FINANCIAL CRISES Stefania Paredes Fuentes [email protected] Department of Economics, S2.121 University of Warwick Money & Banking WESS 2016 THE FINANCIAL CRISIS Crises are costly to the economy • Reinhart and Rogoff (2009) inflation crises, currency crises, sovereign crises and banking crises • Banking crises ‘lead to the closure, merging or takeover by the public sector of one or more financial institutions’ Characteristics: (1) deep and prolonged asset price collapses (2) large and lasting adverse impacts on output and employment (3) government debt explodes • IMF (2009) recessions associated with financial crises are more severe and long-lasting than those associated with other shocks Stefania Paredes Fuentes Money and Banking WESS 2016 THE FINANCIAL CRISIS Crises are costly to the economy • Great Moderation Inflation targeting regime, calm macroeconomic environment, low unemployment levels • levels of debt in households an banks increased dramatically - expansion of credit and debt in the financial and the household sectors - household debt/GDP from 44% in Spain and 69% in UK in 1999 to 88% and 105% in 2008 respectively • booms in assets prices • Central bank should only react to financial developments to the extent that they influenced forecast CPI inflation over the CB’s planning horizon Stefania Paredes Fuentes Money and Banking WESS 2016 THE FINANCIAL CRISIS Bank Behaviour and the Macro-Economy • Banks are a special case for policy makers: - Economic dependence of core banking services - Contagion: Spillovers from one bank affect the whole system • Bank bankruptcy is a special case vs other industries(?): → Expectation that govt. bails out failing banks to prevent crisis • Thus, policy makers face a trade-off between: - Maintaining the continuity of core banking services - Avoiding moral hazard on the part of households and banks Stefania Paredes Fuentes Money and Banking WESS 2016 THE FINANCIAL CRISIS Bank Behaviour and the Macro-Economy • Banks do not take into account the negative externalities of its decisions (e.g. in excessive risk taking) • There is also an information problem: The govt. may impose capital regulation (s.t. bank risks are at the socially optimal level), but this requires that risks are accurately observable. • Banking Activities: We distinguish between 2 types of bank activity: - Retail banking: Deposit-taking, lending, mortgages etc. - Investment Banking (IB): Trading in financial products (securitised assets, derivatives etc.) Also assume: Assets are ‘marked-to-market’ , risk-neutral IBs follow a Value at Risk (VaR) business model Stefania Paredes Fuentes Money and Banking WESS 2016 THE FINANCIAL CRISIS Origins - Risk Excess risk taking by & excessive leverage of banks: Ignored externalities and relied on bail-outs by the govt. Incentives of banks encouraged strategies that increased aggregate risk in the economy. Regulators allowed banks to use their own models to calculate and report riskiness. Widespread lack of concern for the financial system’s risk to the economy Benign macroeconomic environment and inflation targeting encouraged the belief in low aggregate risk. Stefania Paredes Fuentes Money and Banking WESS 2016 THE FINANCIAL CRISIS Risk • Raghuram Rajan (2005) “Has financial development made the world riskier?,” - query the value of recent innovation in the financial markets • Don Khon: “By allowing institutions to diversify risk, to choose their risk profiles more precisely, and to improve the management of the risks they take on, they have made institutions more robust … these development have also made the financial system more resilient and flexible - better able to absolve shocks without increasing the effects of such shocks on the real economy” • Ben Bernanke (2006). “Banking organisations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks” Stefania Paredes Fuentes Money and Banking WESS 2016 THE FINANCIAL CRISIS Risk • Is ‘risk’ another commodity? i.e. can standard economic tools be applied to the trading of risk? • Greenspan’s doctrine: “The effects of trade is to allocate risk to those investors most able and willing to take risk” • Behavioural finance: ‘irrational behaviour’: individuals chasing a dream, liking control, bias towards optimism ‘rational’ people judge uncertain situations by attaching probabilities to the various outcomes and revise their probabilities in the light of new information • Without the presumption that people act in rational self-interest the whole structure of risk evaluation fails (Markowitz model, Black