Question

a) “The uses of deposit insurance might make a financial crisis more likely to occur.” Briefly explain (with not more than 100 words) whether you agree it or not.

b) Explain with not more than 200 words that financial innovation in mortgage markets is one of the main causes for the global financial crisis of 2007-2009.

c) Would you expect a potential increase or decrease of credit spread when the financial crisis is emerged? Would the change of credit spread affect the firms which need additional funds for productive investment? Explain it with not more than 100 words.

Answer 1

A)Deposit insurance is widely offered in a number of countries as part of a financial system safety net to promote stability. An unintended consequence of deposit insurance is the reduction in the incentive of depositors to monitor banks which lead to excessive risk-taking. We examine the relation between deposit insurance and bank risk and systemic fragility in the years leading up to and during the recent financial crisis.

Generous financial safety nets increase bank risk and systemic fragility in the years leading up to the global financial crisis. However, during the crisis, bank risk is lower and systemic stability is greater in countries with deposit insurance coverage.

In addition,good bank supervision can alleviate the unintended consequences of deposit insurance on bank systemic risk during good times, suggesting that fostering the appropriate incentive framework is very important for ensuring systemic stability.

B) The subprime mortgage crisis occurred when banks sold too many mortgages to feed the demand for mortgage-backed securities sold through the secondary market.

When home prices fell in 2006, it triggered defaults. The risk spread into mutual funds, pension funds, and corporations who owned these derivatives.

The ensuing 2007 banking crisis and the 2008 financial crisis produced the worst recession since the Great Depression.

C) Theory predicts that credit spreads should rise in financial crises, because crises are associated with high future default losses, a credit crunch, and high risk/illiquidity and use the estimated b to measure how different growth is in a crisis relative to a non-crisis.

After purchasing a corporate bond, the firms will benefit from declining interest rates and from a narrowing of the credit spread, which contributes to a lessening yield to maturity of newly issued bonds. This, in turn, drives up the price of the firms corporate bond. On the other hand, rising interest rates and a widening of the credit spread work against the firms by causing a higher yield to maturity and a lower bond price. Therefore, because narrowing spreads offer less ongoing yield and because any widening of the spread will hurt the price of the bond, investors should be wary of bonds with abnormally narrow credit spreads.

Therefore it may affect the firms which need fund for productive investment.