ECON7200
Economics of Financial Markets
Lecture 12
An Overview of Financial Crises
Nhan Phan
UQ School of Economics
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Online Quiz Information
• Questions will be available at 9am and due at 4pm (Brisbane time) on
Tuesday 24/10/23
• Takes at most 2-3 hours to do.
• Submit at anytime within the 7-hour period.
• Cover ALL lectures/tutorials.
• Topic 11 will only be covered in MCQ format.
• Submit using the Blackboard submission link in the Assessment tab.
• Type or handwrite and scan your answer.
• You can submit multiple times, only the final attempt will be marked.
• Make sure your final attempt is before the deadline to avoid late penalty.
• Make sure your submission is successful before closing tab – wait for email receipt.
• Submit well before 4pm, as traffic can be high close to the deadline,
making the submission delayed/unsuccessful.
• Technical error is not a valid reason for extension request.
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Online Quiz Information – Content
• Part A: 25 MCQs, worth 25 marks in total
• Similar to tutorial questions.
• To answer: Just write down the answer, such as 1A; 2B; 3C; 4D, etc.
• Part B: 6 Short-answer/Calculation questions, worth 75 marks in total
• More detailed required than those in the tutorials.
• Will most probably contain calculation/graph drawing, etc.
• Some questions can ask about intuition/application.
• No need to put citation if you include research to help your arguments.
• Main thing to do: EVERYTHING the questions ask you to do
• Review UQ Extend/Lecture Notes/Tutorials
Central Bank Report
• Due: 4:00pm (Brisbane time) Tuesday 07/11/23
• Strict upper word limit: 1700 words
• Task: Choose a Central Bank
1. Assess its activities in the past 10 years.
2. Choose an economic crisis, and explain the CB’s response.
3. Evaluate its effectiveness before, during, and after event.
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Central Bank Report
Note:
• The economic crisis in question does not need to be within 10 years
• Asian financial crisis, dot-com bubble, GFC, etc.
• Can extend the time in Task 1 to 15 years if you want to be consistent
• No need for econometric analysis
• You might need to present data/figures/tables/articles
• Feel free to use the table/figure from another article, but cite the source!
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Tips – Central Bank Report
• Make use of your Essay feedbacks.
• Look at our marking rubric. It is what we expect from you!
• Must use data & research articles!
• Reference: very important, make sure it’s adequate & correct!
• Key words: Assess & Evaluate
• Give both sides of the argument, with research/data support
• Provide your own conclusion/judgement
• Sample: Yellen’s speech in 2009
• https://www.frbsf.org/our-district/press/presidents-speeches/yellen-
speeches/2009/june/yellen-economic-crisis-federal-reserve-response/
Learning Objectives
• We study about financial crises and its dynamics.
• We explore the structure and process of securitization and the shadow
banking system.
• We examine the historical facts about the Global Financial Crisis 2007 –
2009 and European Sovereign Debt Crisis.
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UQ Extend – What is a Financial Crisis?
• A financial crisis occurs when there is a particularly large disruption to
information flows in financial markets, with the result that financial
frictions increase sharply, and financial markets stop functioning.
• The Mother of All Financial Crises: The Great Depression
• This event was brought on by:
• Stock market crash
• Bank panics
• Continuing decline in stock prices
• Debt deflation
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UQ Extend – Dynamics of Financial Crises
• Stage One: Initiation of a Financial Crisis
• Credit Boom and Bust: Mismanagement of financial liberalization/innovation
leading to asset price boom and bust
• Asset-price Bubbles and Bursts
• Increase in Uncertainty
• Stage two: Banking Crisis
• Stage three: Debt Deflation
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Debt Deflation
• Substantial unexpected decline in the price level, while debt payments are
contractually fixed in nominal terms.
•  The burden of the debt increases.
• Meanwhile, the asset real value does not change  Lower net worth.
• Example:
• Suppose that a firm has $100 million of assets and $90 million of long-term liabilities
in 2016 dollars.
• The net worth is $10 million.
• If the price level falls by 10% in 2017, the real value of the liabilities would rise to $99
million in 2016 dollars. ($1 in 2017 Value = $1.1 in 2016 Value)
• Then real net worth in 2016 dollars would fall from $10 million to $1 million.
• Increased adverse selection and moral hazard problems.
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UQ Extend –
Figure:
Sequence of
Events in
Financial
Crises in
Advanced
Economies
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Big Five in Advanced Countries
1. Spain 1977
2. Norway 1987
3. Finland 1991
4. Sweden 1991
5. Japan 1992
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Japan and The Financial Crisis
• The start of Lost decades: Burst of Asset Bubbles.
• The Bank for International Settlements (BIS) standard sets a
requirement that international banks have to keep “safe assets”
relative to their total assets, in order to join international markets.
• BIS standards were introduced at two steps, 1991 and 1993.
• Nippon Credit Bank and Hokkaido Takushoku Bank consequently
revealed that they could not meet BIS standard.
• The issue of bad-performing loans came out.
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Crisis in Emerging Markets
1. Asian crises in the 1997– 1998 (in Hong Kong, Indonesia, Korea,
Malaysia, the Philippines, and Thailand).
2. Colombia in 1998.
3. Argentina’s 2001 collapse.
• The economy shrank by 28 percent from 1998 to 2002.
• It caused widespread unemployment, riots, the fall of the government, a
default on the country's foreign debt, the rise of alternative currencies and
the end of the peso's fixed exchange rate to the US dollar.
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Figure: Credit Spreads During the Great Depression
Credit Spread: The difference between the interest rate on loans to households and businesses
and the interest rate on completely safe assets that are sure to be repaid back, such as US treasury
securities.
