THE NEED FOR SYSTEMIC STABILITY

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Lecture 10

• THE NEED FOR SYSTEMIC STABILITY

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Factors driving the financial sector

• The financial system is in a continuing flux
  driven by transactions costs motives.
• The developments of forex markets demonstrate the
  importance of cost reduction.
• The strategies are
• Bundling of funds (economies of scale)
• Risk reduction through diversification
• Explicit Hedging
• Expertise (legal, technological)

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Information inefficiencies

• Market participants can have insufficient
  information about their counterparts (asymmetric
  information). It leads to
• Adverse selection. This is an information problem
  occurring before the transactionPotential bad
  credit risks are those who seek loans most
  actively.
• Moral hazard. This occurs after the trans-action
  Borrowers may take on big risks.

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Adverse selection The lemons problem

• A lemon is a bad car purchased second hand.
• Akerlof studied the used-car market and found an
  asymmetric information problem
• Potential buyers cant tell a lemon from a good
  car.
• They offer an average price,between the value of
  a lemon and a good car.

George Akerlof 1940, Nobel Prize 2001
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The lemons problem

• The owner of a used car knows whether the car is
  good or bad.
• If the car is a lemon, he is of course happy to
  sell at the average price.
• If the car is good, the owner has little
  incentive to sell at average prices.
• Transaction volumes are low and the market may
  even break down.

• Similar problems arise in the securities markets
  (bonds, and stocks).
• An investor will only pay a price that reflects
  the average quality of firms.
• Bad firms are happy to take loans from investors.
• Good firms are not willing to borrow on this
  market.

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Moral hazard in equity contract (1)

• Equity contracts (shares) are subject to a
  particular principal-agent problem.
• Stockholders (principals) are not the same as
  managers (agents). This separation involves moral
  hazard because managers may act in their own
  interest.
• Example Steve has an ice-cream shop, and you
  become his silent partner. The capital is shared
  at 1090. Profits are also shared in these
  proportions.

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Moral hazard in equity contract (2)

• Option 1 Steve works hard and provides good
  service, but earns only 10 or the profit.
• Option 2 Steve does not provide good service,
  and uses the capital to buy artwork for his
  office, a luxury car for business he thus
  acquires fringe benefits at your expense.
• Option 3 Steve is not only a poor manager, but
  also dishonest. In this case the moral hazard
  problem may become extreme.

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Elimination of asymmetric information (1)

• A first solution to the problem is the private
  production and sale of information.
• There are professional rating agencies (Standard
  and Poors, Moodys, Value Line), and you can set
  up costly monitoring and auditing (state
  verification) of the firm.
• But there is s free-rider problem to this. If
  you buy a security, people my simply copy your
  behavior without paying for the information.
• This erodes potential extra profits, and you may
  not have bought the information in the first
  place.

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Elimination of asymmetric information (2)

• A second possibility could be to involve the
  government in regulating the market.
• The objective is to make firms reveal honest
  information by adhering to standard accounting
  practices and to disclose pertinent information.
• Government can also impose stiff criminal
  penalties to contain fraud.
• Government regulation may ease the asymmetric
  information problems, but it is difficult to
  eliminate them totally.

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Elimination of asymmetric information (3)

• A third solution is to involve financial
  intermediaries as experts in the production of
  information.
• A private loan is not traded, so others cannot
  watch and imitate (no free rider).
• This explains why indirect finance is more
  important than direct finance.
• Larger firms (because they are better known)
  obtain easier access to capital markets than
  smaller firms.

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Systemic instability and financial crises

• Financial crises are characterized by abrupt
  declines in asset prices and by insolvencies of
  financial and non-financial firms.
• Such crises are reoccurring in many countries.
  They are caused by a sharp increase in adverse
  selection and moral hazard problems.
• Four categories of factors trigger crises
• Increases in interest rates
• Increases in uncertainty
• Asset market effects on balance sheets and
• (Multiple) bank failures.

