Money and Banking

Money,Banking
and Financial
Markets

ASMAWI HASHIM

Be An Economist In Our Own Way

TOPIC 7

topic 7 FINANCIAL
CRISIS IN
ECO
NOMICS

What is financial crisis?

How Asymmetric Information
Explains Banking Regulation

Political Economy of
the Banking Crisis

Dynamics of Financial Crisis In
Advance Economies

Dynamics of Financial Crises in
Emerging Market Economies

SYNOPSIS:

Analysis of the role of money and monetary policy in
the macro economy. The course provides students with
a solid grasp of the fundamental topic traditionally
covered in courses on money, banking, and financial
markets. Besides, the course also seeks to provide clear
and up to date coverage of such fundamental topics as
the nature and role of money, financial institutions and
markets, banking structure and regulations,
determinants of interest rates, money supply and
demand analysis, the tools and intermediate targets of
central bank policy, the determinants of exchange
rates, international monetary system and economic
crises.

CLO:

1.Evaluate the implementation of monetary policy
based on well-learned financial theory. (C3, PLO1)
2. Integrate the theories, concepts and issues related

to the functions of money, markets and financial
institutions. (A1, PLO10)

3. Demonstrate understanding through suggestions
on solving financial-economic issues effectively.
(A4, PLO9)

FINANCIAL
CRISIS
IN

ECONOMICS

WHAT IS FINANCIAL CRISIS?

Definition of a financial crisis.

A financial crisis is described as a circumstance in which
financial assets lose a significant amount of their value or
the value of assets falls precipitously. During this
circumstance, customers are unable to pay their debts. A
financial crisis can encompass a wide range of
circumstances.

In the other hand, a financial crisis is any of a number of
scenarios in which some financial assets lose a significant
portion of their nominal value all of a sudden. Many
financial crises were linked to banking panics in the 19th
and early 20th centuries, and many recessions followed
these panics. Stock market crashes and the bursting of
other financial bubbles, currency crises, and sovereign
defaults are examples of circumstances that are
commonly referred to as financial crises. Financial crises
cause a loss of paper wealth, but they do not always
cause significant changes in the real economy.

Types of Financial Crisis



1. Currency crisis

A currency crisis occurs when there is uncertainty about
whether a country's central bank has enough foreign
exchange to sustain the country's fixed exchange rate.
The currency crisis has an impact on both the foreign and
domestic stock markets. The currency crisis is a precursor
to the actual economic crisis because it is a financial
crisis.

When a currency crisis occurs, the foreign debt causes a
significant surge in the home currency. The currency
crisis has shown that it may kill open economies but not
enough stable ones. The government plays a critical role
in currency crisis management by meeting excess
demand for a given currency with its foreign reserves,
which are typically USD, Euros, or Pounds.

Currency crises have an impact on all aspects of an
economy, including non-economic areas like politics. It
has a deleterious impact on those in positions of
authority. The currency crises' consequences lead to a
change in government, finance minister, or central bank
governor.

2. Banking crisis

A bank run is another term for the banking crisis.
Customers withdraw their funds from a bank because
they have lost faith in the institution's ability to function.
Every country has regular banking fees.

Different causes that could lead to insolvency could have
an impact on the bank's operations. People withdraw
their money from banks because they are afraid that a
bank may close and affect all of their depositors' money.
The primary cause of the banking crisis, which also
creates a financial crisis, is banking panic. This causes
bank destabilisation, which can lead to bankruptcies.

This is why banks frequently limit or prohibit customer
withdrawals at such periods. People may begin
withdrawing money from the bank in anticipation of the
bank's closure.

If left unchecked, this threat will result in money being
withdrawn from all banks, resulting in bank failure and,
as a result, a financial catastrophe. For a long time, this
will have a direct impact on the economy. This causes a
business economic downturn, with many businesses
shutting down as a result.

3. Speculative Bubbles

This is often referred to as an economic bubble or a price
bubble, in which asset prices are dependent on varying
future expectations. Many theories have been proposed
to explain economic bubbles, however the majority of
them are based on speculation. Non-speculative bubbles
are economic bubbles that are not speculative in nature.
Economic bubbles are almost always detectable in
retrospect.

Prices plummet in this instance, which is also known as a
collapse or a bubble burst. In the event of an economic
bubble, prices vary rapidly and are difficult to separate
and safeguard from demand and supply.

The term "bubble" comes from the British South Sea
bubble, and it refers to corporations inflating their shares
rather than dealing with the situation. Two types of
speculative bubbles are the stock and debt bubbles. A
combined stock and debt bubble can be seen in the
COVID-19 recession, which was triggered by the
corporate debt bubble.

