monetary-policy-notes.pdf

lOMoARcPSD|27073014 Monetary policy notes Economics (Universiteit Stellenbosch) Studocu is not sponsored or endorsed by any college or university Downloaded by Mila Mohlathe ([email protected])  lOMoARc...

lOMoARcPSD|27073014 Monetary policy notes Economics (Universiteit Stellenbosch) Studocu is not sponsored or endorsed by any college or university Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Chapter 1: Why study money, banking, and financial markets? 6 Why study financial markets? 6 Debts markets and interest rates: 6 The stock market: 6 Why study financial institutions and banking? 7 Why study money and monetary policy? 7 Money and business cycles: 7 Money and inflation: 8 Money and interest Rates: 8 Fiscal policy and monetary policy: 8 The foreign exchange market: 8 Chapter 2: An overview of the Financial System 9 Function of financial markets: 9 Structure of financial markets: 9 Debt and equity markets: 9 Primary and Secondary Markets: 10 Exchanges and over-the-counter markets: 10 Money and capital markets: 11 Money market instruments: 11 Capital market instruments: 11 Internationalization of Financial Markets: 12 Function of Financial Intermediaries: Indirect Finance 12 Types of financial intermediaries: 14 Regulation of the financial system: 16 Chapter 12: Crisis in advanced economies 17 Dynamics of a financial crisis: 17 Stage 1: Initiation of a financial crisis 17 Credit boom or bust: 17 Asset-price boom and bust: 18 Increase in uncertainty: 18 Stage 2: Banking crisis 18 Stage 3: Debt deflation 19 The Great Depression: 21 U.S. stock market crash 21 Worldwide decline in asset prices 21 Bank failures 21 Economic contradiction and debt deflation 21 Global Financial crisis of 2007 - 2009 22 Causes: 22 Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Financial innovation in the mortgage markets: 22 Agency problems in mortgage markets; 22 Asymmetric information and credit-rating agencies 23 Effects: 23 Residential housing prices: Boom and Bust 23 Deterioration of financial institutions’ balance sheets 24 Run on the shadow banking system: 24 Global financial markets 25 Failure of high-Profile firms 25 Government Intervention and Recovery 25 Short-term responses and recovery: 25 Financial Bailouts: 25 Fiscal stimulus spending: 25 Long-Term Responses: 26 Global Financial Regulatory framework 26 Policy Areas at the National Level: 26 Policy Areas at International level: 27 Bilateral and multilateral supervisory cooperation 27 Collective supervisory cooperation 27 Collectively coordinated macroeconomic stability plans 27 Self-discipline 28 Chapter 13: Crisis in emerging economies 29 Stages of financial crisis in emerging economies 29 Stage 1: Initiation phase 29 Path A:Credit Boom and Bust 29 Path B: Severe fiscal imbalances 29 Additional factors: 30 Stage 2: currency crisis 30 Deterioration of Bank Balance Sheets Triggers currency crisis 31 Severe fiscal imbalances trigger currency crisis: 31 Stage 3: Full fledged financial crisis 32 Application: Crisis in South Korea, 1997-1998 34 Financial liberalization and globalization mismanaged 34 Perversion of financial liberalization and globalization Process: Chaebols and the South Korea crisis 34 Stock market decline and failure of firms increase uncertainty 34 Adverse selection and moral hazard problems worsen, and the economy contracts 35 Currency crisis ensues 35 Final stage: Currency Crisis Triggers Full-Fledged Financial crisis 35 Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Recovery Commences 36 Global: China and the “Noncrisis” in 1997–1998 36 Application: Argentine Crisis, 2001 - 2002 37 Severe fiscal imbalances 37 Adverse selection and moral hazard problems worsen 37 Bank panic begins 37 Currency crisis ensues 37 Currency crisis triggers full-fledged financial crisis 38 Recovery begins 38 When an Advanced Economy Is Like an Emerging Market Economy: The Icelandic Financial Crisis of 2008 39 Preventing emerging market financial crisis 39 Beef up prudential regulation and supervision of banks 39 Encourage disclosure and market-based discipline 39 Limit currency mismatch 40 Sequence Financial Liberalization 40 Part 1: Why does international trade matter? 42 Theory of international trade timeline: 42 1500-1700: Mercantilism 42 Features of merchantlist economy: 42 Three assumptions of Mercantilism: 43 1776: Adam Smith’s absolute advantage 43 Absolute advantage theory 44 The theory is based of the following assumptions: 44 1800s: David Ricardo’s comparative advantage theory (Ricardian theory) 45 The assumptions of the Ricardian model: 45 Note on opportunity cost: 45 Production possibilities frontier: 46 Single country gains from trade and comparative advantage: 48 Before trade (In Autarky): 48 After trade: 48 1900s: Heckscher-Ohlin Factor endowment theory 50 Main assumptions of the Heckscher-Ohlin Model 50 Heckscher-Ohlin propositions 50 Heckscher-Ohlin Theorem predictions 50 The introduction of ‘new’ trade theories 51 1961: Linder’s overlapping demand theory 52 1979; Paul Krugman and Economies of Scale 54 Economies of scale, imperfect competition and international trade 54 Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Technological gap model of international trade 57 1961: Technological gap or imitation gap model 57 1966: Product life Cycle theory 59 Product life cycle theory summary: 60 1. Introduction stage: 60 2. Growth state: 60 3. Maturity state: 60 4. Decline stage: 60 Part 2: Intervention in international trade 62 1. Why do governments intervene in free trade? 