Financial Crisis: How And Why It Happens

Financial Crisis: How And Why It Happens

Length: 1451 words (4.1 double-spaced pages)

Rating: Excellent

Open Document

Essay Preview

More ↓
Financial Crises: How and Why and Lessons

Recent Major Financial Crises

1980's: Debt crisis for developing countries (Latin America and Africa)

1992: European Exchange Rate Mechanism (especially UK and Sweden)

1994-95: Mexico (Tequila crisis) and Argentina

1997-98: Asian financial crisis (Thailand, Indonesia, Korea, Philippines, Malaysia)

1998: Russia

1999: Brazil

2000-02: Turkey

2001-02: Argentina (again)







Nature of Financial Crises

Exchange rate crises

Sudden, drastic depreciation of the country's currency

Banking crises

Depositors lose confidence (disintermediation)
Banks can't perform lending function

Effects

Severe recession, due to:
Collapse of bank loans
Reduction in consumer demand
Higher interest rates

Inflation, due to:
Higher import costs



Causes of Financial Crises:
1. Macroeconomic Imbalances

Where: Russia 1999, Brazil 1999, Turkey 2000, Argentina 2001

Characteristics of imbalances:

Causes of Macroeconomic Imbalances

High government spending (G) due to:

Public subsidies for businesses
Infrastructure spending
Lack of fiscal discipline

Insufficient tax revenues (T) due to:

Poorly developed tax systems
Lack of tax enforcement

Money supply (M) growth too high due to:

Lack of independence of central bank
Political pressure on central bank to accommodate fiscal deficits



Pressure on Exchange Rates

CA deficit and inflation cause pressure in forex markets on currency to depreciate.

Government does not want that due to:
Higher import costs
Loss of prestige

Government tries to keep currency from depreciating too fast:
By raising interest rates domestically
By using foreign reserves to buy its currency back

But this creates problems:
Higher interest rates slow the domestic economy
Loss of foreign reserves


Loss of Confidence

Foreigners stop lending

Speculators think the currency will depreciate further

Domestic owners of financial capital move that capital out of the country (capital flight)

Causes of Financial Crises:
2. Capital Flow Volatility

Where: Mexico 1994, Asia 1997-98

Characteristics of capital flow patterns:

CA deficits
Offsetting inflows of capital to purchase assets
Factories
Real estate
Stocks
Many investments were economically doubtful

Over-reliance on bank financing

Short-term borrowing and lending
Using foreign money


Recent Capital Flow Patterns

Capital Flows for Asian Crisis Countries (US $ billions)

Source: IMF, World Economic Outlook, Database tables, December 2001

Short-term Debt Exposure

Country S.T. Debt as % of Reserves
Q2 1997
Korea 200%
Indonesia 165%
Thailand 145%
Philippines 75%
Malaysia 40%
Taiwan 20%

Source: The Economist, "Global Finance Survey," January 30, 1999, p. 11


Effects of Dependence on Foreign Capital

Exposure to interest rate risk outside own control

Currency effects

Bank non-performing loans (NPL's)

Capital flight

Recession



Causes of Financial Crises:
3. Banking Practices

Where: Thailand, Indonesia, Korea 1997

Lack of diverse sources of capital:

Underdeveloped equity markets
Underdeveloped bond markets
Over-reliance on bank financing

Poor management

Crony lending
Lack of credit analysis
Moral hazard = risk taking

Non-performing Loan Problems, year-end 2001

Country
NPL as % of GDP Estimated Amount $ billion Officially Reported
$ billion
China 44 – 55 480 – 604 343
Malaysia 36 – 48 32 – 43 20
Thailand 36 – 41 46 – 53 15
Taiwan 20 – 27 60 – 83 27
Japan 25 – 26 1,200 – 1,261 742
Indonesia 11 – 14 18 – 22 7
South Korea 7 – 14 31 – 64 29
Philippines 9 – 13 8 – 11 6
Source: Cited in Lawrence W. Berger, George R. Nast, and Christian Raubach, "Fixing Asia's Bad-Debt Mess," The McKinsey Quarterly, 2002, No.

How to Cite this Page

MLA Citation:
"Financial Crisis: How And Why It Happens." 123HelpMe.com. 17 Nov 2018
    <https://www.123helpme.com/view.asp?id=165043>.

Need Writing Help?

Get feedback on grammar, clarity, concision and logic instantly.

