The Financial System: Opportunities and Dangers Chapter 20 of Macroeconomics, 8 th edition, by N. Gregory MankiwMacroeconomics ECO62ECO62 Udayan RoyUdayan Roy

The Financial System The financial system is the collection of institutions that facilitate the flow of funds between lenders and borrowers.

The Financial System: Saving When people earn income, they typically dont want to consume their entire income all at once. But they may have no idea what to do with the unconsumed income. This unconsumed income is called saving

The Financial System: Investment On the other hand, there are people who may wish to spend money on various potentially valuable projects but either have no money of their own or may wish to spend their personal funds on projects other than their own The money that these people need for their spending plans is called investment

The Financial System Makes Saving Equal Investment The financial system makes it easier for lenders (those who have the saving funds) and borrowers (those who need funds for investment) to find each other Both groups benefit when the financial system does its job well When the financial system fails, both groups suffer

What does the financial system do? The financial system serves multiple purposes: – It helps entrepreneurs find the money needed to turn business ideas into reality – It helps entrepreneurs pursue business projects without having to personally carry too much of the risks associated with their projects – It helps to protect lenders from irresponsible borrowers – It helps to foster economic growth by channeling savings to the most valuable projects and cutting off funds for the less valuable projects

Financing Investment The financial system helps entrepreneurs find the money needed to turn business ideas into reality The money may take the form of – Debt finance (the entrepreneur sells bonds), and – Equity finance (the entrepreneur sells stocks)

Financing Investment The flow of funds takes place through – Financial markets Stock market, bond market – Financial intermediaries Banks, mutual funds, pension funds, insurance companies

What does the financial system do? The financial system serves multiple purposes: – It helps entrepreneurs find the money needed to turn business ideas into reality – It helps entrepreneurs pursue business projects without having to personally carry too much of the risks associated with their projects – It helps to protect lenders from irresponsible borrowers – It helps to foster economic growth by channeling savings to the most valuable projects and cutting off funds for the less valuable projects

Sharing Risk The financial system helps entrepreneurs pursue business projects without having to personally carry too much of the risks associated with their projects The financial system also enables savers to diversifythat is, lend their money to a variety of borrowersthereby reducing the risks of lending

Sharing Risk Suppose it is your dream to start a restaurant. Even if you have enough savings of your own to pay for the restaurant, it might still be better to share the risksand the rewardsof the restaurant venture with others And others may wish to share the risks of your restaurant venture if they believe that the returns would be good

Sharing Risk The financial systemthat is, the financial markets and financial intermediariesmay put you in touch with other investors They would provide you money to get your restaurant started in return for part ownership – This is equity finance This way you would not have to carry the full risk of your restaurant on your own shoulders

Sharing Risk Even if you are not an entrepreneur, the financial system can help you use your savings to acquire ownership of a diversified portfolio of business enterprises This will help you keep your idiosyncratic risks low But systemic risks may remain

What does the financial system do? The financial system serves multiple purposes: – It helps entrepreneurs find the money needed to turn business ideas into reality – It helps entrepreneurs pursue business projects without having to personally carry too much of the risks associated with their projects – It helps to protect lenders from irresponsible borrowers – It helps to foster economic growth by channeling savings to the most valuable projects and cutting off funds for the less valuable projects

Dealing With Asymmetric Information The financial system helps to protect lenders from irresponsible borrowers

Dealing With Asymmetric Information Borrowers can hide crucial information about their abilities and their plansfrom potential lenders As a result, trusting lenders can get ripped off If that happens often enough, all lending would eventually end and the financial system would be unable to do what it is supposed to do

Dealing With Asymmetric Information The financial systemespecially financial intermediaries, such as banks, and watchdogs, such as government regulators and the courtscan help lenders by – ensuring that lenders get adequate information about potential borrowers – keeping a watchful eye on borrowers to ensure that they do nothing stupid or reckless with borrowed money – punishing dishonest treatment of lenders

