The Financial System:

Opportunities and Dangers

Chapter 20 of
Macroeconomics, 9th edition,
by N. Gregory Mankiw
ECO62 Udayan Roy
 Chapter Outline
The Financial System: What is it?
Financial Crises: Six common
features
Case Study: Great Recession of 2008-
9
Policies to recover from a crisis
Policies to prevent a crisis
THE FINANCIAL SYSTEM
 The Financial System
The financial system is the collection
of institutions that facilitate the flow
of funds between lenders and
borrowers.
 The Financial System:
Saving
When people earn income, they
typically dont want to consume their
entire income all at once.
But they may have no idea what to
do with the unconsumed income.
This unconsumed income is called
saving
 The Financial System:
Investment
On the other hand, there are people
who may wish to spend money on
various potentially valuable projects
but either have no money of their
own or may wish to spend their
personal funds on projects other than
their own
The money that these people need
for their spending plans is called
investment
The Financial System Makes Saving
Equal Investment
The financial system makes it easier
for lenders (those who have the
saving funds) and borrowers (those
who need funds for investment) to
find each other
Both groups benefit when the
financial system does its job well
When the financial system fails, both
groups suffer
What does the financial system do?

The financial system serves multiple purposes:

It helps entrepreneurs find the money needed to
turn business ideas into reality
It helps entrepreneurs pursue business projects
without having to personally carry too much of the
risks associated with their projects
It helps to protect lenders from irresponsible
borrowers
It helps to foster economic growth by channeling
savings to the most valuable projects and cutting
off funds for the less valuable projects
 Financing Investment
The financial system helps
entrepreneurs find the money
needed to turn business ideas into
reality
The money may take the form of
Debt finance (the entrepreneur sells
bonds to raise money), and
Equity finance (the entrepreneur sells
stocks to raise money)
 Financing Investment
The flow of funds takes place through
Financial markets
Stock market, bond market
Financial intermediaries
Banks, mutual funds, pension funds,
insurance companies
What does the financial system do?

The financial system serves multiple purposes:

It helps entrepreneurs find the money needed to
turn business ideas into reality
It helps entrepreneurs pursue business projects
without having to personally carry too much of the
risks associated with their projects
It helps to protect lenders from irresponsible
borrowers
It helps to foster economic growth by channeling
savings to the most valuable projects and cutting
off funds for the less valuable projects
 Sharing Risk
The financial system helps
entrepreneurs pursue business
projects without having to personally
carry too much of the risks associated
with their projects
The financial system also enables
savers to diversifythat is, lend their
money to a variety of borrowers
thereby reducing the risks of lending
 Sharing Risk
Suppose it is your dream to start a
restaurant.
Even if you have enough savings of your
own to pay for the restaurant, it might still
be better to share the risksand the
rewardsof the restaurant venture with
others
And others may wish to share the risks of
your restaurant venture if they believe that
the returns would be good
 Sharing Risk
The financial systemthat is, the financial
markets and financial intermediariesmay
put you in touch with other investors
They would provide you money to get your
restaurant started in return for part
ownership
This is equity finance
This way you would not have to carry the
full risk of your restaurant on your own
shoulders
 Sharing Risk
Even if you are not an entrepreneur,
the financial system can help you
use your savings to acquire
ownership of a diversified portfolio of
business enterprises
This will help you keep your
idiosyncratic risks low
But systemic risks may remain
What does the financial system do?

The financial system serves multiple purposes:

