DOCSLIB.ORG

Essays on Financial Stability

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
Essays on Financial Stability Bank of Canada Banque du Canada Technical Report No. 95 / Rapport technique no 95 Essays on Financial Stability by John Chant, Alexandra Lai, Mark Illing, and Fred Daniel September 2003 Essays on Financial Stability John Chant, Alexandra Lai, Mark Illing, and Fred Daniel The views expressed in this report are solely those of the authors. No responsibility for them should be attributed to the Bank of Canada. ISSN 0713-7931 Printed in Canada on recycled paper ISSN 0713-7931 ISBN Printed in Canada on recycled paper iii Contents Introduction . iii Introduction (en français) . xi Financial Stability as a Policy Goal by John Chant 1. Introduction . 1 2. What is Financial Stability? . .3 2.1 The financial dimension of instability . 3 2.2 Criteria for instability . 4 3. Instability and the Financial Sector . 5 4. The Costs of Financial Instability . 8 5. A Role for Policy? . 12 6. The Role of Central Banks in Financial Stability . 14 6.1 Policy for financial stability . 14 6.2 What can a central bank contribute? . 14 6.3 A shared responsibility . 16 7. Challenges of Financial Stability Policy . 17 7.1 Accountability and conduct . 17 7.2 The liquidity dilemma . 19 7.3 Financial stability and other policy goals . 20 7.4 Financial stability and efficiency . 21 8. Conclusion . 22 References . 23 Appendix . 24 Financial Fragility: A Survey of the Theoretical Literature by Alexandra Lai 1. Introduction . 29 2. Stylized Facts about Financial Crises . 32 2.1 Financial crises result in substantial real costs in economic output . 32 2.2 Episodic or transitory? . 32 2.3 Onset difficult to predict . 33 iv 2.4 Often preceded by a period of credit expansion . 33 2.5 Involve liquidity shortages . 33 2.6 Unstable asset prices . 34 2.7 Contagion within and across markets . 34 2.8 Loss of confidence by investors . 34 3. Coordination Failure . .34 3.1 “Sunspot” equilibrium models . 36 3.2 Equilibrium-selection models . 37 3.3 Limited-commitment models . 39 3.4 Discussion and policy implications: Coordination failure . 40 4. Failure of Markets for Liquidity . 42 4.1 Market power in liquidity markets . 42 4.2 Imperfect information in interbank markets . 44 4.3 Discussion and policy information: Failure of liquidity markets . 45 5. Contagion . 46 5.1 Information contagion . 46 5.2 Information via credit linkages . 47 5.3 Discussion and policy implications: Contagion . 48 6. Financial Accelerator . .50 6.1 Financial accelerator caused by information problems . 51 6.2 Financial accelerator arising from commitment problems . 52 6.3 Discussion and policy implications: Financial accelerator . 53 7. Conclusion . 54 References . 57 A Review of Notable Financial-Stress Events by Mark Illing 1. Introduction . 61 2. The Stock Market Crash of October 1987 . 61 2.1 The market crisis . 62 2.2 The threat to financial stability . 64 2.3 The short-term policy response . 64 2.4 Long-term perspective and lessons . 67 v 3. The Collapse of Long-Term Capital Management . 68 3.1 The liquidity crisis . 70 3.2 The threat to financial stability . 72 3.3 The short-term policy response . 73 3.4 Lessons learned from LTCM . 74 4. Failures of Small Canadian Banks . 75 4.1 Why did the banks fail? . 76 4.2 The reaction of markets for liquidity . 79 4.3 The short-term policy response . 80 4.4 The direct costs of the bank failures . 81 4.5 Long-term perspective and lessons . 82 5. The Bank of New York’s $23.6 Billion Computer Bug . 83 5.1 The short-term policy response . 84 5.2 Long-term lessons . 86 6. Summary Remarks . ..
