WHY DO FINANCIAL

CRISES OCCUR AND WHY

ARE THEY SO DAMAGING
TO THE ECONOMY
THE FINANCIAL CRISIS REVEALED
IMPORTANT WEAKNESSES IN MANY
AREAS OF OUR FINANCIAL SYSTEM.

- Jerome Powell
 CHAPTERS

01 02 03
GLOBAL FINANCIAL
04
DETERIORATION OF
THE GREAT CRISIS OF FINANCIAL INSTITUTIONS’
FINANCIAL CRISES DEPRESSION 2007- 2009 BALANCE SHEET
01 FINANCIAL CRISES
Financialcrisis are major
disruptions in financial
markets characterized by
sharp declines in asset
prices and firm failures.
PAST FINANCIAL CRISIS THROUGH-OUT THE WORLD:

2007-2009
AUGUST 2007 FINANCIAL CRISIS
- SUBPRIME - “ONE IN A
BORROWERS CENTURY
- GREAT CREDIT
DEPRESSION, TSUNAMI” - ALAN
“THE WORST GREENSPAN
ECONOMIC - WALL STREET
CONTRACTION FIRMS AND
IN THE U.S COMMERCIAL
HISTORY. BANKS
PAST FINANCIAL CRISIS THROUGH-OUT THE WORLD:

DECEMBER 2007,
OCTOBER 2007 2008 AND 2009
- WORLD STOCK - THE ECONOMY
MARKET CRASHED. IN A TAILSPIN
WITH THE
- COMMERCIAL
RECESSION.
BANKS,
INVESTMENT
- BEING THE MOST
BANKS AND SEVERE SINCE
INSURANCE WORLD WAR II
COMPANY
ADVERSE SELECTION AND
MORAL HAZARDS - Economic
analysis of the effects of
asymmetric information.
FINANCIAL SYSTEM - Performs the
essential function of channeling funds
to individuals or businesses with
productive investment opportunities.
if capital goes to the wrong uses
or does not flow at all, the economy
will operate inefficiently or go to
economic downturn.
AGENCY THEORY AND THE
DEFINITION OF A FINANCIAL
CRISIS
Agency Theory

it is the analysis of how

symmetric information problems
can generate adverse selection and
moral hazard problems.
Financial Crises
information flows in financial
markets experience a particularly
large disruption, with the result that
financial frictions and credit spreads
increase sharply and financial
markets stops functioning. As a
result, Economic activity will collapse
Asymmetric Information Problems
Act as barrier to financial markets channeling funds
efficiently and often described as financial frictions.

financial friction = harder

certainty of creditworthiness
interest rates = credit spread
DYNAMICS OF FINANCIAL
CRISES IN ADVANCED
ECONOMIES
Three stages of Financial Crises in
advanced economies:

Stage One: Initiation of Financial

Crisis
Stage Two: Banking Crisis
Stage Three: Debt Deflation
Stage One: Initiation of Financial Crisis
DETERIORATION Asset-Price Increase in
IN FINANCIAL
Decline Uncertainty
INSTITUTIONS

Adverse Selection and Moral Hazard Problems

Worsen and Lending Contracts.
Stage Two: Banking Crisis
Economic Activity Decline
Banking Crisis
Adverse Selection and Moral Hazard
Problems Worsen and Lending Declines
Economic Activity Decline
Stage Three: Debt Deflation

Unanticipated decline in Price

Adverse Selection and Moral Hazard Problems
Worsen and Lending Declines
Economic Activity Decline
Stage One: Initiation of Financial
Crisis
• Credit boom and Bust
✔ Financial innovation, an economy
introduces new types of loans or
other financial products
✔ Financial liberalization. The
elimination of restrictions on
financial markets and
institutions.
FINANCIAL LIBERATION HAS
TWO SIDES:

POSITIVE:

- In long run, it promotes

financial development and
encourages well-run financial
system that allocates capital
efficiency.
FINANCIAL LIBERATION HAS
TWO SIDES:

Dark side:
- In a short run, it can
prompt financial
institutions to go on a
lending spree called Credit
boom.
DELEVERAGING

- Is a process in which less

capital financial
institutions cut back their
lending to
borrower-spenders.
Lending boom turns into
lending crash:

Fewer funds = fewer loans

to fund productive
investments and a credit
freeze.
When financial institutions stop
collecting information and making
loans:

financial friction = limiting the

financial systems ability to address
the asymmetric information
problems of adverse selection and
moral hazards.
As loans become scares,
borrower-spenders are no longer
able to fund their productive
investment opportunities and
they decrease their spending,
causing economic activity to
contract.
• Asset-Price Boom and
Bust
Fundamental economic
values, the values based on
realistic expectations of
the assets future income
streams.
Asset price bubble. The rise of
asset prices about fundamental
economic value. These are often
driven by credit booms in which:

credit used to fund purchases

of assets = price
 When the bubble bursts and asset prices realign with
fundamental economic values; Stock and real estate
price tumble, companies’ net worth and the values
of collaterals they can pledge that results to:
stake = “skin in the game” ;
risky investments = lose

as a result, financial institutions tighten lending standard

borrower-spenders and lending contracts.
 Asset-price bust also causes in the value of financial
institutions’ assets thereby causing a in their networth
and hence, deterioration in their balance sheets which
causes them to deleverage , steepening the decline in
economic activity.