It helps entrepreneurs find the money needed to
turn business ideas into reality
It helps entrepreneurs pursue business projects
without having to personally carry too much of the
risks associated with their projects
It helps to protect lenders from irresponsible
borrowers
It helps to foster economic growth by channeling
savings to the most valuable projects and cutting
off funds for the less valuable projects
 Dealing With Asymmetric
Information
Borrowers can hide crucial information
about their abilities and their plans
from potential lenders
As a result, unsuspecting lenders can
get ripped off
If that happens often enough, all
lending would eventually end and the
financial system would be unable to
do what it is supposed to do
 Dealing With Asymmetric
Information
The financial systemespecially financial
intermediaries, such as banks, and
watchdogs, such as government regulators
and the courtscan help lenders by
ensuring that lenders get adequate information
about potential borrowers
keeping a watchful eye on borrowers to ensure
that they do nothing stupid or reckless with
borrowed money
punishing dishonest treatment of lenders
 Dealing With Asymmetric
Information
When entrepreneurs hide information
about themselves or the projects for
which they are seeking money,
lenders face the problem of adverse
selection
When entrepreneurs hide information
about how hard they intend to work
to make their projects successful,
lenders face the problem of moral
hazard
 Dealing With Asymmetric
Information
Why would an entrepreneur borrow
money for his/her project?
has no personal funds
has enough personal funds, but wants to
diversify risks
knows something negative about the
project that he/she is hiding from lenders
(adverse selection)
has no intention to work hard for the
project (moral hazard)
 Dealing With Asymmetric
Information
A lender can partially avoid the problems of
adverse selection and moral hazard by lending
money to an intermediary, such as a bank, and
letting the bank deal with the borrower
The bank may have the resources to dig up
hidden information about the borrower and the
project
The bank may be able to ensure that the
borrower will work hard to make the project a
success
 Dealing With Asymmetric
Information
In some cases, asymmetric information may
hurt an honest borrower
An entrepreneur may be honest and hard
working, but may be unable to convince
potential lenders that she is honest and hard
working
Here too, bank finance may be the solution
A bank may be willing to lend money to this
borrower because the bank has resources to
monitor the borrower, who in this case happens
to be genuinely hard working
 Dealing With Asymmetric
Information
Government regulators and the law
enforcement system have obviously
important roles to play in dealing
with adverse selection and moral
hazard
What does the financial system do?

The financial system serves multiple purposes:

It helps entrepreneurs find the money needed to
turn business ideas into reality
It helps entrepreneurs pursue business projects
without having to personally carry too much of the
risks associated with their projects
It helps to protect lenders from irresponsible
borrowers
It helps to foster economic growth by channeling
savings to the most valuable projects and cutting
off funds for the less valuable projects
Fostering Economic Growth
The financial system helps to foster
economic growth by channeling savings to
the most valuable projects and cutting off
funds for the less valuable projects
When asymmetric information is not a
problem, a market for loanable funds in
which people are free to lend and borrow
should ensure the success of economically
valuable projects and the failure of
economically wasteful projects
Fostering Economic Growth
For example, if in a well-functioning
loanable funds market the
equilibrium interest rate is 4%, then
the projects that can earn profits higher
than 4% will succeed, and
the projects that cannot do so will fail
It cannot be that a less profitable project
gets funded and a more profitable
project does not
In this way, a free market will
automatically allocate funds so as to
 Case Study: Microfinance
In poor countries, financial markets
are undeveloped, primarily because
of asymmetric information problems
and weak or nonexistent government
efforts to deal with asymmetric
information
In 1976, Muhammad Yunus, an
economics professor in Bangladesh,
started Grameen Bank to remedy the
situation
 Case Study: Microfinance
The Bank was successful in funding
entrepreneurs to build small-scale
businesses and improve their lives
Grameen Bank and Prof. Yunus were
awarded the Nobel Peace Prize in
2006
How did Grameen Bank succeed in
solving the problem of asymmetric
information?
 Case Study: Microfinance
Loans were given to groups rather
than individuals
All members of the group that took a
loan would be responsible for timely
repayment
So, a group would only admit
members that the other members
knew to be sound
In this way, the group-lending idea
helped solve the asymmetric
 Case Study: Microfinance
Moreover, Grameen Bank gives loans
in small amounts that are repaidand
renewedafter short intervals
Therefore, a continuing relationship
develops between the banks loan
officers and the borrowers
Moreover, as small amounts are
loaned out at any given time, losses
are low
Somehow the pipes get clogged