Check your paper »

How To Solve The Current Finacial Crisis Essay

- The financial crisis that is currently affecting the United States of America is the result of several factors, including the growing number of foreclosures, all of which converged into a “perfect storm” of a severe magnitude. The end result was not only the exacerbation of the already looming housing crisis, but the overall bleak outlook on America’s financial system. The integrity of the financial system was put into question along with the future of America’s economy, including its once thriving housing market....   [tags: Finacial Crisis]

Research Papers
1123 words (3.2 pages)

Essay about How to Solve the Foreclosure Crisis

- How to Solve the Foreclosure Crisis Imagine a young couple was married and bought a house together. They were happy they made an investment together that they would never regret. A few years later, the company the husband worked for suffered critically by the recession and he was one of the hundreds of people who got their job cut. They now have two babies to feed and have to choose between food and the mortgage. They soon began to miss their monthly payments. They waited until things became unbearable to negotiate the loan or an extension to repay the bank but their efforts failed....   [tags: Economics, Mortgage, Housing Crisis]

Research Papers
1286 words (3.7 pages)

Financial Crisis of the 1980s Essay

- The financial crisis of 2008 and 2009 is considered by others as the worst financial crisis since the Great depression of 1930. However there were other financial crisis which had happened after the Great depression which were equally disastrous. The one that comes in mind was the financial crisis of the 1980s and early 1990s. It is always overlook by others because of the 2008 credit crunch which happens to be the recent one. It became known as Savings and Loans crisis which basically let to substantial public-funded rescue of an industry that had crumpled and on it knees begging for help....   [tags: Great Depression, United States, American History]

Research Papers
894 words (2.6 pages)

The Current Financial Crisis Essay

- Frederic Mishkin makes the point in the text, The Economics of Money Banking, and Financial Markets (2010) that “Banks and other financial institutions are what make financial markets work. Without them, financial markets would not be able to move funds from people who save to people who have productive investment opportunities.” (p.7). The movement of funds between savers and those with productive investment opportunities is the means of creating growth. When people lose confidence in the economy this activity freezes or weakens, consequently, asset prices decline, unemployment rises and companies default as was the case of Lehman Brothers in 2008....   [tags: Global Economy]

Research Papers
884 words (2.5 pages)

Global Financial Crisis Essay

- Starting from problems of payment defaults on housing loans (subprime mortgage defaults) in the United States (U.S.), then ballooned damaging crisis of the banking system not only in the United States but extends into Europe and into Asia. Successive cause a domino effect on the solvency and liquidity of financial institutions in these countries, among others, led to the bankruptcy of hundreds of banks, securities firms, mutual funds, pension funds and insurance. The crisis then spread to parts of Asia, especially countries such as Japan, Korea, China, Singapore, Hongkong, Malaysia, Thailand, including Indonesia, which happens to have long had the letters beharga these companies....   [tags: Economics ]

Research Papers
848 words (2.4 pages)

Real Estate Accounting: New Regulations Essay

- The level of agony for individuals and businesses continues to rise as they experience losses in the value of their real estate holdings. In some circumstances, the fair market value of their property has fallen below the loan or mortgage amount. As a result, many debtors decide to walk away from the loan, resulting in repossession of the property by the lender. As shown in Appendix A the default rates continue to rise (United States), affecting accounting issues such as, revenue recognition, measurement, fair value, and impairment....   [tags: The Financial Crisis]

Research Papers
1546 words (4.4 pages)

How to Solve the Foreclosure Crisis Essay

- Within the past three to four years, the United States has seen the dramatic collapse of the housing market. The housing bubble spurred by ill-advised loans to individuals who could not afford a mortgage, complicated contracts which had interest rates and payments changing without reason, and the mass purchasing of bad loans by lending superpowers, had popped. The rapid increase in the value of homes across the country for the previous decade, had been a falsity, in which billions of dollars funded by investments and home purchases were lost within a few months (Wikipedia.org: United States housing bubble)....   [tags: Economics]

Research Papers
2246 words (6.4 pages)

Essay on Education Budget Cuts

- Education is the most important possession a person must have. It is the keys to success, wealth, and knowledge. It is the only possession that cannot be taken away from a person and it will open up the windows of opportunities. Education will help us grow as an individual, have better understanding of life, and give us a financial stability; but what happens when education get cuts down. By making budget cuts to education, is this helping out education or letting it down. In the news article, “Highlights Impact of Budget Cuts to Education” by State School Chief Jack O’Connell, his claim is that governor should not cuts down education budget, but instead protect education and invest it in th...   [tags: FInancial Crisis, Education, School]

Research Papers
1022 words (2.9 pages)

Economic Crisis Essay

- Starting from the problems of failure to pay housing loans (subprime mortgage defaults) in the United States (U.S.), then bubbled damaging crisis banking system not only in America but expanded to Europe and to Asia. Successive causes a domino effect of the solvency and liquidity of financial institutions in these countries, which among others led to the bankruptcy of hundreds of banks, securities firms, mutual funds, pension funds and insurance. The crisis then spread to parts of Asia, especially countries such as Japan, Korea, China, Singapore, Hong Kong, Malaysia, Thailand, including Indonesia, which happens to have long had precious letters these companies....   [tags: Economics]