Increase in uncertainty
Period of uncertainty, financial frictions
= lending and economic activity.
Stage Two: Banking Crisis
Insolvency, Networth becomes
negative.

Bank Panics. Multiple banks fail

simultaneously. Depositors are at
fear for the safety of their deposits
and not knowing the quality of
banks’ loan portfolios, withdraw
their deposits to the point that banks
fail.
Fire sales of asset may cause
their prices to decline so much
the bank becomes insolvent.
Fewer banks operating = information about
creditworthiness of borrower-spenders
disappears.

adverse selection and moral hazard problems

= asset prices and failures of firms through
out the economy who lack funds for productive
investment opportunities.
Stage Three: Debt Deflation

Debt Deflation occurs when a

substantial unanticipated decline in
the price level sets in, leading to
further deterioration in firms’ net
worth because of the increased
burden of indebtedness.
For example:
If firm in 2015 has assets of $100 million (in 2015
dollars) and $90 million of long-term liabilities so that it
has $10 million in net worth. If the price level falls by
10% in 2016, The real value of the liabilities would rise
to $99 million in 2015 dollars, while the real value of the
assets would remain unchanged at $100 million dollars.
The result in net worth in 2015 dollars would fall from
$10 million to $1 million.
02 THE MOTHER OF ALL
FINANCIAL CRISES: THE
GREAT DEPRESSION
THIS WAS PREPARED TO
ANALYSE:

● How a financial crisis unfolded

during the great depression.

● How it led to the worst

economic downturn in U.S.
history.
 •Stock Market
Crash
•Bank Panics
•Continuing Decline
in Stock Prices
•Debt Deflation
•International
Dimensions
STOCK MARKET CRASH
● It is a rapid and often
unanticipated drop in stock
prices.
● In 1928 and 1929, prices doubled
in U.S. stock market.
● Federal Reserve Officials (FED)
viewed the stock market boom
as EXCESSIVE SPECULATION.
● Monetary Policy – to raise
interest rates to limit the rise in
stock market.
● FED got more than it bargained
for when the stock market
crashed in October 1929, falling
by 40% by the end of 1929.
● Normal recession turned into
something far worse.
● However, when severe
droughts in the Midwest led to
sharp decline in agricultural
production.
● The weakness of the economy
and banks in agricultural region
build to full-fledged panic in
November to December 1930,
with the stock market falling
sharply.
● After the era’s final panic
in march 1933, PRESIDENT
FRANKLIN DELANO
ROOSEVELT “declared a
bank holiday, a temporary
closing of all banks.”
CONTINUING DECLINE IN STOCK
PRICES
● Stock prices kept falling. By
mid-1932, stocks had declined to
10% of their value at the 1929
peak.
● Increase in uncertainty from the
unsettled and moral hazard
problems in financial markets.
○ Financial markets struggled to
channel to borrower-spenders
with productive investment
opportunities.
● The amount of outstanding
commercial loans fell by half from
1929 to 1933, and investment
spending collapsed, declining from
its 1929 level.

● Financial frictions is that lenders

began charging businesses much
higher interest rates to protect
themselves from credit losses.
● CREDIT SPREAD –
difference between the
interest rate on loans to
households and
businesses and interest
rate on completely safe
assets that are sure to
paid back.
● DEFT DEFLATION – It is a
concept that pertains to debt’s
effects on the price of
properties, goods, and services.
● Ongoing deflation that started in
1930 eventually led to 25%
decline in the price level. This
deflation short-circuited the
normal recovery process that
occurs in most recessions.
 DEBT DEFLATION– Huge
decline in prices triggered a debt
deflation in which net worth fell
because of the increased burden
of indebtedness borne by firms.
● Financial crisis in the great
depression was the worst ever
experienced in the United
States.
INTERNATIONAL DIMENSIONS