Dealing With Asymmetric Information When entrepreneurs hide information about themselves or the projects for which they are seeking money, lenders face the problem of adverse selection When entrepreneurs hide information about how hard they would work to make their projects successful, lenders face the problem of moral hazard

Dealing With Asymmetric Information Why would an entrepreneur borrow money for his/her project? – has no personal funds – has enough personal funds, but wants to diversify risks – knows something negative about the project that he/she is hiding from lenders (adverse selection) – has no intention to work hard for the project (moral hazard)

Dealing With Asymmetric Information A lender can partially avoid the problems of adverse selection and moral hazard by lending money to an intermediary, such as a bank, and letting the bank deal with the borrower The bank may have the resources to dig up hidden information about the borrower and the project The bank may be able to ensure that the borrower will work hard to make the project a success

Dealing With Asymmetric Information In some cases, asymmetric information may hurt an honest borrower An entrepreneur may be honest and hard working, but may be unable to convince potential lenders that she is hard working Here too, bank finance may be the solution A bank may be willing to lend money to this borrower because the bank has resources to monitor the borrower, who in this case happens to be genuinely hard working

Dealing With Asymmetric Information Government regulators and the law enforcement system have obviously important roles to play in dealing with adverse selection and moral hazard

What does the financial system do? The financial system serves multiple purposes: – It helps entrepreneurs find the money needed to turn business ideas into reality – It helps entrepreneurs pursue business projects without having to personally carry too much of the risks associated with their projects – It helps to protect lenders from irresponsible borrowers – It helps to foster economic growth by channeling savings to the most valuable projects and cutting off funds for the less valuable projects

Fostering Economic Growth The financial system helps to foster economic growth by channeling savings to the most valuable projects and cutting off funds for the less valuable projects When asymmetric information is not a problem, a market for loanable funds in which people are free to lend and borrow should ensure the success of economically valuable projects and the failure of economically wasteful projects

Fostering Economic Growth For example, if in a well-functioning loanable funds market the equilibrium interest rate is 4%, then – the projects that can earn profits higher than 4% will succeed, and – the projects that cannot do so will fail In this way, a free market will automatically allocate funds so as to foster economic growth

Case Study: Microfinance In poor countries, financial markets are undeveloped, primarily because of asymmetric information problems and weak or nonexistent government efforts to deal with asymmetric information In 1976, Muhammad Yunus, and economics professor in Bangladesh, started Grameen Bank to remedy the situation

Case Study: Microfinance The Bank was successful in enabling entrepreneurs get the money to build small- scale businesses and improve their lives Grameen Bank and Prof. Yunus were awarded the Nobel Peace Prize in 2006 How did Grameen Bank succeed in solving the problem of asymmetric information?

Case Study: Microfinance Loans were given to groups rather than individuals All members of the group that took a loan would be responsible for timely repayment A group would only admit members that the other members knew to be sound In this way, the group lending idea helped solve the asymmetric information problem

Case Study: Microfinance Moreover, Grameen Bank gives loans in small amounts that are repaidand renewedafter short intervals Therefore, a continuing relationship develops between the banks loan officers and the borrowers Moreover, as small amounts are loaned out at any given time, losses are low

FINANCIAL CRISIS Somehow the pipes get clogged

Financial Crisis A financial crisis is a major disruption of the economys ability to make money flow between lenders and borrowers Examples: – Great Depression 1930s – Great Recession

Six Common Features Although each financial crisis is unique, most financial crises share certain common elements 1.Asset-price booms and busts 2.Insolvencies in financial institutions 3.Falling confidence 4.Credit crunch 5.Recession 6.A vicious circle

Asset-price booms and busts Financial crises are often preceded by a period of euphoria, called a speculative bubble, during which the prices of assets rise above their fundamental values – The fundamental value of an asset is the price that would prevail if people relied only on objective analyses of the cash flows the asset will generate