Load more

Recommended publications
  • Identifying Financial Fragility in the Financial Sector
    Bard College Bard Digital Commons Senior Projects Spring 2017 Bard Undergraduate Senior Projects Spring 2017 Before 'It' Happens Again: Identifying Financial Fragility in the Financial Sector John Henry Glascock III Bard College, [email protected] Follow this and additional works at: https://digitalcommons.bard.edu/senproj_s2017 Part of the Behavioral Economics Commons, Economic Theory Commons, and the Finance Commons This work is licensed under a Creative Commons Attribution-Noncommercial-No Derivative Works 4.0 License. Recommended Citation Glascock, John Henry III, "Before 'It' Happens Again: Identifying Financial Fragility in the Financial Sector" (2017). Senior Projects Spring 2017. 244. https://digitalcommons.bard.edu/senproj_s2017/244 This Open Access work is protected by copyright and/or related rights. It has been provided to you by Bard College's Stevenson Library with permission from the rights-holder(s). You are free to use this work in any way that is permitted by the copyright and related rights. For other uses you need to obtain permission from the rights- holder(s) directly, unless additional rights are indicated by a Creative Commons license in the record and/or on the work itself. For more information, please contact [email protected]. Before ‘It’ Happens Again: Identifying Financial Fragility in the Financial Sector Senior Project Submitted to The Division of Social Studies of Bard College by John Glascock Annandale-on-Hudson, New York May 2017 Plagiarism Statement I have written this project using in my own words and ideas, except otherwise indicated. I have subsequently attributed each word, idea, figure, and table which are not my own to their respective authors.
    [Show full text]
  • The Run for Safety: Financial Fragility and Deposit Insurance
    The Run for Safety: Financial Fragility and Deposit Insurance Rajkamal Iyer, Thais Jensen, Niels Johannesen and Adam Sheridan * April 2016 Abstract We study a run on uninsured deposits in Danish banks triggered by a reform that limited deposit insurance coverage. Using a unique dataset with information about all individual accounts in Danish banks, we show that the reform caused a 50% decrease in deposits above the insurance limit in non- systemic banks, but a much smaller decrease in systemic banks which experienced less withdrawals from uninsured accounts, but also more openings of new uninsured accounts. Our results highlight the significant risks from a differential reallocation of uninsured deposits across banks and, in turn, the need for high insurance limits during a crisis. * Rajkamal Iyer: MIT Sloan, 100 Main street, Cambridge, MA 02142. E-mail: [email protected]. Thais Jensen: Department of Economics, University of Copenhagen, Øster Farimagsgade 5, DK-1353 Copenhagen K and Danmarks Nationalbank, Havnegade 5, DK-1093 Copenhagen K. E-mail: [email protected]. Niels Johannesen: Department of Economics, University of Copenhagen, Øster Farimagsgade 5, DK-1353 Copenhagen K. E-mail: [email protected]. Adam Sheridan: Department of Economics, University of Copenhagen, Øster Farimagsgade 5, DK-1353. Email: [email protected]. We thank Puriya Abbassi, Nittai Bergman, Doug Diamond, Antoinette Schoar, Andrei Shleifer, Jeremy Stein and Phil Strahan, Haluk Unal and seminar participants at University of Maryland, Wharton, HEC Paris, University of Zurich, University of Oxford, NUS, Imperial College, UCLA, Federal Reserve Board and FDIC for comments. 1 1. Introduction An important concern in most crises is that uninsured depositors, fearing for the safety of their deposits, might run on banks and destabilize the financial system.
