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Econ 492_ Comparative Financial Crises


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									            Econ 492:
     Comparative Financial Crises
                               Lecture 2
                          21 September 2011
                           David Longworth
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                                      Policy Statement.
      Financial Crises in the News:
     European Sovereign Debt Crisis
• Possible default by Greece
  – Solvency or liquidity problem?
  – What should EU and IMF do?
  – Interconnection with potential banking crisis
     • Holding of Greek debt by EU banks (could affect solvency)
     • Difficulty in EU banks raising interbank deposits or CDs,
       especially in U.S. dollars (liquidity problem)
        – Money market funds have stepped back from CP market (“run”)
        – Fed and other central banks cooperating to provide liquidity in U.S.
          dollars to European banks (policy: lender of last resort)

                            Economics 492 Lecture 2                              2
      New Reference on Crises:
 IMF Global Financial Stability Report
• September 2011, Chapter 3, Macroprudential policies
   – Prediction: “Credit growth and asset price growth together
     form powerful signals of systemic risk buildup as early as
     two to four years in advance of crises”
   – Prediction of imminent crises: “Using a combination of the
     LIBOR-OIS spread and the yield curve could signal an
     imminent crisis”
   – Prevention: “Macroprudential policy tools can be used
     across countries with different economic characteristics as
     long as policymakers understand the source of
     shocks….Managed exchange rate regimes that feature
     widespread lending denominated in foreign currencies”
     require more conservative use of tools

                         Economics 492 Lecture 2               3
      New Reference on Crises:
 IMF Global Financial Stability Report
• September 2011, Chapter 3, Macroprudential
  – Prevention: Empirical work on effectiveness of
    macroprudential instruments in reducing
    procyclicality of credit and leverage
  – Macroeconomic Model with financial and real
    sector linkages: allows one to look at effects of
    shocks (e.g., on credit growth) and to examine
    effectiveness of macroprudential tools (e.g.,
    countercyclical capital ratios)

                      Economics 492 Lecture 2           4
I. Transmission
II. Policy Response During the Crisis
III. Prevention

Note: AG indicates Franklin Allen and Douglas Gale
(2009), Understanding Financial Crises. KA indicates
Charles P. Kindleberger and Robert Aliber (2005),
Manias, Panics, and Crashes. RR indicates Carmen
Reinhart and Kenneth Rogoff (2009), This Time is

                     Economics 492 Lecture 2       5
             l. Transmission
• Outline of Course


             Causes                                     Transmission


                             Economics 492 Lecture 2                   6
                 I. Transmission
• Illiquidity (“and all its friends”)
   – Bank runs
   – Margin and liquidity spirals
   – Fire Sales (Cash-in-the-market pricing)
• Interconnectedness and contagion
• Decline in wealth of private sector: effects on
  output and employment
• Zero bound on nominal interest rates takes away
  conventional monetary policy channel
• Effect on sovereign debt crises and vice versa

                        Economics 492 Lecture 2     7
                   I. Transmission
• Illiquidity (“and all its friends”)
   – Recall that there is both “funding liquidity” and
     “market liquidity”
   – “all its friends” include (according to Tirole):
      •   Market freezes
      •   Fire sales
      •   Contagion
      •   Ultimately, insolvencies and bailouts
      •   I would include “bank runs” (as one cause) and market
          liquidity spirals

                          Economics 492 Lecture 2                 8
               I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
  – Banks have liquid liabilities, illiquid assets
  – So banks are susceptible to unexpected liquidity
    demands (bank runs)
  – Model this by having a liquid asset (short asset) that
    doesn’t pay interest, and an illiquid asset that does
  – Banks (intermediation) solve mismatch between time
    preference and asset maturity
  – Typically, markets are incomplete and so can’t
    provide an efficient solution to this mismatch problem
                      Economics 492 Lecture 2            9
                I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
  – In a two-period model with no aggregate uncertainty
    about liquidity withdrawals, there is an equilibrium in
    which the bank provides withdrawals (consumption)
    c(1) to its depositors at time 1 and c(2) to its
    depositors at time 2, invests x in the long asset and y
    in the short asset
  – In the same model, if the bank can sell the long asset
    early (period 1), taking a discount, a bank run will also
    be an equilibrium. This is because, if all depositors,
    whether they would normally withdraw to consume
    at time 1 or time 2, decide to withdraw at time 1, the
    bank cannot possibly pay them all off.

