Econ 492:
Comparative Financial Crises
Lecture 2
19 January 2011
David Longworth
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Policy Statement.
Overview
I.
II.
III.
IV.
Transmission
Policy Response During the Crisis
Prevention
Data Sources
Note: AG indicates Franklin Allen and Douglas Gale
(2009), Understanding Financial Crises. KA indicates
Charles P. Kindleberger and Robert Aliber (2005), Manias,
Panics, and Crashes. RR indicates Carmen Reinhart and
Kenneth Rogoff (2009), This Time is Different.
Economics 492 Lecture 2
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l. Transmission
• Outline of Course
(Prediction)
Causes
Transmission
Prevention
Policy
Response
Economics 492 Lecture 2
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I. Transmission
•
•
•
•
•
Fire Sales (Cash-in-the-market pricing)
Margin and liquidity spirals
Bank runs
Interconnectedness and contagion
Decline in wealth of private sector: effects on
output and employment
• Zero bound on nominal interest rates takes
away conventional monetary policy channel
Economics 492 Lecture 2
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I. Transmission
• Fire Sales (Cash-in-the-market pricing)(AG 4,5)
– First, assume a model with markets only, no banks
– Limited market participation: not everyone
participates in every market (fixed set-up cost)
– Market liquidity depends on amount of cash held by
market participants
– If there is a lack of cash in the market, small shocks
have large effects on prices
• Then prices are not determined by expected present values,
but by ratio of available liquidity to amount of asset supplied
Economics 492 Lecture 2
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I. Transmission
• Fire Sales (Cash-in-the-market pricing)(AG 4,5)
– Amount of cash in market depends on
participants’ liquidity preference, which will
determine the average level of the short-term
asset held
– Changes in liquidity demand relative to liquidity
supply determines price volatility
Economics 492 Lecture 2
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I. Transmission
• Fire Sales (Cash-in-the-market pricing)(AG 4,5)
– Now add banks to the model
• Small events (e.g., small liquidity shocks) can have a large impact
on the financial system because of how banks and markets
interact: can lead to systemic crises
• If banks have to provide liquidity to customers, they may have to
sell much less liquid assets (if they are running out of liquid ones)
• Prices in those markets may be determined by cash in the market
• The resulting “fire sale prices” may be quite low
• Banks have to mark assets held in their trading book to market. At
the end of the quarter, these losses will show up in the calculation
of profits/losses and thus affect the bank’s capital
– The market anticipates this effects even before quarterly statements are
released.
Economics 492 Lecture 2
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I. Transmission
• Margin and Liquidity Spirals
– Financial institutions (and large investors) engage
in securities financing transactions
• Repos (sales and repurchase agreements)
– A “haircut” determines the fraction of the market value that
can be borrowed
• Securities borrowing
– A “haircut” again determines what collateral must be posted
• As well, they engage in derivatives transactions
– Except for large highly-rated banks and securities dealers,
“initial margin” must be posted
Economics 492 Lecture 2
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I. Transmission
• Margin and Liquidity Spirals
– When market liquidity becomes lower, it is typically
associated with higher market volatility
– But higher market volatility means that collateral
coverage for a given “haircut” or “initial margin” is
less: haircuts and margins tend to rise in the market
– One tends to get the type of liquidity and margin
spiral shown in the following diagram
• Spiral can work in the opposite direction in boom periods
Economics 492 Lecture 2
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Liquidity Spiral
Liquidity/Margin Spiral
less market making
lower market
liquidity
funding problems
higher margins
losses on existing positions
Adapted from Brunnermeier & Pederson (2009) and
Economics 492 Lecture 2
presentations by Mark Carney and David Longworth
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I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
– Banks have liquid liabilities, illiquid assets
– So banks are susceptible to unexpected liquidity
demands (bank runs)
– Model this by having a liquid asset (short asset) that
doesn’t pay interest, and an illiquid asset that does
– Banks (intermediation) solve mismatch between time
preference and asset maturity
– Typically, markets are incomplete and so can’t provide
an efficient solution to this mismatch problem
Economics 492 Lecture 2
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I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
– In a two-period model with no aggregate uncertainty about liquidity
withdrawals, there is an equilibrium in which the bank provides c(1) to
its depositors at time 1 and c(2) to its depositors at time 2, invests x in
the long asset and y in the short asset
– In the same model, if the bank can sell the long asset early (period 1),
taking a discount, a bank run will also be an equilibrium. This is
because, if all depositors, whether they would normally withdraw to
consume at time 1 or time 2, decide to withdraw at time 1, the bank
cannot possibly pay them all off.