Asset-price booms and busts If people start buying assets not for the expected cash flows from the asset but because they hope to sell the asset later at a higher price, an assets price can rise above its fundamental value However, such speculative bubbles inevitably crash when euphoria ends and doubts set in

Asset-price booms and busts In the Great Recession of , a speculative bubble developed in home prices

Asset-price booms and busts Banks fueled the boom because they failed to do their job of identifying irresponsible borrowers and not giving them loans. Why? – Banks assumed that home prices would keep rising. – Under that assumption, it would not matter if a borrower defaulted. – The bank would simply take the house the defaulter had bought and sell it off at a higher price, thereby making a profit.

Recap: Six Common Features Although each financial crisis is unique, most financial crises share certain common elements 1.Asset-price booms and busts 2.Insolvencies in financial institutions 3.Falling confidence 4.Credit crunch 5.Recession 6.A vicious circle

Insolvencies in financial institutions Eventually, home prices stopped rising and then started to fall Borrowers then owed more money than the value of the house theyd bought with the loan Such borrowers stopped repaying their loans – Mortgage loans are non-recourse – Better to just return the house keys to the bank

Insolvencies in financial institutions Of course, banks could take the homes (collateral) and sell them But then banks would lose money because home prices had fallen When banks assets (the homes) lose value, their Capital (owners equity) turns negative – See Ch. 4 At that point, the bank is insolvent

Insolvencies in financial institutions Many financial institutions turned insolvent – Financial institutions have assets and liabilities Assets are what others owe them Liabilities are what they owe others – When the value of assets falls below the value of liabilities, the financial institution is insolvent – When a financial institution becomes insolvent, it is forced to stop operations – When financial institutions stop operations, the economy suffers

Insolvencies in financial institutions Suppose you and your friends decide to start a bank You and your friends put $1,000 of your own money in the business. – This is called capital You borrow $39,000. – These are your liabilities You lend $40,000. – That is, you buy $40,000 in assets Your leverage ratio = assets/capital = 40

Insolvencies in financial institutions Suppose your assets then increase in value by $400 – a mere +1% The return on your capital is +40%!!! This is the magic of leverage

Insolvencies in financial institutions But the magic of leverage cuts both ways If your assets decrease in value by $1,000 (or, a mere -2.5%), you will lose all your capital (or, a loss of -100%)

Insolvencies in financial institutions The heavy reliance on leverage by financial institutions at the time of the Great Recession meant that many such institutions became insolvent when home prices began to fall

Recap: Six Common Features Although each financial crisis is unique, most financial crises share certain common elements 1.Asset-price booms and busts 2.Insolvencies in financial institutions 3.Falling confidence 4.Credit crunch 5.Recession 6.A vicious circle

Falling confidence Some bank deposits are insured by the government But not all As banks and other financial institutions faced the threat of insolvency, many lenders withdrew their deposits (a run) This reduced the ability of businesses to get loans for business projects

Falling confidence Troubled financial institutions also had to sell their assets (loans) at fire sale prices to increase their cash reserves – Banks use short-term deposits to give long-term loans – When short-term deposits dry up for troubled banks, they are forced to sell their long-term loans (to less troubled financial institutions) at fire sale prices

Falling confidence But the fire sale of assets reduces asset prices And, as we saw before, this fall in asset prices can make many financial institutions, that are otherwise healthy, insolvent In this way, trouble spreads like infectious disease

Falling confidence Moreover, if the number of financial institutions is small, each will have lots of financial dealings with the others In that case, if one institution becomes insolvent, the others would also be hurt and may themselves become insolvent

Recap: Six Common Features Although each financial crisis is unique, most financial crises share certain common elements 1.Asset-price booms and busts 2.Insolvencies in financial institutions 3.Falling confidence 4.Credit crunch 5.Recession 6.A vicious circle

