MONEY AND BANKING

TOPIC II: CHAPTER 9 and CHAPTER 10

LECTURER: Prof. MadyaDr. Wong Hock Tsen

NAME
MOHD IBRAHIM BIN BAKI
AZLAN BIN ENTAWAN
ROSINAH BINTI SAMSUDIN
CHRISTIN ANAK GRAN
SUZANA BINTI ONGKOMG

MATIRIC NO.
BB12110330
BB12110050
BB12110501
BB12110097
BB12110587
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CHAPTER 9 (QUESTION 8)
How can government fiscal imbalances lead to a financial crisis?
The emerging market or developing countries are particularly facing to financial
market problems because their legal systems and accounting practices tend to be
less well established and their governments tend to play a much larger role in
financial market activity. However, even developed countries are not immune to
financial crisis.
Government fiscal imbalance, which is budget deficits are a particular
problem for many emerging market economies. Government fiscal imbalances can
lead to increased fears of default on the government debt, forcing the government to
sell any new bond issue to banks rather than to private investors, where assuming
government can exert sufficient pressure on banks to buy its bonds. This is
dangerous, since subsequent actions by investors, both foreign and domestic, to
protect themselves against default by selling their holdings of government bonds can
lead to sharp contractions in government bond prices and hence to sharp declines in
the balance sheets of the banks holding government bonds. This can then trigger
problems in the banking sector. In addition, the actions of foreign investors to take
their money out of the country (referred to as capital outflow or capital flight) can
also spark a foreign exchange crisis which is a form of balance of payments crisis.
For example Brazil and Russia as emerging market countries where the
imbalances usually happen; they create fear of default on government debt.
Therefore, individual investors have a very low demand for government bonds. Thus,
the government forces financial institutions to purchase them. If the debt then
declines in price then, this weakens the financial institutions' balance sheets. This
can also spark a foreigner exchange crisis and make them pull their money out too.
Causing domestic currency value to decline which results foreign exchange currency
in the domestic can be predicted. This all leads to increase in adverse selection and
moral hazard problems.

10. What role does weak financial regulation and supervision

play in causing financial crises?
The policy influences the operation of financial systems through financial
regulation and supervision. The need for the regulation and supervision of the
financial system arises because financial intermediaries and markets, like
firms, are subject to asymmetric information. A key objective and supervision
I to increase and maintain financial stability
Financial instability
Financial instability occurs when shocks to the financial system
interfere with the payment system and impact on the ability for the
normal business and other shock. Any disruptions in the financial
system can potential have severe real economic effects. For example,
during the Asian crisis in the second half of the 1990s disruptions in
the supply of credit was major factor in the recession experienced by
the affected countries. An economic downturn may be exacerbated by
the falling prices (fisher 1933). Given that most debt contract are
written in nominal terms, a fall in prices increase real debt burdens and
reduces firms ability to borrow adding further to the decline in
economic activity. There are four factors that can initiate financial
instability are increase in interest rate, increase in uncertainty, negative
shock to firms balance sheets, and deterioration in financial
intermediaries balance sheet (Mishkin 1997)
Financial liberalization
Defined refers to reduction of any sort of organizations on the financial
industry of a given country for example, the Chinese economy is one
with very regulated liberalization, the government control and restricts
ability of anyone to invest in china, except foreign direct investment
which physical investments, and not financial I.T is important to draw
the distinction between liberalization and liberal. Liberal means free,
liberalization means becoming freer. If a much regulated system like
the Chinese financial system reduces some of its restrictions, the
system is going through some liberalization. Other than that, The U.S
has an extremely liberal system which we've liberalized over the last 3
decades. Many people blame the current crisis on to much
liberalization, since it essentially allowed the creation of risky financial
instruments, and failings of rating institutions created many of the
problems that have caused recession. Such as too much credit, high
number of risky loans, and many bubbles. As well as bubbles
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generated by too much speculation. Therefore, It's Mismanagement of

Financial Liberalization. If there isn't a great supervisor, they will go on
a lending spree and have a great amount of risk, where they wont be
able to keep up with information resources. Which later the
government will put a safety net in with tax payers money so the bank
can take higher risk and possibly receive that profit and not create a
bank panic.

