Financial Markets and Institutions (2-downloads)

Financial Institutions’ Balance Sheets, in the top row of Figure 8.1). As loans

become scarce, firms are no longer able to fund their attractive investment oppor-

tunities; they decrease their spending and economic activity contracts.

Asset Price Boom and Bust

Prices of assets such as shares and real estate can

be driven well above their fundamental economic values by investor psychology

(dubbed “irrational exuberance” by Alan Greenspan when he was Chairman of the

Federal Reserve). The rise of asset prices above their fundamental economic val-

ues is an asset-price bubble. Examples of asset-price bubbles are the tech stock

market bubble of the late 1990s and the recent housing price bubble that we will

discuss later in this chapter. Asset-price bubbles are often also driven by credit

booms, in which the large increase in credit is used to fund purchases of assets,

thereby driving up their price.

When the bubble bursts and asset prices realign with fundamental economic val-

ues, stock prices tumble and companies see their net worth drop. Lenders look

askance at firms with little to lose (“skin in the game”) because those firms are more

likely to make risky investments, a problem of moral hazard. Lending contracts as

borrowers become less creditworthy from the fall in net worth (as shown by the

downward arrow pointing from the second factor, Asset Price Decline, in the top row

of Figure 8.1).

The asset price bust can also, as we have seen, deteriorate financial institu-

tions’ balance sheets (shown by the arrow from the second factor to the first factor

in the top row of Figure 8.1), which causes them to deleverage, steepening the decline

in economic activity.

Spikes in Interest Rates

Many nineteenth-century U.S. financial crises were pre-

cipitated by increases in interest rates, either when interest rates shot up in London,

which at the time was the world’s financial center, or when bank panics led to a scram-

ble for liquidity in the United States that produced sharp upward spikes in interest

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Chapter 8 Why Do Financial Crises Occur and Why Are They So Damaging to the Economy?

167

rates (sometimes rising by 100 percentage points in a couple of days). The spike in

interest rates led to an increase in adverse selection and moral hazard, causing a

decline in economic activity (as shown by the downward arrow pointing from the

third factor, Increase in Interest Rates, in the top row of Figure 8.1).

To see why, recall from Chapter 7 that individuals and firms with the riskiest

investment projects are those who are willing to pay the highest interest rates. If

increased demand for credit or a decline in the money supply market drives up inter-

est rates sufficiently, good credit risks are less likely to want to borrow while bad

credit risks are still willing to borrow. Because of the resulting increase in adverse

selection, lenders will no longer want to make loans.

Increases in interest rates also play a role in promoting a financial crisis through

their effect on cash flow, the difference between cash receipts and expenditures. A

firm with sufficient cash flow can finance its projects internally, and there is no asym-

metric information because it knows how good its own projects are. (Indeed,

American businesses fund around two-thirds of their investments with internal

funds.) An increase in interest rates and therefore in household and firm interest pay-

ments decreases their cash flow. With less cash flow, the firm has fewer internal funds

and must raise funds from an external source, say, a bank, which does not know

the firm as well as its owners or managers. How can the bank be sure if the firm

will invest in safe projects or instead take on big risks and then be unlikely to pay

back the loan? Because of this increased adverse selection and moral hazard, the bank

may choose not to lend to firms, even those with good risks, the money to under-

take potentially profitable investments. Thus, when cash flow drops as a result of

an increase in interest rates, adverse selection and moral hazard problems become

more severe, again curtailing lending, investment, and economic activity.

Increase in Uncertainty

U.S. financial crises have usually begun in periods of high

uncertainty, such as just after the start of a recession, a crash in the stock market,

or the failure of a major financial institution. Crises began after the failure of Ohio

Life Insurance and Trust Company in 1857; the Jay Cooke and Company in 1873;

Grant and Ward in 1884; the Knickerbocker Trust Company in 1907; the Bank of

the United States in 1930; and Bear Stearns, Lehman Brothers, and AIG in 2008. With

information hard to come by in a period of high uncertainty, adverse selection and

moral hazard problems increase, reducing lending and economic activity (as shown

by the arrow pointing from the last factor, Increase in Uncertainty, in the top row

of Figure 8.1).

