2014 Pearson Education Inc LEARNING OBJECTIVES After studying

LEARNING OBJECTIVES After studying this chapter, you should be able to: 12. 1 Explain what financial crises are and what causes them. 12. 2 Understand the financial crisis that occurred during the Great Depression. 12. 3 Understand what caused the financial crisis of 2007 -2009. 12. 4 Discuss the connection between financial crises and financial regulation. © 2014 Pearson Education, Inc.

A Cloudy Crystal Ball on the Financial Crisis • Now we know that the housing market led to the worst recession since the Great Depression. • Yet many policymakers, business leaders, and economists failed to see the crisis developing. • Policymakers, managers of financial firms, investors, and households were struggling to deal with unprecedented events. © 2014 Pearson Education, Inc.

Key Issue and Question Issue: The financial crisis of 2007– 2009 was the most severe since the Great Depression of the 1930 s. Question: Was the severity of the 2007– 2009 recession due to the financial crisis? © 2014 Pearson Education, Inc. 4 of 57

12. 1 Learning Objective Explain what financial crises are and what causes them. ©

The Origins of Financial Crises Financial crisis is a significant disruption in the flow of funds from lenders to borrowers. • Economic activity depends on the ability of households and firms to borrow. • A financial crisis disrupts the flow of funds from lenders to borrowers. • A financial crisis typically leads to an economic recession as households and firms face difficulty in borrowing money. • In the past, most of the financial crises in the United States involved the commercial banking system. The Origins of Financial Crises © 2014 Pearson Education, Inc. 6 of 57

The Underlying Fragility of Commercial Banking • Banks have a maturity mismatch because they borrow short term from depositors and lend long term to households and firms. • This means that banks face a liquidity risk because they may be unable to meet their depositors’ withdrawals. • Banks can borrow or sell assets to raise funds. Insolvent is the situation for a bank or other firm whose assets have less value than its liabilities, so its net worth is negative. • An insolvent bank may be unable to meets its obligations to pay off its depositors. The Origins of Financial Crises © 2014 Pearson Education, Inc. 7 of 57

Bank Runs, Contagion, and Bank Panics • Prior to 1933, the United States had no system of government deposit insurance. • Once the bank’s liquid assets were exhausted, the bank would have to shut its doors, at least temporarily. Bank run is the process by which depositors who have lost confidence in a bank simultaneously withdraw enough funds to force the bank to close. • In the absence of deposit insurance, the stability of a bank depends on the confidence of its depositors. The Origins of Financial Crises © 2014 Pearson Education, Inc. 8 of 57

Contagion is the process by which a run on one bank spreads to other banks resulting in a bank panic. • If multiple banks have to sell the same assets—for example, mortgagebacked securities—the prices of these assets are likely to decline and some banks may even be pushed to insolvency. Bank panic is the situation in which many banks simultaneously experience runs. • A bank panic feeds on a self-fulfilling perception: If depositors believe that their banks are in trouble, the banks are in trouble. The Origins of Financial Crises © 2014 Pearson Education, Inc. 9 of 57

Government Intervention to Stop Bank Panics • Governments have two main ways they can attempt to avoid bank panics: (1) A central bank can act as a lender of last resort. (2) The government can insure deposits. Lender of last resort is a central bank acting as the ultimate source of credit to the banking system, making loans to solvent banks against their good, but illiquid, loans. Federal Deposit Insurance Corporation (FDIC) is a federal government agency established by Congress in 1934 to insure deposits in commercial banks. The Origins of Financial Crises © 2014 Pearson Education, Inc. 10 of 57

Solved Problem 12. 1 Would Requiring Banks to Hold 100% Reserves Eliminate Bank Runs? The Federal Reserve requires banks to hold reserves equal to 10% of their holdings of checkable deposits above a certain level. In the 1950 s, Milton Friedman, a Nobel Prize winner in Economics, proposed that banks be required to hold 100% reserves. In 2010, Laurence J. Kotlikoff of Boston University advocated a similar plan. If required to hold 100% reserves, banks would make loans and buy securities with their capital rather than with deposits. Briefly discuss how this proposal would affect the likelihood of bank runs. The Origins of Financial Crises © 2014 Pearson Education, Inc. 11 of 57