4. International financial crisis

A balance of payments crisis or an international
financial crisis occurs when a country's fixed exchange
rate is abruptly devalued due to an unsustainable current
account deficit.

The balance of payments is a statement kept by
governments that lists all monetary transactions
performed between the country and the rest of the world
over a specific time period. The period of time can be as
short as a quarter of a year or as long as a year.

A country's BOP statement indicates whether the
country's funds are in surplus or deficit. A capital account,
a current account, and a financial account are all part of
the balance of payments.

A sovereign default occurs when a country is unable to
pay its sovereign debt.

A sovereign default occurs when a sovereign state's
government fails or refuses to pay its debt in full when it
is due. The cessation of due payments (or receivables)
may be preceded by a formal declaration by that
government that it will not pay (or only partially pay) its
debts (repudiation), or it may occur unexpectedly. Capital,
interest, superfluous and procedural defaults, and
failures to comply with the conditions of bonds or other
debt instruments are all factors considered by credit
rating agencies.

5. Wider economic crisis

This is often referred to as a depression or a downturn. A
recession is defined as a period of negative GDP for more
than two quarters. When a recession lasts for a long time,
it is referred to as depression. Economic stagnation is
caused by recessions and depressions.

In a recession, all economic activities suffer. A recession
can be triggered by a variety of events, such as financial
crises or trade shocks.

When a recession lasts for an extended period of time, it
becomes a depression. One of the best illustrations of
depression is the Great Depression of the 1920s. It began
in the 1930s and quickly spread over the globe.

Economic stagnation occurs when economic growth is
lacking for an extended period of time. In most cases,
high unemployment is a result of economic stagnation.

Factors causing financial crises



1.Asset-price bubble

Investor psychology can lead to unregulated
securitization market prices that are significantly
higher than their intrinsic values.

2.After the bubble breaks, financial institutions'
balance sheets deteriorate

Lending has decreased.

3.Banking crisis
Disintermediation and loss of information
production

4. Uncertainty increases
Lending decreases

5.Interest rate increases -
Increases the problem of adverse selection
Increases the need for outside finances, resulting in
adverse selection and moral hazard.

6.Government budget imbalances
Fears of government debt default -> Investors may
withdraw funds from the country

What Caused 2008 Global Financial Crisis (thebalance.com)

Deregulation in the financial industry was the primary
cause of the financial crisis. This allowed banks to engage
in derivatives-based hedge fund trading. To support the
profitable sale of these derivatives, banks demanded
more mortgages. They devised interest-only loans that
subprime applicants could afford.

There is rarely a single cause of a crisis, most are the
result of a combination of complex factors involving a
range of market, policy and regulatory failures.

Key Takeaways



A change in bank investing regulations allowed banks
to invest customer’s money in derivatives.
Subprime residential mortgage derivatives were
formed, and demand for homes surged.
Subprime mortgage borrowers couldn't afford their
mortgages once the Federal Reserve boosted interest
rates.
Borrowers defaulted on their mortgages, and
derivatives and other investments linked to them lost
value.
Unscrupulous investment banking and insurance
practises contributed to the financial crisis by passing
all risk to investors.

Summary of key causes

Financial market failures
Irrational exuberance among agents (Shiller)
Increased complexity arising from financial innovation
Minsky hypothesis – stability breeds instability
Policy failures

Unintended consequences of financial deregulation
Banks too big to fail? Risky behaviour due to moral
hazard?
Interest rates too low for too long (e.g. USA, EZ 2002-
2007)
Large models of the economy which assume agents
(businesses and consumers) always behave rationally
Failures of ratings agencies in pricing risk accurately
Structural changes in the global economy

Economic imbalances including global savings glut and
low real interest rates

Media and modern communications – immediate
feedback

ASYMMETRIC INFORMATION
AND FINANCIAL CRISIS



How does the concept of asymmetric
information help define a crisis?




A financial crisis happens when information flows in
markets are disrupted, resulting in increased financial
frictions and credit spreads – asymmetric problems lead to
less lending and a drop in economic activity.

1.Government Safety Net and Deposit Insurance

'Safety nets' in banking relate to government assurances
given to depositors and, in some cases, all bank creditors.
When a bank is deemed 'too big to fail,' and aid is granted,
the safety net extends to all of the bank's stakeholders,
including customers, workers, and (typically to a lesser
extent) stockholders. The negative incentives created by
these safety nets are referred to as'moral hazard.'
Depositors and maybe other creditors do not supervise
banks as closely as they should because they do not fear
losing their money. In the absence of other restraints, bank
owners and management are enticed to take more risks
than they would have taken if the safety net were not
present.