Research Papers
829 words (2.4 pages)

Financial Globalization Essay

- Executive Summary During the past two decades, financial markets around the world have become increasingly interrelated. Financial globalization has brought considerable benefits to national economies and to investors, but it has also changed the structure of markets, creating new risks and challenges for market participants and policymakers. The international marketplace continues to present opportunities for companies. But change is constant and prudent so companies must work to minimize their risks while maximizing their opportunities....   [tags: Globalisation Essays]

Research Papers
1800 words (5.1 pages)

4.

Causes of Financial Crises:
4. Bad Exchange Rate Policies

Where: Thailand 1997, Brazil 1999, Argentina 2001
Almost: Hong Kong 1997-98, China (anytime?)

Problem: Fixed exchange rates are difficult to maintain.


Story #1: Thailand 1997

Thailand had fixed the THB at 25 per USD
Currency became over valued relative to PPP and to its neighbors.
Contributed to CA deficit
Attracted FDI

Required high domestic interest rates to attract money to preserve the peg.
Attracted "hot money" to banking sector
Hot money loaned out
Stock market
Property market

The lending expanded the money supply and created inflationary pressures.

Inflation created downward pressure on the THB, but since nominal exchange rate was fixed, the real exchange rate appreciated.

Interest rates had to be increased to maintain the THB peg.
Bank of Thailand uses international reserves to buy THB.

Eventually confidence in ability to maintain peg eroded.
Hot money leaves (capital flight)
Tried to maintain peg but can't.

Peg abandoned. Start of the Asian Financial Crisis.




Story #2: Hong Kong Withstands Speculative Attack

Appreciation of real exchange rate of HKD:

Speculators anticipated devaluation of HKD August 1998
Highly-leveraged institutions (HLI's)
(Also took positions in JPY, HKD, SGD, AUD, NZD)

"Double Play": Speculators took short positions in HKD and HK stock market
Borrow HKD
E.g., at 7.79 HKD/USD
Agree to sell them back (hopefully at lower price)
E.g., at 8.00 HKD/USD
Hope that profit from movement exceeds interest cost


HK Policy Response

Hong Kong Monetary Authority (HKMA):
• Raised short-term interest rates (Aug 98 avg = 12.24%)
• Used foreign reserves to buy HKD
• Use reserves to buy stocks
o August 13 – 28, 1998: HKMA intervened in exchange, stock, and futures markets
o Bought $15 billion of stocks to prop up markets

Goals:
• To increase confidence (fight the herd mentality)
• Punish speculators (especially "double play" speculators)

Impacts:
• Stock market up 18% during intervention
• Down 10% after intervention stopped
• Exchange rate stabilized
• Economic slow-down and deflation

Contagion

What is it:

Rapid spread of financial and exchange rate crises from one country to another, sometimes with no fundamental reason.

Is it increasingly likely?

Globalization
Trade linkages
Financial linkages

Faster transmission
Open capital markets
Deregulation


What are the Causes of Contagion?

Economic fundamentals

Inability to maintain balance between exchange rate policies and domestic policies

Speculation

Driven by economic fundamentals
Herd mentality due to imperfect information



Why Does Contagion Start and Spread?

Shocks with wide impact:

For example:
World-wide interest rate changes
Slowing of Japanese economy
Oil shock

Trade spillovers:

Terms of trade change with competitors or trading partners

For example:
Indonesia and Malaysia

Financial linkages:

For example:
Exposure of Japanese banks in SE Asia
Financial linkages between Malaysia and Singapore
Perceived linkages between Mexico and Argentina
Exposure of HK in China

Investor sentiments:

Affected by fundamentals


What are the Important Fundamental Factors?

External factors:

Appreciation of real exchange rates
CA deficits
High s.t. debt relative to total debt
High s.t. debt relative to reserves

Domestic imbalances:

Loose monetary policy
High real interest rates
Slow GDP growth
High unemployment
Excessive domestic credit growth
Bank lending problems

Trade linkages

Financial linkages



Measuring Credit Risk

Who evaluates country credit risk?
Moody's
Standard and Poors
Fitch IBCA, Duff and Phelps

What do they evaluate?
Sovereign credit
Long term and short term
Local currency and foreign currency
Bank health

What they look at to make their ratings:
Indicators of economic strength
GDP per capita (at current exchange rates)
Real GDP growth
Inflation
Investment as percent of GDP
Indicators of liquidity (ability to repay debt)
International debt to export ratio
International debt service as % of exports