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UQ Extend
Securitization and the Shadow Banking System
• Securitization is the process of bundling small and otherwise illiquid
financial assets (such as residential mortgages, auto loans, and credit
card receivables), which have typically been the bread and butter of
banking institutions, into marketable capital market securities.
• Securitization is the fundamental building block of the shadow
banking system.
• Securitization is also characterized as an originate-to-distribute
business model:
Loan origination → servicing → bundling → distribution
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Tranches
AAA/Aaa B/B and belowBB/Ba to AA/Aa
UQ Extend
The Global Financial Crisis of 2007-2009
• Causes of the 2007-2009 Financial Crisis:
• Financial innovations emerge in the mortgage markets
• Subprime mortgage
• Mortgage-backed securities
• Collateralized debt obligations (CDOs)
• Housing price bubble forms
• Increase in liquidity from cash flows surging to the United States
• Development of subprime mortgage market fueled housing demand and housing prices
• Deterioration of financial institutions’ balance sheets:
• Write downs
• Sell of assets and credit restriction
• High-profile firms fail
• Bear Stearns (March 2008) -> JP Morgan
• Fannie Mae and Freddie Mac (July 2008)
• Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund (mutual fund) and Washington
Mutual (September 2008)
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Figure: Housing Prices and the Financial Crisis of 2007–
2009
Source: Case-Shiller U.S. National Composite House Price Index from Federal Reserve Bank
of St. Louis FRED database: http://research.stlouisfed.org/fred2/.
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Figure: Stock Prices and the Financial Crisis of 2007–2009
Source: Dow-Jones Industrial Average (DJIA). Global Financial Data:
http://www.globalfinancialdata.com/index_tabs.php?action=detailedinfo&id=1165.
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Was the Fed to Blame for the Housing Price
Bubble?
• Some economists have argued that the low rate interest policies of
the Federal Reserve in the 2003–2006 period caused the housing
price bubble.
• Taylor argues that the low federal funds rate led to low mortgage
rates that stimulated housing demand and encouraged the issuance
of subprime mortgages, both of which led to rising housing prices and
a bubble.
• Taylor’s Rule: Federal funds rate target = Inflation rate + equilibrium real fed funds rat + 12 Inflation gap + 12 Output gap
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Was the Fed to Blame for the Housing Price
Bubble?
• Federal Reserve Chairman Ben Bernanke countered this argument,
saying the culprits were
• proliferation of new mortgage products that lowered mortgage payments
• a relaxation of lending standards that brought more buyers into the housing
market
• capital inflows from emerging market countries (“Global Saving Glut”)
• The debate over whether monetary policy was to blame for the
housing price bubble continues to this day.
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The Global Financial Crisis of 2007-2009
Height of the 2007-2009 Financial Crisis
• The stock market crash gathered pace in the fall of 2008, with the
week beginning October 6, 2008, showing the worst weekly decline in
U.S. history.
• Surging interest rates faced by borrowers led to sharp declines in
consumer spending and investment.
• The unemployment rate shot up, going over the 10% level in late
2009 in the midst of the “Great Recession,” the worst economic
contraction in the United States since World War II.
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Figure 6 Credit Spreads and the 2007–2009 Financial Crisis
Source: Dow-Jones Industrial Average (DJIA). Global Financial Data:
http://www.globalfinancialdata.com/index_tabs.php?action=detailedinfo&id=1165.
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The European Sovereign Debt Crisis
• Although the subprime mortgage market problem began in the
United States, the first indication of the seriousness of the crisis
began in Europe.
• The increase in budget deficits that followed the financial crash of
2007-2009 led to fears of government defaults and a surge in interest
rates.
• The sovereign debt crisis, which began in Greece, moved on to
Ireland, Portugal, Spain and Italy.
• The stresses created by this and related events continue to threaten
the viability of the Euro.
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UQ Extend – Government Intervention and
the Recovery
• Short-term Responses and Recovery
• Financial Bailouts: In order to save their financial sectors and to avoid
contagion, financial support was provided by many governments to bail out
banks, other financial institutions, and even the so-called “too-big-to-fail”
firms that were severely affected by the financial crisis.
• Fiscal Stimulus Spending: To boost their individual economies, most
governments used fiscal stimulus packages that combined government
expenditure and tax cuts.
• Japan’s consecutive stimulus packages, totaling $568 billion, were among the
highest during the crisis, but these proved largely ineffective
• European nations showed moderate success.
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UQ Extend – Long-Term Responses
• With the individual emergency national bailouts to rescue national economies and
financial sectors, global leaders looked to building a more stable and robust global
financial system.
• Steps taken by governments included
• Implement sound macroeconomic policies
• enhance their financial infrastructure
• develop financial education and consumer protection rules
• enact macro and microprudential regulations.
• At the international level
– proactive globally-binding supervision was designed
– financial market discipline enforced
– systemic risk managed
• To avoid collective action problems and to ensure that policy actions are mutually
consistent with national growth objectives, aggregate plans began to be drafted
simultaneously.
• The first ever of these is the Mutual Assessment Process launched in 2009 by the G20.
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• Debt deflation
• Shadow banking system
• Financial Crisis
• The Great Depression
• The Global Financial Crisis of
07-09
• The European sovereign debt
crisis
• Credit spread
• Securitization
• Loan origination
• Servicing & bundling
• Subprime mortgage
• Mortgage-backed securities
• Collateralized debt obligations
• Bubbles
• Originate-to-distribute model
• Special purpose vehicle
Summary: Concepts for This Week