2. Significant disruption in flow of funds from lenders to borrowers, typically leads to econ recession as there is not enough money to borrow. Insolvency: assets worth < liabilities or net worth < 0. Past US fin crises involved commercial banks. Maturity mismatch (borrow short term & lend long term) => liquidity risk (unable to pay withdrawals) => insolvent banks borrow or sell assets to raise funds. Contagion when run on one spreads to other banks => bank panic (self-fulfilling perception: If depositors believe banks are in trouble, they are). Lower asset prices (many banks sell same assets - mortgage-backed securities) => insolvency & recess. Before 1933 when banks exhaust liquid assets, simultaneous withdrawals by depositors w/o confidence forces closure. Banks stability = f(depositor’s confidence). Between 1885 & 1933, 11 of 13 bank panics resulted in recession. To avoid bank panics government established: FDIC for commercial bank’s deposits & FED as lender of last resort to solvent banks against their good, but illiquid loans. Alternative: impose 100% reserves (currently banks hold 10% of checkable deposits) forcing banks to make loans & buy securities with their capital, not deposits. Depositors no longer at risk of losing money if banks make poor investments, avoiding bank runs. Financial Crises

3. Severity of the 2007–2009 Recession Since 1933 bank panics didn’t accompany US recessions, but 07-09 recession involved panic in “shadow banking system.” Data for US during Great Depression & other countries after WWII (e.g. Japan, Korea Norway & Sweden) show that recessions following bank crises were quite severe (higher unemployment, sharper & longer RGDP declines). Government debt also ↑ from higher government spending & higher budget deficits (tax revenues ↓ w/ lower incomes & profits due to recession). Comparison of key indicators for the 07–09 with other post WWII US recessions.

4. Exchange Rate Crises Pegging the Won-Dollar Exchange Rate Pegged exchange rate (E 2 ) was above the equilibrium exchange rate (E 1 ). To maintain the peg, the Korean central bank had to use dollars from currency reserves to buy surplus won equal to Won 3 – Won 2 (can’t go on forever or reserves ). Countries attempted to keep the value of their currency by pegging it. Does not work unless the source of currency depreciation is removed. Currency boards used to re-establish confidence in fiat money.

5. Sovereign Debt Crises When a country has difficulty payments its government issued bonds. If government defaults & can’t issue bonds, only tax revenues finance spending. Even if avoids default, it will have to pay much higher rates when it issues bonds. The resulting decreases in spending or increases in taxes can cause recession. Sovereign debt crises results from either: 1) chronic budget deficits & interest payments ↑ fraction of government spending, 2) severe recession that ↑ government spending & ↓ tax revenues, ↑ budget deficits. Following the 2007–2009 recession, several European governments (e.g., Greece) pushed to debt crises edge & imposed sharp spending cuts and higher taxes. In 2012, Greek politicians vowed to reverse the policy of government spending cuts and higher taxes, leading to speculation that Greece would abandon the euro. Many Greeks were afraid that the government might decide to exchange euro bank deposits for drachmas, which might subsequently depreciate. In May 2012, Greek banks began to lose deposits slowly as depositors were unsure exactly when Greece would actually stop using the euro.

6. Factors Increasing Severity of Downturn During the Great Depression Stock prices plunged, reducing household wealth, making it more difficult for firms to raise funds, increasing uncertainty which led to decreases in spending. Tariff Act of 1930 led to retaliatory foreign tariffs, reducing U.S. exports. Following anti-immigration legislation spending on new houses fell. Debt-deflation process (cycle of falling prices of assets, goods and services) can increase the severity of an economic downturn. Two negative effects of ↓ prices: Real interest rates would rise, and the real value of debts would increase. This process of ↓ prices combined with ↑bankruptcies & defaults ↑ severity. Why Did Fed Not Intervene to Stabilize Banking System 1. No one was in charge. Power w/in Fed was divided. Fed was less independent & important decisions required consensus which was hard to come by. 2. Fed was reluctant to rescue insolvent banks. Fed believed that saving them encouraged risky behavior (moral hazard) by bank managers. 3. Fed did not understand difference between nominal & real interest rates. With ↓ prices real interest % were much higher than Fed believed them to be. 4. Fed was “purging speculative excess”. Many Fed members blamed speculators for Depression & used “liquidationist” policy: allowing price, weak banks & firms to fall.