Most modern regulatory financial safety nets include
deposit insurance as a key component. It is still
controversial whether deposit insurance is required in all
instances, as it is with banking regulation in general. While
most deposit insurance schemes have the dual goals of
financial stability and depositor protection, there are
inherent challenges to their implementation, including
moral hazard and agency issues.

2.Restrictions on Asset Holdings

A restricted asset is money or another monetary item set
aside for a specific purpose, usually to meet regulatory or
contractual obligations. Restricted assets, which are
subject to particular accounting rules, are kept separate
from other assets to demarcate their intended use.
Companies in the private sector, nonprofit groups, and
government agencies all deal with restricted assets in
various forms. The purpose of restricting the asset holding
is to reduces moral hazard of too much risk taking.

A restricted asset can be used as collateral for a loan by a
firm. The corporation must keep the restricted asset's
value up to support its borrowings, and if it wishes to sell it,
it must get permission from the lender and replace it with
another asset to secure the loan. Securities firms, trading
and clearing exchanges, and other financial institutions
frequently hold restricted funds and investments for
regulatory purposes.

3.Bank Capital Requirements

Capital requirements are standardised regulation that
specify how much liquid capital (that is, easily marketable
securities) must be retained in relation to a given amount
of assets for banks and other depository institutions.

Regulatory capital is defined by regulatory bodies
including the Bank for International Settlements (BIS), the
Federal Deposit Insurance Corporation (FDIC), and the
Federal Reserve Board (the Fed).

An uneasy investment climate are generally the drivers
for capital-requirement change, especially when large
institutions' imprudent financial activity is blamed for a
financial crisis, market crash, or recession.

Capital requirements are set to ensure that banks and
depository institutions' holdings are not dominated by
investments that increase the risk of default. They also
ensure that banks and depository institutions have
enough capital to sustain operating losses (OL) while still
honoring withdrawals.

4.Bank Supervision: Chartering and Examination

Bank supervision is a regulatory duty tasked with
safeguarding the overall safety and soundness of the
banking system. As part of its supervisory responsibility,
the books and affairs of every licenced insured institution
are examined.

The purpose of bank supervision is to develop, improve,
and implement a long-term, progressive, and robust risk-
based supervision framework for the financial institutions
under their jurisdiction, in order to ensure the safety and
soundness of these institutions through the adoption of
best practises, sound governance, and proper risk
management. The following are the tasks of the separate
Supervision Departments in Bank Negara (BN):

Financial Conglomerates Supervision: Financial
conglomerates in the United States are supervised.

Banking supervision includes international banks,
stand-alone investment banks, and all Islamic banks,
including domestic banks' Islamic banking subsidiaries.

Insurance and Takaful Supervision: Insurance firms,
reinsurance companies, takaful operators, retakaful
operators, and foreign takaful operators are all subject to
supervision.

5.Disclosure Requirements

Disclosure regulations are laws that oblige a person or a
company to divulge accurate information to other people
or companies. In other words, disclosure regulations may
compel persons and entities to reveal information that
was previously considered private. In some countries, a
property seller, for example, may be required to present
a potential buyer with a statement listing any flaws the
seller is aware of on the property.

Most governments have passed disclosure laws that
address a wide range of legal issues, including business,
real estate, and banking law. Other areas that are
frequently restricted by disclosure requirements include
manufacturing, retail sales, and gaming. Better
information reduces asymmetric information problem.

Do banks have to disclose deposits to consumers?
Only disclosures for consumer deposit accounts are
required. Many federal regulations mandating financial
institutions to give disclosures to deposit account holders
are intended to protect consumers and are hence not
necessary in the case of business deposit accounts.

6. New Trend: Assessment of Risk Management

Risk management is the process of identifying, evaluating,
and prioritising risks, as well as the coordinated and cost-
effective application of resources to reduce, monitor, and
control the likelihood or impact of unfavourable events,
or to maximise the realisation of opportunities.

The RMA, or Risk Management Assessment, is the first
stage in creating a comprehensive risk management
programme. The RMA is responsible for identifying,
analysing, and reporting on a company's material risk
exposures. It offers a multi-dimensional view of risk,
taking into account both enterprise-wide risks and
specific insurance-related concerns.

A Risk Management Assessment (RMA)
consists of five steps:



1.Get to know the organization.
Gather as much information as possible to learn about
the organization, establish objectives, and review a
timeline for completion of the RMA.

2.Examine risk management techniques.
Take a closer look at the existing insurance coverage,
what losses have been experienced, and the
organization’s Total Cost of Risk (TCoR), as well as the
risk management best practices currently in use.

