Financial fragility

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Financial Fragility is the vulnerability of a financial system to a financial crisis. [1] Franklin Allen and Douglas Gale define financial fragility as the degree to which "...small shocks have disproportionately large effects." [2] Roger Lagunoff and Stacey Schreft write, "In macroeconomics, the term "financial fragility" is used...to refer to a financial system's susceptibility to large-scale financial crises caused by small, routine economic shocks." [3]

A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth but do not necessarily result in significant changes in the real economy.

Contents

Sources of Financial Fragility

Why does the financial system exhibit fragility in the first place? Why do banks choose to take on a capital structure that makes them vulnerable to financial crises? There are two views of financial fragility which correspond to two views on the origins of financial crises. According to the fundamental equilibrium or business cycle view, financial crises arise from the poor fundamentals of the economy, which make it vulnerable during a time of duress such as a recession. According to the self-fulfilling or sunspot equilibrium view, the economy may always be vulnerable to a financial crisis whose onset may be triggered by some random external event, or simply be the result of herd mentality. [2] [4]

Capital structure

In finance, particularly corporate finance capital structure is the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.

The business cycle, also known as the economic cycle or trade cycle, is the downward and upward movement of gross domestic product (GDP) around its long-term growth trend. The length of a business cycle is the period of time containing a single boom and contraction in sequence. These fluctuations typically involve shifts over time between periods of relatively rapid economic growth, and periods of relative stagnation or decline.

In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Macroeconomic indicators such as GDP, investment spending, capacity utilization, household income, business profits, and inflation fall, while bankruptcies and the unemployment rate rise. In the United Kingdom, it is defined as a negative economic growth for two consecutive quarters.

Self-Fulfilling Crisis Views

Diamond-Dybvig

In the standard Diamond-Dybvig model, financial systems are vulnerable to a financial crisis in the form of a bank run due to the inherent nature of banking. Banks serve as intermediaries between depositors and borrowers. Depositors want immediate access to their deposits, while borrowers are not able to pay on demand. This creates a fundamental fragility, as a bank's assets cannot be liquidated in the event of a crisis to pay all depositors. This tension makes the financial system susceptible to a sudden change in demand for money by depositors, resulting in a bank run. [5]

Bank run economic problem

A bank run occurs when a large number of people withdraw their money from a bank, because they believe the bank may cease to function in the near future. In other words, it is when, in a fractional-reserve banking system, a large number of customers withdraw cash from deposit accounts with a financial institution at the same time because they believe that the financial institution is, or might become, insolvent; they keep the cash or transfer it into other assets, such as government bonds, precious metals or gemstones. When they transfer funds to another institution, it may be characterized as a capital flight. As a bank run progresses, it generates its own momentum: as more people withdraw cash, the likelihood of default increases, triggering further withdrawals. This can destabilize the bank to the point where it runs out of cash and thus faces sudden bankruptcy. To combat a bank run, a bank may limit how much cash each customer may withdraw, suspend withdrawals altogether, or promptly acquire more cash from other banks or from the central bank, besides other measures.

A financial intermediary is an institution or individual that serves as a middleman among diverse parties in order to facilitate financial transactions. Common types include commercial banks, investment banks, stockbrokers, pooled investment funds, and stock exchanges. Financial intermediaries reallocate otherwise uninvested capital to productive enterprises through a variety of debt, equity, or hybrid stakeholding structures.

Diamond-Rajan

Economists Douglas Diamond and Raghuram Rajan argued that banks purposefully adopt a fragile structure as a commitment device. Under this view, depositors would not normally trust banks with their deposits because they fear that when they want to withdraw their money, the bank may try to avoid repaying, or try to repay at a lower rate. However, if the bank does not have enough liquid assets to cover all depositor claims, a refusal to pay any one depositor the promised amount will prompt all other depositors to try to withdraw as well, and effectively cut off all lending to the bank. Banks voluntarily submit themselves to the risk of a bank run so that depositors will trust them with their loans, since depositors know that the bank will not be able to get away with their money without prompting a run. [6]

Precommitment is a strategy in which a party to a conflict uses a commitment device to strengthen its position by cutting off some of its options to make its threats more credible. Any party employing a Strategy of Deterrence faces the problem that retaliating against an attack may ultimately result in significant damage to their own side. If this damage is significant enough, then the opponent may take the view that such retaliation would be irrational, and therefore, that the threat lacks credibility, and hence, it ceases to be an effective deterrent. Precommitment improves the credibility of a threat, either by imposing significant penalties on the threatening party for not following through, or, by making it impossible to not respond.