Scholes model, EMH, Capital Asset Pricing Model, etc) Stefania Paredes Fuentes Money and Banking WESS 2016 THE FINANCIAL CRISIS Risk We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance. “The State of Long-Term Expectation” in Keynes (1936), Ch. 12 Stefania Paredes Fuentes Money and Banking WESS 2016 THE FINANCIAL CRISIS • Financial Cycle vs Business Cycle: Business cycles are based on GDP fluctuations; Financial cycles based on key financial variables (e.g. credit, house prices) Stefania Paredes Fuentes Money and Banking WESS 2016 THE FINANCIAL CRISIS Bank Behaviour and the Macro-Economy Key Features of the Financial Cycle: 1. Upswing: House prices ↑ → Household borrowing ↑ → Bank borrowing ↑ (positive feedback process) 2. Upswings often end with ↓ in house prices & a banking crisis 3. Downswing: Households & Banks deleverage (↓ indebtedness) → Banks ↑ int. rate spread, ↓ willingness to make loans 4. Housing boom reverses: Borrower households need to ↑ savings and recover from negative equity 5. 3. and 4. (balance sheet effects) imply a deeper recession 6. Public sector debt increases sharply Stefania Paredes Fuentes Money and Banking WESS 2016 THE FINANCIAL CRISIS Financial Cycles and Business Cycles Stylised Facts about the Financial Cycle: 1. Banks play a key role in the financial cycle through their lending and borrowing behaviour. 2. The housing sector is procyclical and house purchase is often financed by borrowing from banks 3. The inter-relationship between banks and housing is central to the fin. cycle; Peak of fin. cycle often followed by banking crisis. • The BIS measure of financial cycles uses 3 variables: Private credit, Private credit-to-GDP ratio, Residential property prices • Fluctuations in fin. cycle variables typically longer than business cycle fluctuations in output. Stefania Paredes Fuentes Money and Banking WESS 2016 THE FINANCIAL CRISIS Origins - Actors 1. Retail banks and govt-sponsored housing agencies US Regulations: Hard to ↑ leverage to ↑ returns, so instead,↑ riskiness of asset pool to ↑ returns ∴ Made sub-prime loans and sold them (via MBSs) to eliminate own credit risks → ↓ incentive to check borrower’s credit status 2. Global banks, rating agencies & financial regulators Europe: Lack of regulation on simple leverage; Lax treatment of ‘risk-weighted assets’ Basel II: Assets with a low risk weight do not need much or any equity to be held against it ∴ To purchase AAA-rated assets, banks can easily borrow to fund them, without equity (thus ↑ leverage) Heavy reliance was placed on CRAs; AAA assets proliferated. Stefania Paredes Fuentes Money and Banking WESS 2016 THE FINANCIAL CRISIS Origins - Actors 3. The shadow banking system Bank-like entities outside the scope of banking regulation also traded heavily in securitised assets. The rapidly growing shadow banking system further boosted aggregate risks in the regulated banking sector. 4. Bank concentration and interconnectedness Consolidation of banks into ‘too-big-to-fail’ financial giants Increased fin. dependence (mutual claims) between banks Homogeneity in the financial system increases systemic risk ∴ Need for focus on Macro-prudential regulation (to manage system-wide risks), as well as traditional Micro-prudential regulation (of individual banks) Stefania Paredes Fuentes Money and Banking WESS 2016 THE FINANCIAL CRISIS Origins - Subprime lending in the US • US government promoting home ownership extended housing loans to previously credit constrained households rapid expansion of sub-prime lending • source of aggregate demand (little attention to the potential risks of financial fragility from rising household indebtedness) • rising house prices increase value of banks’ collateral increase willingness of banks to lend without adequate checks Financial Accelerator: More lending → House P ↑ → ↑ Collateral → ↑ Further lending •expectations of rising house prices increased the incentive for households to borrow more their leverage increased Stefania Paredes Fuentes Money and Banking WESS 2016 THE FINANCIAL CRISIS Origins - Subprime lending in the US • Aron et al. (2012) - rise in house prices positively affects consumption in the UK and the US - the strength of this relationship increased as these economies became more financially liberalised during the Great Moderation • a fall of house pricing can wipe out all the equity of the household - any greater fall in the house price means that they own an asset worth less than the amount they owe on it • bubble in house prices - price of an asset rises