What do you think prevented the financial crisis of 2007-2009 from

becoming a depression?
The latest economic data suggests that recession is returning to most advanced
economies, with financial markets now reaching levels of stress unseen since the
collapse of Lehman Brothers in 2008. The risks of an economic and financial crisis
even worse than the previous one and now involving not just the private sector, but
also near-insolvent sovereigns are significant. Thus, between 2007 and 2009 the U.S.
witnessed a series of banking failures that led to a prolonged recession. The financial
crisis was the worst since the Great Depression and caused a significant increase in
the federal budget deficit.
There are several ways to prevent the financial crisis in 2007-2009 from becoming
depression. First, while monetary policy has limited impact when the problems are
excessive debt and insolvency rather than illiquidity, credit easing, rather than just
quantitative easing, can be helpful. The European Central Bank should reverse its
mistaken decision to hike interest rates. More monetary and credit easing is also
required for the US Federal Reserve, the Bank of Japan, the Bank of England, and
the Swiss National Bank. Inflation will soon be the last problem that central banks
will fear, as renewed slack in goods, labor, real estate, and commodity markets feeds
disinflationary pressures.
Second, restore credit growth, Eurozone banks and banking systems that are undercapitalized should be strengthened with public financing in a European Union-wide
program. To avoid an additional credit crunch as banks deleverage, banks should be
given some short-term forbearance on capital and liquidity requirements. Also, since
the US and EU financial systems remain unlikely to provide credit to small and
medium-size enterprises, direct government provision of credit to solvent but illiquid
SMEs is essential.
Third, large-scale liquidity provision for solvent governments is necessary to avoid a
spike in spreads and loss of market access that would turn illiquidity into insolvency.
Even with policy changes, it takes time for governments to restore their credibility.
Until then, markets will keep pressure on sovereign spreads, making a self-fulfilling
crisis likely.

Today, Spain and Italy are at risk of losing market access. Official resources need to
be tripled through a larger European Financial Stability Facility (EFSF), Eurobonds,
or massive ECB action to avoid a disastrous run on these sovereigns.
Forth, debt burdens that cannot be eased by growth, savings, or inflation must be
rendered sustainable through orderly debt restructuring, debt reduction, and
conversion of debt into equity. This needs to be carried out for insolvent
governments, households, and financial institutions alike.
Thus, the risks ahead are not just of a mild double-dip recession, but of a severe
contraction that could turn into Great Depression II, especially if the eurozone crisis
becomes disorderly and leads to a global financial meltdown. Wrong-headed policies
during the first Great Depression led to trade and currency wars, disorderly debt
defaults, deflation, rising income and wealth inequality, poverty, desperation, and
social and political instability that eventually led to the rise of authoritarian regimes
and World War II. The best way to avoid the risk of repeating such a sequence is
bold and aggressive global policy action now.

Extra Question: Discuss was the Fed (Federal Reserve) to blame for the
housing price bubble in the US?
The Federal Reserve isn't to blame for the housing bubble, the slides on the housing
bubble show how clearly one thing led to another. When you were observing the
economy in the 2000s, what did you think would happen to rising house prices and
the housing bubble? the decline in house prices by itself was not obviously a major
threat. It was that whole chain of events that was critical. Fed had little to do with
home prices that rose rapidly in the early 2000s, and then came crashing down.
Housing booms and busts around the world as evidence that the rise in real estate
prices was not limited to the United States and the Fed's area of influence.
The research by economist Robert Shiller showing that the housing bubble
began in 1998, which is three years before the Fed started slashing interest rates,
making it cheaper to get a mortgage. As what the Federal Reserve Chairman Ben
Bernanke said "You'll probably hear different points of view, but the evidence that
I've seen and that we've done within the Fed suggests that monetary policy did not
play an important role in raising house prices during the upswing," Bernanke said.
The housing bubble was caused by "regulatory rather than monetary-policy
failures". It was the absence of an effective regulatory function that created the
mess were in now. It is not fair to blame the Great Recession only on the Feds
monetary-policy stance nor is the Fed now breeding the next US financial crisis. In
the context of our model and according to this evidence, regulatory rather than
monetary-policy failures are largely to blame for the occurrence and the severity of
the Great Recession. Only by assuming that the Fed was the sole institutional
guardian of financial stability, or at least the main one, is it possible to contend that

monetary policy is to blame for the 2007-09 financial crises and the ensuing Great
Recession.