3.Identify and analyze exposures.
Ask a series of questions designed to uncover risk
exposures and prepare an action plan to protect against
these risks.

4.Implement the plan.
Address gaps in insurance, finalize loss reserve reviews
and procedures and set a strategy for improvement.

5.Monitor results and provide support.
Form a work group with members from the organization
and provide ongoing guidance on risk-related issues.
Recommend actions that support continued TCoR
improvement.

POLITICAL ECONOMY OF
THE BANKING CRISIS





Government intervention to stabilise financial systems in
times of banking crises ultimately involves political
decisions.Politicians propose, promote, and enact laws
and regulations that govern the land and, by implication,
the people that live there. A "politician," in broad terms, is
somebody who pursues political authority in any
bureaucratic entity.

1. Politicians influenced by bank lobbyists rather than
public

a. Deny funds to close banks
Politician influence by lobbyist to close the bank - will
deny the funds to let the bank close due to some bad
experience of that bank in the past.

b. Legislation to relax restrictions
When the restriction relaxing or loose it will create the
assymnetric information.

2.Regulators influenced by politicians and desire to
avoid blame

a. Loosened capital requirements
Capital requirements are standardised standards that
specify how much liquid capital (that is, easily
marketable securities) must be retained in relation to a
given amount of assets for banks and other depository
institutions.

The goal of capital requirements is to make banks
sustainable and, by extension, the entire financial
system safe. As regulatory advocates point out, no bank
is an island in an era of national and international
banking, and a shock to one might affect several. All the
more reason for strict standards that can be
implemented consistently and used to compare the
various institutions' soundness.

Pros
Ensure banks stay solvent, avoid default
Ensure depositors have access to funds
Set industry standards
Provide way to compare, evaluate institutions

Cons
Raise costs for banks and eventually consumers
Inhibit banks' ability to invest
Reduce availability of credit, loans

b. Regulatory restrictions on risky asset holdings
A restricted asset is money or another monetary item set
aside for a specific purpose, usually to meet regulatory or
contractual obligations. Restricted assets, which are
subject to particular accounting rules, are kept separate
from other assets to demarcate their intended use.

A restricted asset can be used as collateral for a loan by a
firm. The corporation must keep the restricted asset's
value up to support its borrowings, and if it wishes to sell
it, it must get permission from the lender and replace it
with another asset to secure the loan.

c. Regulatory forbearance
In the context of a mortgage procedure, forbearance is
an unique arrangement between the borrower and the
lender to postpone a foreclosure. "Holding back" is the
exact definition of forbearance. Lenders may choose to
foreclose on mortgage debtors who are unable to satisfy
their repayment obligations.

To avoid foreclosure, the lender and the borrower can
reach a "forbearance" arrangement. The lender's power
to foreclose is postponed under this agreement if the
borrower can catch up on their payments by a specific
date. This time frame and payment schedule are
determined by the terms of the agreement that both
parties have agreed to.

Why a Banking Crisis in 1980s?



The United States had its worst banking crisis since the
1930s, and the second worst crisis in its 200-year history,
in the 1980s. Commercial banks, savings banks, and
savings and loan associations (S&Ls) were all affected by
the financial crisis .

Between 1980 and 1994, 1,617 commercial and savings
banks collapsed, according to the Federal Deposit
Insurance Corporation's (FDIC) Division of Research and
Statistics. The assets of these failing institutions totaled
$206.2 billion.

The 1980s banking crisis was thus a two-headed beast,
with one head tied to the failure of the S&L crisis—which
accounted for the majority of assets and bank numbers—
and the other linked to the bankruptcy of large
commercial banks. When compared to bank failure
statistics before to the 1980s, the depth of the crisis
becomes clear. From 1965 to 1979, for example, only 0.3
percent of all existing banks failed

As the crisis worsened during the 1980s, bank failures
reached a post-Depression high of 279 in 1988, totaling
$54 billion in nominal assets. Despite the fact that it was a
tiny number of banks and bank assets in comparison to
the total number of banks and bank assets—and in light of
the ultimate costs—it resulted in the FDIC's first operating
deficit. Those losses persisted until the year's end.

Factors Contributing to the Crisis




The rise in bankrupt banking institutions in the United
States during the 1980s and early 1990s was caused by a
variety of factors. The legislative and regulatory contexts
were shifting before to the commencement of the crisis:

Many restrictions on thrifts and credit unions were
abolished by the Depository Institutions
Deregulation Committee and the Monetary Control
Act of 1980.
The Garn-St. Germain Depository Institutions Act of
1982 allowed thrift banks to invest in real estate
loans with more freedom.
The 1986 Tax Reform Act drastically transformed the
banking sector, creating conditions that aided in the
banking crisis.