Lagunoff-Schreft

Economists Roger Lagunoff and Stacey Schreft have argued that financial fragility arises from linked portfolios of investors. If investors have linked portfolios such that if one investor withdraws funds the investment will fail and the other investor will also take a loss, then any event that causes investors to change their portfolio could cause others to take losses. If these losses are large enough to prompt further portfolio changes, a small change could initiate a chain reaction of losses. Moreover, Lagunoff and Schreft argue that investors will anticipate the possibility of such a chain reaction, so that the belief that it may happen in the future could cause investors to reallocate their portfolios, thus triggering a self-fulfilling crisis. [3] [7]

Fundamental Crisis Views

Robert Van Order

Economist Robert Van Order argued in 2006 that a small change in economic fundamentals can prompt a large change in asset prices and financial structure due to the asymmetric information problem in financial markets. According to Van Order, lenders can choose to make loans to borrowers directly through financial markets such as the stock market, or to operate through a financial intermediary such as a bank. Banks are better able to verify the quality of borrowers, but they charge a fee for their services in the form of lower returns to their depositors then the full returns on the investments. Financial markets allow lenders to circumvent banks and avoid this fee, but they lose the banks ability to verify the quality of borrowers. According to Van Order, a small change in economic fundamentals that made borrowers more nervous about financial markets caused some borrowers to move their savings from financial markets to banks. Such a change would raise the costs of borrowing in financial markets, which could prompt high-quality borrowers to try to get loans from banks rather than financial markets. This could snowball as all the good borrowers stop getting loans from financial markets, prompting lenders to charge still higher rates to those who remain prompting still more borrowers to switch. This process is called an adverse selection spiral, and could lead to the sudden collapse of a financial market. The opposite effect might also occur, leading to a large-scale change in the capital structure in the other direction. [8]

Adverse selection is a term commonly used in economics, insurance, and risk management that describes a situation where market participation is affected by asymmetric information. When buyers and sellers have different information, it is known as a state of asymmetric information. Traders with better private information about the quality of a product will selectively participate in trades which benefit them the most, at the expense of the other trader. A textbook example is Akerlof's market for lemons.

Allen-Gale

Franklin Allen and Douglas Gale discuss financial fragility as large effects from small shocks. They formalize this idea by considering the case of an economy in which the size of financial shocks approaches zero. They show that even in such an economy there will still be significant fluctuations arising solely from these vanishingly small financial shocks. In their view, banks are risk-sharing institutions where deposits act to insure depositors against a lack of access to money. Even minuscule shocks can set off self-reinforcing price changes. [2]

Bailouts

Another reason banks might adopt a fragile financial structure is because they expect a government bailout in the event of a financial crisis. This is an example of moral hazard, since the bank engages in risky behavior because it believes it has insurance against downside risks. If the government is considered likely to step in and reduce losses incurred by banks, bankers will have an incentive to take on more risk and increase the financial fragility of the banking system. In general, a bailout is the optimal response of policy-makers once a crisis has occurred (ex post), because the bailout will reduce the negative effects of the crisis on the economy. Before the crisis occurs (ex ante), policy-makers would like to convince banks that they will not bail them out in the event of a crisis so that banks do not adopt a fragile capital structure. However, if policy-makers announce that they will not bail out banks in the event of a crisis, bankers will not believe them because they rationally anticipate that policy-makers will in fact bail them out in the event of a crisis. Policy-makers stated policy of no bailouts in the event of a crisis is not credible, so in the absence of a commitment device banks will take on excess risk. [9]

Moreover, some economists have argued that the presence of bailouts will force banks to take on more risk than they would like. In 2007, Charles Prince the CEO of Citigroup was quoted as saying, "As long as the music is playing, you have to get up and dance." [10] More formally, economists Emmanuel Farhi and Jean Tirole have argued that policy in response to a crisis naturally gives greater benefits to those banks that have taken on more leverage. Given this, banks have an incentive to imitate other banks so that they achieve their worse losses when everyone else does, and thus maximally benefit from the bailout or other policies. This leads banks to adopt a particularly fragile capital structure, so that they all fail together. [11]