– Critics of this type of model have argued that suspension of
convertibility of deposits into cash could stave off bank runs
– But Diamond and Dybvig have shown that a sequential payout by bank
tellers would mean that they would not find out until too late that a
run was in progress.
Economics 492 Lecture 2
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I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
– Equilibrium bank runs:
• Impossible to predict
• Coordination among individuals facilitated by
“sunspots” (extraneous variables)
• If “the probability of a bank run is sufficiently small,
there will exist an equilibrium in which the bank is
willing to risk a run because the cost of avoiding the run
outweighs the benefit.” (AG, p.82)
Economics 492 Lecture 2
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I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
– Are bank runs associated with the business cycle (and not
“sunspots”)? Potential paper.
• Some support for this: Gorton’s 1988 study of U.S. (1865-1914)
• Indeed, if bank runs are part of transmission of crises, and crises
are typically associated with the credit cycle, which is highly
correlated with the business cycle, this would not be a surprise
• Many suspect that liquidity problems are associated with fears of
credit problems (some evidence of this in the last crisis) and
perhaps actual credit problems
– Runs in the last crisis weren’t just from banks (like
Northern Rock in the U.K.)
• But from “shadow banking system” as well
– Canadian asset-backed commercial paper, money market mutual funds,
U.S. commercial paper, structured investment vehicles (SIVs), etc.
Economics 492 Lecture 2
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I. Transmission
• Interconnectedness and contagion(KA8, AG10)
– Interconnectedness: banks hold many liabilities of
other banks (short-term deposits—including those
for settling payments, shares, repos, derivative
instruments)
• Therefore the failure or weakness of one bank could
translate into the failure or weakness of other banks
• As well, the failure of one bank may lead to loss-sharing
arrangements being invoked in payments systems and
central counterparties (for repos or OTC derivatives)
– By their current design, such losses should be limited
Economics 492 Lecture 2
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I. Transmission
• Interconnectedness and contagion(KA8, AG10)
– Contagion (usually used only for across regions or across
countries) can arise from a number of factors:
• Interconnectedness as described above
• Common exposures, with fire sales driving down prices
• Contagion of bubbles: “when money flows from one country to
another and adjustments automatically occur both in the
countries that receive these funds and in the countries that are
the sources of them.” (KA, p.143)
– Example from KA, pp. 142-3(: From real estate and stock market bubble
in Japan (late 1980s) to real estate and stock market bubbles in Nordic
countries (late 1980s) and to markets in south-east Asia (mid 1990s) and
to tech stocks in the U.S. (late 1990s)Potential topics: (1)What is the
analogue in the most recent crisis and how did it compare with previous
crises? (2) How were various emerging market economies affected in the
current crisis when international banks cut back in foreign lending,
particularly in trade finance (why, and what were the effects?)
Economics 492 Lecture 2
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I. Transmission
• Interconnectedness and contagion(KA8, AG10)
– Potential topic: why was there more contagion
from the U.S. to continental Europe and the U.K.
than to other regions? Why was there financial
contagion at all to countries such as Japan and
Canada?
