Question

What are the stages of a financial crisis?  Briefly explain each and provide an example from the 2007-09 financial crisis.?

Answer 1

3 Stages of Financial Crisis:

Stage 1: Initiation of a financial crisis:

It is caused by

i) mismanagement of financial liberalization or innovation and eliminating rest. On fin. Institutions or mkts, or introducing new types of products

ii) Government interference

a) Sarbanes-Oxley Act (enron) - created more restrictive accounting hiring practices to prevent fraud; overreacted to what happened

b) Dodd-Frank - created in reaction to ’07 crisis, regulates derivatives

c) Glass-Steagall Act - Limits activities between commercial banks and security firms

d) Pendulum swings back and forth between much/little restrictions

e) Removal of restrictions - allows capital to flow effectively - Short-run creates credit boom leading to -Too much lending, crash, hammers economic activity; Attitude around moral hazard and gov’t guarantees lead to more risk ; Bad loands = writeoffs = less lending ; Paul Krugman (economist) believes low interest rate environment created the bubble by making loans cheap.

Stage 2: Banking Crisis When consumers/business both do poorly so do banks that loan to them

i) Writeoffs weaken the balance sheets -

(a) Bank panic can happen = domino effect

(b) Solved when bank regulation close down/take over weak institutions (FDIC) increasing payout limit to build depositor confidence

ii) TARP (Troubled Asset Relief Program) - Government purchase of assets and equity from financial institutions to strengthen financial sector.

Stage 3: Debt Deflation Falling prices a concern in slowdown in economic activity

i) Banks sell loans at lower prices to stimulate demand

ii) If sold @ fixed, as prices rise, banks squeezed by higher borrowing costs of their own

iii) Margins squeezed leading to pull back on lending

iv) Can create asset bubbles - Irrational exuberance; Tech bubble of late 1990s, housing bubble of 2008; When bubble bursts, lenders draw back when borrowers default

2007-2009 Financial Crisis

i) Financial innovation in mortgage markets

ii) Defaults at Bear Stearns/ Lehman Brothers due to drops in val. Of housing related securities

iii) Lenders froze up and pulled out so feds funds mkt froze

iv) Fear of failure caused consumer withdrawal from mkt and lower borrowing

v) Falling housing asset value makes matters worse

vi) Deterioration of financial institution balance sheets, global financial market contagion

vii) Schiller index