Solved Problem 12. 1 Would Requiring Banks to Hold 100% Reserves Eliminate Bank Runs? Solving the Problem Step 1 Review the chapter material. Step 2 Answer the problem by discussing what causes bank runs and whether requiring banks to hold 100% reserves would affect the likelihood of runs. We have seen that bank runs are caused by depositors’ knowledge that banks keep only a fraction of deposits on reserve and loan out or invest the remainder. If banks held 100% reserves, depositors would also not be at risk of losing their money if banks made poor investments because the value of a bank’s loans and securities would no longer be connected to the bank’s ability to refund depositors’ money. We can conclude that such a system would not be subject to runs. The Origins of Financial Crises © 2014 Pearson Education, Inc. 12 of 57

Bank Panics and Recessions From the 1985 recession until 1933, all but two bank

Figure 12. 1 The Feedback Loop During a Bank Panic Bank runs can cause good banks, as well as bad banks, to fail. Bank failures reduce credit availability to households and firms. The Origins of Financial Crises © 2014 Pearson Education, Inc. 14 of 57

Making the Connection Why Was the Severity of the 2007– 2009 Recession So Difficult to Predict? • Recessions in the United States between 1933 and 2007 were not accompanied by bank panics, but the recession of 2007– 2009 did involve a panic in the “shadow banking system. ” • Both the Great Depression and the recession of 2007– 2009 were severe. Do recessions accompanied by bank panics tend to be more severe? • Research shows that recessions following bank crises have been more severe with higher unemployment rates, and sharper and longer declines in real GDP. • Government debt also soared from increased government spending and higher budget deficits. The Origins of Financial Crises © 2014 Pearson Education, Inc. 15 of 57

Making the Connection Why Was the Severity of the 2007– 2009 Recession So Difficult to Predict? The table below shows some key indicators for the 2007– 2009 U. S. recession compared with other U. S. recessions of the post-World War II period. The Origins of Financial Crises © 2014 Pearson Education, Inc. 16 of 57

Exchange Rate Crises Countries have attempted to keep the value of their currency fixed by pegging it against another currency Figure 12. 2 Pegging the Exchange Rate between the Won and the Dollar The pegged exchange rate (E 2) was above the equilibrium exchange rate (E 1). To maintain the peg, the Korean central bank had to use dollars to buy surplus won equal to Won 3 – Won 2. The Origins of Financial Crises © 2014 Pearson Education, Inc. 17 of 57

Sovereign Debt Crises • Sovereign debt refers to bonds issued by a government. • A sovereign debt crisis occurs when a country has difficulty making interest or principal payments on its bonds. • If the government defaults and is unable to issue bonds, it will have to depend on tax revenues to pay for its spending. • Even if the government avoids default, it will probably have to pay much higher interest rates when it issues bonds. • The resulting decreases in government spending or increases in taxes can push the economy into recession. The Origins of Financial Crises © 2014 Pearson Education, Inc. 18 of 57

• Sovereign debt crises result from either of two circumstances: (1) chronic government budget deficits and interest payments taking up an unsustainably large fraction of government spending, (2) a severe recession that increases government spending and reduces tax revenues, resulting in soaring budget deficits. • Following the 2007– 2009 recession, several European governments (e. g. , Greece) were pushed to the edge of debt crises and so imposed sharp spending cuts and higher taxes. The Origins of Financial Crises © 2014 Pearson Education, Inc. 19 of 57

Making the Connection Greece Experiences a “Bank Jog” • In 2012, Greek politicians vowed to reverse the policy of government spending cuts and higher taxes, leading to speculation that Greece would abandon the euro. • Many Greeks were afraid that the government might decide to exchange euro bank deposits for drachmas, which might subsequently depreciate. • In May 2012, Greek banks began to lose deposits slowly as depositors were unsure exactly when Greece would actually stop using the euro. The Origins of Financial Crises © 2014 Pearson Education, Inc. 20 of 57

12. 2 Learning Objective Understand the financial crisis that occurred during the Great Depression.