62 A. Economic reasons 62 Preventing unemployment 62 Protection of infant industries 62 Strategic trade policy Argument: 63 B. Political and other reasons 63 To prevent dumping: 63 National-security: 63 Fairtrade v Free trade argument: 63 Generation of Government revenue: 63 2. How does the Government intervene in free trade? 64 A. Tariffs 64 B. Non-tariff barriers 64 3. What is the impact of intervention of free trade? 65 Diffused winners, concentrated losers 66 3. Reducing barriers to trade 67 Barriers to trade: 67 Reducing barriers to trade: The multilateral way 67 Bretton woods conference: 67 The GATT was based on 4 principles: 68 Rounds in GATT: 68 The WTO’s trade facilitation agreement (TFA) 70 How it works: 70 Ratification 71 Advantages of the TFA: 71 1. Reduction of trade costs 71 2. Increased trade flows and Gross Domestic Product 71 3. Induced positive effects from implementing trade facilitation 71 4. Implementation flexibility 71 Reducing barriers to trade: The regional way 72 Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Economic integration: 72 Recap: Insights from international trade theories for africa: 73 Part 4: Africa and SA prospects through trade 74 Regional integration in Africa 74 How The WTO’s TFA And The AfCFTA Can Propel Africa’s Growth Amid The FIR And The Global Pandemic: 74 The fourth industrial revolution (FIR): 75 The AfCFTA and FIR: 76 Blockchain technology: 76 Automated border control system (ABC): 77 1. How can the WTO’s TFA and the FIR with AfCFTA, help Africa increase trade and economic prospects? 77 Precision agriculture for africa with FIR technologies 78 2. How can WTO’s TFA and the FIR with the AfCFTA, help reduce youth unemployment? 79 3. How can WTO’s TFA and the FIR with the AfCFTA help women to participate more in the economy? 79 Why does greater success and access for women matter for the economy? 80 Challenges faced by women: 80 Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Chapter 1: Why study money, banking, and financial markets? Why study financial markets? Financial markets - Markets in which funds are transferred from people who have excess of available funds to people who have a shortage. ○ This reduces transaction costs and asymmetric information They are crucial in promoting greater economic efficiency Well-functioning: A key factor in promoting development and high economic growth Poor Performing: The reason several countries in the world remain poor Debts markets and interest rates: A security (financial instrument) - A claim on the issuer’s future income or assets A Bond - A debt security that promises to make periodic payments for a specified period Debt/Bond Markets allow corporations and governments to borrow money to finance their activities AND it is where interest rates are determined Interest Rate - The cost of borrowing or the price paid for the rental of funds High interest rates might: ○ Deter one from buying a product because the cost of financing would be high ○ Encourage one to saving to invest because one can earn more interest income ○ Deter businesses from building a new plant that would provide multiple jobs Interest rates have an impact of the overall health of the economy because it affects consumers’ willingness to spend or save and businesses investment decisions The stock market: Common Stock - A share of ownership in a corporation ○ It is a security that is a claim on the earnings and assets of the corporation ○ By issuing and selling stock corporations raise funds to finance their activities ○ Higher price for a firm's shares = firm raises a larger amount of funds = used to buy production facilities and equipment Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Why study financial institutions and banking? Financial intermediaries - Institutions that borrow funds from people who have saved and in turn make loans to people who needs funds Banks - Financial institutions that accept deposits and make loans ○ Other financial institutions: insurance companies, finance companies, pension funds, mutual funds, and investment companies Financial innovation - The development of new financial products and services ○ The improvement of information technology leads to the ability to deliver financial services electronically (e-finance) Financial crises - Major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms ○ E.g., August 2007 -> U.S. Economy -> Great Depression Why study money and monetary policy? Money - Anything that is generally accepted as payment for goods or services or is the repayment of debts. Money is linked to changes in the economic variables that affect all of us and are important to the health of the economy. Money and business cycles: Aggregate output - Total production of goods and services Business cycles - Upward & downward movement of aggregate output produced in the economy ○ Rising output: Easier to find a good job ○ Falling output: Finding a good job might be difficult Recessions - Periods of declining aggregate output Monetary theory - The theory that relates the quantity of money and monetary policy to changes in aggregate economic activity and inflation The price level and money supply generally rise together Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Money and inflation: Aggregate price level - The average price of goods and services in an economy Inflation - A continual increase in the price level ○ A continual rise in the price level (inflation) affects all economic players Inflation rate - The rate of change of the price level (usually measured as a % change per year) ○ Countries with the highest inflation rate are also ones with the highest money growth rates Money and interest Rates: Interest rates are the opportunity cost (price) of money The rate of money growth is still an important determinant of interest rates Fiscal policy and monetary policy: Monetary policy - The management of the money supply and interest rates ○ Federal reserve system (US) and South African Reserve Bank Fiscal Policy - Decisions about government spending and taxation ○ Budget deficit: Excess of expenditures over revenues for a particular year ○ Budget Surplus: Excess of revenues over expenditures for a particular year ○ Any deficit must be financed by borrowing The foreign exchange market: Foreign exchange market - Where funds are converted from one currency into another Foreign exchange rate - The price of one currency in terms of another currency ○ A change in this has a direct effect on a countries consumer because it affects the cost of imports The foreign exchange market determines the foreign exchange rate Practical application: a strong Rand means that SA goods exported abroad will cost more in foreign countries; therefore, foreigners will buy fewer of them Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Chapter 2: An overview of the Financial System Function of financial markets: Performs the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds Direct finance - Borrowers borrow funds directly from lenders in financial markets by selling the lender’s securities that are claims on the borrower’s future income or assets Securities are an asset for those who buy and a liability for those who sell Bond - A debt security that promises to make periodic payments for a specific time period Stock - A security that entitles the owner to a share of the company’s profits and assets ○ Allow funds to more from people who lack productive investment opportunities to people who has such opportunities ○ Critical for producing efficient allocation of capital = contributes to higher production and efficiency for the overall economy Structure of financial markets: Debt and equity markets: Debt instrument - Contractual agreement by the borrower to pay the holder of the instrument fixed Dollar amounts a regular interval until the maturity date when a final payment is made ○ Short-term if its maturity term is less than a year and ○ Long-term if its maturity term is ten years or longer Equities - Claims to share in the net income and assets of a business (incl. Common stocks) ○ Dividends - Periodic payments to shareholders and are considered LT securities because they have no maturity date ○ Disadvantage is a residual claimant - The corporation must pay all its debt holders before it pays its equity holders Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Primary and Secondary Markets: Primary Markets - A financial market in which new issues of security (bond or a stock) are sold to initial buyers by the corporation or government agency borrowing the funds ○ Not well known to the public because the selling of securities to initial buyers often occurs behind closed doors ○ The initial sale of securities in the primary market is the investment bank that is done by underwriting securities wherein it guarantees a price for a corporation's securities and then sell them to the public ○ A corporation only acquires new funds when the securities are sold on the primary market Secondary Markets - A financial market in which securities that have been previously issued can be resold ○ These markets make it easier and quicker to sell these financial instruments to raise cash (more liquidity) ○ Increased liquidity makes an instrument more desirable, making it easier for the issuing firm to sell securities on the primary market. ○ They determine the price of the security that the issuing firm sells in the primary market Brokers - Agents of investors who match buyers with sellers of securities Dealers - Link buyers and sellers by buying and selling securities at stated prices ○ Both are essential to the well-functioning of secondary market Exchanges and over-the-counter markets: Secondary markets are organized in two ways: 1. Exchanges - Buyers and sellers of securities meet in one central location to conduct trades. 2. Over-the-counter (OTC) Market - Dealers at different locations who have an inventory of securities stand ready to buy and sell securities to anyone who comes to them and is willing to accept their prices OTC dealers are in contact via computers and know the prices set by one another, which makes the OTC market very competitive and not very different from a market with an organized exchange Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Money and capital markets: Money market - Financial market in which only ST debt instruments are traded ○ Least risky investment Capital market - Market in which LT debt instruments and equity instruments are traded ○ Have a far wider price fluctuation than money market instruments and are risky investments Money market instruments: Treasury bills - ST debt Instruments of the U.S. government are issues in 1-, 3-, and 6-month maturities to finance the federal government ○ Pay a set amount of maturity and no interest payments ○ The most liquid money market instruments because they are the most actively traded ○ Also, safest because there is a low probability of default (issuer is unable to make interest payments or pay off amount owed when the instrument matures) Negotiable bank certificate of deposits - Debt instrument