                       Economics 492 Lecture 2              10
               I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
  – Critics of this type of model have argued that
    suspension of convertibility of deposits into cash
    could stave off bank runs
  – But Diamond and Dybvig have shown that a
    sequential payout by bank tellers would mean
    that they would not find out until too late that a
    run was in progress.

                     Economics 492 Lecture 2             11
                I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
  – Equilibrium bank runs:
     • Impossible to predict
     • Coordination among individuals facilitated by
       “sunspots” (extraneous variables, not “fundamental”)
     • If “the probability of a bank run is sufficiently small,
       there will exist an equilibrium in which the bank is
       willing to risk a run because the cost of avoiding the
       run outweighs the benefit.” (AG, p.82)

                        Economics 492 Lecture 2                   12
                  I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
  – Are bank runs associated with the business cycle (and
    not “sunspots”)? Potential paper. Also, how correlated
    is the leverage cycle (C/Y) with the business cycle (Y)?
     • Some support for a yes answer: Gorton’s 1988 study of U.S.
     • Indeed, if bank runs are part of transmission of crises, and
       crises are typically associated with the credit cycle, which is
       highly correlated with the business cycle, this would not be
       a surprise
     • Many suspect that liquidity problems are associated with
       fears of credit problems (some evidence of this in the last
       crisis) and perhaps actual credit problems

                          Economics 492 Lecture 2                        13
                I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
  – Runs in the last crisis weren’t just from banks (like
    Northern Rock in the U.K.)
     • But from “shadow banking system” as well
        – Canadian asset-backed commercial paper, money market
          mutual funds, U.S. commercial paper, structured investment
          vehicles (SIVs), etc.
  – Currently w.r.t. European banks, money market
    funds are running from bank commercial paper
    and holders of interbank deposits and certificates
    of deposit are running too

                         Economics 492 Lecture 2                       14
                 I. Transmission
• Margin and Liquidity Spirals
  – Financial institutions (and large investors) engage
    in securities financing transactions
     • Repos (sales and repurchase agreements)
        – A “haircut” determines the fraction of the market value that
          can be borrowed
     • Securities borrowing
        – A “haircut” again determines what collateral must be posted
     • As well, they engage in derivatives transactions
        – Except for large highly-rated banks and securities dealers,
          “initial margin” must be posted

                          Economics 492 Lecture 2                        15
                 I. Transmission
• Margin and Liquidity Spirals
  – When market liquidity becomes lower, it is typically
    associated with higher market volatility
  – But higher market volatility means that collateral
    coverage for a given “haircut” or “initial margin” is
    less: haircuts and margins tend to rise in the market
  – One tends to get the type of liquidity and margin
    spiral shown in the following diagram
     • Spiral can work in the opposite direction in boom periods

                         Economics 492 Lecture 2                   16
                                                                              Liquidity Spiral
                        Liquidity/Margin Spiral
                                                less market making

                                                                            lower market
                    funding problems                                          liquidity

                                                  higher margins

                                             losses on existing positions

Adapted from Brunnermeier & Pederson (2009) and
presentations by Mark Carney and David Longworth
                                               Economics 492 Lecture 2                     17
                 I. Transmission
• Fire Sales (Cash-in-the-market pricing)(AG 4,5)
  – First, assume a model with markets only, no banks
  – Limited market participation: not everyone
    participates in every market (fixed set-up cost)
  – Market liquidity depends on amount of cash held by
    market participants
  – If there is a lack of cash in the market, small shocks
    have large effects on prices
     • Then prices are not determined by expected present values,
       but by ratio of available liquidity to amount of asset supplied

