R GLENN HUBBARD ANTHONY PATRICK O’BRIEN Money, Banking, and the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 12 Financial Crises and Financial Regulation LEARNING OBJECTIVES After studying this chapter, you should be able to: 12.1 Explain what financial crises are and what causes them 12.2 Understand the financial crisis that occurred during the Great Depression 12.3 Understand what caused the financial crisis of 2007-2009 12.4 Discuss the connection between financial crises and financial regulation © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 12 Financial Crises and Financial Regulation A CLOUDY CRYSTAL BALL ON THE FINANCIAL CRISIS •Problems with the U.S housing market ultimately led to the worst recession since the Great Depression, yet many policymakers, business leaders, and economists failed to see the crisis approaching •Policymakers, managers of financial firms, investors, and households were struggling to deal with unprecedented events •An Inside Look at Policy on page 374 discusses the issues Congress grappled with in 2010 during the debate over the Dodd-Frank Act © 2012 Pearson Education, Inc Publishing as Prentice Hall Key Issue and Question Issue: The financial crisis of 2007–2009 was the most severe since the Great Depression of the 1930s Question: Does the severity of the 2007–2009 financial crisis explain the severity of the recession during those years? © 2012 Pearson Education, Inc Publishing as Prentice Hall of 57 Learning 12.1 Objective Explain what financial crises are and what causes them © 2012 Pearson Education, Inc Publishing as Prentice Hall of 57 Financial crisis A significant disruption in the flow of funds from lenders to borrowers •Economic activity depends on the ability of households and firms to borrow •A financial crisis disrupts the flow of funds from lenders to borrowers •A financial crisis typically leads to an economic recession as households and firms face difficulty in borrowing money •In the past, most of the financial crises in the United States involved the commercial banking system The Origins of Financial Crises © 2012 Pearson Education, Inc Publishing as Prentice Hall of 57 The Underlying Fragility of Commercial Banking • Banks have a maturity mismatch because they borrow short term from depositors and lend long term to households and firms • This means that banks face a liquidity risk because they may be unable to meet their depositors’ withdrawals • Banks can borrow or sell assets to raise funds Insolvent The situation for a bank or other firm whose assets have less value than its liabilities, so its net worth is negative • An insolvent bank may be unable to meets its obligations to pay off its depositors The Origins of Financial Crises © 2012 Pearson Education, Inc Publishing as Prentice Hall of 57 Bank Runs, Contagion, and Bank Panics • Prior to 1933, the United States had no system of government deposit insurance • Once the bank’s liquid assets were exhausted, the bank would have to shut its doors, at least temporarily Bank run The process by which depositors who have lost confidence in a bank simultaneously withdraw enough funds to force the bank to close • In the absence of deposit insurance, the stability of a bank depends on the confidence of its depositors The Origins of Financial Crises © 2012 Pearson Education, Inc Publishing as Prentice Hall of 57 Contagion The process by which a run on one bank spreads to other banks resulting in a bank panic • If multiple banks have to sell the same assets—for example, mortgagebacked securities—the prices of these assets are likely to decline and some banks may even be pushed to insolvency Bank panic The situation in which many banks simultaneously experience runs • A bank panic feeds on a self-fulfilling perception: If depositors believe that their banks are in trouble, the banks are in trouble The Origins of Financial Crises © 2012 Pearson Education, Inc Publishing as Prentice Hall of 57 Government Intervention to Stop Bank Panics • Governments have two main ways they can attempt to avoid bank panics: (1) A central bank can act as a lender of last resort (2) The government can insure deposits Lender of last resort A central bank that acts as the ultimate source of credit to the banking system, making loans to solvent banks against their good, but illiquid, loans Federal Deposit Insurance Corporation (FDIC) A federal government agency established by Congress in 1934 to insure deposits in commercial banks The Origins of Financial Crises © 2012 Pearson Education, Inc Publishing as Prentice Hall 10 of 57 Making the Connection Was Long-Term Capital Management the Pebble That Caused the Landslide? • It is clear that many financial firms underestimated the risk involved with mortgage-backed securities, but could it be that they made those risky investments because they expected