sold by a bank to depositors that pay annual interest of a given amount and at maturity pays back the original purchase price Commercial papers - ST debt instrument issued by large banks and well-known corporations Repurchase agreement - ST loans for which the Treasury bills serve as collateral (an asset that the lender will receive if the borrower defaults) Federal Funds - overnight loans between banks of their deposits at the federal reserve Capital market instruments: Stocks - Equity claims on the net income and assets of a corporation Mortgages - Loans to households or firms to purchase land, housing, or other real structures, in which the structure or land itself serves as collateral for the loans ○ Mortgages-backed securities: Bond-like debt instruments backed by a bundle of individual mortgages, whose interest and principal payments are collectively paid to the holders of the security Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Corporate bond - Send the holders an interest payment twice a year and pays off the face value when the bond matures U.S. Gov securities - LT debt instruments issued by the U.S. ○ Most liquid security traded in the capital market ○ State and local bonds - LT Debt instruments issued by state and local governments to finance expenditures on schools, roads, act. Internationalization of Financial Markets: Foreign bonds - Sold in a foreign country and denominated in that country’s currency Eurobond - Bond denominated in a currency other than that of the country in which it is sold Eurocurrencies - Foreign currencies deposited in banks outside the home country ○ Eurodollars - U.S. dollars deposited in foreign branches of U.S. banks World Stock Markets - Help finance corporations in the US and the U.S. federal government Function of Financial Intermediaries: Indirect Finance It is called indirect finance because it involves a financial intermediary that stands between the lender-savers and the borrower-spenders and helps transfers funds from one to the other ○ It does this by borrowing funds from lender-savers and then using these funds to make loans to borrower-spenders Financial intermediaries can lower transaction costs because they have developed expertise and their large size allows them to take advantage of economies of scale ○ Reduction in transaction costs per $ of transactions as the size of transaction increases Can provide customers with liquidity services because of low transaction costs ○ Services that make it easier for customers to conduct transactions Low transaction costs can help reduce exposure of investors to risk (uncertainty about the returns investors will earn on assets) ○ Risk sharing (asset transformation) - create and sell assets with risk characteristics that people are comfortable with, the intermediaries then use the funds by selling these assets to purchase other assets that may have far more risk Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 ○ Diversification - Investing in a portfolio of assets whose returns do not always move together, with the result that overall risk is lower than for individual assets Asymmetric information - one party does not know enough about the other party to make accurate decisions Asymmetric information can lead to the widespread collapse of financial intermediaries (financial panic) Asymmetric information creates problems such as: ○ Adverse selection (before transaction) - potential borrowers who are bad credit risks are ones most likely to seek out a loan and most likely to be selected ○ Moral hazard (after transaction) - one party engages in risky behavior of fails to act in good faith because they know the other party bears the economic consequences of their behavior ○ Economies of scope - Lowering costs of information production for each service by applying one information resource to many different services. ○ This can lead to a conflict of interest - A type of moral hazard problem that arises when a person or intuition has multiple objectives, some of which conflict with each other Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Types of financial intermediaries: Type of intermediary Primary liabilities Primary Assets (Source of funds) (Use of funds) Depository institutions (Banks) Commercial Banks Deposits Business and consumer loans, U.S. Gov. securities, multiple bonds, mortgages Saving and loan associations Deposits Mortgages Mutual savings banks Deposits Mortgages Credit unions Deposits Consumer Loans Contractual savings institutions Life insurance Companies Premiums from Corporate bonds and Mortgages policies Fire and Casualty insurance Premiums from Municipal bonds, corporate bonds companies policies and stock, U.S. Gov securities Pension funds, Gov retirement Employer and Corporate bonds and stock fund employee contributions Investment intermediaries Finance companies Commercial paper, Consumer and business loans stocks, bonds Mutual funds shares Stocks, bonds Money market mutual funds Shares Money market instruments Hedge funds Partnership Stocks, bonds, loans, foreign participation currencies, and many other assets Depository institutions - Financial intermediaries that accept deposits and make loans Commercial banks - Financial intermediaries that raise funds primarily by issuing checkable despotism, saving deposits, and time deposits Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Savings and loan associations and mutual savings banks -They obtain funds primarily through savings deposits and time checkable deposits Credit unions - Small cooperative