                          Economics 492 Lecture 2                   18
               I. Transmission
• Fire Sales (Cash-in-the-market pricing)(AG 4,5)
  – Amount of cash in market depends on
    participants’ liquidity preference, which will
    determine the average level of the short-term
    asset held
  – Changes in liquidity demand relative to liquidity
    supply determines price volatility

                     Economics 492 Lecture 2            19
                I. Transmission
• Fire Sales (Cash-in-the-market pricing)(AG 4,5)
  – Now add banks to the model
     • Small events (e.g., small liquidity shocks) can have a
       large impact on the financial system because of how
       banks and markets interact: can lead to systemic crises
     • If banks have to provide liquidity to customers, they
       may have to sell much-less-liquid assets (if they are
       running out of liquid ones)

                        Economics 492 Lecture 2              20
                 I. Transmission
• Fire Sales (Cash-in-the-market pricing)(AG 4,5)
  – With banks added to the model:
     • Prices in those markets may be determined by cash in
       the market
     • The resulting “fire sale prices” may be quite low
     • Banks have to mark assets held in their trading book to
       market. At the end of the quarter, these losses will
       show up in the calculation of profits/losses and thus
       affect the bank’s capital
        – The market anticipates this effects even before quarterly
          statements are released.

                          Economics 492 Lecture 2                     21
                 I. Transmission
• Interconnectedness and contagion(KA8,
  – Interconnectedness: banks hold many liabilities of
    other banks (short-term deposits—including those
    for settling payments, shares, repos, derivative
     • Therefore the failure or weakness of one bank could
       translate into the failure or weakness of other banks
     • As well, the failure of one bank may lead to loss-sharing
       arrangements being invoked in payments systems and
       central counterparties (for repos or OTC derivatives)
        – By their current design, such losses should be limited
                          Economics 492 Lecture 2                  22
                      I. Transmission
• Interconnectedness and contagion(KA8, AG10)
   – Contagion (usually used only for across regions or across
     countries) can arise from a number of factors:
       • Interconnectedness as described above
       • Concern about common exposures, with fire sales potentially driving
         down prices
       • Contagion of bubbles: “when money flows from one country to
         another and adjustments automatically occur both in the countries
         that receive these funds and in the countries that are the sources of
         them.” (KA, p.143)
           – Example from KA, pp. 142-3(: From real estate and stock market bubble in
             Japan (late 1980s) to real estate and stock market bubbles in Nordic
             countries (late 1980s) and to markets in south-east Asia (mid 1990s) and to
             tech stocks in the U.S. (late 1990s)Potential topics: (1)What is the analogue in
             the most recent crisis and how did it compare with previous crises? (2) How
             were various emerging market economies affected in the current crisis when
             international banks cut back in foreign lending, particularly in trade finance
             (why, and what were the effects?)

                                  Economics 492 Lecture 2                                  23
              I. Transmission
• Interconnectedness and contagion(KA8,
  – Potential topic: why was there more contagion
    from the U.S. to continental Europe and the U.K.
    than to other regions? Why was there financial
    contagion at all to countries such as Japan and

                     Economics 492 Lecture 2           24
                I. Transmission
• Interconnectedness and contagion(KA8,
  – AG have a model of U.S. regional contagion
     • “even though the initial shock occurs only in one region,
       which can be an arbitrarily small part of the economy,
       it can nevertheless cause banks in all regions to go
     • Results depend on the nature of the network of
       interbank deposits across institutions
  – AG cite a number of references to studies of the
    actual nature of interbank relationships in
    certain countries.
                        Economics 492 Lecture 2               25
                I. Transmission
• Decline in wealth in private sector: effects on
  income and employment
   – Lower wealth arises from fire sales, bursting of
     bubbles, lower valuation of financial sector firms
   – Wealth effects on consumption (standard
     consumption function)
   – Through financial accelerator, lower collateral means
     can borrow less, so lower consumption and housing
     expenditure (and investment by businesses)
   – Through bank capital channel, less lending by banks,
     which means less consumption, housing, and
     investment expenditure