Credit crunch With spreading insolvency shutting down financial institutions, and falling confidence leading depositors to take money out of financial institutions, would-be borrowers even those with profitable investment projectshave trouble getting loans

Credit crunch During the Great Recession, loans for home buyers dried up almost completely, as it became clear that home prices do not always go up

Recap: Six Common Features Although each financial crisis is unique, most financial crises share certain common elements 1.Asset-price booms and busts 2.Insolvencies in financial institutions 3.Falling confidence 4.Credit crunch 5.Recession 6.A vicious circle

Recession Many households were unable to borrow money to buy homes or to even buy simple things Many businesses were unable to borrow money to build new factories or buy machines, furniture, etc. So, aggregate planned expenditure fell A recession began

Recession GDP fell Unemployment rose Officially the economy began to recover in June 2009 But in reality, that recovery has been very weak

Recap: Six Common Features Although each financial crisis is unique, most financial crises share certain common elements 1.Asset-price booms and busts 2.Insolvencies in financial institutions 3.Falling confidence 4.Credit crunch 5.Recession 6.A vicious circle

A vicious circle A recession sets off a vicious circle Businesses fail and cant repay their loans This further intensifies the insolvency of financial institutions, which had helped cause the recession in the first place As people lose their jobs, they default on their debts, again adding to the vicious circle

Six Common Features

Case Study: Who should be blamed for the financial crisis of ? Possible culprits include: – The Federal Reserve: it may have kept interest rates too low for too long after the 2001 recession, thereby fueling the housing bubble – Home buyers: they were too stupid to realize that home prices could fall at some point and that theyd be better off renting – Mortgage brokers: knowing that they could sell the loans to investment banksand being greedy and unprincipledthey paid no attention to loan quality

Case Study: Who should be blamed for the financial crisis of ? – Investment banks: they were greedy and unprincipled enough to package the mortgage loans and sell them to gullible buyers (such as pension funds) who believed what the rating agencies said about the mortgage loan packages – Rating agencies: they gave high grades to mortgage assets that later turned out to be highly risky. Maybe they were just stupid. Others say they were greedy for the investment banks business and did not want to make them angry.

Case Study: Who should be blamed for the financial crisis of ? – Regulators: government regulators were not paying any attention to the rampant misbehavior of the private sector. These regulatory bodies were often underfunded. There was a general ideology that hated regulation. – Government policy makers: for decades, politicians in both the Republican and Democratic parties sought to use government policies to encourage home ownership over renting. This may have partially fed the home price bubble

Policy Responses to a Crisis Policy makers used many tools to fight the crisis: – Conventional fiscal policy – Conventional monetary policy – Central banks lender-of-last-resort role – Injections of government funds

Policy Responses to a Crisis Conventional fiscal policy – Taxes were cut – Government spending was increased – But this meant increased budget deficits, which would make already high government debt even higher and, therefore, raise the possibility of a government debt crisis

Policy Responses to a Crisis Conventional monetary policy – Short-term nominal interest rates were cut – But nominal interest rates cannot be reduced below zero

Policy Responses to a Crisis Central banks lender-of-last-resort role – Banks take short-term deposits from savers and lend money for long-term business projects – So, if falling confidence leads to a sudden withdrawal of deposits, even a solvent bank would face a liquidity crisis – The bank may have to sell its assets at fire sale prices, which could crash asset prices, and turn the liquidity crisis into an insolvency crisis

Policy Responses to a Crisis Central banks lender-of-last-resort role – A central bank could prevent such a dire outcome by printing money and lending it to banks that face a liquidity crisis When the central bank makes loans when nobody else would, it is acting as a lender of last resort

Policy Responses to a Crisis Central banks lender-of-last-resort role – During the Great Recession, the Fed made lots of such loans, not only to banks, but to other financial institutions that faced liquidity crises These institutions are called shadow banks because they take short-term deposits and make long-term loans, just like banks Example: money market mutual funds. Fed became a lender of last resort to these funds, when depositors fled