Beginning in the late 1970s and extending into the early
1980s, changes in legislative and economic
circumstances resulted in unrestricted real estate
lending. Many commentators believe this was the root of
the banking crisis at the time. In an increasingly unstable
financial environment, severe economic downturns in
the early 1980s and early 1990s, as well as the collapse
in real estate and energy prices during this time, were
both results and important precipitating factors. Fraud,
particularly looting and control fraud, as well as other
sorts of insider misbehaviour, played a significant role in
the whole crisis.

Interventions by the government to solve the
problem

While government intervention in the banking sector was
considered as one of the key contributing elements to the
1980s financial crisis, following government action also
assisted in the sector's rescue and reconstitution, albeit in
a fundamentally different form. As the savings and loan
crisis deteriorated in the late 1980s, a slew of regulatory
and legislative changes were implemented, resulting in an
alphabet soup of organisations and institutions.

The Office of Thrift Supervision (OTS) was established,
with the authority to charter and regulate S&Ls
The Resolution Trust Corporation (RTC) was set up in
1989 to dispose of the failed thrifts that fell into the
hands of regulatory bodies

The 1980s banking crisis was primarily a crisis of thrift
institutions, with a few significant commercial bank
failures thrown in for good measure. The crisis was
exacerbated by a fast changing regulatory framework for
banks, growing competitive pressures, thrifts' investment
in real estate and other assets, and unpredictable
economic conditions. The outcome is a banking
landscape in which banking concentration has never
been higher.

Decreasing of net worth of bank



a. Insolvencies
Insolvency is defined as the inability of a person or
corporation (debtor) to pay their debts at maturity;
individuals who are insolvent are referred to as insolvent.
There are two types of insolvency: cash-flow and balance-
sheet insolvency.

A bank's insolvency occurs when it is unable to satisfy its
financial obligations and must either close or reorganise
to resolve the issue. Insolvency is a phrase used in
Europe to describe situations in which banks collapse,
whereas in the United States, it is referred to as "bank
failure" or "bankruptcy." Bank insolvencies differ from
other types of business failures in that a bank's failure
could result in considerable financial hardship for its
customers. As a result, the process may involve
regulatory bodies.

b. Incentives for risk taking
Relaxing limits on banking activities may encourage
banks to take more risks by broadening their scope of
operations. However, loosening the restrictions may
boost options for bank diversification, reducing risk-
taking.

Regulatory Forbearance :
Regulators allow insolvent banks to operate because:

a. Insufficient funds

Insufficient funds, often known as non-sufficient funds
(NSF), is a bank account condition . If a transaction
withdraws funds from a bank account while the account
balance is inadequate to cover the withdrawal, the
account will be marked as insufficient funds. A note will
appear on the account holder's bank statement or
receipt.

b. Sweep problems under rug / to overcome banking
crisis.

Bank regulation is designed to address several issues:
information asymmetry; bank failures; depositors’ ability
to recover their funds; unfair, discriminatory, or
fraudulent practices; and systemic risk.

1997 Asian Financial Crisis

Beginning in July 1997, the Asian financial crisis gripped
most of East Asia and Southeast Asia, raising worries of a
worldwide economic disaster owing to financial
contagion. However, in 1998–1999, the recovery was
quick, and fears of a meltdown faded.

The Cause of Asia's Financial Crisis
The reasons of Asia's financial crisis are complex and
contentious. The burst of the hot money bubble is seen
to be a major factor. Many Southeast Asian countries,
notably Thailand, Singapore, Malaysia, Indonesia, and
South Korea, saw enormous economic growth in the late
1980s and early 1990s, with gross domestic product
increases of 8% to 12%. (GDP). The "Asian economic
miracle" was coined to describe the feat. However, the
achievement came with a major danger.

Export expansion and foreign investment were the main
drivers of economic growth in the countries described
above. In order to attract hot money, high interest rates
and fixed currency exchange rates (pegged to the US
dollar) were adopted. Furthermore, the currency rate was
set at a level that was advantageous to exporters. Due to
the fixed currency exchange rate policy, however, both
the capital market and corporations were vulnerable to
foreign exchange risk.

The value of currencies tied to the US dollar increased as
well, stifling export growth. Asset prices, which were
leveraged by massive levels of credit, began to decline as
a result of a shock in both export and foreign investment.
Foreign investors, fearful of losing their money, began to
withdraw.