FINANCIAL CRISIS: SIX

COMMON FEATURES
 Financial Crisis
A financial crisis is a major disruption
of the financial systems ability to
make money flow between lenders
and borrowers
Examples:
Great Depression 1930s
Great Recession 2008-09
 Six Common Features
Although each financial crisis is
unique, most financial crises share
certain common elements
1. Asset-price booms and busts
2. Insolvencies in financial institutions
3. Falling confidence
4. Credit crunch
5. Recession
6. A vicious circle
 Asset-price booms and
busts
Financial crises are often preceded
by a period of euphoria, called a
speculative bubble, during which the
prices of assets rise above their
fundamental values
The fundamental value of an asset is the
price that would prevail if people relied
only on objective analyses of the cash
flows the asset can be expected to
generate
 Asset-price booms and
busts
If people start buying assets not for
the expected cash flows from the
asset but because they hope to sell
the asset later at a higher price, an
assets price can rise above its
fundamental value
However, such speculative bubbles
inevitably crash when euphoria ends
and doubts set in
 Asset-price booms and
busts
In the Great Recession of 2008-09, a
speculative bubble developed in
home prices
 Asset-price booms and
busts
Banks fueled the boom because they failed
to do their job of identifying irresponsible
borrowers and refusing their loan requests.
Why?
Banks assumed that home prices would keep
rising.
Under that assumption, it would not matter if a
borrower defaulted.
The bank would simply take the house the
defaulter had bought and sell it off at a now
higher price, thereby making a profit.
 Recap: Six Common
Features
Although each financial crisis is
unique, most financial crises share
certain common elements
1. Asset-price booms and busts
2. Insolvencies in financial institutions
3. Falling confidence
4. Credit crunch
5. Recession
6. A vicious circle
 Insolvencies in financial
institutions
Eventually, home prices stopped rising
and then started to fall
Borrowers then owed more money than
the value of the house theyd bought with
the loan
Such borrowers stopped repaying their
loans
Mortgage loans are non-recourse
Better to just return the house keys to the
bank
 Insolvencies in financial
institutions
Of course, banks could take the homes
(collateral) and sell them
But then banks would lose money
because home prices had fallen
When banks assets (the homes) lose
value, their capital (owners equity)
turns negative
See Ch. 4
At that point, the bank is insolvent
 Insolvencies in financial
institutions
Many financial institutions turned insolvent
Financial institutions have assets and liabilities
Assets are what others owe them
Liabilities are what they owe others
When the value of assets falls below the value
of liabilities, the financial institution is insolvent
When a financial institution becomes insolvent,
it is forced to shut down
When financial institutions shut down, the
economy suffers
 Insolvencies in financial
institutions
Suppose you and your friends decide to start
a bank
You and your friends put $1,000 of your own
money in the business.
This is called capital
You borrow $39,000.
These are your liabilities
You lend $40,000.
That is, you buy $40,000 in assets
Your leverage ratio = assets/capital = 40
 Insolvencies in financial
institutions
Suppose your assets then increase in
value by $400
a mere +1%
The return on your capital is +40%!!!
This is the magic of leverage
 Insolvencies in financial
institutions
But the magic of leverage cuts both
ways
If your assets decrease in value by
$1,000 (or, a mere -2.5%) to $39,000,
you have just enough money to repay
the $39,000 youd borrowed
So, after repaying your debts, youll
have nothing left. You will lose all your
capital (or, a loss of -100%)
 Insolvencies in financial
institutions
The heavy reliance on leverage by
financial institutions at the time of
the Great Recession meant that
many such institutions became
insolvent when home prices began to
fall
 Recap: Six Common
Features
Although each financial crisis is
unique, most financial crises share
certain common elements
1. Asset-price booms and busts
2. Insolvencies in financial institutions
3. Falling confidence
4. Credit crunch
5. Recession
6. A vicious circle
 Falling confidence
Some bank deposits are insured by
the government
But not all
As banks and other financial
institutions faced the threat of
insolvency, many lenders withdrew
their deposits (a run)
This reduced the ability of businesses
to get loans for business projects
 Falling confidence
Troubled financial institutions also
had to sell their assets (loans) at fire
sale prices to get cash to repay
fleeing lenders
Banks use short-term deposits to give
long-term loans
When short-term deposits dry up for
troubled banks, they are forced to sell
their long-term loans (to less troubled
financial institutions) at fire sale prices
 Falling confidence
But the fire sale of assets reduces
asset prices
And, as we saw before, this fall in
asset prices can make many financial
institutions, that are otherwise
healthy, insolvent
In this way, trouble spreads like
infectious disease
 Falling confidence
Moreover, if the number of financial
institutions is small, each will have
lots of financial dealings with the
others
In that case, if one institution
becomes insolvent, the others would
also be hurt and may themselves
become insolvent
Falling Confidence:
Measuring it
The TED Spread is the interest
rate on 3-month interbank
loans minus the interest rate
on 3-month Treasury bills.
Lenders will not lend to risky
borrowers unless they get a
high interest rate. So, the TED
Spread rises when lending to
banks is considered
particularly risky.