Economics 492 Lecture 2
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I. Transmission
• Interconnectedness and contagion(KA8, AG10)
– AG have a model of U.S. regional contagion
• “even though the initial shock occurs only in one
region, which can be an arbitrarily small part of the
economy, it can nevertheless cause banks in all regions
to go bankrupt.”
• Results depend on the nature of the network of
interbank deposits across institutions
– AG cite a number of references to studies of the
actual nature of interbank relationships in
certain countries.
Economics 492 Lecture 2
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I. Transmission
• Decline in wealth in private sector: effects on
income and employment
– Lower wealth arises from fire sales, bursting of
bubbles, lower valuation of financial sector firms
– Wealth effects on consumption (standard
consumption function)
– Through financial accelerator, lower collateral means
can borrow less, so lower consumption and housing
expenditure (and investment by businesses)
– Through bank capital channel, less lending by banks,
which means less consumption, housing, and
investment expenditure
Economics 492 Lecture 2
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I. Transmission
• Decline in wealth in private sector: effects on
income and employment
– Spreads increase between interest rates on
loans/market debt and government yields (even
separately from bank capital channel), lowering
housing and investment spending
– In New Keynesian models, lower aggregate demand
leads to lower employment
– Spillovers across borders from lower import demand
in countries suffering declines in wealth and income
Economics 492 Lecture 2
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I. Transmission
• Zero bound on nominal interest rates takes away
conventional monetary policy channel
– Normally, the response of monetary policy authorities
to the decline in wealth, income, and employment
would be to lower the policy interest rate because of
the downward pressure on inflation
– When the policy interest rate gets to zero (or near
zero), that option is no longer available
– Central bank must turn to unconventional policy
instruments (discussed in the next section)
– ZLB in history: BoJ; recent crisis: Fed, BoE, BoJ, BoC,
ECB, Riksbank
Economics 492 Lecture 2
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I. Transmission
• Potential topic: relationship between banking
crises and sovereign debt crises over history.
What is the direction of transmission/
causation? Has the direction changed?
– See RR. Also Piergiorgio Alessandri & Andrew G.
Haldane (2009), “Banking on the State,” Bank of
England, November.
Economics 492 Lecture 2
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II. Policy Response During the Crisis
(Prediction)
Causes
Transmission
Prevention
Policy
Response
Economics 492 Lecture 2
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II. Policy Response During a Crisis
•
•
•
•
Guarantees and closures
Domestic lender of last resort: liquidity policy
Monetary Policy
International lender of last resort: IMF, EU,
etc.
• Other policies (not the focus of this seminar:
fiscal policy, structural policy, debt
management policy)
Economics 492 Lecture 2
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II. Policy Response During a Crisis
• Guarantees and closures
– Deposit insurance limits increased
– Bank bond debt guaranteed (e.g., Ireland)
– Nationalization of bank (with or without paying)
– Bank holiday (cannot withdraw funds)
– Markets closed (especially stock markets)
– Issues: effectiveness, moral hazard, benefit/cost
(including exposure of the tax payer)
Economics 492 Lecture 2
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II. Policy Response During a Crisis
• Domestic lender of last resort: liquidity policy
– Central bank policy existing before recent crisis
• “Discount window” lending against good collateral (bonds, paper)
with haircut (reduction from market value) and small penalty rate
• Repo (purchase and resale agreement) of good bonds and paper
with haircut
• These provided additional liquidity for banks needing it
– Broad (ECB) vs. narrow (BoC, Fed) in normal times
• Potential topic: Does a broad list of collateral in normal times lead
to moral hazard and to major problems in crisis times?
– Expansion in recent crisis was initially in frequency of repo
operations, size of operations, length of period, and range
of eligible collateral
Economics 492 Lecture 2
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II. Policy Response During a Crisis
• Domestic lender of last resort: liquidity policy
– Because of “stigma” attached to discount window
in U.S., a Term Auction Facility was introduced
that had a wider range of collateral than repo
operations. In Canada, the non-mortgage loan
portfolio of banks was eligible for a TAF-like facility
– Central banks also introduced liquidity facilities to
deal with problems in specific financial markets
(as opposed to financial institutions). The Fed did
this in particular for the commercial paper market.
