Financial Crises

1
Financial Crises
2
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 transactionPotential bad
  credit risks are those who seek loans most
  actively.
• Moral hazard. This occurs after the trans-action
  Borrowers may take on big risks.

3
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 Poors, Moodys, 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.

4
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.

5
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.

6
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.

7
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.

8
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.

9
Typical financial crises
Increase inuncertainty
Stock marketdecline
Increase ininterest rates
Deterioration of a banks balance sheet
Adverse selection andmoral hazard problems worsen
Economic activity declines
Bank panic
Adverse selection andmoral hazard problems worsen
Economic activity declines
10
How do financial bubbles affect activity?

• The NY stock market crashed on Friday, October
  1929, initiating a persistent and long downturn
  of the economy

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Development of Stock Market Index
12
Repercussions on the real economy
13
Impact on peoples lives

• Top CEOs had a especially hard time !

14
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

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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)

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The Great Depression US imports
November
Monthly data. Imports from 75 Countries (in bill.
Gold )
January
February
December
March
November
April
October
May
September
June
August
July
17
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?

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Lecture 6

• DETERMINANTS OF THE MONEY SUPPLY, AND THE TOOLS
  OF CENTRAL BANKS, Part One

19
European System of Central Banks
20
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 decision-making
  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.

22
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.

23
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.

24
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.

25
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.

26
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.

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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 self-interest.

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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
  ECBs 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 ECBs
  activities and policy conduct.
• The Chairman of the Fed reports to the US
  Congress.

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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.

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The mandates of central banks
31
Reporting requirements of central banks
32
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.

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Money supply process

• In order to understand the money supply process,
  we have to come back to the ECBs 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.

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Schematic central bank balance
Assets
Liabilities
Gold and SDR
Bank notes
Bank lending
Bank reserves
Securities
35
Bundesbank, Balance sheet 2001
31st of December, in bill.
36
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.

37
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.

38
Forex inflows with sterilization
Assets
Liabilities
Base money remains fixed
Securities
39
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.

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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.

41
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.

42
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.

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The use of the standing facility
44
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?
46
ECB interest rates
EONIA (euro overnight index average)
47
Interest rate policy in Europe and the US
48
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
  relationshipbetween 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.

49
Money creation through bank credit

• Credit money is created (destroyed) if the sum of
  demand deposits of non-banks 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.

50
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..

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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.

52
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.

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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.....

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Example, continued

• It is best to imagine this process in terms of
  rounds of credit creation

55
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.

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The credit multiplier

• By subtracting R2 from R1 it is obtained1 -
  (1-?) ? Cr 1-?1 - 1-??1 ER
• ? ? Cr 1-? ER ? CrER (1-? / ? )
• or in this case (1-.2 / .2 ) 4

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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.

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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.