1. 1 Understanding Financial Crises Franklin Allen and Douglas Gale Clarendon Lectures in Finance June 9-11, 2003

2. 2 Lecture 3 Bubbles and Crises Franklin Allen University of Pennsylvania June 11, 2003 http://finance.wharton.upenn.edu/~allenf/

3. 3 Introduction In the previous lectures fundamental driven crises were caused by low asset returns or high liquidity demand In the previous lectures fundamental driven crises were caused by low asset returns or high liquidity demand These events are often associated with the bursting of bubbles These events are often associated with the bursting of bubbles Kindleberger (1978) suggests that such bubbles are often driven by an expansion of money and credit Kindleberger (1978) suggests that such bubbles are often driven by an expansion of money and credit

4. 4 Can bubbles exist? Historical bubbles Tulipmania 1635 Tulipmania 1635 South Sea Bubble 1720 South Sea Bubble 1720 Wall Street Crash of 1929 Wall Street Crash of 1929 Recent bubbles Japan late 1980’s Japan late 1980’s Scandinavia early 1990’s Scandinavia early 1990’s The technology bubble late 1990’s The technology bubble late 1990’s

5. 5 What is a bubble? Standard models of asset pricing assume people invest with their own money Standard models of asset pricing assume people invest with their own money We call the price of an asset in this benchmark case is the "fundamental" We call the price of an asset in this benchmark case is the "fundamental" We say a bubble occurs when the price of an asset rises above this fundamental We say a bubble occurs when the price of an asset rises above this fundamental

6. 6 Can bubbles be rational? Infinite horizon bubbles Possibility of bubbles: Samuelson (1958), Blanchard and Watson (1982), Tirole (1985) Possibility of bubbles: Samuelson (1958), Blanchard and Watson (1982), Tirole (1985) Rarity of bubbles in standard general equilibrium models: Santos and Woodford (1997) Rarity of bubbles in standard general equilibrium models: Santos and Woodford (1997)

7. 7 Finite horizon bubbles Ruling out bubbles with symmetric information: Tirole (1982) Ruling out bubbles with symmetric information: Tirole (1982) Bubbles as market failures due to asymmetric information Bubbles as market failures due to asymmetric information Agency problems: Allen and Gorton (1993), Allen and Gale (2000) Agency problems: Allen and Gorton (1993), Allen and Gale (2000) Lack of common knowledge: Allen, Morris and Postlewaite (1993), Morris, Postlewaite and Shin (1995), Brunnermeier (2001), Allen, Morris and Shin (2003) Lack of common knowledge: Allen, Morris and Postlewaite (1993), Morris, Postlewaite and Shin (1995), Brunnermeier (2001), Allen, Morris and Shin (2003)

8. 8 A model of rational bubbles Allen and Gale (2000) assume the people who make investment decisions do so with borrowed money Allen and Gale (2000) assume the people who make investment decisions do so with borrowed money Lenders cannot observe the riskiness of projects so there is an agency problem Lenders cannot observe the riskiness of projects so there is an agency problem Borrowers prefer risky projects because they receive the excess above debt payments Borrowers prefer risky projects because they receive the excess above debt payments They bid the prices of risky projects above their fundamentals and there is a bubble They bid the prices of risky projects above their fundamentals and there is a bubble The more money and credit that is available the higher that prices are bid The more money and credit that is available the higher that prices are bid

9. 9 Two assets: t = 01 Safe asset: 1 1.5 (variable supply) Risky asset 1 unit6 w. pr. 0.25 (fixed supply)costs P1 “ “ 0.75 ER = 2.25 All investors are risk neutral

10. 10 The fundamental Investors have wealth 1 and invest own money Investors have wealth 1 and invest own money Equating marginal returns Equating marginal returns 2.25 = 1.5 P F 1 P F 1 P F = 2.25 = 1.5 P F = 2.25 = 1.5 1.5 1.5

11. 11 Intermediated case Investors have no wealth of their own Investors have no wealth of their own They can borrow 1 at date 0 and repay 1.33 at date 1 if they can They can borrow 1 at date 0 and repay 1.33 at date 1 if they can Lenders can’t observe how loans are invested Lenders can’t observe how loans are invested

12. 12 Can P = 1.5 be equilibrium price? Borrow 1 and invest in safe asset R Safe = 1.5 – 1.33 = 0.17 R Safe = 1.5 – 1.33 = 0.17 Borrow 1 to buy 1/1.5 units of risky asset R Risky = 0.25( 1 x 6–1.33) + 0.75x0 = 0.67 > 0.17 1.5 1.5

13. 13 What is the equilibrium P? Since risky asset is in fixed supply, P will be bid up until returns are equated Since risky asset is in fixed supply, P will be bid up until returns are equated 0.25( 1 x 6 – 1.33) + 0.75 x 0 = 1.5 – 1.33 0.25( 1 x 6 – 1.33) + 0.75 x 0 = 1.5 – 1.33 P P = 3 There’s a bubble since P = 3 > P F = 1.5 There’s a bubble since P = 3 > P F = 1.5