lending institutions organized around a particular group (union members, employees or a firm, act.) Contractual saving institutions - Financial intermediaries that acquire funds at periodic intervals on a contractual basis; that invest their funds primarily in LT securities such as corporate bonds, stocks, and mortgages Life insurance companies - Insure people against financial hazards following death and sell annuities Fire and casualty insurance companies - Insures their policyholders against loss from theft, fire, and accidents Private pension funds and state and local retirement funds - Provides retirement income in the form of annuities to employees who are covered by a pension plan Investment intermediaries Finance companies - Raise funds by selling commercial paper and by issuing stocks and bonds and then lend these funds to consumers, who use them to purchase such items as furniture, automobiles, and home improvements, and to small businesses Mutual funds - Acquire funds by selling shares to many individuals and then suing the proceeds to purchase diversified portfolios of stocks and bonds Money market mutual funds - They function to some extent as depository institutions because they offer deposit-type accounts; where shareholders can write checks against the value of their shareholdings Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Regulation of the financial system: Increase information available to investors Reduce adverse selection and moral hazard problems Reduce insider trading ○ United states securities and Exchange commission (SEC) ○ South Africa financial sector conduct authority (FSCA) - a statutory body that supervises market conduct in relation to the provision of financial products and financial services Ensure the soundness of financial intermediaries: Restrictions on entry - regulations governing who is allowed to set up a financial intermediary Disclosure - reporting requirements for financial intermediaries are strict Restrictions on assets and activities - restricted in what they are allowed to do and what assets they can hold Deposit insurance - avoid bank runs Limits on competition - branching and restrictions of interest rates Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Chapter 12: Crisis in advanced economies A well-functioning system solves asymmetric information problems so that capital is allocated to its most productive uses Asymmetric problems lead to financial frictions ○ When financial frictions increase; financial markets biome less capable of channeling funds efficiently from savers to households and firms with productive investment opportunities which leads to a decrease in economic activity 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 and economic activity collapses Dynamics of a financial crisis: Stage 1: Initiation of a financial crisis Credit boom or bust: Financial innovation (Economy introduces new types of loans or other financial products) and financial liberalization (Elimination of restrictions on financial markets and institutions) In the LR Financial liberalization promotes financial development and encourages a well-run financial system that allocates capital efficiently BUT In the SR it can prompt financial institutions to go on a lending spree (credit boom) ○ Lenders do not have the expertise to manage risk appropriately which leads to overly risky lending ○ Gov. safety nets decrease market discipline and increase moral hazard incentive for banks to take a greater risk that they would normally ○ Eventually losses on loans begin to mount, the value of the loans falls relative to the liabilities, driving down the net worth (capital) ○ With less capital, the institutions cut back on lending to borrower-spenders (deleveraging) ○ Banks and other financial institutions become riskier, causing lender-savers and other to pull out their funds Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 ○ Fewer funds mean fewer loans to fund productive investments and a credit freeze (Lending boom turns into a lending crash) Asset-price boom and bust: Rise of an asset prices above their fundamental economic values is an asset-price bubble ○ Often driven by credit booms because a large increase in credit is used to fund purchases of assets, driving up their price When the bubble bursts (asset prices realign with fundamental economic values), stock and real estate prices decrease sharply, companies’ net worth decline, and the value of collateral these companies can pledge drops These companies now have less stake, so they are more likely to make risky investments because they have less to lose, the problem of moral hazard As a result, financial institutions tighten lending standards for these borrower-spenders and lending contracts. Asset-price bust leads to a decrease in value of financial institutions’ assets because causing a decrease in an institutions’ net worth and therefore deterioration in balance sheets (deleverage) Increase in uncertainty: Financial crises usually begin in periods of high uncertainty ○ Start of a recession, a crash in the stock market, failure of a financial institution Stage 2: Banking crisis Deteriorating balance sheet and tougher business conditions lead some financial institutions into insolvency (net worth is negative) which means they are unable to pay of debtors or other creditors, some banks of out of business ○ If severe enough, these factors can lead to bank panic in which multiple banks fail simultaneously caused by asymmetric information Savers withdraw their deposits (bank