1. finance
2. bank

The Financial System:
Opportunities and Dangers
Chapter 20 of Macroeconomics, 8th
edition, by N. Gregory Mankiw
ECO62 Udayan Roy
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
don’t 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), and
– Equity finance (the entrepreneur sells stocks)
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
diversify—that 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 risks—and the rewards—of
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 system—that is, the financial
markets and financial intermediaries—may
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
• The financial system helps to protect lenders
from irresponsible borrowers
Dealing With Asymmetric Information
• Borrowers can hide crucial information—
about their abilities and their plans—from
potential lenders
• As a result, trusting 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 system—especially financial
intermediaries, such as banks, and watchdogs,
such as government regulators and the
courts—can 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 would 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 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
• In this way, a free market will automatically
allocate funds so as to foster economic growth
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, and economics
professor in Bangladesh, started Grameen
Bank to remedy the situation
Case Study: Microfinance
• The Bank was successful in enabling
entrepreneurs get the money to build smallscale 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
• 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 information problem
Case Study: Microfinance
• Moreover, Grameen Bank gives loans in small
amounts that are repaid—and renewed—after
short intervals
• Therefore, a continuing relationship develops
between the bank’s 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
Financial Crisis
• A financial crisis is a major disruption of the
economy’s 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.
2.
3.
4.
5.
6.
Asset-price booms and busts
Insolvencies in financial institutions
Falling confidence
Credit crunch
Recession
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 will 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 asset’s 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 not giving them loans.
• 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 higher price, thereby
making a profit.
Recap: Six Common Features
• Although each financial crisis is unique, most
financial crises share certain common
elements
1.
2.
3.
4.
5.
6.
Asset-price booms and busts
Insolvencies in financial institutions
Falling confidence
Credit crunch
Recession
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 they’d 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 stop operations
– When financial institutions stop operations, 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%), 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.
2.
3.
4.
5.
6.
Asset-price booms and busts
Insolvencies in financial institutions
Falling confidence
Credit crunch
Recession
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
increase their cash reserves
– 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
Recap: Six Common Features
• Although each financial crisis is unique, most
financial crises share certain common
elements
1.
2.
3.
4.
5.
6.
Asset-price booms and busts
Insolvencies in financial institutions
Falling confidence
Credit crunch
Recession
A vicious circle
Credit crunch
• With spreading insolvency shutting down
financial institutions, and falling confidence
leading depositors to take money out of
financial institutions, would-be borrowers—
even those with profitable investment
projects—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.
2.
3.
4.
5.
6.
Asset-price booms and busts
Insolvencies in financial institutions
Falling confidence
Credit crunch
Recession
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.
2.
3.
4.
5.
6.
Asset-price booms and busts
Insolvencies in financial institutions
Falling confidence
Credit crunch
Recession
A vicious circle
A vicious circle
• A recession sets off a vicious circle
• Businesses fail and can’t 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 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 they’d
be better off renting
– Mortgage brokers: knowing that they could sell the
loans to investment banks—and being greedy and
unprincipled—they 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 makers used many tools to fight the
crisis:
– Conventional fiscal policy
– Conventional monetary policy
– Central bank’s 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
– But nominal interest rates cannot be reduced
below zero
Policy Responses to a Crisis
• Central bank’s 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 an insolvency crisis
Policy Responses to a Crisis
• Central bank’s 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 bank’s 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 projects—
especially somewhat risky ones—business
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
• 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 and leash the managers
• One way to leash 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 sensible risks
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
• 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 only
sensible risks
• 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 banks—whose deposits
are guaranteed by the FDIC—from 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 government’s 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