    [Show full text]
  • Sources of Financial Fragility: the Role of Debt Management
    Sources of Financial Fragility: The Role of Debt Management Thesis submitted in accordance with the requirements for the degree of D o c t o r o f P h il o s o p h y by Elisabetta Falcetti Supervisor: Vassilis Hajivassiliou The London School of Economics and Political Science University of London United Kingdom April 2004 UMI Number: U185800 All rights reserved INFORMATION TO ALL USERS The quality of this reproduction is dependent upon the quality of the copy submitted. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if material had to be removed, a note will indicate the deletion. Dissertation Publishing UMI U185800 Published by ProQuest LLC 2014. Copyright in the Dissertation held by the Author. Microform Edition © ProQuest LLC. All rights reserved. This work is protected against unauthorized copying under Title 17, United States Code. ProQuest LLC 789 East Eisenhower Parkway P.O. Box 1346 Ann Arbor, Ml 48106-1346 TH£S£S f V 710-1 ACKNOWLEDGMENTS I would like to thank everyone —academics, colleagues and friends— who has influenced this work and persuaded me to finish it. To begin with, I am grateful to my professors at Bocconi University in Milan who encouraged me to undertake my post-graduate studies abroad, first at DELTA (Paris) and then at the London School of Economics. The year in Paris has been highly instructive, not only from a scientific point of view but also a personal one. I would like to thank in particular Prof.
    [Show full text]
  • The Moral Hazard Paradox of Financial Safety Nets
    \\jciprod01\productn\C\CJP\25-1\CJP102.txt unknown Seq: 1 23-DEC-15 16:49 THE MORAL HAZARD PARADOX OF FINANCIAL SAFETY NETS John Crawford* Moral hazard plays a central role in almost every narrative of the recent financial crisis: the government’s implicit guarantees led to ex- cessive risk-taking, and when the guarantees turned explicit, it exacer- bated moral hazard going forward. The moral hazard narrative of crisis causes and effects motivated key reform efforts, including the statutory elimination of authorities regulators used to guarantee trillions of dol- lars of private debt in an effort to halt widespread panic in late 2008. Some argue that the elimination of these broad guarantee authorities was a mistake, but even these critics acknowledge that the moral hazard costs of guarantees are significant. This Article argues that the absence of broad guarantee authorities could, counterintuitively, exacerbate moral hazard in the current U.S. financial system. Broad guarantee authorities can be seen as a “strong” tool for stopping panics. Stripped of this strong tool, regulators never- theless retain a number of weaker tools that, while unequal to containing a full-blown panic, might prevent one from starting in the first place through targeted bailouts of specific firms or their creditors. Lacking a strong panic-prevention tool, regulators are likelier to err on the side of caution in saving a weak firm even when the firm’s failure might not have sparked a panic. It is possible, therefore, that weak firms are more likely, rather than less likely, to be bailed out in the current system.
    [Show full text]
  • Neglected Risks, Financial Innovation, and Financial Fragility
    Neglected Risks, Financial Innovation, and Financial Fragility The Harvard community has made this article openly available. Please share how this access benefits you. Your story matters Citation Gennaioli, Nicola, Andrei Shleifer, and Robert W. Vishny. 2012. Neglected risks, financial innovation and financial fragility. Journal of Financial Economics 104(3): 452-468. Published Version dx.doi.org/10.1016/j.jfineco.2011.05.005 Citable link http://nrs.harvard.edu/urn-3:HUL.InstRepos:10886835 Terms of Use This article was downloaded from Harvard University’s DASH repository, and is made available under the terms and conditions applicable to Open Access Policy Articles, as set forth at http:// nrs.harvard.edu/urn-3:HUL.InstRepos:dash.current.terms-of- use#OAP Neglected risks, financial innovation, and financial fragility Nicola Gennaioli, Andrei Shleifer, and Robert Vishny* Final Draft, May 2011 Abstract We present a standard model of financial innovation, in which intermediaries engineer securities with cash flows that investors seek, but modify two assumptions. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second, investors demand securities with safe cash flows. Financial intermediaries cater to these preferences and beliefs by engineering securities perceived to be safe but exposed to neglected risks. Because the risks are neglected, security issuance is excessive. As investors eventually recognize these risks, they fly back to the safety of traditional securities and markets become fragile, even without leverage, precisely because the volume of new claims is excessive. JEL Codes: E44, G01, G21, G32 Keywords: banks, local thinking, crisis * We are grateful to Pedro Bordalo, Robin Greenwood, Sam Hanson, Anil Kashyap, Brock Mendel, Vladimir Mukharlyamov, Adriano Rampini, Michael Rashes, Joshua Schwartzstein, Jeremy Stein, seminar participants at the Harvard Business School, National Bureau of Economic Research, Stern School, and Chicago Booth, as well as the editor and two referees for helpful comments.