runs) and banks will sell off assets to raise necessary funds Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 ○ Banks have fire sales of assets that cause their prices to decline so much that more banks become insolvent and can lead to multiple bank failures and full-fledged bank panic With fewer banks operating, information about creditworthiness of borrower-spenders disappears which increases severe adverse selection and moral hazard These problems cause financial markets to deepen into a financial crisis, causing declines in asset prices and failure of firms throughout the economy that lack funds for productive investment opportunities Eventually, public, and private authorities shut down insolvent firms and sell them off or liquidate them ○ Uncertainty in financial markets declines, the stock market recovers, and balance sheets improve ○ Financial frictions diminish and the financial crisis subsides and therefore is ready for economic recovery Stage 3: Debt deflation Debt deflation occurs when 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 Economies with a moderate inflation (advanced) and debt contracts that have a fixed interest rate: ○ As debt payments are fixed in nominal terms, an unanticipated decline in price level will raise the value of borrowing firms’ and households’ liabilities in real terms (increases the burden of debt) but does not raise the real value of their assets ○ Therefore, the borrowers net worth in real terms (assets - liabilities) declines A substantial decline in the real net worth of borrowers caused by a short drop in the price level creates an increase in adverse selection and moral hazard problems for lenders Lending and economic activity decline for a long time ○ The great depression: the worst economic contraction in the history of most advanced economies Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Application: The Great Depression: U.S. stock market crash In 1929 a boom in stock market occurs - U.S. Stock prices double Federal Reserve Officials thought the stock market boom was caused by excessive speculation To curb it they tightened monetary policy to raise interest rates to limit the rise in stock prices which then lead to a crash Worldwide decline in asset prices The crash of the U’S stock market quickly affected other countries Arbitrage and panic propagate downward trends in stock prices in other advanced economies The stock market crash although a significant factor was not the only one: ○ Worldwide commodities prices had been decreasing since early 1920s ○ The decline in commodity prices accelerated the aftershock of the market crash Bank failures Sharp drop in stock prices, together with the decline in commodity prices and a collapse of the currency’ external value = huge strain on banks’ balance sheets in most advanced industrial countries This triggered bank panic - massive withdrawals from banks in the US, Italy, Belgium, Germany, Switzerland, and Austria Economic contradiction and debt deflation Decline in asset prices, with bank failures and panics = Fed massive economic contraction, which worsened adverse selection and moral hazard problems in financial markets ○ Worsening the economic downturn World trade decreases tremendously and debt deflation kicked in ○ New lending stopped because of falling prices, which continued falling because of no new lending ○ Mass unemployment Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 The ST consequences ○ Economic dislocation and impoverishment throughout the most advanced industrial countries ○ Economic duress in developing countries Global Financial crisis of 2007 - 2009 Global in two respects: 1. Some of the LT problems of the crisis were related to global economic imbalances 2. Although it originated in the U.S. it quickly spread to other countries financial systems because of non-U.S. banks exposure to U.S. derivatives’ markets (increase in interdependence of financial markets with globalization Causes: Financial innovation in the mortgage markets: Advances in information technology made it easier to securities subprime mortgages, leading to an explosion in subprime mortgage-backed securities The development of structured credit products, that paid out income streams from many underlying assets, designed to have particular risk characteristics that appealed to investors with deferring preferences ○ Most notorious being collateralized debt obligations Agency problems in mortgage markets; Mortgage brokers did not make a strong effort to evaluate whether a borrower could pay off the mortgage = since they planned to quickly distribute the loans to investors in the form of mortgage-backed securities Adverse selection became a major problem as borrowers had little incentive to disclose information about their ability to pay because investors wanted to obtain loans to acquire houses that would be very profitable if housing prices increase because they could simply walk away is housing prices decreased Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 This created incentives for mortgages brokers to encourage households to take on mortgages they could afford or commit fraud by falsifying information on borrowers’ mortgages applications to qualify them for applications Asymmetric information and credit-rating agencies Credit-rating agencies - Rate the quality of debt securities in terms of the probability of default, were another contributor to asymmetric information in financial markets They were subject to conflict of interest as they advised clients on how to structure