See https://
research.stlouisfed.org/fred2/s
eries/TEDRATE
for current data.
 Recap: Six Common
Features
Although each financial crisis is
unique, most financial crises share
certain common elements
1. Asset-price booms and busts
2. Insolvencies in financial institutions
3. Falling confidence
4. Credit crunch
5. Recession
6. A vicious circle
 Credit Crunch
With spreading insolvency shutting
down one financial institution after
another, and falling confidence
causing depositors to take money out
of financial institutions, would-be
borrowerseven those with
profitable investment projects
would have trouble getting loans
 Credit Crunch
During the Great Recession, loans for
home buyers dried up almost
completely, as it became clear that
home prices do not always go up
 Recap: Six Common
Features
Although each financial crisis is
unique, most financial crises share
certain common elements
1. Asset-price booms and busts
2. Insolvencies in financial institutions
3. Falling confidence
4. Credit crunch
5. Recession
6. A vicious circle
 Recession
Many households were unable to
borrow money to buy homes or to
even buy simple things
Many businesses were unable to
borrow money to build new factories
or buy machines, furniture, etc.
So, aggregate planned expenditure
fell
A recession began
 Recession
GDP fell
Unemployment rose
Officially the economy began to
recover in June 2009
But in reality, that recovery has been
very weak
 Recap: Six Common
Features
Although each financial crisis is
unique, most financial crises share
certain common elements
1. Asset-price booms and busts
2. Insolvencies in financial institutions
3. Falling confidence
4. Credit crunch
5. Recession
6. A vicious circle
 A vicious circle
A recession sets off a vicious circle
Businesses fail and cant repay their
loans
This further intensifies the insolvency
of financial institutions, which had
helped cause the recession in the
first place
As people lose their jobs, they
default on their debts, again adding
to the vicious circle
Six Common Features
CASE STUDY: WHO IS TO BLAME
FOR THE CRISIS OF 2008-2009?
 Case Study: Who should be blamed
for the financial crisis of 2008-2009?
Possible culprits include:
The Federal Reserve: it may have kept interest
rates too low for too long after the 2001
recession, thereby fueling the housing bubble
Home buyers: they were too stupid to realize
that home prices could fall at some point and
that theyd be better off renting
Mortgage brokers: knowing that they could sell
to investment banks the loans theyd made
and being greedy and unprincipledthey paid
no attention to loan quality
 Case Study: Who should be blamed
for the financial crisis of 2008-2009?
Investment banks: they were greedy and
unprincipled enough to package the mortgage
loans and sell them to gullible buyers (such as
pension funds) who believed what the rating
agencies said about the mortgage loan
packages
Rating agencies: they gave high grades to
mortgage assets that later turned out to be
highly risky.
Maybe they were just stupid.
Others say they were greedy for the investment
banks business and did not want to make them angry.
 Case Study: Who should be blamed
for the financial crisis of 2008-2009?
Regulators: government regulators were not
paying any attention to the rampant
misbehavior of the private sector.
These regulatory bodies were often underfunded.
There was a general ideology that hated regulation.
Government policy makers: for decades,
politicians in both the Republican and
Democratic parties sought to use government
policies to encourage home ownership over
renting.
This may have partially fed the home price bubble
POLICY RESPONSES TO A
CRISIS
Policy Responses to a Crisis
Policy makers used many tools to
fight the crisis:
Conventional fiscal policy
Conventional monetary policy
Central banks lender-of-last-resort role
Injections of government funds
Policy Responses to a Crisis
Conventional fiscal policy
Taxes were cut
Government spending was increased
But this meant increased budget
deficits, which would make already high
government debt even higher and,
therefore, raise the possibility of a
government debt crisis
Policy Responses to a Crisis
Conventional monetary policy
Short-term nominal interest rates were
cut till they reached zero
But nominal interest rates cannot be
reduced below zero
Policy Responses to a Crisis
Central banks lender-of-last-resort
role
Banks take short-term deposits from
savers and lend money for long-term
