Financial crises

1. Financial crises Dr Katarzyna Sum International monetary system

2. Financial crisis- definition • Powerful shocks within the financial system which trigger a decrease or a deepening of the already ongoing production decrease

3. Stock market crunches (1) • Stock market crunches are relatively rare but their occurrence affects seriously the economy • The source of a stock market crunch is usually a speculative bubble • The optimism of investors drives the emergence of a speculative bubble

4. Stock market crunches (2) • Speculative bubbles emerge on the base of rational expectations • Initially investors expect that the positive trend concerning e.g. a productivity increase will go on • This happened for example during Dot Com crisis

5. Stock market crunches (3) • Behavioural finance can explain stock market crunches • Small investors just follow the trend without qny rational economic analysis • Large investors can predict the burst of a speculative bubble but they are usually unwilling ton withdraw their funds dueto competitory pressures

6. Stock market crunches (4) • Once the speculative bubble burst it affects majorly investor who purchased stock by borrowing money from banks • This was e.g. the source of the Japanese stock market crisis in the 90-ties • The Dot Com crisis was much softer since investors financed their purchases via own capital

7. Banking crises (1) • Banks play a prominent role in financing economic activity • The willingness of banks to grant loan depends largely on the economic cycle and the net value of enterprises • In times of economic recession banks lack of objective information concerning the situation of the enterprises

8. Banking crises (2) • Banks know that enterprises in times of recessions need the funds to maintain liquidity instead of financing production • This situation creates moral hazard- enterprises will require loans even if they can not pay them back • Since banks know that they are forced to negative selection of companies requiring loans • Banks raise the risk premium and hence the interest on granted loans • As an effect liable companies limit their loan requirements, only companies who want to support their liquidity require loans

9. Banking crises (3) • Due to lending money to unreliable companies banks have to face toxic debt • This can seriously affect the solvency of the banks • The risk of the occurrence of financial crisis is the greater the larger the preceding credit expansion is • Banking crises can also occur due to a disadvantageous change of the economic situation e.g the Norwegian banking crisis in the 80-ties was due to of an oil price decrease

10. Currency crises (1) • Currency crises occur if the financial markets participants start to mistrust a specific currency and subsequently withdraw their funds and the central banks are not able to counteract this tendency

11. Currency crises (2) • Currency crises can bbe grouped into three generations • First generation- Krugman • Second generation- Obstfeld • Third generation- eclectic model

12. The first generation of currency crises (1) • The Krugman model • Internal reasons for the outbreak of the crisis • The reason of the currency crisis is inadequate economic policy especially concerning the fiscal situation

13. The first generation of currency crises crises (2) • Lax fiscal policy the budget deficit is financed by the central bank inflation the internal unequilibrium can not be reconciled with the fixed exchange rate • Fiscla expansion increasing internal demand for imports +inflation balance of payment deficit devaulation pressure decrease of reserves speculative attack currency crisis

14. The first generation of currency crises crises (3) • Currency crises in the 80-ties • Latin American countries (Argentina, Chile) • This were usually emerging economies who had to cope with high inflation, fiscal deficit and fixed exchange rates

15. The first generation of currency crises crises (4) • Low level of foreign currency reserves • Capital flow liberalisation+ lack of banking regulation  lack of control over excess money supply • Additional contsraint- high level of foreign loans to latin Amertican Countries insolvency

16. The second generation of currency crises (1) • The Obstfeld model • The main reason for the crisis are speculative attacks • Especially fixed or intermediate exchange rate regimes are prone to this type of currency crises

17. The second generation of currency crises (2) • The crisis occurs in economies with good economic policy • Countries with high levels of foreign reserves • External reasons for the crisis

18. The second generation of currency crises (3) • Second generation crises occurred in the 90-ties • E.g. the ERM crisis • Restructuring of the German economy  inflationary pressure in Germany strict monetray policy incraesed interest rates  overvaluation of the DM • Other economies within the ERM system raised the intsrest rates as well to maintain the exchange rate parity

19. The second generation of currency crises (4) • Speculative attack on the GBP- the only economy that did not increase the interest rate devaluation of GBP • This triggered speculative attacks on all the currencies within the ERM which were related to the DM • As a consequence all countries who participated in the ERM were forced the devalue their currencies

20. The third generation of currency crises (1) • An eclectic model describes the third generation crises • The theory was a reaction to the currency crises which occurred in emerging economies at the end of the 90-ties • A characteristic feature was the fact that the economies hit by the crisis had fixed exchange rates • The crisis hit well performing, promising economies (Malaysia, Indonesia, South Korea)

21. The third generation of currency crises (2) • Microeconomic reasons for the crisis- risky investments undertaken by banks and companies • Macroeconomic reasons- insufficient competiveness of the economy, lack of financial supervision • Underdeveloped financial markets external funding of investments • Foreign investors expected large productivity increases and when their expectations were not met they withdrew their funds

22. The elements of third generation crises • Moral hazard • Too big to fail • The investments financed by banks loans were concentrated • Twin crises • Banking crises and currency crises simultaneously • This can occur if the banking sector has a large foreign debt • Especially a currency mismatch can exacerbate an excessive foreign debt

23. The elements of third generation crises • Herding effects can cause the outflow of foreign capital • The domino effect can cause international contagion

24. Examples of third generation crises • Emerging economies in south Asia faced currency crises at the end of the nineties • Their banking sectors had large foreign debt • These counties had costly production and underdeveloped financial markets • Additionally the appreciation of USD caused the outflow of capital and subsequently the collapse of domestic exchange rates

25. References • A. Sławiński, Rynki finansowe, PWE, Warszawa 2006 • P. Krugman, M.Obstfeld, International economics: theory and policy, Pearson, Addison Wesley, Boston2009, • J. A. Frankel, G. Saravelos, Are Leading Indicators of Financial Crises Useful for Assessing Country Vulnerability? Evidence from the 2008-09 Global Crisis, NBER Working Paper No. 16047, Cambridge 2010, • J. Aizenman, Financial Crisis and the Paradox of Under- and Over-Regulation, NBER Working Paper No. 15018, Cambridge 2009, • J. B. Taylor, The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong, NBER Working Paper No. 14631, Cambridge 2009, • C. M. Reinhart, K. S. Rogoff, From Financial Crash to Debt Crisis, NBER Working Paper No. 15795, Cambridge 2010 • A. Szyszka, Behawioralne aspekty kryzysu finansowego, Bank i Kredyt 40 (4), Warszawa 2009