complex financial instruments (like CDOs) while rating the identical products. They were subject to conflict of interest because the large fees they earned from advising clients on how to structure products that they were rating themselves ○ They did not have sufficient incentives to make sure the ratings were accurate The result was wildly inflated ratings that enabled the sale of complex financial products that were far riskier than investors recognized Effects of 2007-2009 Financial crisis: Residential housing prices: Boom and Bust In the U.S. the subprime mortgages market took off after the recession ended in 2001 High housing prices and easy mortgages = Subprime borrowers could refinance their houses with even larger loans when their homes appreciated in value. Subprime borrowers were also unlikely to default because they could always sell their house to pay off the loan The growth in subprime mortgage market increased demand for houses and so fueled the boom in housing prices, resulting is a housing-price bubble Eventually the housing price bubble burst and housing prices fell, the weakness of the finial system was revealed ○ Decrease in housing prices led many subprime borrowers to find the value of their house below the value of the mortgage ○ Many had to walk away from their homes and send the keys back to the lender because defaults on mortgages shot up sharply, eventually leading to foreclosures in millions of mortgages Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Deterioration of financial institutions’ balance sheets The decline in housing prices contributed to a rise in defaults on mortgages As a result, the values of mortgages backed securities and CDOs collapsed, leaving banks and other financial institutions holding those securities with a lower value of assets with a lower net worth. With a weakened balance sheets = banks and financial institutions began to deleverage, selling off assets and restricting the availability of credit to both households and businesses The reduction in bank lending meant that financial frictions increased in financial markets This development in turn caused a run on the shadow banking system. Run on the shadow banking system: Decline in the values of mortgages and other financial assets triggered a run on the shadow banking Funds from shadow banks flowed through the financial system and supported the issuance of low-interest-rate mortgages and auto loans Securities were funded primarily by repurchase agreements (repos), that useless assets like mortgage-backed securities as collateral ○ Rising concern about the financial institutions balance sheet led lenders to require larger amounts of collateral, known as haircuts Rising defaults caused values of mortgage-backed securities to fall, which led to a rise in haircuts ○ Financial institutions could borrow only half as much with the same amount of collateral. Therefore, to raise funds financial institutions had to engage in fire sales and sell off their assets quickly ○ This required lowering their price, which led to a further decline in financial institutions asset values. ○ The decline lowered the value of collateral further, raising haircuts and forcing financial institutions to scramble for liquidity Result - Massive deleveraging with restricted lending This meant that both consumption expenditure and investment fell, causing the economy to contract Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Global financial markets Problem originated in US but spread to Europe French investment house (BNP Paribas) suspended redemption of shares held in some of its MMF which has sustained hard losses = run on shadow banking system began Particularly hard-hit nations: Greece, Ireland, Portugal, and Spain Failure of high-Profile firms Impact of financial crisis of firms’ balance sheets forced major players in financial markets to take drastic action Financial crisis generated multiple failures of non-US financial institutions as well as man high profile US firms Government Intervention and Recovery Short-term responses and recovery: For most governments the immediate ST response to the global recession was to draw up emergency plans to avoid deflationary spirals (stop lower prices from causing ever- decreasing demand and output) Financial Bailouts: In order to save their financial sectors and to avoid contagion, financial support was provided by many governments to bail out banks and other financial institutions, and even firms that were deemed “too-big-to-fail” were severely affected by the financial crisis. Fiscal stimulus spending: Too boost their individual economies, most governments used fiscal stimulus packages that combined government expenditure and tax cuts While fiscal stimulus deferred from one country to the other, most nations tried to adhere to a benchmark GDP, which was mainly financed by deficit spending (public debt borrowing from central banks and international institutions) ○ Success varied from country to country Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Long-Term Responses: Global Financial Regulatory framework Construction of global financial framework that is resilient to shocks requires: ○ Reducing hazardous effect of financial instruments ○ Reigning in of financial institutions’ riskiness = combination of national and global strategies Policy Areas at the National Level: 1. Implement sound monetary policy 2. Fiscal policy must reduce fiscal debt levels so that additional debt can be taken on in times of stress and must build up fiscal buffers