financial markets external funding of
investments
 Foreign investors expected large productivity increases and when
their expectations were not met they withdrew their funds
The elements of third generation
crises
 Moral hazard
 Too big to fail
 The investments financed by banks loans were concentrated
 Twin crises
 Banking crises and currency crises simultaneously
 This can occur if the banking sector has a large foreign debt
 Especially a currency mismatch can exacerbate an excessive
foreign debt
The elements of third generation
crises
 Herding effects can cause the outflow of
foreign capital
The domino effect can cause international
contagion
Examples of third generation crises
 Emerging economies in south Asia faced
currency crises at the end of the nineties
 Their banking sectors had large foreign debt
 These counties had costly production and
underdeveloped financial markets
 Additionally the appreciation of USD caused
the outflow of capital and subsequently the
collapse of domestic exchange rates
References


A. Sławiński, Rynki finansowe, PWE, Warszawa 2006
P. Krugman, M.Obstfeld, International economics: theory and policy, Pearson,
Addison Wesley, Boston 2009,

J. A. Frankel, G. Saravelos, Are Leading Indicators of Financial Crises Useful for
Assessing Country Vulnerability? Evidence
from the 2008-09 Global Crisis, NBER Working Paper No. 16047, Cambridge 2010,

J. Aizenman, Financial Crisis and the Paradox of Under- and Over-Regulation,
NBER Working Paper No. 15018, Cambridge 2009,

J. B. Taylor, The Financial Crisis and the Policy Responses: An Empirical Analysis
of What Went Wrong, NBER Working Paper No. 14631, Cambridge 2009,

C. M. Reinhart, K. S. Rogoff, From Financial Crash to Debt Crisis, NBER Working
Paper No. 15795, Cambridge 2010

A. Szyszka, Behawioralne aspekty kryzysu finansowego, Bank i Kredyt 40 (4),
Warszawa 2009