Connection to Exchange Rate Regimes

An important aspect of financial fragility of the international system is the connection to exchange rate regimes. Barry Eichengreen and Ricardo Hausmann describe three views on the connection between exchange rate regimes and financial fragility. One view relates to the moral hazard created by the belief of market participants that governments will provide bailouts in the event of a crisis. A pegged exchange rate is a form of implicit guarantee, and leads market participants to expect such bailouts. A second view is that, due to lack of confidence in a country's currency, borrowers in that country seeking financing will not be able to borrow long-term, or borrow from international lenders at all, in that country's own currency. Yet often the returns of the borrower's project will be in the domestic currency. This is a source of financial fragility, because a drop in the exchange rate can cause a debt crisis, as debt denominated in foreign currency becomes much more expensive. A third view holds that the fundamental cause of international financial fragility is a lack of institutions to enforce contracts between parties. This lack of strong contracts makes lenders suspicious of borrowers, and can prompt a crisis should lenders begin to suspect that borrowers will not repay. [12]

Reducing Financial Fragility

The natural financial fragility of banking systems is seen by many economists as an important justification for financial regulation designed to reduce financial fragility. [13] [14]

Circuit Breakers

Some economists including Joseph Stiglitz have argued for the use of capital controls to act as circuit breakers to prevent crises from spreading from one country to another, a process called financial contagion. Under one proposed system, countries would be divided into groups that would have free capital flows among the group's members, but not between the groups. A system would be put in place such that in the event of a crisis, capital flows out of the affected countries could be cut off automatically in order to isolate the crisis. This system is partly modeled on electrical networks such as power grids, which are typically well-integrated in order to prevent shortages due to unusually high demand for electricity in one part of the network, but that have circuit breakers in place to prevent damage to the network in one part of the grid from causing a blackout throughout all houses connected through the network. [15]

Taxing Liabilities

As described above, many economists believe that financial fragility arises when financial agents such as banks take on too many or too illiquid liabilities relative to the liquidity of their assets. Note that asset liquidity is also a function of the degree of stable funding available to market participants. As a result, the reliance on cheap short term funding creates a negative risk externality (Perotti and Suarez, 2011). Some economists propose that the government tax or limit such liabilities to reduce such excessive risk-taking. Perotti and Suarez (2009) proposed prudential Pigouvian charges on unstable short term funding, while Shin (2010) targets unstable foreign flows. Others have supported this approach. [9]

Capital Requirements

Another form of financial regulation designed to reduce financial fragility is to regulate bank's balance sheets directly via capital requirements.

Related Research Articles

Fractional-reserve banking banking system where bank holds reserves equal to fraction of deposit liabilities

Fractional-reserve banking is the common practice by commercial banks of accepting deposits, and making loans or investments, while holding reserves at least equal to a fraction of the bank's deposit liabilities. Reserves are held as currency in the bank, or as balances in the bank's accounts at the central bank. Fractional-reserve banking is the current form of banking practiced in most countries worldwide.

Full-reserve banking

Full-reserve banking is a proposed alternative to fractional-reserve banking in which banks would be required to keep the full amount of each depositor's funds in cash, ready for immediate withdrawal on demand. Funds deposited by customers in demand deposit accounts would not be loaned out by the bank because it would be legally required to retain the full deposit to satisfy potential demand for payments. Proposals for such systems generally do not place such restrictions on deposits that are not payable on demand, for example time deposits.

Lender of last resort lender (provider of liquidity), that supplies liquidity to a financial institution or to the financial market in general when it is lacking

A lender of last resort (LOLR) is the institution in a financial system that acts as the provider of liquidity to a financial institution which finds itself unable to obtain sufficient liquidity in the interbank lending market and other facilities or sources have been exhausted. It is, in effect, a government guarantee of liquidity to financial institutions. Since the beginning of the 20th century, most central banks have been providers of lender of last resort facilities, and their functions usually also include ensuring liquidity in the financial market in general. The objective is to prevent economic disruption as a result of financial panics and bank runs spreading from one bank to the next from a lack of liquidity in one. Different definitions of the lender of last resort exist in literature. A comprehensive one is that it is "the discretionary provision of liquidity to a financial institution by the central bank in reaction to an adverse shock which causes an abnormal increase in demand for liquidity which cannot be met from an alternative source".