Economics 492 Lecture 2
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II. Policy Response During a Crisis
• Domestic lender of last resort: liquidity policy
– Making foreign currency liquidity available: central
bank FX swap lines
– Potential topic: Why did the range of special
liquidity facilities vary across countries? Why were
special liquidity facilities not needed in previous
crises?
Economics 492 Lecture 2
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II. Policy Response During a Crisis
• Monetary Policy
– Conventional monetary policy, reducing policy interest rate
(incentive to get to ZLB quickly in some instances)
– Unconventional monetary policy
• Conditional or unconditional commitment regarding future policy
interest rate
• Expansion of excess bank reserves (settlement balances)
purchasing government debt or repos (“QE”)
– If particular maturities of government debt is purchased, it is also a form
of debt-management policy
– If private sector debt is purchased, it is also a form of fiscal policy (credit
policy)
– In these two cases, there is a question of governance/coordination
• Potential topic: What was the effectiveness of unconventional
monetary policy across countries in the recent crisis?
Economics 492 Lecture 2
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II. Policy Response During a Crisis
• International Lender of Last Resort
– IMF, or EU, or bilateral sovereign loans
– Typically in an exchange crisis (fixed exchange
rates)
– But also could be in cases where there is extreme
pressure on exchange rates; or significant
associated fiscal problems
– The history of IMF loans in the last 30 years has
been about the appropriate “conditionality” of
loans
Economics 492 Lecture 2
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III. Prevention
(Prediction)
Causes
Transmission
Prevention
Policy
Response
Economics 492 Lecture 2
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III. Prevention
• Macroprudential policy
• Contingent capital and bail-in debt
• Monetary policy
Economics 492 Lecture 2
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III. Prevention
• Macroprudential policy
– Focuses on the safety and soundness of the financial
system as a whole, as opposed to the safety and
soundness of individual financial institutions
– Macroprudential tools: deal with market failures
associated with procyclicality of aspects of the
financial system, as well as the interconnections and
similar exposures across financial institutions (crosssectional aspect)
• Possible topic: How do financial cycles compare with “real
cycles and inflation cycles” across countries? How should one
measure a “financial cycle”? Implications?
Economics 492 Lecture 2
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Objective: avoiding significant financial
F
instability
r
Goals: dampening procyclicality and
a
reducing potential effects of contagion
m
e
Policy Instruments: Macroprudential
w instruments, advice on policies, warnings
o
r
Activities: Data Collection, Surveillance,
k
Analysis, Risk Assessment, Stress Testing
Powers
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III. Prevention
Cycle
Risk
Macroprudential
Instruments
Credit Cycle
Credit Risk
Capital Requirements
Leverage Requirements
Liquidity Cycle
Liquidity Risk
Liquidity Requirements
Financial Asset Price Cycle
Market Risk
Collateral Risk
Margin & Haircut
Requirements
Property Price Cycle
Collateral Risk
Loan-to-Value Ratios
(& mortgage restrictions)
Policies should be justified by pointing to externalities, financial frictions.
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III. Prevention
• Macroprudential policy
– Capital requirements, leverage requirements, and liquidity
requirements are being dealt with in Basel III
• Higher capital requirements, capital buffer built up, countercyclical
requirements (typically linked to credit) (Note that effects overall
depends on extent to which Modigliani-Miller theorem violated.)
