Question

During a period of financial crisis when funds cannot be raised easily or quickly, the fundamental values of some assets can depart from market prices. Explain how this relates to the distinction between loans and securities. Identify consequences that can be transmitted to the real economy.

Answer 1

The financial crisis is a situation where prices fall especially of assets, debtors are unable to pay debts and financial institutions like banks face liquidity deficit. Financial crises happen due to a bank run, where investors sell their assets at a low price and withdraw their capital from their respective bank saving accounts. other situations similar to financial crises are - crash of the stock market or a currency crises. Since there is a dynamic change in the market and financial environment along with the fear of investors regarding their investments, funds are difficult to raise. Also, the prices of assets either goes up or falls very low.

Explain how this relates to the distinction between loans and securities.

Securities and Loans, both are debts.

• A loan is a type of debt where creditor lends the money to debtor along with a specified rate of interest for a predecided time period. Usually, banks give loans but there could be many informal ways to take a loan.
• Securities are a type of debt instrument where the general public is the creditor to a government, securities could be easily traded in the market whereas loans cannot be easily traded in the market. So securities are the type of investment the general public can make by lending finance to the government at a specified rate and locked for some years.
• In the situation of financial crises, banks are unable to recover from debt, credit, and mortgages from the public. Therefore the interest rate of loan gets high to prevent the public from taking out loans. It becomes tougher for the public to take credit since banks lose their all money from their deposits from the public due to a bank run and interbank lending freezes.
• The situation of securities in case of financial crises is different than that of loans. Prices of securities and interests on them get low during the financial crisis reason of which is less liquidity in the economy. Lower prices of securities may attract patient investors to buy more securities and sell them later at a higher price in the market. However, this situation is a loss for those people who sold the securities are lower rate from which they purchased the securities.

Identify consequences that can be transmitted to the real economy

Financial crises are caused by overvaluing of assets leading to an investor rush, absence of proper regulations, risk-averse human behavior, and currency crises. However, the consequences of financial crises affect all sector of the economy including financial and banking sector the most. The consequences of financial crises are

• Political Instability
• Increase in the Debt cycle.
• A collapse in asset market for a long period.
• The rise in the Unemployment rate and the decline in output rates
• Political Instability
• Depreciation in the foreign exchange market
• Increase in market uncertainty.
• Shrinking of tax revenue causing an increase in the fiscal deficit of the government.