Resolving and Avoiding Financial Crises

Dimensions of crisis resolution:

Unilateral or multilateral
Domestic or international focus
Short-term fixes or long-term structural reforms
Cosmetic or substantive


Obvious Answers to Obvious Problems

Cause of Problem Solutions Multilateral Role
Macroeconomic imbalances • Fiscal policy discipline
• Monetary policy discipline • Provide policy guidance
Capital flow volatility • Better regulation of domestic financial institutions
• Development of broader sources of capital domestic • Provide institutional guidance
• Develop regional cooperation
Banking sector weaknesses • Rationalize bank sector
• Improved bank management
• Better bank regulation
• Better bank supervision • International standards
Exchange rate policies • Avoid exchange rate over valuation
• Float exchange rate
• Capital controls
• Currency board • IMF support

Domestic Financial Reforms

Diversification of financing sources:

Less reliance on bank financing

More reliance on market financing
Equity markets
Bond markets

Requires institutional infrastructure
Property rights
Commercial codes
Bankruptcy laws

Banking sector reforms:

Rationalization of banking sector

Credit analysis (e.g., Thai Central Information System Comp.)

Debt restructuring (non-performing loans)



Role of Multinational Institutions in Domestic Reforms

Global standards

Banking (Bank for International Settlements)
Accounting (Intl Acc Stand Comm)
Securities (Intl Org of Securities Commissions)
Legal (International Bar Association)

Essential questions

What are the appropriate standards?
Who will determine them?
How will they be enforced?
Who will be held accountable?

Possible institutions

Global central bank
Global bankruptcy court


Appropriate Bank Regulation

Bank for International Settlements

Capital adequacy requirements

Supervisory review

Information disclosure

Commercial Bank of Jakarta

Assets Liabilities
Cash Deposits of customers
Government bonds
Loans to individuals
Loans to corporations



Multilateral Rescues

Mexico 1994-54:

U.S. takes leadership position

$50 billion stand-by credit to Mexico from the U.S. Treasury's Exchange Stabilization Fund


Asia 1997-98:

IMF and World Bank take leadership role


IMF Rescues: Thailand and Indonesia

Thailand Indonesia
When August 1997 November 1997
Total Initial Package (tranches)
IMF
World Bank
Asian Dev Bank
Other
$17 billion

$4 bill
$1.5 bill
$1.5 bill
$10 bill (Japan, Sing, Aus, Mal, China, HK, Kor) $33 billion

$10 bill
$4.5 bill
$3.5 bill
$15 bill (Japan, Sing, USA, Aust, Mal)
Conditionality -increase excise tax to create fiscal surplus
-strengthen banks and finance companies:
* declare non-performing loans at 6 months instead of 12
* foreigners allowed to own majority share
-resolve 58 finance companies
* Financial Sector Restructuring Agency
* strict capital requirements and auditing standards
*set up asset management company to dispose of non-performing loans -removal of trading monololies on wheat, soybeans, garlic held by National Logistics Agency
- remove price ceilings on cement
-eliminate 2,000 local content rules for car assembly
-lower tariffs on chemicals and steel (now 15-40%) protecting state-run firms
-close 16 bad banks
Sources: FEER 10/23/97, p. 94;
www.imf.org Economist, 11/8/97, p. 79;
FEER, 11/13/97, p. 68


IMF Rescue: South Korea


When December 1997
Total Initial Package (tranches)
IMF
World Bank
Asian Dev Bank
Other
$55 billion

$21 bill
$10 bill
$ 4 bill
$20 bill (Japan, Aus, Belg, Can, France, Ger, Italy, Neth, Sweden, Switz, UK)
Conditionality Monetary and forex policies:
-reduce M growth; raise int rates
-allow won to float
Fiscal policy:
-increase taxes
-reduce spending
Financial sector restructuring:
-close bad banks
-more independence for BOK
-better supervision of institutions
-reform deposit insurance
-greater transparency
-international standards for reporting
Other restructuring:
-trade liberalization per WTO rules
-liberalization of foreign investment
-corporate governance reform
-increased labor market flexibility
Source: www.imf.org



To Rescue or Not To Rescue?

Why Rescue?

Maintain financial stability
Maintain political stability
Maintain trade relationships
Reduce the chance of "contagion"

Why Not Rescue?

Helps the wrong people
Protects domestic political powers
Protects reckless decision makers
Reckless borrowers
Careless lenders

Creates "moral hazard"
Could encourage reckless behavior in future

Does the IMF do it right?

Too much emphasis on austerity?


Asian Alternative to IMF?

Regional exchange rate stabilization fund

Led by Japan

Purpose: to provide short-term liquidity to countries if their currency comes under attack.
Return to 123HelpMe.com