Stage Two: Banking Crisis

Deteriorating balance sheets and tougher business conditions lead some financial

institutions into insolvency, when net worth becomes negative. Unable to pay off

depositors or other creditors, some banks go out of business. If severe enough, these

factors can lead to a bank panic, in which multiple banks fail simultaneously.

To understand why bank panics occur, consider the following situation. Suppose

that as a result of an adverse shock to the economy, 5% of the banks have such large

losses on their loans that they become insolvent (have a negative net worth and so are

bankrupt). Because of asymmetric information, depositors are unable to tell whether

their bank is a good bank or one of the 5% that are insolvent. Depositors at bad and

good banks recognize that they may not get back 100 cents on the dollar for their

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Part 3 Fundamentals of Financial Institutions

deposits (in the absence of or limited amounts of deposit insurance) and will want

to withdraw them. Indeed because banks operate on a first-come, first-served basis,

depositors have a very strong incentive to show up at the bank first (run to the bank),

because if they are later in line, the bank may not have enough funds left to pay them

anything. Uncertainty about the health of the banking system in general can lead to

runs on banks, both good and bad, which will force the bank to sell off its assets to

raise the necessary funds. As a result of this “fire sale” of assets, their prices may

decline so much in value that the bank becomes insolvent, even if under normal cir-

cumstances it would have survived. Furthermore, the failure of one bank can lead

to runs on other banks, which can cause them to fail, and the resulting contagion

can then lead to multiple bank failures and a full-fledged bank panic.

With fewer banks operating, information about the creditworthiness of bor-

rowers disappears. Adverse selection and moral hazard problems become severe in

the credit markets, and the economy spirals down further. Figure 8.1 represents

this progression in the Stage Two portion. Bank panics have been a feature of all

U.S. financial crises during the nineteenth and twentieth centuries until World

War II, occurring every twenty years or so—1819, 1837, 1857, 1873, 1884, 1893,

1907, and 1930–1933.

1

Eventually, public and private authorities sift through the wreckage of the bank-

ing system, shutting down insolvent firms and selling them off or liquidating them.

Uncertainty in financial markets declines, the stock market recovers, and interest

rates fall. Adverse selection and moral hazard problems diminish, and the financial

crisis subsides. With the financial markets able to operate well again, the stage is

set for an economic recovery.

Stage Three: Debt Deflation

If, however, the economic downturn leads to a sharp decline in prices, the recovery

process can be short-circuited. In this situation, shown as Stage Three in Figure 8.1,

a process called debt deflation occurs, in which a substantial unanticipated decline

in the price level sets in, leading to a further deterioration in firms’ net worth because

of the increased burden of indebtedness.

To see how this works, we need to recognize that in economies with moder-

ate inflation, which characterizes most advanced countries, many debt contracts

with fixed interest rates are typically of fairly long maturity, 10 years or more.

Because debt payments are contractually fixed in nominal terms, an unanticipated

decline in the price level raises the value of borrowing firms’ liabilities in real terms

(increases the burden of the debt) but does not raise the real value of firms’ assets.

The result is that net worth in real terms (the difference between assets and lia-

bilities in real terms) declines. A sharp drop in the price level therefore causes a

substantial decline in real net worth for borrowing firms and an increase in adverse

selection and moral hazard problems facing lenders. An unanticipated decline in

the aggregate price level thus leads to a drop in lending and economic activity,

and aggregate economic activity remains depressed for a long time. The most sig-

nificant financial crisis that displayed debt deflation was the Great Depression,

the worst economic contraction in U.S. history.

1

For a discussion of U.S. banking and financial crises in the nineteenth and twentieth centuries, see

Frederic S. Mishkin, “Asymmetric Information and Financial Crises: A Historical Perspective,” in R.

Glenn Hubbard, ed., Financial Markets and Financial Crises (University of Chicago Press: Chicago,

1991, pp: 69–108).

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Chapter 8 Why Do Financial Crises Occur and Why Are They So Damaging to the Economy?