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Asset market effects on balance sheets

• Balance sheets have important repercussions on
  the financial system
• A deterioration (fall in stock or housing prices)
  of the balance sheet reduces the net worth of a
  firm.
• Lenders are less willing to lend because of
  reduced collateral.
• This induces moral hazard because borrowers take
  higher risks.
• The increase in moral hazard makes lending less
  attractive this reduces economic activity.

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Typical financial crises
Increase inuncertainty
Stock marketdecline
Increase ininterest rates
Deterioration of a banks balance sheet
Adverse selection andmoral hazard problems worsen
Economic activity declines
Bank panic
Adverse selection andmoral hazard problems worsen
Economic activity declines
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The stock market and speculative frenzies

• Stock markets have indeed often created havoc to
  the economy and to peoples life
• Early example the tulip bubble in the
  Netherlands (approximately 1620 to 1637)

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The tulip boom

• The boom involved rare tulips
• Bulb prices rose steadily throughout the 1630s,
  as ever more speculators wedged into the market.
• In 1633, a farmhouse in Hoorn changed hands for
  three bulbs
• In 1637 the bubble stretched . and burst !!

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Precedents of the crisis

• The basis of the bubble was an economic boom
  caused by shocking new technologies (Amsterdam
  merchants were at the center of the new and
  lucrative East Indies trade)
• But enabling the bubble was leverage through
  credit, future contracts, and an innovative
  climate of Dutch finance (that coined new
  instruments such as options)
• Did the burst of the bubble drag down the Dutch
  economy?

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Financial crisisThe US stock market 1871-1914

• Financial crises have been frequent and
  persistent throughout economic history

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What causes stock market volatility?

• Financial crises exhibit a similar pattern
• Promising novel technologies or markets
• A psychologically boosted investment frenzy
• Financial leverage and concentration of
  resources into an emerging segment of the
  economy
• Over-expansion of a sector and its bust
• Contagion of the overall economy

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Examples

• This pattern was typical for
• The railway frenzy of the mid-19th century
• The initiation of electrical appliances at the
  turn of the last century
• But the best analyzed event in economic history
  is the one following the expansion of the
  roaring 1920s ..

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How do financial bubbles affect activity?

• The NY stock market crashed on Friday, October
  1929, initiating a persistent and long downturn
  of the economy

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Development of Stock Market Index
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Repercussions on the real economy
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Impact on peoples lives

• Top CEOs had a especially hard time !

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What dragged the economy down?

• The impact was then
• Increase of personal savings (and hence a
  reduction of consumer spending) due to a
  perceived reduction of personal wealth
• Change in consumer behavior due to higher
  unemployment
• Credit implosion with an induced reduction of
  demand, notably fixed investment
• Reduction of housing investment due to prior
  over-investment

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The Great Depression Further problems

• And
• A general loss in consumers and investors
  confidence
• Change in spending behavior due to insolvencies
  and bankruptcies
• Disintermediation due to a lack of liquidity
• Negative impact on public investment due to a
  fall in tax revenue
• Policy failures, e.g. strategic trade policies
  (Smoot-Hawley Act)

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The Great Depression US imports
November
Monthly data. Imports from 75 Countries (in bill.
Gold )
January
February
December
March
November
April
October
May
September
June
August
July
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The Great Depression Monetary policy

• Policy failure of central banking
• Reduction in the supply of money
• High real interest rates
• Failure of financial institutions

Anna Schwartz
Milton Friedman
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What have we learned since?

• Social protection, especially of the old and the
  unemployed
• Consolidation of financial sector to avoid credit
  implosion, insolvency and break-downs
• Fiscal and monetary management
• International institutions to provide
  international means of payment (IMF) and to
  protect free trade (WTO)
• International cooperation and integration
• And in particular ..

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Our leaders are much brighter !!
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• Today we are technically more advanced and
  smarter than our grandparents!

However animal spirits are persistent and
remain
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Irrational exuberance A bubble that will burst!
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and it did!
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The central bank and systemic stability

• The health of the economy and the effectiveness
  of monetary policy depend on a sound financial
  system. Through supervising and regulating
  financial institutions, the ECB is better able to
  make policy decisions.
• But should it intervene?
• Rescue failing banks?