A bailout is a colloquial term for the provision of financial help to a corporation or country which otherwise would be on the brink of failure or bankruptcy.

A currency crisis is a situation in which serious doubt exists as to whether a country's central bank has sufficient foreign exchange reserves to maintain the country's fixed exchange rate. The crisis is often accompanied by a speculative attack in the foreign exchange market. A currency crisis results from chronic balance of payments deficits, and thus is also called a balance of payments crisis. Often such a crisis culminates in a devaluation of the currency.

Financial contagion

Financial contagion refers to "the spread of market disturbances – mostly on the downside – from one country to the other, a process observed through co-movements in exchange rates, stock prices, sovereign spreads, and capital flows". Financial contagion can be a potential risk for countries who are trying to integrate their financial system with international financial markets and institutions. It helps explain an economic crisis extending across neighboring countries, or even regions.

Hyman Minsky American economist

Hyman Philip Minsky was an American economist, a professor of economics at Washington University in St. Louis, and a distinguished scholar at the Levy Economics Institute of Bard College. His research attempted to provide an understanding and explanation of the characteristics of financial crises, which he attributed to swings in a potentially fragile financial system. Minsky is sometimes described as a post-Keynesian economist because, in the Keynesian tradition, he supported some government intervention in financial markets, opposed some of the financial deregulation policies popular in the 1980s, stressed the importance of the Federal Reserve as a lender of last resort and argued against the over-accumulation of private debt in the financial markets.

Too big to fail Concept in economics

The "too big to fail" theory asserts that certain corporations, particularly financial institutions, are so large and so interconnected that their failure would be disastrous to the greater economic system, and that they therefore must be supported by government when they face potential failure. The colloquial term "too big to fail" was popularized by U.S. Congressman Stewart McKinney in a 1984 Congressional hearing, discussing the Federal Deposit Insurance Corporation's intervention with Continental Illinois. The term had previously been used occasionally in the press.

The United States subprime mortgage crisis was a nationwide financial crisis, occurring between 2007 and 2010, that contributed to the U.S. recession of December 2007 – June 2009. It was triggered by a large decline in home prices after the collapse of a housing bubble, leading to mortgage delinquencies and foreclosures and the devaluation of housing-related securities. Declines in residential investment preceded the recession and were followed by reductions in household spending and then business investment. Spending reductions were more significant in areas with a combination of high household debt and larger housing price declines.

A flight-to-quality, or flight-to-safety, is a financial market phenomenon occurring when investors sell what they perceive to be higher-risk investments and purchase safer investments, such as US treasuries or gold. This is considered a sign of fear in the marketplace, as investors seek less risk in exchange for lower profits.

In financial economics, a liquidity crisis refers to an acute shortage of liquidity. Liquidity may refer to market liquidity, funding liquidity, or accounting liquidity. Additionally, some economists define a market to be liquid if it can absorb "liquidity trades" without large changes in price. This shortage of liquidity could reflect a fall in asset prices below their long run fundamental price, deterioration in external financing conditions, reduction in the number of market participants, or simply difficulty in trading assets.

A credit crunch is a sudden reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates. In such situations, the relationship between credit availability and interest rates changes. Credit becomes less available at any given official interest rate, or there ceases to be a clear relationship between interest rates and credit availability. Many times, a credit crunch is accompanied by a flight to quality by lenders and investors, as they seek less risky investments.

This article provides background information regarding the subprime mortgage crisis. It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved were affected by the crisis.

The Emergency Economic Stabilization Act of 2008, commonly referred to as a bailout of the U.S. financial system, is a law enacted subsequently to the subprime mortgage crisis authorizing the United States Secretary of the Treasury to spend up to $700 billion to purchase distressed assets, especially mortgage-backed securities, and supply cash directly to banks. The funds for purchase of distressed assets were mostly redirected to inject capital into banks and other financial institutions while the Treasury continued to examine the usefulness of targeted asset purchases. Both foreign and domestic banks are included in the program. The Act was proposed by Treasury Secretary Henry Paulson during the global financial crisis of 2008 and signed into law by President George W. Bush on October 3, 2008.