The Financial Crisis of the Great Depression The Start of the Great Depression • Several factors helped to increase the severity of the downturn during the Great Depression. • Stock prices plunged, thereby reducing household wealth, making it more difficult for firms to raise funds, and increasing uncertainty. Higher uncertainty leads to decreases in spending. • In 1930, Congress passed the Smoot-Hawley Tariff Act, which led to retaliatory increases in foreign tariffs, thereby reducing U. S. exports. • Following legislation that restricted immigration, population growth declined, and spending on new houses fell. The Financial Crisis of the Great Depression © 2014 Pearson Education, Inc. 22 of 57

Figure 12. 3 The Great Depression Panel (a) shows that real GDP declined by 27% between 1929 and 1933, while real consumption declined by 18% and real investment fell by 81%. Panel (b) shows that the unemployment rate tripled from 1929 to 1930, was above 20% in 1932 and 1933, and was still above 10% in 1939. The Financial Crisis of the Great Depression © 2014 Pearson Education, Inc. 23 of 57

Figure 12. 4 The S&P 500, 1920– 1939 The Federal Reserve raised interest rates after it became concerned by the rapid increases in stock prices during 1928 and 1929. The decline in stock prices from 1929 to 1932 was the largest in U. S. history. The Financial Crisis of the Great Depression © 2014 Pearson Education, Inc. 24 of 57

The Bank Panics of the Early 1930 s Figure 12. 5 Bank Suspensions, 1920– 1939 Bank suspensions soared during the bank panics of the early 1930 s before falling to low levels following the establishment of the FDIC in 1934. The Financial Crisis of the Great Depression © 2014 Pearson Education, Inc. 25 of 57

Debt-deflation process is a cycle of falling asset prices and falling prices of goods and services that can increase the severity of an economic downturn. As the economic downturn worsened, the price level would fall with two negative effects: • Real interest rates would rise, and the real value of debts would increase. • This process of falling asset prices, falling prices of goods and services, and increasing bankruptcies and defaults can increase the severity of an economic downturn. The Financial Crisis of the Great Depression © 2014 Pearson Education, Inc. 26 of 57

The Failure of Federal Reserve Policy during the Great Depression Why did the Fed not intervene to stabilize the banking system? 1. No one was in charge. Power within the Federal Reserve System was divided. The Fed had less independence from the executive branch, and important decisions required forming a consensus which was hard to come by. 2. The Fed was reluctant to rescue insolvent banks. Fed officials believed that taking actions to save them might encourage risky behavior (moral hazard) by bank managers. The Financial Crisis of the Great Depression © 2014 Pearson Education, Inc. 27 of 57

3. The Fed failed to understand the difference between nominal and real interest rates. With the price level falling, real interest rates were much higher in the early 1930 s than policymakers at the Fed believed them to be. 4. The Fed wanted to “purge speculative excess. ” Many Fed members believed that the Depression was the result of financial speculation, so the Fed followed the “liquidationist” policy: allowing the price level to fall and weak banks and weak firms to fail before a recovery could begin. The Financial Crisis of the Great Depression © 2014 Pearson Education, Inc. 28 of 57

Making the Connection Did the Failure of the Bank of United States Cause the Great Depression? • In the early 1960 s, Milton Friedman and Anna Schwartz wrote about the importance of bank panics in their book A Monetary History of the United States, 1867– 1960. • They singled out the failure in December 1930 of the Bank of United States, which was the largest bank to have failed in the United States up to that time. • Economists continue to disagree as to whether the Federal Reserve should have moved more forcefully to keep the bank from closing. • Some economists argue that this episode was important in leading the Fed to develop the “too-big-to-fail” doctrine: no large financial institution can be allowed to fail because its failure may destabilize the financial system. The Financial Crisis of the Great Depression © 2014 Pearson Education, Inc. 29 of 57