business projects
So, if falling confidence leads to a
sudden withdrawal of deposits, even a
solvent bank would face a liquidity crisis
The bank may have to sell its assets at
fire sale prices, which could crash asset
prices, and turn the liquidity crisis into
Policy Responses to a Crisis
Central banks lender-of-last-resort
role
A central bank could prevent such a dire
outcome by printing money and lending
it to banks that face a liquidity crisis
When the central bank makes loans when
nobody else would, it is acting as a lender of
last resort
Policy Responses to a Crisis
Central banks lender-of-last-resort role
During the Great Recession, the Fed made
lots of such loans, not only to banks, but
to other financial institutions that faced
liquidity crises
These institutions are called shadow banks
because they take short-term deposits and
make long-term loans, just like banks
Example: money market mutual funds. Fed
became a lender of last resort to these funds,
when depositors fled
Policy Responses to a Crisis
Injections of government funds
When borrowers default on their bank loans, a
bank may have to shut down, in which case its
depositors would lose their money
That could have ripple effects because the
depositors would cut back on their spending
plans
The FDIC insures bank deposits up to a limit.
This limit was raised from $100k to $250k in 2008
This reduces the adverse ripple effects of bank
failure
Policy Responses to a Crisis
Injections of government funds
But the FDIC does not insure all deposits
at a failed bank.
Therefore, some adverse ripple effects
could still occur
When those ripple effects are likely to be
large enough, the bank is called too big
to fail and the government uses its
money to rescue it
Policy Responses to a Crisis
Injections of government funds
Moreover, if it becomes impossible for
businesses to borrow money to finance
their projectsespecially somewhat risky
onesbusiness investment spending
could crash, causing a recession
In such a case, the government could use
its funds to directly lend money for such
projects
Policy Responses to a Crisis
Injections of government funds
Governments may also use their funds
to invest money into a bank to enable it
to keep lending even when depositors
have withdrawn their deposits
The hope is that the crisis is temporary
and that the government would get its
money back when the crisis ends and
depositors return
Policy Responses to a Crisis
Injections of government funds
The use of government funds to bail out the
financial sector is obviously risky because
the government may not get its money back
Moreover, if financial institutions know that
the government would always rescue too-
big-to-fail firms, they would have incentives
to take huge risks (moral hazard) and
to become large just to become TBTF
Policy Responses to a Crisis
Injections of government funds
However, despite the downside of using
taxpayer funds to prop up the financial
industry, it may be necessary to do so in
order to avoid a huge financial
catastrophe
POLICIES TO PREVENT A
CRISIS
 Policies to Prevent a Crisis
There are no easy ways to prevent
financial crises. They will definitely
happen again and again.
However, here are a few ideas on
prevention:
Pay more attention to shadow banks
Try to make financial institutions smaller
Force banks to reduce risky lending
Toughen up the enforcement of
regulations
 Prevention: Shadow Banks
Commercial banks deposits are
insured by the FDIC
This could induce these banks to take
huge risks
If the risks succeed, the bank keeps the
gains
If the risks fail, the taxpayer takes the
losses
To avoid this, commercial banking is
heavily regulated
 Prevention: Shadow Banks
As a result, the commercial banking
sector behaved very well during the
crisis of 2008-09
The bulk of bad behavior came from
the shadow banking sector, which is
only lightly regulated
Investment banks, hedge funds,
insurance companies, private equity
funds, etc.
 Prevention: Shadow Banks
The obvious lesson is to treat the
shadow banks just like regular banks:
insure the depositors, but regulate
the shadow bankers
One way to regulate these financial
institutions is to require them to hold
more capital (owners equity) and
less leverage
When more of the owners money is at
stake, these institutions may take more
 Prevention: Smaller Wall
Street
No financial institution should be so
vital to the financial system that it
becomes too big to fail