the Federal Reserve to save them from bankruptcy? • In 1998, the Fed intervened in the failure of the hedge fund Long-Term Capital Management (LTCM) The Fed gathered 16 financial firms that agreed to invest in LTCM to stabilize the firm so that its positions could be “unwound,” or slowly sold off without destabilizing financial markets • The seeds of the 2007–2009 financial crisis may lie in the Fed’s actions with respect to LTCM in 1998 Confident that the Fed would intervene on their behalf, financial firms may have taken on risky investments However, no hedge funds received aid from the Fed during the crisis Financial Crises and Financial Regulation © 2012 Pearson Education, Inc Publishing as Prentice Hall 43 of 57 Reducing Bank Instability • One argument for limiting competition among banks is that it increases a bank’s value, thereby reducing bankers’ willingness to make excessively risky investments • However, in the long run, anticompetitive regulations may create incentives for unregulated financial institutions and markets to compete with banks • The Banking Act of 1933, which authorized Regulation Q, was an attempt to maintain profitability by limiting competition for funds among banks Regulation Q placed ceilings on the interest rates banks could pay on time and savings deposits and prohibited banks from paying interest on demand deposits In practice, however, the regulation forced banks to innovate to survive • As rising inflation rates drove interest rates above the Regulation Q ceilings, corporations and wealthy households substituted short-term investments in Treasury bills, commercial paper, and repurchase agreements for short-term deposits in banks The introduction of money market mutual funds in 1971 also gave savers another alternative to bank deposits Financial Crises and Financial Regulation © 2012 Pearson Education, Inc Publishing as Prentice Hall 44 of 57 Firms sold a substantial fraction of their commercial paper to money market mutual funds Banks suffered because, as our analysis of adverse selection predicts, only high-quality borrowers can successfully sell commercial paper, leaving banks with low-quality borrowers Disintermediation The exit of savers and borrowers from banks to financial markets To circumvent Regulation Q, banks developed new financial instruments for savers Citibank introduced negotiable certificates of deposit that were not subject to Regulation Q interest rate ceilings In addition, they developed negotiable order of withdrawal (NOW) accounts on which they paid interest Banks also developed automatic transfer system (ATS) accounts that effectively pay interest on checking accounts Financial Crises and Financial Regulation © 2012 Pearson Education, Inc Publishing as Prentice Hall 45 of 57 • With the passage of the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) and the Garn-St Germain Act of 1982, Congress eased the anticompetitive burden on banks by phasing out Regulation Q • Congress passed the Garn-St Germain Act to help reverse disintermediation by allowing banks to offer money market deposit accounts (MMDAs), which would be covered by FDIC insurance but against which banks were not required to hold reserves Financial Crises and Financial Regulation © 2012 Pearson Education, Inc Publishing as Prentice Hall 46 of 57 Figure 12.7 Interest Rate Ceilings: Crisis, Regulation, Financial System Response, and Regulatory Response Financial Crises and Financial Regulation © 2012 Pearson Education, Inc Publishing as Prentice Hall 47 of 57 Capital Requirements • After an examination, a bank receives a grade in the form of a CAMELS rating based on the following: Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk • Regulating the minimum amount of capital that banks are required to hold reduces the potential for moral hazard and the cost of bank failures • Regulators increased their focus on capital requirements following the savings-and-loan (S&L) crisis of the 1980s Financial Crises and Financial Regulation © 2012 Pearson Education, Inc Publishing as Prentice Hall 48 of 57 Basel accord An international agreement about bank capital requirements • The fallout from the S&L crisis led a program by the Bank for International Settlements (BIS), located in Basel, Switzerland • The Basel Committee on Banking Supervision developed the Basel accord to regulate bank capital requirements • Under the Basel accord, bank assets are grouped into four categories based on their degree of risk These categories are used to calculate a measure of a bank’s risk-adjusted assets by multiplying the dollar value of each asset by a risk-adjustment factor Financial Crises and Financial Regulation © 2012 Pearson Education, Inc Publishing as Prentice Hall 49 of 57 A bank’s capital adequacy is calculated using two measures of the bank’s capital relative to its