Financial crises

Dr Katarzyna SumInternational monetary system

Financial crisis- definition

Powerful shocks within the financial

system which trigger a decrease or a

deepening of the already ongoing

production decrease

Stock market crunches (1)

Stock market crunches are relatively rare but their occurrence affects seriously the economy

The source of a stock market crunch is usually a speculative bubble

The optimism of investors drives the emergence of a speculative bubble

Stock market crunches (2)

Speculative bubbles emerge on the base of

rational expectations

Initially investors expect that the positive trend

concerning e.g. a productivity increase will go on

This happened for example during Dot Com

crisis

Stock market crunches (3)

Behavioural finance can explain stock market crunches

Small investors just follow the trend without qny rational

economic analysis

Large investors can predict the burst of a speculative

bubble but they are usually unwilling ton withdraw their

funds due to competitory pressures

Stock market crunches (4)

Once the speculative bubble burst it affects majorly

investor who purchased stock by borrowing money from

banks

This was e.g. the source of the Japanese stock market

crisis in the 90-ties

The Dot Com crisis was much softer since investors

financed their purchases via own capital

Banking crises (1)

Banks play a prominent role in financing economic activity

The willingness of banks to grant loan depends largely on the economic cycle and the net value of enterprises

In times of economic recession banks lack of objective information concerning the situation of the enterprises

Banking crises (2)

Banks know that enterprises in times of recessions need the funds

to maintain liquidity instead of financing production

This situation creates moral hazard- enterprises will require loans

even if they can not pay them back

Since banks know that they are forced to negative selection of

companies requiring loans

Banks raise the risk premium and hence the interest on granted

loans

As an effect liable companies limit their loan requirements, only

companies who want to support their liquidity require loans

Banking crises (3)

Due to lending money to unreliable companies banks

have to face toxic debt

This can seriously affect the solvency of the banks

The risk of the occurrence of financial crisis is the

greater the larger the preceding credit expansion is

Banking crises can also occur due to a disadvantageous

change of the economic situation e.g the Norwegian

banking crisis in the 80-ties was due to of an oil price

decrease

Currency crises (1)

Currency crises occur if the financial markets participants start to mistrust a specific currency and subsequently withdraw their funds and the central banks are not able to counteract this tendency

Currency crises (2)

Currency crises can bbe grouped into three generations First generation- KrugmanSecond generation- Obstfeld Third generation- eclectic model

The first generation of currency crises (1)

The Krugman model Internal reasons for the outbreak of the

crisisThe reason of the currency crisis is

inadequate economic policy especially concerning the fiscal situation

The first generation of currency crises crises (2)

Lax fiscal policy the budget deficit is financed by the central bank inflation the internal unequilibrium can not be reconciled with the fixed exchange rate

Fiscla expansion increasing internal demand for imports +inflation balance of payment deficit devaulation pressure decrease of reserves speculative attack currency crisis

The first generation of currency crises crises (3)

Currency crises in the 80-ties

Latin American countries (Argentina,

Chile)

This were usually emerging economies

who had to cope with high inflation, fiscal

deficit and fixed exchange rates

The first generation of currency crises crises (4)

Low level of foreign currency reserves

Capital flow liberalisation+ lack of banking

regulation lack of control over excess

money supply

Additional contsraint- high level of foreign

loans to latin Amertican Countries

insolvency

The second generation of currency crises (1)

The Obstfeld model The main reason for the crisis are

speculative attacks Especially fixed or intermediate exchange

rate regimes are prone to this type of currency crises

The second generation of currency crises (2)

The crisis occurs in economies with good economic policy

Countries with high levels of foreign reserves

External reasons for the crisis

The second generation of currency crises (3)

Second generation crises occurred in the 90-ties

E.g. the ERM crisis

Restructuring of the German economy inflationary

pressure in Germany strict monetray policy

incraesed interest rates overvaluation of the DM

Other economies within the ERM system raised the

intsrest rates as well to maintain the exchange rate parity

The second generation of currency crises (4)

Speculative attack on the GBP- the only economy that

did not increase the interest rate devaluation of GBP

This triggered speculative attacks on all the currencies

within the ERM which were related to the DM

As a consequence all countries who participated in the

ERM were forced the devalue their currencies

The third generation of currency crises (1)

An eclectic model describes the third generation crises

The theory was a reaction to the currency crises which

occurred in emerging economies at the end of the 90-

ties

A characteristic feature was the fact that the economies

hit by the crisis had fixed exchange rates

The crisis hit well performing, promising economies

(Malaysia, Indonesia, South Korea)

The third generation of currency crises (2)

Microeconomic reasons for the crisis- risky investments

undertaken by banks and companies

Macroeconomic reasons- insufficient competiveness of the

economy, lack of financial supervision

Underdeveloped financial markets external funding of

investments

Foreign investors expected large productivity increases and when

their expectations were not met they withdrew their funds

The elements of third generation crises

Moral hazard Too big to fail

The investments financed by banks loans were concentrated Twin crises

Banking crises and currency crises simultaneously

This can occur if the banking sector has a large foreign debt

Especially a currency mismatch can exacerbate an excessive

foreign debt

The elements of third generation crises

Herding effects can cause the outflow of

foreign capital

The domino effect can cause international

contagion

Examples of third generation crises

Emerging economies in south Asia faced currency crises at the end of the nineties

Their banking sectors had large foreign debt These counties had costly production and

underdeveloped financial markets Additionally the appreciation of USD caused

the outflow of capital and subsequently the collapse of domestic exchange rates

References

A. Sławiński, Rynki finansowe, PWE, Warszawa 2006 P. Krugman, M.Obstfeld, International economics: theory and policy, Pearson,

Addison Wesley, Boston 2009,

J. A. Frankel, G. Saravelos, Are Leading Indicators of Financial Crises Useful for Assessing Country Vulnerability? Evidence

from the 2008-09 Global Crisis, NBER Working Paper No. 16047, Cambridge 2010,

J. Aizenman, Financial Crisis and the Paradox of Under- and Over-Regulation, NBER Working Paper No. 15018, Cambridge 2009,

J. B. Taylor, The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong, NBER Working Paper No. 14631, Cambridge 2009,

C. M. Reinhart, K. S. Rogoff, From Financial Crash to Debt Crisis, NBER Working Paper No. 15795, Cambridge 2010

A. Szyszka, Behawioralne aspekty kryzysu finansowego, Bank i Kredyt 40 (4), Warszawa 2009