THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 232

200 PA R T I I I Financial Institutions Financial crises in Canada have progressed in two and sometimes three stages To help you understand how these crises have unfolded, refer to Figure 9-1, a diagram that identifies the stages and sequence of events in Canadian financial crises Stage One: Initiation of Financial Crisis There are several possible ways that financial crises start: mismanagement of financial liberalization or innovation, asset price booms and busts, spikes in interest rates, or a general increase in uncertainty when there are failures of major financial institutions (see the top row of Figure 9-1) The seeds of a financial crisis are often sown when countries engage in financial liberalization, the elimination of restrictions on financial markets and institutions, or when major financial innovations are introduced to the marketplace, as occurred recently with subprime residential mortgages Financial innovation or liberalization is highly beneficial in the long run because it facilitates the process of financial development discussed in the previous chapter, which leads to a more efficient financial system that can allocate capital better However, financial liberalization or innovation has a dark side: if managed improperly, it can lead financial institutions to take on excessive risk With restrictions lifted or new financial products introduced, financial institutions frequently go on a lending spree, often called a credit boom, and expand their lending at a rapid pace Unfortunately, the managers of these financial institutions may not have the expertise to manage risk appropriately in these new lines of business Even if the required managerial expertise is initially present, the rapid growth of credit will likely outstrip the information resources available to these institutions, leading to overly risky lending As we will discuss in Chapter 10, most governments try to prevent bank panics and encourage banks to keep on lending during bad times by providing a government safety net If depositors and other providers of funds to banks are protected from losses, they will keep on supplying banks with funds so banks can continue to lend and will not fail However, there is a catch: The government safety net weakens market discipline for the bank With a safety net, depositors know that they will not lose anything if a bank fails Thus, the bank can still acquire funds even if it takes on excessive risk The government safety net therefore increases the moral hazard incentive for banks to take on greater risk than they otherwise would, because if their risky, high-interest loans pay off, the banks make a lot of money; if they don t and the bank fails, taxpayers pay most of the bill for the safety net that protects the banks depositors In other words, banks can play the game of heads, I win: tails, the taxpayer loses The presence of a government safety net requires regulation and government supervision of the financial system to prevent excessive risk taking However, new lines of business and rapid credit growth stretch the resources of the government s supervisory agencies Financial supervisors find themselves without the expertise or the additional resources needed to appropriately monitor the new lending activities Without this monitoring, risk-taking can explode Eventually, this risk-taking comes home to roost Losses on loans begin to mount and the drop in the value of the loans (on the asset side of the balance sheet) falls relative to liabilities, thereby driving down the net worth (capital) of banks and other financial institutions With less capital, these financial institutions cut back on their lending, a process that is called deleveraging Furthermore, with less capital, banks and other financial institutions become riskier, causing depositors and other potential lenders to these institutions to pull out their funds Fewer MISMANAGEMENT OF FINANCIAL LIBERALIZATION/INNOVATION