                       Economics 492 Lecture 2               26
                I. Transmission
• Decline in wealth in private sector: effects on
  income and employment
   – Spreads increase between interest rates on
     loans/market debt and government yields (even
     separately from bank capital channel), lowering
     housing and investment spending
   – In New Keynesian models, lower aggregate demand
     leads to lower employment
   – Spillovers across borders from lower import demand
     in countries suffering declines in wealth and income

                       Economics 492 Lecture 2              27
                I. Transmission
• Zero bound on nominal interest rates takes away
  conventional monetary policy channel
  – Normally, the response of monetary policy authorities
    to the decline in wealth, income, and employment
    would be to lower the policy interest rate because of
    the downward pressure on inflation
  – When the policy interest rate gets to zero (or near
    zero), that option is no longer available
  – Central bank must turn to unconventional policy
    instruments (discussed in the next section)
  – ZLB in history: BoJ; recent crisis: Fed, BoE, BoJ, BoC,
    ECB, Riksbank

                       Economics 492 Lecture 2            28
               I. Transmission
• Effect on sovereign debt crises and vice versa
  – Government bailouts or payouts to insured
    depositors increase sovereign debt
  – Fall in GDP leads to decline in government
    revenue and increase in sovereign debt
  – If sovereign debt was high before banking crisis, a
    sovereign debt crisis may occur
  – Banks hold lots of sovereign debt, so a sovereign
    debt crisis can lead to a banking crisis

                     Economics 492 Lecture 2          29
              I. Transmission
• Potential topic: relationship between banking
  crises and sovereign debt crises over history.
  What is the direction of transmission/
  causation (leads, lags, simultaneity)? Has the
  direction changed?
  – See RR. See also RR (2011, AER). Also Piergiorgio
    Alessandri & Andrew G. Haldane (2009), “Banking
    on the State,” Bank of England, November.

                     Economics 492 Lecture 2        30
II. Policy Response During the Crisis


          Causes                                     Transmission


                          Economics 492 Lecture 2                   31
    II. Policy Response During a Crisis
•   Guarantees and closures
•   Domestic lender of last resort: liquidity policy
•   Monetary Policy
•   International lender of last resort: IMF, EU, etc.
•   Other policies (not the focus of this seminar:
    fiscal policy, structural policy, debt
    management policy)

                      Economics 492 Lecture 2       32
 II. Policy Response During a Crisis
• Guarantees and closures
   –   Deposit insurance introduced or limits increased
   –   Bank bond debt guaranteed (e.g., Ireland)
   –   Bank holiday (cannot withdraw funds)
   –   Markets closed (especially stock markets)
   –   Short-selling of bank stocks banned temporarily
   –   Resolution of bank (range of possibilities)
        • Government injects capital or nationalizes (with or without paying)
        • Bank taken over by deposit insurance fund to be wound down
          (only insured depositors paid off in first instance, then other
   – Issues: effectiveness, moral hazard, benefit/cost (including
     exposure of the tax payer)

                              Economics 492 Lecture 2                      33
 II. Policy Response During a Crisis
• Domestic lender of last resort: liquidity policy
   – Central bank policy existing before recent crisis
      • “Discount window” lending against good collateral (bonds, paper)
        with haircut (reduction from market value) and small penalty rate
      • Repo (purchase and resale agreement) of good bonds and paper
        with haircut
      • These provided additional liquidity for banks needing it
   – Broad (ECB) vs. narrow (BoC, Fed) in normal times
      • Potential topic: Does a broad list of collateral in normal times lead
        to moral hazard and to major problems in crisis times?
   – Expansion in recent crisis was initially in frequency of repo
     operations, size of operations, length of period, and range
     of eligible collateral

                             Economics 492 Lecture 2                        34
 II. Policy Response During a Crisis
• Domestic lender of last resort: liquidity policy
   – Because of “stigma” attached to discount window in
     U.S., a Term Auction Facility was introduced that had
     a wider range of collateral than repo operations. In
     Canada, the non-mortgage loan portfolio of banks
     was eligible for a TAF-like facility
      • BoE has changed auctions of liquidity so that they always
        happen—this is to avoid stigma in a crisis
   – Central banks also introduced liquidity facilities to
     deal with problems in specific financial markets (as
     opposed to financial institutions). The Fed did this in
     particular for the commercial paper market.