• Study of how systemically important institutions should have
higher capital requirements
• Two types of liquidity requirements
– Liquidity coverage ratio
» “Sufficiently high quality liquid assets to survive a significant stress
scenario lasting one month” (BCBS)
– Net stable funding ratio
» “Incentive for banks to fund their activities with more stable sources
of funding” (BCBS)
Economics 492 Lecture 2
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III. Prevention
• Macroprudential policy
– A Study Group that I chaired for the Committee on
the Global Financial System proposed regulating
margin requirements and haircuts on a “through
the cycle basis” to reduce the procyclicality of the
margin cycle
Economics 492 Lecture 2
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III. Prevention
• Macroprudential policy
– Several Asian countries regulate loan-to-value ratios
for mortgages (particularly on residential properties)
in an active manner to reduce the cycle in property
prices
• There are several aspects of requirements for mortgage
insurance that could be examined for more active regulation
in Canada (LTV ratios, debt-service-to-income ratio, home
equity loan ratio, amortization period); constant level or
varying countercyclically. Potential topic: How should
macroprudential policy connected to mortgages and housing
prices be carried out, i.e., what should be the proximate goal
and the tools? How would this have worked in previous
housing bubbles?
Economics 492 Lecture 2
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III. Prevention
• Macroprudential policy
– Some consider “through the cycle provisioning” for
loan losses (as was used in Spain) to be a
macroprudential policy instrument
– There are other possible macroprudential policy
instruments, such as reserve requirements on assets
and levies on non-core deposits
– Potential topics: Would macroprudential policy “x”
have prevented the recent and other financial crises?
When household debt is high relative to personal
disposable income (e.g., Canada, New Zealand,
Sweden), should the authorities respond in order to
prevent future crises and, if so, how?
Economics 492 Lecture 2
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III. Prevention
• Contingent capital and bail-in debt
– To deal with moral hazard of “too big or complex
to fail” as well as the practical issue of having time
to wind down a large institution or to change its
owners
– “Contingent capital is a subordinated security,
such as a preferred share or subordinated
debenture, that converts to common equity under
certain conditions.” (BoC FSR, Dec 2010, p.52)
Economics 492 Lecture 2
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III. Prevention
• Contingent capital (CC) and bail-in debt
– Gone-concern CC converts when supervisor judges
that bank is no longer viable
– Going-concern CC converts well before, for modest
erosions of capital
– Bail-in debt applies to senior debt as well
– Conceptually, “the sum of common equity plus
contingent capital and bail-in senior debt could be
subject to an overall minimum requirement, chosen to
provide for the restoration of prudential capital
requirements” (BoC FSR, Dec 2010, p.54)
Economics 492 Lecture 2
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III. Prevention
• Monetary policy
– Giving monetary policy a full-fledged financial stability
objective in addition to, but secondary to, its price
stability objective
• Inflation targeters would implement this by sometimes
returning inflation to target over a longer time period
– Potential topic: What should the role of monetary
policy (or the relative roles of monetary policy and
macroprudential policy) be in maintaining financial
stability? Could monetary policy have prevented the
recent crisis in some countries? At what cost?
Economics 492 Lecture 2
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III. Prevention
• Monetary policy
– Or, having monetary policy play a supporting role
where not in conflict with its price stability
objective:
• Choice of target inflation rate (e.g., inclusion of house
prices)
• Price level target versus inflation target (Carney, 2009)
• Making very prominent the uncertainty about the
future interest rate path (note related criticism of Fed
in past decade)
Economics 492 Lecture 2
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IV. Data Sources
• Data appendixes in This Time is Different by Reinhart and Rogoff
• OECD Economic Outlook 88 Annex Tables
http://www.oecd.org/document/61/0,3343,en_2649_34573_2483
901_1_1_1_1,00.html
• IMF International Financial Statistics
http://www.imfstatistics.org/imf/
• CANSIM for Canadian time series
• Data from BIS that underlay study by Borio and Drehmann (contact
me)
• Bank of Canada Weekly Financial Statistics
• For graphs of financial data see IMF’s Global Financial Stability
Report and Bank of Canada’s Financial System Review (various
issues during the crisis)
Economics 492 Lecture 2
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