•Bank panics in the United states also

spread to the rest of the world, and the
contraction of the U.S. economy sharply
decreased the demand of foreign goods.
•Worldwide depression caused great
hardship, with millions upon millions of
people out of work.
•The consequences of the great
depression financial crisis were
disastrous.
03
THE GLOBAL FINANCIAL
CRISIS OF 2007 - 2009
KEY TERMINOLOGIES
MORTGAGE
- A mortgage is a debt instrument,
secured by the collateral of
specified real estate property,
that the borrower is obliged to
pay back with a predetermined
set of payments. Mortgages are
used by individuals and
businesses to make large real
estate purchases without paying
the entire purchase price up
front.
SUBPRIME MORTGAGE
- A subprime mortgage is a housing
loan that's granted to borrowers
with impaired credit history.
Often, they have no credit history
whatsoever. Their credit scores
don't allow them to get a
conventional mortgage.
 COLLATERALIZED DEBT
OBLIGATIONS ( CDO)
- A collateralized debt obligation is
named for the pooled assets —
such as mortgages, bonds and
loans — that are essentially debt
obligations that serve as collateral
for the CDO.
 CREDIT DEFAULT SWAPS
- A collateralized debt obligation is
named for the pooled assets —
such as mortgages, bonds and
loans — that are essentially debt
obligations that serve as collateral
for the CDO.
04
DETERIORATION OF
FINANCIAL INSTITUTIONS’
BALANCE SHEET
- The decline
in U.S.
housing
prices led to
rising
defaults on
mortgages.
- As a result, the
value of
mortgage-backed
securities and
CDO’s collapsed,
leaving banks and
other financial
institutions with a
lower value of
assets and thus a
decline in net
worth.
- With a weak
balance sheet,
banks and other
financial
institutions began
to deleverage,
selling off assets
and restricting
availability of
credit to both
households and
businesses.
Run on the Shadow Banking
System

What triggered a run of a Shadow

Banking System?
- the sharp decline in the value of
mortgages and other financial
assets.
- These securities were funded
primarily by Repurchase
Agreement or REPOS, short
term borrowing that, in effect,
uses assets like mortgage
backed securities as collateral.
- Haircuts- the rising concern
about the quality of a
financial institutions’ balance
sheet led lenders to require
larger amounts of collateral.
- With rising defaults on
mortgages, the value of
mortgage backed securities
fell, then lead to rise in
haircuts.
- And if this happen, to be able
to raise funds , financial
institutions had to engage in
fire sales and sell off their
assets very rapidly and to sell
them immediately lowering of
price occurs that will result
into a decline in their asset’s
values.
- The result was similar to the run on
the banking system that occurred
during the Great Depression,
causing massive deleveraging that
resulted in a restriction of lending
and a decline in economic activity.
- Worsening financial frictions
caused higher cost of credit for
households and business and tighter
lending standards.
GLOBAL FINANCIAL
MARKETS
- The problem originated in
United States but the wake
up call for the financial crisis
came from Europe, which is
a sign of how extensive the
globalization of financial
markets had become.
- The drying up of credit led to
the first major bank failure in
the United Kingdom in over
100 years, when Northern
Rock, which had relied on short
term borrowing in the repo
market rather than deposits
for its funding, collapsed in
September 2007.
- Particularly hard hit were
countries like Greece,
Ireland, Portugal, Spain and
Italy which led to a
sovereign debt crisis, which
is called as the The European
Sovereign Debt Crisis.
FAILURE OF HIGH
PROFILE FIRMS
- March 2008- Bear Sterns , the
fifth largest investment bank
in the U.S. , which had invested
heavily in subprime- related
securities, had a run on its repo
funding and was forced to sell
itself to JP Morgan for less
than 5% of its worth.
- July- Fannie Mae and Freddie
Mac , two privately owned
government sponsored
enterprises , was propped up
by the U.S. Treasury and
Federal Reserve after
suffering substantial losses.
In September 2008 was put
into conservatorship.
- September 15 2008- Lehman
Brothers , fourth largest
investment banks by asset of
$600 billion and 25 000
employees, filed for
bankruptcy, after suffering
losses in the subprime market.
Making it the largest
bankruptcy filing in the U.S.
history.
- The day before, Merrill Lynch
, the third largest investment
bank , who had also
suffered large losses on its
holding of subprime
securities, announced its sale
to Bank of America for a
price 60% below its value.
- September 16- AIG , an
insurance giant with assets
of over $1 trillion , suffered
an extreme liquidity crisis.
 HEIGHT OF THE
2007-2009 FINANCIAL
CRISIS
- The stock market crash accelerated,
with the week beginning October 6,
2008, showing the worst weekly decline
in U.S. history
- The recession that started in December
2007 become the worst economic
contraction in the United States since
World War 2 and as result is now
referred to as the Great Recession.
- The pace of recovery has been slow.
THANKS!