                          Economics 492 Lecture 2                   35
 II. Policy Response During a Crisis
• Domestic lender of last resort: liquidity policy
  – Making foreign currency liquidity available:
    central bank FX swap lines
  – Potential topic: Why did the range of special
    liquidity facilities vary across countries? Why were
    special liquidity facilities not needed in previous

                      Economics 492 Lecture 2          36
 II. Policy Response During a Crisis
• Monetary Policy
   – Conventional monetary policy, reducing policy interest rate
     (incentive to get to ZLB quickly in some instances)
   – Unconventional monetary policy
      • Conditional or unconditional commitment regarding future policy
        interest rate
      • Expansion of excess bank reserves (settlement balances) purchasing
        government debt or repos (“QE”)
          – If particular maturities of government debt is purchased, it is also a form of
            debt-management policy
          – If private sector debt is purchased, it is also a form of fiscal policy (credit
          – In these two cases, there is a question of governance/coordination
      • Potential topic: What was the effectiveness of unconventional
        monetary policy across countries in the recent crisis (e.g., QE2 vs. QE1
        in the U.S.)?

                                 Economics 492 Lecture 2                                      37
 II. Policy Response During a Crisis
• International Lender of Last Resort
  – IMF, or EU, or bilateral sovereign loans
  – Typically in an exchange crisis (fixed exchange rates)
  – But also could be in cases where there is extreme
    pressure on exchange rates; or significant associated
    fiscal problems
  – The history of IMF loans in the last 30 years has been
    about the appropriate “conditionality” of loans
  – Current episode: EU and IMF loans: Greece, Ireland,
    Portugal and …. (will there be more?)
                       Economics 492 Lecture 2               38
  III. Prevention


Causes                                     Transmission


                Economics 492 Lecture 2                   39
              III. Prevention
• Macroprudential policy
• Contingent capital and bail-in debt
• Monetary policy

                   Economics 492 Lecture 2   40
                  III. Prevention
• Macroprudential policy
  – Focuses on the safety and soundness of the financial
    system as a whole, as opposed to the safety and
    soundness of individual financial institutions
  – Macroprudential tools: deal with market failures
    associated with procyclicality of aspects of the
    financial system, as well as the interconnections and
    similar exposures across financial institutions (cross-
    sectional aspect) (recall market failures from last
     • Possible topic: How do financial cycles compare with “real
       cycles and inflation cycles” across countries? How should one
       measure a “financial cycle”? Implications?

                         Economics 492 Lecture 2                  41
F   Objective: avoiding significant financial
r                  instability
a    Goals: dampening procyclicality and
m   reducing potential effects of contagion
e    Policy Instruments: Macroprudential
w instruments, advice on policies, warnings
r  Activities: Data Collection, Surveillance,
k  Analysis, Risk Assessment, Stress Testing

                  III. Prevention
Proximate Object Excessive     Insufficient    Continuation
of Concern:      Credit        Liquidity       of a Bank
Capital          √ (total or   √ (maturity    √ (Contingent
Requirements     sectoral)     mismatch)      capital)
Pigovian Taxes   √             √ (on non-core √
Constraints on    √ (Cred; RR √ (BCBS
quantities, or    on assets) Liquidity)
on credit         √ (Haircuts, √ (Haircuts,
conditions        LTV)         LTV)                         43
                      III. Prevention
• Macroprudential policy
   – Capital requirements, leverage requirements, and liquidity
     requirements are being dealt with in Basel III
      • Higher capital requirements, capital buffer built up, countercyclical
        requirements (typically linked to credit) (Note that effects overall
        depends on extent to which Modigliani-Miller theorem violated.)
      • Study of how systemically important institutions should have
        higher capital requirements
      • Two types of liquidity requirements
          – Liquidity coverage ratio
               » “Sufficiently high quality liquid assets to survive a significant stress
                 scenario lasting one month” (BCBS)
          – Net stable funding ratio
               » “Incentive for banks to fund their activities with more stable
                 sources of funding” (BCBS)