    [Show full text]
  • Economics of Capital Controls
    RESEARCH INSTITUTE POLITICAL ECONOMY The Myth of Financial Protectionism: The New (and Old) Economics of Capital Controls Kevin P. Gallagher Gordon Hall 418 North Pleasant Street January 2012 Amherst, MA 01002 Phone: 413.545.6355 Fax: 413.577.0261 [email protected] www.peri.umass.edu WORKINGPAPER SERIES Number 278 The Myth of Financial Protectionism: The New (and old) Economics of Capital Controls Kevin P. Gallagher1 Abstract Unstable global capital flows to developing countries have been characteristic of the world economy in the wake of the global financial crisis. The nations that have deployed capital controls to mitigate the negative effects of such flows have been branded as “protectionist” by some. This paper argues that such claims are unfounded. There is a longstanding strand of modern economic theory that dates back to Keynes and Prebisch and continues to this day that sees the use of capital controls as essential for macroeconomic stability and in order to deploy an independent monetary policy. In a most recent development, a “new welfare economics” of capital controls has arisen within the mainstream that sees controls as measures to correct for market failures due to imperfect information, contagion, uncertainty and beyond. Taken as a whole then, rather than the “new protectionism,” capital controls could be seen as the “new correctionism” that re-justifies a tool that has long been recognized to promote stability and growth in developing countries. JEL codes: E44,E5,F3,F30,F32,F34,F41 I. Introduction “the imposition of barriers to inward capital flows have begun to replace tariffs and quotas in the trade protectionism arsenals of governments.” Richard Dodd and Michael Spence, Financial Times 2011 Unstable global capital flows to developing countries have been characteristic of the world economy in the wake of the global financial crisis.
    [Show full text]
  • Capital Inflows, Policy Responses, and Their Ill Consequences: Thailand, Malaysia, and Indonesia in the Decade Before the Crises
    RESEARCH INSTITUTE POLITICAL ECONOMY POLITICAL ECONOMY RESEARCH INSTITUTE University of Massachusetts Amherst Capital inflows, policy responses, and their ill consequences: Thailand, Malaysia, and Indonesia in the decade before the crises Clara García 2004 10th floor Thompson Hall University of Massachusetts Amherst, MA, 01003-7510 Telephone: (413) 545-6355 Facsimile: (413) 545-2921 Email:[email protected] Website: http://www.umass.edu/peri/ WORKINGPAPER SERIES Number 81 Capital inflows, policy responses, and their ill consequences: Thailand, Malaysia, and Indonesia in the decade before the crises Clara García April 2004 Abstract Capital inflows, especially when volatile, denominated in foreign currencies and not properly hedged against exchange rate risks, may pose macroeconomic and financial problems in the recipient economy. In this paper we analyze the mechanisms through which those problems arise; and we assess the policies that national authorities may resort to in order to prevent them, under the assumption that capital inflows are the result of previous stabilization and liberalization packages. Also, we study the use and effectiveness of policy responses to capital inflows in Thailand, Malaysia, and Indonesia in the years prior to the 1997-98 financial crises. We conclude that policies that reinforce the stabilization and adjustment trends of the 1980s are more likely to be (at least partially) ineffective or even counterproductive, whereas the measures that depart from those trends appear to have a higher potential for effectiveness but face obstacles to implementation. Clara García is a Visiting Scholar at Political Economy Research Institute (PERI), University of Massachusetts Amherst; and Assistant Professor at University of Huelva (Spain). The author thanks Caja Madrid Foundation for financial support.