The large capital outflow put downward pressure on
Asian currencies, causing them to depreciate. The Thai
government was forced to float the baht when it ran out
of foreign cash to support its exchange rate. As a result,
the baht's value plummeted almost instantly. Shortly
later, the same thing happened to the rest of Asia.

Effects of the Asian Financial Crisis

The Asian Financial Crisis has political ramifications in
addition to its economic consequences. Yongchaiyudh,
Thailand's Prime Minister General, and Suharto,
Indonesia's President, both resigned. Anti-Western
sentiment was stoked, particularly against George Soros,
who was blamed by some for causing the crisis by
engaging in large-scale currency speculating.

The Asian Financial Crisis had an impact that was not
restricted to Asia. Not only in Asia, but also in other parts
of the world, international investors have become less
eager to invest in and lend to emerging countries. Oil
prices have also dropped as a result of the turmoil. As a
result, the oil business has seen several big mergers and
acquisitions in order to attain economies of scale.



Financial crisis of 2007–2008: Global Crisis

The global financial crisis (GFC), often known as the
financial crisis of 2007–2008, was a catastrophic
worldwide economic disaster. Many economists believed
the COVID-19 recession, which began in 2020, to be the
worst financial disaster since the Great Depression.

The Crisis's Causes

For the first time in decades, house prices began to fall in
2006. The overheated of real estate market will cool
down and become more sustainable. Nobody take into
account a variety of issues, including the fact that a large
number of homeowners with bad credit were approved
for mortgage loans, some of which were for 100% or
more of the home's worth.

Some attributed the problem to the Community
Reinvestment Act, which encouraged banks to invest in
subprime neighbourhoods. The Federal Reserve
concluded that it did not increase risky lending in several
investigations.

When banks realised they would have to shoulder the
losses in 2007, they panicked and stopped lending to one
another. Because they didn't want other banks to provide
them worthless mortgages as collateral, interbank
borrowing costs, sometimes known as Libor, increased.
The Term Auction Facility was established by the Federal
Reserve to inject liquidity into the banking system, but it
was insufficient.

Former U.S. Federal Reserve chairman Alan Greenspan
has admitted that he was blindsided by the 'once-in-a-
century credit tsunami' that has wreaked havoc on the
world's economies.Given the financial damage to date,
He cannot see how they can avoid a significant rise in
layoffs and unemployment - that also can harm the world
economics.

•The financial crisis of 2007–2008, also known as the
global financial crisis (GFC), was a severe worldwide
financial crisis. Excessive risk-taking by banks combined
with the bursting of the United States housing bubble,
caused the values of securities tied to U.S. real estate to
plummet, damaging financial institutions globally,
culminating with the bankruptcy of Lehman Brothers on
September 15, 2008, and an international banking crisis.

The crisis sparked the Great Recession, which, at the time,
was the most severe global recession since the Great
Depression. It was also followed by the European debt
crisis, which began with a deficit in Greece in late 2009,
and the 2008–2011 Icelandic financial crisis, which
involved the bank failure of all three of the major banks
in Iceland and, relative to the size of its economy, was the
largest economic collapse suffered by any country in
economic history.

Main Causes of the GFC:

1.Excessive risk-taking in a favorable macroeconomic
environment

Many of the mortgage loans were for amounts near to
(or even exceeding) the purchase price of a home,
particularly in the United States. Investors seeking short-
term profits by 'flipping' houses and'subprime' borrowers
(who have higher default risks because their income and
wealth are relatively low and/or they have missed loan
repayments in the past) accounted for a big share of such
risky borrowing.

2. Increased borrowing by banks and investors

Banks and other investors in the US and overseas
borrowed increasingly large sums to expand their lending
and buy ‘mortgage-backed securities’ (MBS) products.
Borrowing money to buy an asset (also known as
increasing leverage) increases possible earnings while
also increasing potential losses. As a result, when home
prices began to collapse, banks and investors suffered
significant losses as a result of their excessive borrowing.

Furthermore, banks and certain investors have
increasingly borrowed money for very short periods of
time, even overnight, to buy assets that could not be sold
rapidly. As a result, they became more reliant on lenders,
including other banks, for fresh loans as old short-term
loans were returned.

Mortgage-Backed Securities (MBS):
A type of asset-backed security that is created exclusively
by pooling mortgages. When an investor purchases a
mortgage-backed asset, he or she is effectively lending
money to home buyers. A broker can help you buy and
sell an MBS.