7. ↓ by 27% ↓ by 81% ↓ by 18% tripled over 1929-30, was > 20% in 1932-3, and > 10% in 1939 In 1943 FDIC established Stock prices ↑ 1928-9 => Fed ↑ interest % => stock price ↓ 1929-32 was the largest in US history.

8. The Housing Bubble Bursts 2000.01. – 2006.05. house prices ↑ > 100%, rent ↑ evidence of a bubble. Home prices began ↓ in 2006 after some homebuyers couldn’t pay mortgages. Prices further ↓ when lenders foreclosed & sold homes & new homebuyers couldn’t get mortgages credit crunch (banks tightened borrowing requirements). Bank Runs at Bear Stearns and Lehman Brothers 2007.08. BNP Paribas suspends shares redemption in three funds with large amounts of mortgage-backed securities (MBS). Credit conditions worsen. 2008.03. Bear Sterns’ MBS concern lenders, Fed’s aid temporary prevent bankruptcy, but days later bought by JPMorgan Chase at $10/share (07.03. $170/share). 2008.08. Crisis deepens, almost 25% of subprime mortgages ≥ 30 days past due. 2008.09. Lehman Brothers files for bankruptcy Treasury & Fed decline to help. Merrill Lynch agrees to sell itself to Bank of America. Reserve Primary Fund announces it would “break the buck” shares fall to $0.97. Many parts of fin system become frozen as trading in securitized loans largely stops. The Financial Crisis of 2007–2009

9. The Federal Government’s Extraordinary Response to Financial Crisis Focusing on commercial banks, government ill equipped for shadow banks crisis. Well into 2007 policymakers didn’t realize subprime crisis might evolve to fin crisis. The Fed began aggressively driving down short-term interest rates. The federal government effectively nationalized Fannie Mae & Freddie Mac. The Treasury moved to stop the runs on money market mutual funds. The Treasury began to lend directly to corporations through the Commercial Paper Funding Facility. In 2008 Fed & Treasury proposed Congress to authorize $700 billion used to purchase mortgages & MBS from fin firms & other investors thorough Troubled Asset Relief Program (direct preferred stock purchases in banks to increase bank capital). In early 2009, Treasury administered a stress test to 19 large fin firms to reassure investors that firms had sufficient capital to deal with a severe economic downturn. The Financial Crisis of 2007–2009

10. Pattern: 1) crisis, 2) regulation, 3) response by fin firms & 4) response by regulators. Fed as Lender of Last Resort Fed (as lender of last resort) created to provide liquidity to banks during bank panics. Fed failed its 1 st crucial test when it stood by banking system collapse in early 1930s. Fix: FDIC & Fed’s Federal Open Market Committee to centralize decision making. Fed’s Post WWII Success & Development of Too-Big-to-Fail Policy In 1970 gave loans to commercial banks when quality commercial paper questioned. In 1974 saved Franklin National Bank from run by depositors holding negotiable CDs. During 1987.10.19. stock market crash, Fed Chairman Alan Greenspan, announced Fed’s readiness to provide liquidity to support econ & fin systems. In 1984 comptroller of currency named banks too big to fail (systemic risk to fin system) given unlimited deposit insurance (↑ moral hazard & unfair to small banks). In 1991, FDIC Improvement Act (FDICIA): use the least costly method (support or close & reimburse depositors), except when bank’s failure would cause “serious adverse effects on economic conditions or financial stability.” Financial Crises and Financial Regulation