Such an institution would be tempted
to take big risks because
If the risk succeeds, the managers make
money
If the risk fails, the taxpayer will come to
the rescue
 Prevention: Smaller Wall
Street
If the financial system is dominated
by just a few firms, they are likely to
be deeply interconnected
In such a situation, the failure of
even one firm may lead to big losses
in all firms, thus making each firm
TBTF
So, the financial system needs
moderately sized firms, and lots of
them
 Prevention: Smaller Wall
Street
So, mergers and acquisitions among
financial firms need to be
discouraged
Bigger firms should be required to
have more capital (owners equity)
so that they take sensible risks only
On the other hand, bigness has the
advantage of economies of scale
 Prevention: Safer Wall
Street
Apart from higher capital
requirements, the financial system
could be made safer by requiring
commercial bankswhose deposits
are guaranteed by the FDICfrom
trading in complex assets such as
derivatives (Volcker Rule)
Derivatives should be traded in
exchanges, so that regulators can
have better information
 Prevention: Tougher
Regulators
The governments regulators clearly
failed in doing their job
The numerous regulatory agencies
could be consolidated into a smaller
number
New regulatory agencies have been
set up in the US to watch the credit
rating agencies, the treatment of
consumers of financial products, and
coordination of regulators
Prevention: Macroprudential
Regs
Traditionally, the governments
regulation of the financial sector has
been microprudential
Focused on what an individual financial
institution needed to do to reduce the
risk of its collapse
Today, financial regulation is also
macroprudential
Focused on what the economy as a
whole needed to do to reduce the risk of
financial crisis
Prevention: Macroprudential
Regs
Example of a macroprudential policy
that could reduce the risk of bubbles
in the housing market:
require homebuyers to pay a higher
down payment when home prices rise
this would make it harder for people to
buy homes when home prices rise,
which would keep home prices from
rising too quickly
 Case Study: Europes Sovereign
Debt Crisis
The debts incurred by European
governments had been widely
considered safe
Consequently, lenders had charged
very low interest rates when lending
to those governments
But things changed in Greece in
2010
 Case Study: Europes Sovereign
Debt Crisis
In 2010, the Greek governments
debt had risen to 116 percent of
GDP, which was twice the European
average
It was revealed that the Greek
government had been misreporting
its finances to keep lenders happy
Fears of default caused the price of
Greeces government bonds to fall.
Lenders began asking for 100
 Case Study: Europes Sovereign
Debt Crisis
Banks in other European countries
such as Germany and France had
loaned money to the Greek
government in the past by buying
Greeces government bonds
With the fall in the price of those
bonds, the banks faced the threat of
insolvency
Remember what you learned in Ch. 4
This could cause a financial crisis
 Case Study: Europes Sovereign
Debt Crisis
So, other European countries got
together and arranged a bailout for
the Greek government
The idea was that the Greek
government would use the money
provided by other countries to repay
its debts
This would stabilize the price of
Greek government bonds and
prevent European banks outside
 Case Study: Europes Sovereign
Debt Crisis
As a condition for the bailout, the
Greek government was forced to cut
spending and raise taxes
The idea was that this would reduce
the Greek governments borrowing
and gradually return Greece to
normality
 Case Study: Europes Sovereign
Debt Crisis
Greece is a member of the European
Monetary Union
Had Greece defaulted on its
government debt, it would have been
forced to leave the Eurozone and
return to using its old currency, the
Drachma
So far, the bailout has worked and
Greece is still in the Eurozone
 Case Study: Europes Sovereign
Debt Crisis
However, the European countries
that bailed out Greece resent having
had to pay to keep Greece in the
Eurozone
It is still not clear whether Greeces
budgetary problems have been
solved
 Conclusion
The financial system is fragile and
crisis prone
But it is a big help when it works well
So it needs to be kept in working
condition
This requires regulators to watch it
carefully all the time for signs of
trouble
At times, bailouts may be needed
even though people may hate bailing