Policy Responses to a Crisis Injections of government funds – When borrowers default on their bank loans, a bank may have to shut down, in which case its depositors would lose their money – That could have ripple effects because the depositors would cut back on their spending plans – The FDIC insures bank deposits up to a limit. This limit was raised from $100k to $250k in 2008 – This reduces the adverse ripple effects of bank failure

Policy Responses to a Crisis Injections of government funds – But the FDIC does not insure all deposits at a failed bank. – Therefore, some adverse ripple effects could still occur – When those ripple effects are likely to be large enough, the bank is called too big to fail and the government uses its money to rescue it

Policy Responses to a Crisis Injections of government funds – Moreover, if it becomes impossible for businesses to borrow money to finance their projects especially somewhat risky onesbusiness investment spending could crash, causing a recession – In such a case, the government could use its funds to directly lend money for such projects

Policy Responses to a Crisis Injections of government funds – Governments may also use their funds to invest money into a bank to enable it to keep lending even when depositors have withdrawn their deposits – The hope is that the crisis is temporary and that the government would get its money back when the crisis ends and depositors return

Policy Responses to a Crisis Injections of government funds – The use of government funds to bail out the financial sector is obviously risky because the government may not get its money back – Moreover, if financial institutions know that the government would always rescue too-big-to-fail firms, they would have incentives to take huge risks (moral hazard) and to become large just to become TBTF

Policy Responses to a Crisis Injections of government funds – However, despite the downside of using taxpayer funds to prop up the financial industry, it may be necessary to do so in order to avoid a huge financial catastrophe

Policies to Prevent a Crisis There are no easy ways to prevent financial crises. They will definitely happen again and again. However, here are a few ideas on prevention: – Pay more attention to shadow banks – Try to make financial institutions smaller – Force banks to reduce risky lending – Toughen up the enforcement of regulations

Prevention: Shadow Banks Commercial banks deposits are insured by the FDIC This could induce these banks to take huge risks – If the risks succeed, the bank keeps the gains – If the risks fail, the taxpayer takes the losses To avoid this, commercial banking is heavily regulated

Prevention: Shadow Banks As a result, the commercial banking sector behaved very well during the crisis of The bulk of bad behavior came from the shadow banking sector, which is only lightly regulated – Investment banks, hedge funds, insurance companies, private equity funds, etc.

Prevention: Shadow Banks The obvious lesson is to treat the shadow banks just like regular banks: insure the depositors and leash the managers One way to leash these financial institutions is to require them to hold more capital (owners equity) and less leverage – When more of the owners money is at stake, these institutions may take more sensible risks

Prevention: Smaller Wall Street No financial institution should be so vital to the financial system that it becomes too big to fail Such an institution would be tempted to take big risks because – If the risk succeeds, the managers make money – If the risk fails, the taxpayer will come to the rescue

Prevention: Smaller Wall Street If the financial system is dominated by just a few firms, they are likely to be deeply interconnected In such a situation, the failure of even one firm may lead to big losses in all firms, thus making each firm TBTF So, the financial system needs moderately sized firms, and lots of them

Prevention: Smaller Wall Street Mergers and acquisitions among financial firms need to be discouraged Bigger firms should be required to have more capital (owners equity) so that they take only sensible risks On the other hand, bigness has the advantage of economies of scale

Prevention: Safer Wall Street Apart from higher capital requirements, the financial system could be made safer by requiring commercial bankswhose deposits are guaranteed by the FDICfrom trading in complex assets such as derivatives (Volcker Rule) Derivatives should be traded in exchanges, so that regulators can have better information

Prevention: Tougher Regulators The governments regulators clearly failed in doing their job The numerous regulatory agencies could be consolidated into a smaller number New regulatory agencies have been set up in the US to watch the credit rating agencies, the treatment of consumers of financial products, and coordination of regulators