3. Regulation and policy errors

Subprime loans and MBS products were regulated too
loosely. In particular, the institutions that manufactured
and sold the complicated and opaque MBS to investors
were not adequately regulated. Not only were many
individual borrowers given loans that they were unlikely
to repay, but fraud – such as overstating a borrower's
income and over-promising investors on the safety of the
MBS products they were being sold – was becoming more
common.

Furthermore, as the crisis progressed, many central
banks and governments failed to recognise the extent to
which faulty loans had been extended during the boom,
as well as the numerous ways in which mortgage losses
were spreading throughout the financial system.

How the GFC Unfolded:

1.US house prices fell, borrowers missed repayments

Falling US housing values and an increasing number of
borrowers unable to repay their loans were the drivers
for the GFC. House prices in the United States peaked in
mid-2006, coinciding with a surge in the supply of newly
constructed homes in some locations. As home prices
began to decrease, the percentage of borrowers who
defaulted on their loans increased. Because the share of
US households (including owner-occupiers and investors)
with huge loans had risen dramatically during the boom
and was larger than in other countries, loan repayments
were particularly sensitive to housing prices in the US.

2.Stresses in the financial system

Around the middle of 2007, the financial system began to
show signs of stress. Because many of the residences
confiscated after borrowers missed payments could only
be sold at prices below the loan level, some lenders and
investors began to suffer significant losses. As a result,
investors became less willing to buy MBS and actively
sought to sell their holdings. As a result, MBS prices fell,
lowering the value of MBS and, as a result, MBS investors'
net worth. As a result, investors who bought MBS with
short-term loans found it much more difficult to
refinance them, thereby exacerbating MBS selling and
price falls.

3.Spill overs to other countries

Foreign banks were active participants in the US housing
market during the boom, including purchasing MBS, as
previously mentioned (with short-term US dollar funding).
Banks from the United States also had significant
operations in other nations. The issues in the US housing
market were able to spread to other countries' financial
systems and economies thanks to these
interconnections.

4.Failure of financial firms, panic in financial markets

Following the fall of the US financial giant Lehman
Brothers in September 2008, financial tensions reached
an all-time high. This, together with the bankruptcy or
near-failure of a number of other financial organisations
around the same time, sparked a global panic in financial
markets. Investors began withdrawing cash from banks
and investment funds all throughout the world, unsure of
who would be the next to fail or how exposed each
institution was to subprime and other distressed loans.
As a result, financial markets became dysfunctional as
everyone attempted to sell at the same moment, and
many organisations seeking new funding were unable to
do so. As confidence plummeted, businesses and people
both were less ready to invest and spend. As a result, the
US and other economies entered their greatest
recessions since the Great Depression.

Policy Responses

The main policy reaction to the crisis until September
2008 came from central banks, which slashed interest
rates to promote economic activity, which had started
to stagnate in late 2007. Following the collapse of
Lehman Brothers and the global economic slump,
however, governmental responses became more
aggressive.

1.Lower interest rates
Once policy interest rates were near zero, central
banks lowered interest rates rapidly to very low levels
(often near zero); lent large sums of money to banks
and other institutions with good assets that couldn't
borrow in financial markets; and purchased a large
amount of financial securities to support dysfunctional
markets and stimulate economic activity (known as
'quantitative easing').

2. Increased government spending
Governments increased spending to boost demand and
support employment across the economy; guaranteed
deposits and bank bonds to bolster confidence in
financial firms; and purchased ownership stakes in some
banks and other financial firms to avoid bankruptcies
that could have exacerbated financial market panic.

Despite the fact that the global economy was in its worst
slump since the Great Depression, policy responses
prevented a global depression. Despite this, millions of
people have lost their jobs, houses, and enormous sums
of money. Many economies also recovered from the GFC
far more slowly than from prior recessions that were not
linked to financial crises. For example, nine years after
the crisis began, the unemployment rate in the United
States barely returned to pre-crisis levels in 2016.

3.Stronger oversight of financial firms
Regulators expanded their monitoring of banks and
other financial institutions in reaction to the crisis.
Among a slew of new international requirements, banks
must now assess the risk of the loans they provide and
employ more stable funding sources. Banks, for
example, must now operate with less leverage and may
no longer support their consumer loans with as many
short-term loans. Regulators are also increasingly aware
of the ways in which risks can spread throughout the
financial system, and they demand that actions be taken
to prevent this from happening.