                                Economics 492 Lecture 2                                     44
                III. Prevention
• Macroprudential policy
  – A Study Group that I chaired for the Committee
    on the Global Financial System proposed
    regulating margin requirements on derivatives
    and haircuts on repo transactions on a “through
    the cycle basis” to reduce the procyclicality of the
    margin cycle

                      Economics 492 Lecture 2          45
                  III. Prevention
• Macroprudential policy
  – Several Asian countries regulate loan-to-value ratios
    for mortgages (particularly on residential properties)
    in an active manner to reduce the cycle in property
     • There are several aspects of requirements for mortgage
       insurance that could be examined for more active regulation
       in Canada (LTV ratios, debt-service-to-income ratio, home
       equity loan ratio, amortization period); constant level or
       varying countercyclically. Potential topic: How should
       macroprudential policy connected to mortgages and housing
       prices be carried out, i.e., what should be the proximate goal
       and the tools? How would this have worked in previous
       housing bubbles?

                         Economics 492 Lecture 2                   46
                 III. Prevention
• Macroprudential policy
  – Some consider “through the cycle provisioning” for
    loan losses (as was used in Spain) to be a
    macroprudential policy instrument
  – There are other possible macroprudential policy
    instruments, such as reserve requirements on
    assets and levies (taxes) on non-core deposits
     • There is some evidence that in modern financial systems
       rapid credit growth has as its counterpart the growth in
       non-core deposit liabilities (wholesale deposits,
       commercial paper, repos, etc.)

                        Economics 492 Lecture 2              47
                III. Prevention
• Macroprudential policy
  – Potential topics: Would macroprudential policy “x”
    have prevented the recent and other financial
    crises? When household debt is high relative to
    personal disposable income (e.g., Canada, New
    Zealand, Sweden), should the authorities respond
    in order to prevent future crises and, if so, how?

                     Economics 492 Lecture 2         48
                III. Prevention
• Contingent capital and bail-in debt
  – To deal with moral hazard of “too big or complex
    to fail” as well as the practical issue of having time
    to wind down a large institution or to change its
  – “Contingent capital is a subordinated security,
    such as a preferred share or subordinated
    debenture, that converts to common equity under
    certain conditions.” (BoC FSR, Dec 2010, p.52)

                      Economics 492 Lecture 2           49
                III. Prevention
• Contingent capital (CC) and bail-in debt
  – Gone-concern CC converts when supervisor judges
    that bank is no longer viable
  – Going-concern CC converts well before, for modest
    erosions of capital
  – Bail-in debt applies to senior debt as well
  – Conceptually, “the sum of common equity plus
    contingent capital and bail-in senior debt could be
    subject to an overall minimum requirement, chosen
    to provide for the restoration of prudential capital
    requirements” (BoC FSR, Dec 2010, p.54)

                      Economics 492 Lecture 2              50
                  III. Prevention
• Monetary policy
  – Giving monetary policy a full-fledged financial stability
    objective in addition to, but secondary to, its price
    stability objective
     • Inflation targeters would implement this by sometimes
       returning inflation to target over a longer time period
  – Potential topic: What should the role of monetary
    policy (or the relative roles of monetary policy and
    macroprudential policy) be in maintaining financial
    stability? Could monetary policy have prevented the
    recent crisis in some countries? At what cost?

                         Economics 492 Lecture 2                 51
                 III. Prevention
• Monetary policy
  – Or, having monetary policy play a supporting role
    where not in conflict with its price stability
     • Choice of target inflation rate (e.g., inclusion of house
     • Price level target versus inflation target (Carney, 2009)
     • Making very prominent the uncertainty about the
       future interest rate path (note related criticism of Fed
       in past decade)

                        Economics 492 Lecture 2                52
                 This Week
• Prepare one-paragraph topic description for
  next class (paper copy necessary)
  – What is hypothesis or question to be answered?
  – Which crises or countries are being compared?
• Reference list on course web site should be
  helpful; also Lectures 1 and 2
• I have office hours this afternoon and
  tomorrow morning; or can e-mail me

                    Economics 492 Lecture 2          53

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