Financial crisis
1
Objectives
Financial Crises and the Subprime Meltdown
1- Factors Causing Financial Crises
2- Dynamics of past U.S. Financial Crises
3- The Subprime Financial Crisis of 2007 – 2008
1. Factors Causing Financial Crises
1- Asset Markets Effects on Balance Sheets
A- Stock market decline (Decreases net worth of corporations).
B- Unanticipated decline in the price level (Liabilities increase in real terms and net worth decreases).
C- Unanticipated decline in the value of the domestic currency (Increases debt denominated in foreign currencies and
decreases net worth).
D- Asset write-downs.
2- Deterioration in Financial Institutions’ Balance Sheets
• Decline in lending.
3. Banking Crisis
• Loss of information production and disintermediation.
4. Increases in Uncertainty
• Decrease in lending.
5. Increases in Interest Rates
A- Increases adverse selection problem
B- Increases need for external funds and therefore adverse selection and moral hazard.
6. Government Fiscal Imbalances
A- Create fears of default on government debt.
B- Investors might pull their money out of the country.
2. Dynamics of past U.S. Financial Crises
1- Stage One: Initiation of Financial Crisis
- Mismanagement of financial liberalization/innovation
- Asset price boom and bust
- Spikes in interest rates
- Increase in uncertainty
2- Stage two: Banking Crisis
3- Stage three: Debt Deflation
3. The Subprime Financial Crisis of 2007 – 2008
Dynamics of Financial Crises in Emerging Market Economies
➢ Stage one: Initiation of Financial Crisis.
Path one: mismanagement of financial liberalization/globalization:
- Weak supervision and lack of expertise leads to a lending boom.
- Domestic banks borrow from foreign banks.
- Fixed exchange rates give a sense of lower risk.
- Banks play a more important role in emerging market economies, since securities markets are not well developed yet.
Path two: severe fiscal imbalances:
- Governments in need of funds sometimes force banks to buy government debt.
- When government debt loses value, banks lose and their net worth decreases.
Additional factors:
- Increase in interest rates (from abroad)
- Asset price decrease
- Uncertainty linked to unstable political systems