The U.S. subprime mortgage crisis was a set of events and conditions that led to a financial crisis and subsequent recession that began in 2007. It was characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages. Several major financial institutions collapsed in September 2008, with significant disruption in the flow of credit to businesses and consumers and the onset of a severe global recession.

The Subprime mortgage crisis solutions debate discusses various actions and proposals by economists, government officials, journalists, and business leaders to address the subprime mortgage crisis and broader financial crisis of 2007–08.

Financial crisis of 2007–2008 Global financial crisis

The financial crisis of 2007–2008, also known as the global financial crisis and the 2008 financial crisis, is considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930s.

Causes of the European debt crisis

The European debt crisis is an ongoing financial crisis that has made it difficult or impossible for some countries in the euro area to repay or re-finance their government debt without the assistance of third parties.

References

  1. ↑ Krugman, Paul (4 February 2011). "Another Kind of Financial Fragility". The New York Times.
  2. 1 2 3 Allen, Franklin; Douglas Gale (Dec 2004). "Financial Fragility, Liquidity, and Asset Prices". Journal of the European Economic Association. 2 (6): 1015–1048. CiteSeerX   10.1.1.207.3882 . doi:10.1162/jeea.2004.2.6.1015.
  3. 1 2 Lagunoff, Roger; Stacey Schreft (2001). "A Model of Financial Fragility". Journal of Economic Theory. 99 (1–2): 220–264. CiteSeerX   10.1.1.199.8934 . doi:10.1006/jeth.2000.2733.
  4. ↑ Krugman, Paul, "Balance Sheets, the Transfer Problem, and Financial Crises", Draft 1999, http://web.mit.edu/krugman/www/FLOOD.pdf
  5. ↑ Diamond DW, Dybvig PH (1983). "Bank runs, deposit insurance, and liquidity". Journal of Political Economy . 91 (3): 401–419. CiteSeerX   10.1.1.434.6020 . doi:10.1086/261155. Reprinted (2000) Fed Res Bank Mn Q Rev 24 (1), 14–23.
  6. ↑ Diamond, Douglas; Raghuran Rajan (April 2001). "Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking". The Journal of Political Economy. 109 (2): 287–327. CiteSeerX   10.1.1.674.246 . doi:10.1086/319552.
  7. ↑ Lagunoff, Roger; Stacey Schreft (August 1999). "Financial Fragility with Rational and Irrational Exuberance". Journal of Money, Credit and Banking. 31 (3): 531–560. CiteSeerX   10.1.1.194.5557 . doi:10.2307/2601071. JSTOR   2601071.
  8. ↑ Van Order, Robert (April 2006). "A Model of Financial Structure and Financial Fragility". Journal of Money, Credit, and Banking. 38 (3): 565–585. doi:10.1353/mcb.2006.0047.
  9. 1 2 Keister, Todd (September 2010). "Bailouts and Financial Fragility" (PDF). Federal Reserve Bank of New York Staff Reports (473).
  10. ↑ Quoted in Farhi-Tirole AER Forthcoming
  11. ↑ Farhi, Emmanuel; Jean Tirole. "Collective Moral Hazard Maturity Mismatch and Systemic Bailouts" (PDF). NBER Working Paper (AER Forthcoming).
  12. ↑ Eichengreen, Barry; Ricardo Hausmann. "Exchange Rates and Financial Fragility". NBER Working Paper Series (WP 7418).
  13. ↑ Krugman, Paul (11 January 2010). "Too big to fail fail?". The New York Times.
  14. ↑ Stein, Jeremy (2010). "Securitization, Shadow Banking, and Financial Fragility". Daedalus. 139 (4): 41–51. doi:10.1162/DAED_a_00041.
  15. ↑ Stiglitz, Joseph (May 2010). "Capital Flows, Contagion, and Regulatory Responses". American Economic Review: Papers and Proceedings. 100 (2): 388–392. doi:10.1257/aer.100.2.388.
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