11. Financial Crisis and Broader Fed Role as Lender of Last Resort Criticism that Fed & Treasury aid Bear Stearns 2008.03. ↑ moral hazard in fin system, may have caused Fed’s not to save Lehman Brothers in 2008.09. In few days Fed loaned American International Group for 80% ownership of firm. Too-big-to-fail was back: Fed, FDIC & Treasury prevented failure of any large fin firm. 2010 Dodd-Frank Act Financial Overhaul: End of Too-Big-to-Fail Policy? Wall Street Reform & Consumer Protection (Dodd-Frank) Act allows Fed, FDIC & Treasury to seize & close large fin firms (before only FDIC close commercial banks). FDIC: Dodd-Frank Act shifts investments toward smaller firms with lower info costs. Larger firm have to pay higher E(R) to compensate for absence of bailout. Consumer Financial Protection Bureau (against deceptive practices by fin firms). Financial Stability Oversight Council (identify & act on systemic risk to fin system). Ended too-big-to-fail policy for large financial firms. Made several changes to Fed’s operations. Required certain derivatives to be traded on exchanges, not over the counter. Implemented Volcker Rule banning most proprietary trading at commercial banks. Required hedge funds & private equity firms to register with the SEC. Required firms selling MBS & similar assets to retain at least 5% of credit risk. Financial Crises and Financial Regulation

12. Fed as Lender of Last Resort: Crisis, Regulation, Fin System & Regulatory Response 2007-09 Fin Crisis: Crisis, Regulation, Fin System & Regulatory Response

13. Limiting banks competition ↓ bankers’ propensity for excessively risky investments, but may ↑ incentives for unregulated fin institutions & markets to compete with banks. Regulation Q (limit % banks pay on time & savings deposits & prohibit % on demand deposits) established by Banking Act of 1933 to limit competition for funds & ↓ loan %. In 1970s rising inflation ↑ % above Regulation Q ceilings, households substitute money market mutual funds & other short-term investment instruments for bank deposits. Disintermediation savers (no funds to loan) & borrowers (only low- as high-quality sold commercial papers to money market mutual funds) exit banks for fin markets. To circumvent Regulation Q, banks developed new fin instruments for savers. Citibank introduced negotiable CDs not subject to Regulation Q % ceilings, & negotiable order of withdrawal (NOW) accounts on which they paid %. Automatic transfer system (ATS) accounts “sweeping” customer’s checking account balance at day’s end into interest paying repo in order to pay % on checking account. Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) & Garn-St. Germain Act of 1982 phased out Regulation Q & helped reverse disintermediation with money market deposit accounts (no reserve requirement & processing only up to 6 checks/month ↓ cost allowing ↑ % than on NOW accounts). Reducing Bank Instability

14. Bank receives CAMELS rating based on:Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk Capital requirements reduces the potential for moral hazard & cost of bank failures. Regulators ↑ focus on capital requirements after S&L crisis of 1980s. (In 1979 ↑ % ↑ cost for S&Ls, ↓ PV of existing mortgage assets & net worth. High leverage (capital often 3% of assets) magnifying losses. Costly government bailout ended S&L failures). After S&L crises Basel Committee on Banking Supervision (from Bank of International Settlements) developed Basel accord (4 risk based categories of bank’s assets multiplied by risk-adjusted factor to get risk-adjusted assets). Capital adequacy uses two measures of bank’s capital relative to risk-adjusted assets: Tier 1 capital consists mostly of bank capital, or shareholder’s equity. Tier 2 capital equals the bank’s loan loss reserves, its subordinated debt (↑ incentive to monitor managers) & several other bank balances sheet items. Capital Requirements

15. Implementing capital requirements forced banks with low capital ratios to close or to raise additional capital. Holding relatively risky assets (e.g. MBS) required banks to hold additional capital. Large commercial banks developed fin innovations allowing banks to push some assets off their balance sheets. Citigroup formed special investment vehicles (SIVs) to hold risky assets. By the time of fin crisis, there were about 30 SIVs, holding about $320 billion in assets. As assets in SIVs lost value, banks were forced to bring them back into balance sheet.

16. Capital Requirements: Crisis, Regulation, Fin System & Regulatory Response Interest Rate Ceilings: Crisis, Regulation, Fin System & Regulatory Response