12. 3 Learning Objective Understand what caused the financial crisis of 2007– 2009. ©

The Financial Crisis of 2007– 2009 The Housing Bubble Bursts • Between January 2000 and May 2006, house prices more than doubled, while rents increased by less than 25%, providing evidence of a bubble. • Home prices began to decline in 2006 after some homebuyers had trouble making mortgage payments. • When lenders foreclosed on some of these loans, they sold the homes, causing housing prices to decline further. • A credit crunch occurred as most banks tightened their requirements for borrowers. • Home prices dropped further as potential homebuyers had trouble obtaining mortgages. The Financial Crisis of 2007– 2009 © 2014 Pearson Education, Inc. 31 of 57

Figure 12. 6 Housing Prices and Housing Rents, 1987 -2012 Except for the housing bubble period, housing prices increase at about the same rate as housing rents. Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 32 of 57

Bank Runs at Bear Stearns and Lehman Brothers • August 2007: French bank BNP Paribas announces that it would not allow investors to redeem their shares in three funds that had held large amounts of mortgage-backed securities. Credit conditions worsen. • March 2008: Lenders become concerned about the decline in mortgagebacked securities at Bear Stearns. With aid from the Federal Reserve, Bear is saved from bankruptcy. • August 2008: The crisis deepens as nearly 25% of subprime mortgages are at least 30 days past due. The Financial Crisis of 2007– 2009 © 2014 Pearson Education, Inc. 33 of 57

• September 2008: Lehman Brothers files for bankruptcy protection after the Treasury and the Fed decline to help. Merrill Lynch agrees to sell itself to Bank of America. • Reserve Primary Fund announces that it would “break the buck” by allowing the value of shares in the fund to fall to $0. 97. • Many parts of the financial system become frozen as trading in securitized loans largely stops. The Financial Crisis of 2007– 2009 © 2014 Pearson Education, Inc. 34 of 57

The Federal Government’s Extraordinary Response to the Financial Crisis • Having focused on the commercial banking system, the government was poorly equipped to deal with a crisis in the shadow banking system. • Most policymakers did not realize until well into 2007 that the subprime crisis might evolve into a full-blown financial crisis. • The Fed began aggressively driving down short-term interest rates. • The federal government effectively nationalized Fannie Mae and Freddie Mac. • The Treasury moved to stop the runs on money market mutual funds. The Financial Crisis of 2007– 2009 © 2014 Pearson Education, Inc. 35 of 57

• In 2008, the Fed and the Treasury unveiled a plan for Congress to authorize $700 billion used to purchase mortgages and mortgage-backed securities from financial firms and other investors. • They used Troubled Asset Relief Program (TARP) funds to make direct preferred stock purchases in banks to increase bank capital. • In early 2009, the Treasury administered a stress test to 19 large financial firms in order to reassure investors that the firms had sufficient capital to deal with a severe economic downturn. The Financial Crisis of 2007– 2009 © 2014 Pearson Education, Inc. 36 of 57

12. 4 Learning Objective Discuss the connection between financial crises and financial regulation. ©

Financial Crises and Financial Regulation • New government financial regulations typically occur in response to a crisis. There is a regular pattern: (1) crisis, (2) regulation, (3) response to new regulations by financial firms, and (4) response by regulators. Lender of Last Resort • Congress created the Federal Reserve System as the lender of last resort to provide liquidity to banks during bank panics. • The Fed failed its first crucial test when it stood by while the banking system collapsed in the early 1930 s. • Congress responded to this failure by establishing the FDIC and by reorganizing the Fed to make the Federal Open Market Committee (FOMC) to centralize decision making. Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 38 of 57

Success in the Postwar Years and the Development of the “Too-Big-to. Fail” Policy • The Fed has performed its role well during most of the post-World War II period. • In 1970, when the quality of commercial paper issued by large corporations came into question, the Fed provided commercial banks with loans. • In 1974, the Fed saved Franklin National Bank, which experienced a run by depositors holding negotiable CDs. • During the stock market crash of October 19, 1987, Fed Chairman Alan Greenspan announced the Fed’s readiness to provide liquidity to support the economic and financial systems. Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 39 of 57