14. 14 The more risk there is the greater is the risk shifting and the larger the bubble The more risk there is the greater is the risk shifting and the larger the bubble Default and a financial crisis occurs in this model when the return on the risky asset is low Default and a financial crisis occurs in this model when the return on the risky asset is low Risk shifting can occur in equilibrium provided there is a spread between the rate depositors receive and the rate the bank lends at so competitive banks earn zero profits Risk shifting can occur in equilibrium provided there is a spread between the rate depositors receive and the rate the bank lends at so competitive banks earn zero profits The bank’s depositors bear the costs of the agency problem and this requires markets are segmented to be possible in equilibrium The bank’s depositors bear the costs of the agency problem and this requires markets are segmented to be possible in equilibrium

15. 15 Credit and interest rates The central bank sets credit B The central bank sets credit B The interest rate r is equal to the marginal product of capital f’(B-P) The interest rate r is equal to the marginal product of capital f’(B-P) r = f’(B-P) So the central bank controls r So the central bank controls r

16. 16 Pricing equation is now 0.25( 1 x 6 – f’(B-P)) + 0.75 x 0 = 0 0.25( 1 x 6 – f’(B-P)) + 0.75 x 0 = 0 P With f(x) = 3x 0.5 it can be shown P(B) = 8(- 1 + (1+0.25B) 0.5 )

17. 17 Fundamental pricing equation P F = 2.25 f’(B-P F ) f’(B-P F ) P F (B) = -1.125 + 0.75(2.25 + 4B) 0.5

18. 18

19. 19 Financial risk The model can be developed to consider the dynamic relationship between the amount of credit available to investors and asset prices The model can be developed to consider the dynamic relationship between the amount of credit available to investors and asset prices What is meant by financial risk? What is meant by financial risk? The amount of credit and hence interest rates are taken as random variables by investors and this uncertainty leads to uncertainty in asset prices The amount of credit and hence interest rates are taken as random variables by investors and this uncertainty leads to uncertainty in asset prices

20. 20 Level of credit = B 0 Random level of credit = B 1 P(B 1 ) random Asset in fixed supply pays R t = 0 12

21. 21 Initially investors must anticipate the amount of credit at the subsequent date since this determines asset prices at the subsequent date Initially investors must anticipate the amount of credit at the subsequent date since this determines asset prices at the subsequent date If credit turns out to be too low asset prices will not be high enough for loans to be repaid and default will occur If credit turns out to be too low asset prices will not be high enough for loans to be repaid and default will occur Risk results from uncertainty about credit and so is financial Risk results from uncertainty about credit and so is financial

22. 22 The risk shifting effect operates for financial risk in the same way as it does for real risk so there can again be a bubble The risk shifting effect operates for financial risk in the same way as it does for real risk so there can again be a bubble The possibility of credit expansion over a period of years may create a great deal of uncertainty about how high the bubble may go and when it may collapse The possibility of credit expansion over a period of years may create a great deal of uncertainty about how high the bubble may go and when it may collapse

23. 23 The level and volatility of credit are important in the determination of asset prices The level and volatility of credit are important in the determination of asset prices Governments and central banks should avoid unnecessary expansion in the level of credit and uncertainty about the path of credit expansion Governments and central banks should avoid unnecessary expansion in the level of credit and uncertainty about the path of credit expansion Financial liberalization is particularly risky Financial liberalization is particularly risky Policies to prevent bubbles

24. 24 Policies to minimize after-effects Financial problems of the banking sector spill over into the real economy because of debt overhang and inefficient liquidation Financial problems of the banking sector spill over into the real economy because of debt overhang and inefficient liquidation Effective solution in Effective solution in Norway, Sweden Ineffective solution in Ineffective solution inJapan

25. 25 Post-bubble debt overhang Ineffective policies to eliminate banking sector problem may lead to large government debt as in Japan Ineffective policies to eliminate banking sector problem may lead to large government debt as in Japan This government debt in itself becomes the problem This government debt in itself becomes the problem How have large debt overhangs been eliminated in the past? How have large debt overhangs been eliminated in the past?

26. 26 Prolonged growth Britain after Napoleonic Wars Britain after Napoleonic Wars Extended period of moderate inflation Britain after mid 1950’s Britain after mid 1950’s Burst of hyperinflation Austria after WW1 and Japan after WW2 Austria after WW1 and Japan after WW2

27. 27 Extended hyperinflation Germany after WW1 (Weimar inflation) Germany after WW1 (Weimar inflation)Default Germany after WW2 Germany after WW2

28. 28 The future What will happen in Japan? What will happen in Japan?