    [Show full text]
  • The Moral Hazard Paradox of Financial Safety Nets, 25 Cornell J
    University of California, Hastings College of the Law UC Hastings Scholarship Repository Faculty Scholarship 2015 The orM al Hazard Paradox of Financial Safety Nets John Crawford UC Hastings College of the Law, [email protected] Follow this and additional works at: https://repository.uchastings.edu/faculty_scholarship Recommended Citation John Crawford, The Moral Hazard Paradox of Financial Safety Nets, 25 Cornell J. L. & Pub. Pol'y 95 (2015). Available at: https://repository.uchastings.edu/faculty_scholarship/1419 This Article is brought to you for free and open access by UC Hastings Scholarship Repository. It has been accepted for inclusion in Faculty Scholarship by an authorized administrator of UC Hastings Scholarship Repository. For more information, please contact [email protected]. THE MORAL HAZARD PARADOX OF FINANCIAL SAFETY NETS John Crawford* Moral hazard plays a central role in almost every narrative of the recent financial crisis: the government's implicit guarantees led to ex- cessive risk-taking, and when the guarantees turned explicit, it exacer- bated moral hazard going forward. The moral hazard narrative of crisis causes and effects motivated key reform efforts, including the statutory elimination of authorities regulators used to guarantee trillions of dol- lars of private debt in an effort to halt widespread panic in late 2008. Some argue that the elimination of these broad guarantee authorities was a mistake, but even these critics acknowledge that the moral hazard costs of guarantees are significant. This Article argues that the absence of broad guarantee authorities could, counterintuitively, exacerbate moral hazard in the current U.S. financial system. Broad guarantee authorities can be seen as a "strong" tool for stopping panics.
    [Show full text]
  • Capital Controls Or Macroprudential Regulation?
    NBER WORKING PAPER SERIES CAPITAL CONTROLS OR MACROPRUDENTIAL REGULATION? Anton Korinek Damiano Sandri Working Paper 20805 http://www.nber.org/papers/w20805 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 December 2014 The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, its management, or the National Bureau of Economic Research. We thank Larry Ball, Suman Basu, Marcos Chamon, Giovanni Dell’Ariccia, Pierre-Olivier Gourinchas, Sebnem Kalemli-Ozcan, Luc Laeven, Albert Martin, and Joseph Stiglitz as well as participants at the CBRT-NBER-pre-conference and at a seminar at the IMF for helpful comments and suggestions and Olivier Blanchard, Rex Ghosh and Jonathan Ostry for detailed discussions on the topic. Korinek acknowledges financial support from the IMF Research Fellowship and from CIGI/INET. NBER working papers are circulated for discussion and comment purposes. They have not been peer- reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2014 by Anton Korinek and Damiano Sandri. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Capital Controls or Macroprudential Regulation? Anton Korinek and Damiano Sandri NBER Working Paper No. 20805 December 2014 JEL No. E44,F34,F41 ABSTRACT We examine the effectiveness of capital controls versus macroprudential regulation in reducing financial fragility in a small open economy model in which there is excessive borrowing because of externalities associated with financial crises and contractionary exchange rate depreciations.