• In 1984, the comptroller of the currency provided Congress with a list of banks that were considered “too big to fail. ” o A failure by any of these banks might pose systemic risk to the financial system. Too-big-to-fail policy is a policy under which the federal government does not allow large financial firms to fail, for fear of damaging the financial system. • Banks that were not allow to fail had unlimited deposit insurance, increasing moral hazard. o Depositors had much less incentive to monitor the behavior of bank managers or demand higher interest rates if the managers made reckless investments. • The too-big-to-fail policy also was criticized for being unfair because it treated small and large banks differently. Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 40 of 57

• In 1991, Congress passed the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA): o The act required the FDIC to deal with failed banks using the method that would be least costly to the taxpayer (e. g. , closing the bank and reimbursing the bank’s insured depositors). • The act contained an exception for cases in which a bank’s failure would cause “serious adverse effects on economic conditions or financial stability. ” • During the financial crisis of 2007– 2009, this exception proved to be important. Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 41 of 57

The Financial Crisis and a Broader Fed Role as Lender of Last Resort • In March 2008, the Fed and the Treasury intervened to keep Bear Stearns from failing. • Some economists and policymakers argued that it increased moral hazard in the financial system. This criticism may have played a role in the Fed’s decision not to attempt to save Lehman Brothers in September 2008. • A few days later, the Fed made a large loan to the American International Group (AIG) insurance company in exchange for 80% ownership of the firm. • The too-big-to-fail policy appeared to be back: the Fed, FDIC, and the Treasury have taken actions that resulted in no large financial firms failing with losses to investors (except Lehman Brothers). Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 42 of 57

The 2010 Financial Overhaul: The End of the Too-Big-to-Fail Policy? • Congress intended to end the too-big-to-fail policy by passing the Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) in 2010. • The act allows the Fed, FDIC, and Treasury to seize and “wind down” large financial firms. Previously, only the FDIC had this power, and it could only use it to close commercial banks. • According to the FDIC, the act would lead investors to shift funds toward smaller firms that have lower information costs of determining the riskiness of investments. o Larger firms would have to provide investors with higher expected returns to compensate them for the absence of any bailout. Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 43 of 57

Figure 12. 7 Lender of Last Resort: Crisis, Regulation, Financial System Response, and Regulatory

Making the Connection The Consumer Financial Protection Bureau: The New Sheriff of Financial Town? • The Dodd-Frank Act of 2010 created the Consumer Financial Protection Bureau (CFPB) to deal mainly with deceptive practices by financial firms. • Supporters of the CFPB argue that the financial crisis of 2007– 2009 revealed that more regulation for consumer lending and other financial services is necessary. • Critics of the CFPB complain that the costs and complexity of additional regulation outweigh the benefits to consumers. • Economists and policymakers continue to debate about the costs vs. benefits of CFPB’s activities. Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 45 of 57

Reducing Bank Instability • One argument for limiting competition among banks is that it reduces bankers’ willingness to make excessively risky investments. • In the long run, anticompetitive regulations may create incentives for unregulated financial institutions and markets to compete with banks. • Regulation Q was established under the Banking Act of 1933 to limit competition for funds among banks. • Regulation Q placed ceilings on the interest rates banks could pay on time and savings deposits and prohibited banks from paying interest on demand deposits. • In the 1970 s, rising inflation rates drove interest rates above the Regulation Q ceilings, and led households to substitute money market mutual funds and other short-term investment instruments for deposits in banks. Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 46 of 57