risk-adjusted assets: •Tier capital consists mostly of bank capital, or shareholder’s equity •Tier capital equals the bank’s loan loss reserves, its subordinated debt, and several other bank balances sheet items Financial Crises and Financial Regulation © 2012 Pearson Education, Inc Publishing as Prentice Hall 50 of 57 • Implementation of these capital requirements meant that banks with low capital ratios were forced to close or to raise additional capital, thereby increasing the stability of the commercial banking system • Large commercial banks developed financial innovations that allowed these banks to push some assets off their balance sheets • Some large banks, such as Citigroup, formed special investment vehicles (SIVs) to hold risky assets • By the time of the financial crisis, there were about 30 SIVs, holding about $320 billion in assets • As the assets held by the SIVs lost value, banks were forced to bring the SIVs back into the bank’s balance sheet Financial Crises and Financial Regulation © 2012 Pearson Education, Inc Publishing as Prentice Hall 51 of 57 Figure 12.8 Capital Requirements: Crisis, Regulation, Financial System Response, and Regulatory Response Financial Crises and Financial Regulation © 2012 Pearson Education, Inc Publishing as Prentice Hall 52 of 57 The 2007–2009 Financial Crisis and the Pattern of Crisis and Response Key provisions of the Wall Street Reform and Consumer Protection Act, referred to as the Dodd-Frank Act: •Created the Consumer Financial Protection Bureau to protect consumers in their borrowing and investing activities •Established the Financial Stability Oversight Council, to identify and act on systemic risks to the financial system •Ended the too-big-to-fail policy for large financial firms •Made several changes to the Fed’s operations •Required certain derivatives to be traded on exchanges, not over the counter •Implemented the “Volcker Rule” by banning most proprietary trading at commercial banks •Required hedge funds and private equity firms to register with the SEC •Required that firms selling mortgage-backed securities and similar assets retain at least 5% of the credit risk Financial Crises and Financial Regulation © 2012 Pearson Education, Inc Publishing as Prentice Hall 53 of 57 Figure 12.9 The Financial Crisis of 2007–2009: Crisis, Regulation, Financial System Response, and Regulatory Response Financial Crises and Financial Regulation © 2012 Pearson Education, Inc Publishing as Prentice Hall 54 of 57 Answering the Key Question At the beginning of this chapter, we asked the question: “Does the severity of the 2007–2009 financial crisis explain the severity of the recession during those years?” We have seen that the recession of 2007–2009 was the most severe since the Great Depression of the 1930s It was also the first to be accompanied by a financial crisis We discussed research showing that recessions involving financial crises have been longer and deeper than recessions that not involve financial crises We noted that because financial crises disrupt the flow of funds from savers to households and firms, they cause substantial reductions in spending, which is the key reason they make recessions worse So, it is likely that the severity of the 2007–2009 financial crisis explains the severity of the recession © 2012 Pearson Education, Inc Publishing as Prentice Hall 55 of 57 AN INSIDE LOOK AT POLICY Congress Struggles to Reform Financial Markets, Prevent Future Crisis WALL STREET JOURNAL, Regulating a Moving Target Key Points in the Article • How much should Congress write strict rules to reduce risks of another global financial crisis? And how much should it leave to regulators who failed to prevent the crisis in the first place? Pending legislation would give less discretion to regulators • Two countervailing forces were evident during the Congressional deliberations: (1) Because markets are constantly evolving, when Congress writes too many rigid rules, it often fails to get them right (2) Congress doesn’t revisit the rules of finance frequently enough to avoid future crises © 2012 Pearson Education, Inc Publishing as Prentice Hall 56 of 57 AN INSIDE LOOK AT POLICY © 2012 Pearson Education, Inc Publishing as Prentice Hall 57 of 57 ... Understand the financial crisis that occurred during the Great Depression 12. 3 Understand what caused the financial crisis of 2007-2009 12. 4 Discuss the connection between financial crises and financial. .. households and firms face difficulty in borrowing money •In the past, most of the financial crises in the United States involved the commercial banking system The Origins of Financial Crises © 2 012 Pearson.. .CHAPTER 12 Financial Crises and Financial Regulation LEARNING OBJECTIVES After studying this chapter, you should be able to: 12. 1 Explain what financial crises are and what causes them 12. 2