The 2007–2009 Financial Crisis

At the 2007–2009 financial crisis by examining three
central factors:

1. Financial innovation in mortgage markets

Financial innovation in mortgage markets developed
along a few lines:

1. Less-than-credit worthy - borrowers found the ability
to purchase homes through subprime lending, a
practice almost non-existent until the 2000s

2. Financial engineering developed new financial
products to further enhance and distribute risk from
mortgage lending - aggravates Asymmetric Information

2. Agency problems in mortgage markets

Agency problems in mortgage markets also reached new
levels:
1. Mortgage originators did not hold the actual mortgage,

but sold the note in the secondary market
2. Mortgage originators earned fees from the volume of

the loans produced, not the quality — Moral hazard
problem occurs

In the extreme, unqualified borrowers bought houses
they could not afford through either creative
mortgage products or outright fraud (such as inflated
income)— adverse selection

3. The role of asymmetric information in the credit
rating process

Finally, the rating agencies made asymmetric information
worse!

Agencies consulted with firms on structuring products
to achieve the highest rating, creating a clear conflict –
aggravates Asymmetric Information
Further, the rating system was hardly designed to
address the complex nature of the structured debt
designs.
The result was meaningless ratings that investors had
relied on to assess the quality of their investments.

DYNAMIC OF FINANCIAL CRISIS

IN ADVANCE ECONOMIES




Financial crises in
Economies
progressed in two and sthoemetAimdveasn
tcherdee stages : have

Stage One : Initation of finacial crises

Mismanagement of financial liberalization (the
elimination of restrictions on financial markets and
institutions) / innovation (introducing new types of
loans or other financial products)
Asset price boom and bust
Spikes in interest rates
Increases in uncertainty

Stage two : Banking crises
-Bank panic : depositors withdraw their deposits from
banks, because they no longer trust the banking
system. Deposit insurance has decreased the
possibility of bank panics
There exists less information on borrowers and
lenders : the increase of asymmetric information
problems

Stage three : Debt deflation

If the economic downturn leads to a decline in price level
(deflation), the real values of liabilities (debts) increase,
but the value of assets does not increase, which leads to
a decline in net worth. This causes an increase in adverse
selection and moral hazard problems facing lenders.
Lending and economic activity decline for a long time.

The mother of all financial crises

The Great Depression in the 1930s

Event was brought on by :
Stock market crash
Bank panics
Continuing decline in stock prices
Debt deflation

- Unemployement ; Bank panic & depression causing
worldwide umemployement

- Rise of facism, lead to world war II





DYNAMICS OF FINANCIAL CRISES
IN EMERGING MARKET
ECONOMIES



Financial crisis dynamics in emerg
ing market economies—

economies in the early stages of market development that

have recently opened up to the flo
w of goods, services, and
capital from the rest of the world
—are similar to those in

advanced countries like the United States, but with some
key differences. Figure 8.7 depicts the sequence and stages
of events in these emerging market economies' financial
crises, which we shall discuss in this section.

Stage One: Initiation of Financial Crisis

A variety of reasons can contribute to crises in advanced
economies. However, financial crises in developing market
countries can take one of two forms: mismanagement of
financial liberalisation and globalisation or significant fiscal
imbalances. The most common reason is mishandling of
financial liberalisation and globalisation, which triggered
crises in Mexico in 1994 and many East Asian countries in
1997.

Stage Two: Currency Crisis

Participants in the foreign exchange market detect an
opportunity when the impacts of any or all of the
elements at the top of Figure 8.7 build on each other:
they can make big gains if they bet on a currency decline.
A currency that is set against the US dollar is now
vulnerable to a speculative attack, in which speculators
sell the currency in large quantities. As currency sales
flood the market, supply vastly outstrips demand, causing
the currency's value to plummet and triggering a
currency crisis (see the Stage Two section of Figure 8.7).

High international interest rates, increased uncertainty,
and plummeting asset prices are all factors. The two
essential conditions that ignite speculative attacks and
push economies into a full-scale, catastrophic downward
spiral of currency crisis, financial crisis, and catastrophe
are deteriorating bank balance sheets and massive fiscal
imbalances.

Stage Three: Full-Fledged Financial Crisis

Unlike most advanced economies, which denominate
debt in domestic currency, emerging market economies
denominate many debt contracts in foreign currency
(usually dollars), resulting in currency mismatch. In an
emerging market economy, an unanticipated
depreciation or devaluation of the domestic currency (for
example, pesos) raises the debt load of its domestic
enterprises in terms of domestic currency.

That is, repaying the dollarized debt requires more pesos.
Because most businesses price their goods and services
in pesos, their assets do not appreciate in value, whereas
their debt does. The value of debt increases in relation to
assets when the domestic currency depreciates, and the
firms' net worth decreases.The unfavourable selection
and moral hazard issues discussed previously are
exacerbated by the reduction in net worth. Following this,
there is a drop in investment and economic activity (as
shown by the Stage Three section of Figure 8.7).