CHAPTER 10
4. What other factors can initiate financial crises in emerging market
economies?
Other factors that can initiate the financial crises in emerging market
economies are a rise in interest rates. It happens due to events abroad such as
tightening of US monetary policy. When interest rate rises, high risk firms are most
willing to pay the high interest rates, so the adverse selection problem is more
severe. In addition, the high interest rates reduce firms cash flows, forcing them to
seek funds in external capital markets in which asymmetric problems are greater.
Increase in interest rates abroad that raise domestic interest rates can then increase
adverse selection and moral hazard problem.
Asset market plays a less prominent role in financial crises. If the asset price
decreases it will decrease the net worth of firms and therefore increase the adverse
selection problems. Thus there is less collateral for lenders to seize and increased
moral hazard problems. The decrease in asset price will worsen the adverse selection
and moral hazard by causing deterioration in banks balance sheets from asset writedowns.
In advanced countries, when emerging market economy is in a recession,
people will become uncertain about the return of investment projects. In emerging
market countries, when there is uncertainty, it is hard for lenders to screen out good
credit risks from bad and monitor the activities of firms to whom they have loaned
money. Therefore, it will worsen the adverse selection and moral hazard.

8. What can emerging market countries do to strengthen prudential

regulation and supervision of their banking systems? How would these
steps help avoid future financial crises?
First, regulators should ensure that banks hold ample capital to cushion the
losses from economic shocks, and to give bank owners an incentive to pursue safer
investments, since they have more to lose. Prudential supervision can also help
promote a safer and sounder banking system by ensuring that banks have proper
risk management procedures in place, including good risk measurement and
monitoring systems, policies to limit activities that present significant risks, and
internal controls to prevent fraud or unauthorized activities by employees.
Financial institutions have incentives to hide information from bank supervisors in
order to avoid restrictions on their activities, and can become quite adept and crafty
at masking risk. Also, supervisors may be corrupt or give in to political pressure and
so may not do their jobs properly. To eliminate these problems, financial markets
need to discipline financial institutions from taking on too much risk. Government
regulations to promote disclosure by banking and other financial institutions of their
balance sheet positions, therefore, are needed to encourage these institutions to
hold more capital because depositors and creditors will be unwilling to put their
money into an institution that is thinly capitalized. Regulations to promote disclosure
of banks activities will also limit risk taking because depositors and creditors will pull
their money out of institutions that are engaging in these risky activities.

Extra Question: Explain how financial market crisis in the emerging market
can be prevented?
There are a number of policies that can help prevented the financial crisis in
the emerging market. First is by beef up prudential regulation and supervision of the
banks. Thus, to prevent crises, governments must improve prudential regulations
and supervision of banks to limit their risk taking. By ensuring that bank hold ample
capital to cushion the losses from economic shocks and to gives incentives to the
bank holder to pursue safer investment due to the loses that they have gain.
Prudential supervision can also promote a safer and sounder banking system.
They can do so by ensuring that banks have proper risk management procedures.
There are three
procedures included which is good risk measurement and
monitoring system, policies to limit activities that present significant risks and also
internal controls to prevent fraud or unauthorized activities by employee. For the
prudential supervision to do work, they must have adequate resources to be able to
do their jobs. Because politicians often pressure prudential supervisors to discourage
them from being too tough on banks that make political contributions or outright
bribes a more independent regulatory and supervisory agency can better withstand
political influence, increasing the likelihood that they will do their jobs and limit bank
risk taking.
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Next is by encouraged disclosure and market-based discipline. Financial

institutions have to hide information from bank supervisors in order to avoid
restrictions on their activities and they also tend to corrupt or give in to the political
pressure and may not do their jobs properly. Therefore, financial market needs to
discipline financial institutions from taking too much risk. Government regulations to
promote disclosure are needed to encourage their institutions to hold more capital
because creditor and depositor will be unwilling to put their money into institutions
that are thinly capitalized. Regulations to promote disclosure of banks activities will
also limit risk taking. This is because depositors and creditors will pull their money
out of institutions that are engaging in these risky activities.
Thirdly is limit currency mismatch. As we have seen, emerging market
financial system can become very vulnerable to a decline in the value of the nations
currency. Government can limit currency mismatch by implementing regulations or
taxes that discourage the issuance of debt denominated in foreign currency by
nonfinancial firms. Regulations of banks can also limit bank borrowing in foreign
currencies. Beside in order to discourage borrowing, regulations have to move to a
flexible exchange rate regimes. Other than that, monetary policy that promotes price
stability also helps by making the domestic currency less subject to decrease in its
value as a result of high inflation thus making it more desirable for firms to borrow in
domestic currency rather than foreign currency.
In conclusion, to avoid financial crises, policy makers will need to put in place
the proper institutional infrastructure before liberalizing their financial systems.
Because implementing these policies takes times, financial liberalization may have to
be phased in gradually, with some restrictions on credit issues imposed along the
way.