    [Show full text]
  • Financial Fragility
    Financial Fragility Itay Goldstein Wharton School, University of Pennsylvania Itay Goldstein: Financial Fragility Introduction Vienna Graduate School of Finance Page 2 Itay Goldstein: Financial Fragility Financial Systems Financial systems are crucial for the efficiency of real activity and resource allocation o Vast empirical evidence: e.g., Levine (1997), Rajan and Zingales (1998) Different roles performed by the financial sector: o Transmission of resources from savers/lenders to investors/borrowers o Risk sharing possibilities, encouraging more risk taking o Information aggregation guiding investment decisions Vienna Graduate School of Finance Page 3 Itay Goldstein: Financial Fragility Not always working perfectly… Vienna Graduate School of Finance Page 4 Itay Goldstein: Financial Fragility Financial Crises Financial markets and institutions are often subject to crises: o Failure of banks, and/or the sharp decrease in credit and trade, and/or the collapse of an exchange rate regime, etc. o Generate extreme disruption of these normal functions of financial and monetary systems, thereby hurting the efficiency of the economy Many examples: o East-Asian crisis of late 90s o Global financial crisis of 2007-2009 and its aftermath Vienna Graduate School of Finance Page 5 Itay Goldstein: Financial Fragility Three Branches of Theories of Financial Crises Banking Crises and Panics Banks provide liquidity transformation allowing people to benefit from the fruits of illiquid long-term investments even if they need early liquidity This exposes
    [Show full text]
  • Institutional Prerequisites of Financial Fragility Within Minsky's Financial
    Working Paper No. 674 Institutional Prerequisites of Financial Fragility within Minsky’s Financial Instability Hypothesis: A Proposal in Terms of “Institutional Fragility”* by Christine Sinapi Burgundy School of Business, Dijon July 2011 * This paper was presented at the Hyman P. Minsky Summer Seminar, Levy Economics Institute of Bard College, June 2011. Comments: [email protected]. The Levy Economics Institute Working Paper Collection presents research in progress by Levy Institute scholars and conference participants. The purpose of the series is to disseminate ideas to and elicit comments from academics and professionals. Levy Economics Institute of Bard College, founded in 1986, is a nonprofit, nonpartisan, independently funded research organization devoted to public service. Through scholarship and economic research it generates viable, effective public policy responses to important economic problems that profoundly affect the quality of life in the United States and abroad. Levy Economics Institute P.O. Box 5000 Annandale-on-Hudson, NY 12504-5000 http://www.levyinstitute.org Copyright © Levy Economics Institute 2011 All rights reserved ABSTRACT The relevancy of Minsky’s Financial Instability Hypothesis (FIH) in the current (and still unfolding) crisis has been clearly acknowledged by both economists and regulators. While most papers focus on discussing to what extent the FIH or Minsky’s Big Bank/Big Government interpretation is appropriate to explain and sort out the crisis, some authors have also emphasized the need to consider the institutional foundations of Minsky’s work (Whalen 2007, Wray 2008, Dimsky 2010). The importance of institutions within the FIH was strongly emphasized by Minsky himself, who assigned them the function of constraining the development of financial fragility.
    [Show full text]
  • Preventing Bank Runs;
    A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Andolfatto, David; Nosal, Ed; Sultanum, Bruno Working Paper Preventing bank runs Working Paper, No. 2014-19 Provided in Cooperation with: Federal Reserve Bank of Chicago Suggested Citation: Andolfatto, David; Nosal, Ed; Sultanum, Bruno (2014) : Preventing bank runs, Working Paper, No. 2014-19, Federal Reserve Bank of Chicago, Chicago, IL This Version is available at: http://hdl.handle.net/10419/130668 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle You are not to copy documents for public or commercial Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich purposes, to exhibit the documents publicly, to make them machen, vertreiben oder anderweitig nutzen. publicly available on the internet, or to distribute or otherwise use the documents in public. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend von diesen Nutzungsbedingungen die in der dort Content Licence (especially Creative Commons Licences), you genannten Lizenz gewährten Nutzungsrechte. may exercise further usage rights as specified in the indicated licence. www.econstor.eu Preventing Bank Runs David Andolfatto, Ed Nosal, and Bruno Sultanum September 2014 Federal Reserve Bank of Chicago Reserve Federal WP 2014-19 WORKING PAPER PREVENTING BANK RUNS ∗ BY DAVID ANDOLFATTO,ED NOSAL AND BRUNO SULTANUM SEPTEMBER, 2014 Diamond and Dybvig (1983) is commonly understood as providing a formal rationale for the existence of bank-run equilibria.
    [Show full text]