• Disintermediation occurred when: o Banks did not have savers’ funds to loan, and o Banks ended up with only low-quality borrowers as firms sold a substantial fraction of their commercial paper to money market mutual funds. Disintermediation is the exit of savers and borrowers from banks to financial markets. • To circumvent Regulation Q, banks developed new financial instruments for savers. • Citibank introduced negotiable certificates of deposit that were not subject to Regulation Q interest rate ceilings, and negotiable order of withdrawal (NOW) accounts on which they paid interest. • Banks also developed automatic transfer system (ATS) accounts that effectively pay interest on checking accounts. Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 47 of 57

• The passage of the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) and the Garn-St. Germain Act of 1982 eased the anticompetitive burden on banks by phasing out Regulation Q. • The Garn-St. Germain Act also helped reverse disintermediation by allowing banks to offer money market deposit accounts (MMDAs). Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 48 of 57

Figure 12. 8 Interest Rate Ceilings: Crisis, Regulation, Financial System Response, and Regulatory Response

Capital Requirements • After an examination, a bank receives a grade in the form of a CAMELS rating based on the following: Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk • Regulating the minimum amount of capital that banks are required to hold reduces the potential for moral hazard and the cost of bank failures. • Regulators increased their focus on capital requirements following the savings-and-loan (S&L) crisis of the 1980 s. Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 50 of 57

• The fallout from the S&L crisis led a program by the Bank for International Settlements (BIS), located in Basel, Switzerland. • The Basel Committee on Banking Supervision developed the Basel accord to regulate bank capital requirements. Basel accord is an international agreement about bank capital requirements. • Under the Basel accord, bank assets are grouped into four categories based on their degree of risk. • These four categories are used to calculate a measure of a bank’s riskadjusted assets by multiplying the dollar value of each asset by a riskadjustment factor. Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 51 of 57

A bank’s capital adequacy is calculated using two measures of the bank’s capital relative to its risk-adjusted assets: • Tier 1 capital consists mostly of bank capital, or shareholder’s equity. • Tier 2 capital equals the bank’s loan loss reserves, its subordinated debt, and several other bank balances sheet items. Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 52 of 57

• Implementation of capital requirements meant that banks with low capital ratios were forced to close or to raise additional capital. • Large commercial banks developed financial innovations that allowed these banks to push some assets off their balance sheets. • Some large banks (e. g. , Citigroup) formed special investment vehicles (SIVs) to hold risky assets. • By the time of the financial crisis, there were about 30 SIVs, holding about $320 billion in assets. • As the assets held by SIVs lost value, banks were forced to bring those SIVs back into the bank’s balance sheet. Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 53 of 57

Figure 12. 9 Capital Requirements: Crisis, Regulation, Financial System Response, and Regulatory Response Financial

The 2007– 2009 Financial Crisis and the Pattern of Crisis and Response Key provisions of the Dodd-Frank Act: • Created the Consumer Financial Protection Bureau to protect consumers in their borrowing and investing activities. • Established the Financial Stability Oversight Council, to identify and act on systemic risks to the financial system. • Ended the too-big-to-fail policy for large financial firms. • Made several changes to the Fed’s operations. • Required certain derivatives to be traded on exchanges, not over the counter. • Implemented the “Volcker Rule” by banning most proprietary trading at commercial banks. • Required hedge funds and private equity firms to register with the SEC. • Required that firms selling mortgage-backed securities and similar assets retain at least 5% of the credit risk. Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 55 of 57

Figure 12. 10 The Financial Crisis of 2007 -2009: Crisis, Regulation, Financial System Response, and Regulatory Response Financial Crises and Financial Regulation © 2014 Pearson Education, Inc. 56 of 57

Answering the Key Question At the beginning of this chapter, we asked the question: “Was the severity of the 2007– 2009 recession due to the financial crisis? ” The recession of 2007– 2009 was the most severe since the Great Depression of the 1930 s; it was also the first to be accompanied by a financial crisis. Research has shown that recessions involving financial crises have been longer and deeper than recessions that do not involve financial crises. Because financial crises disrupt the flow of funds from savers to households and firms, they cause substantial reductions in spending. So, it is likely that the severity of the 2007– 2009 financial crisis explains the severity of the recession. © 2014 Pearson Education, Inc. 57 of 57