in periods of economic health to be used in times of financial distress instead of using taxpayers’ money or unsettling financial markets 3. Strengthen financial infrastructure which will promote financial market growth, facilitate the smooth flow of funds, enable savers and investors to select from a larger array of different risk and return investment opportunities, reduce transaction costs, enhance information and knowledge, and hence assist with increasing capital information. a. Strengthen the legal framework - in terms of effective conflict resolution mechanisms and bankruptcy codes to lubricate the flow of funds that would have been otherwise trapped awaiting legal arbitration b. Strong customer-deposit insurance schemes, liquidity arrangements, and safety net facilities would help increase trust in the entire financial sector (trust that cannot be established in the absence of a reliable information infrastructure c. Include provisions for modern trading platforms, state-of-art communication, technology networks and reliable clearing houses will enable swift settlement of funds 4. Consumer protection in order to enable consumers to unfold the complexity of financial instruments and prevent bankers from luring customers into buying financial instruments without adequately explaining the extent of the risk they Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 may face or high fees they may be charged Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 5. Enactment of microprudential and macroprudential policies. a. Microprudential policy aims to reduce risk exposure of individual financial institutions b. Macroprudential policy aims to reduce systemic risk expose of the entire financial sector c. Prior to the global crisis, globally designed regulations were confined to microprudential supervision, which focuses on the safety and soundness of individual financial institutions with little regard to how individual bank actions affect the entire financial system. d. Concerns of macroprudential regulations: It introduces capital buffers, new liquidity buffers (both insufficient), and the drastic asset sales at artificially depressed levels during the crisis prompted the need to make banks less leveraged. Policy Areas at International level: Proactive and globally binding supervision strategies, financial market discipline, systemic risk must be managed = cooperation is key ○ Regulatory arbitrage will prevent banks and institutions from taking advantage of loopholes in regulatory systems Bilateral and multilateral supervisory cooperation Collective supervisory cooperation Establishment of Financial Stability Board (FSB) by G20 in 2009 ○ Reveal regulatory gaps ○ Harmonize financial regulations among national regulators and international financial institutions ○ Provide policymakers with useful recommendations ○ Gauge the level of adherence of jurisdictions to regulatory standards ○ Monitor their progress on past commitments Collectively coordinated macroeconomic stability plans Mutual Assessment Process (MAP) → 2009 by G20 ○ Each nation shares details of macroeconomic and financial policy plans and coordinates among other members to ensure that policy actions benefit all member states and are mutually consistent with their growth objectives. Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Self-discipline Ethical banking and financial literacy education Systemic Risk Council (SRC) in USA in 2012: societal watchdog that is fully independent of the government and CB ○ Responsible for monitoring macroprudential policy measures related to systemic risk ○ Ensuring that preemptive corrective actions are undertaken by the responsible agencies to protect financial consumers’ stakes. Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Chapter 13: Crisis in emerging economies Stages of financial crisis in emerging economies Stage 1: Initiation phase Path A: Credit Boom and Bust Usually occurs when financial liberalization occurs; as a result, it opens the economy to flows of capital and financial firms from other nations - financial globalization ○ Financial liberalization and globalization are more problematic for less developed financial system as they are more vulnerable to external shocks Lack of expertise and weak supervision leads to a lending boom Credit boom that accompanies financial liberalization in emerging market nations are typically marked by risky lending practices, beginning the event of enormous loan losses later Financial globalization adds fuel to the fire because it allows banks to borrow aboard Banks pay high interest rates to attract foreign capital and so can rapidly increase their lending Capital inflow in further stimulated as the government implements policies that fix the value of domestic currency to the U.S. dollar, which provides foreign investors comfort Significant loan losses emerge from long periods of risky lending, weakening bank balance sheets and prompting banks to cut back on lending Deterioration in financial institutions balance sheets (more severe effect on advanced countries) Banks stop lending, there are rarely other players to solve adverse selection and moral hazard problems Path B: Severe fiscal imbalances Inappropriate spending of government spending can also place the emerging market economies on a path towards financial crisis When governments face large fiscal imbalance and cannot finance their debt, they force domestic banks to buy their debt Investors who lose confidence in the ability of the government to repay debt then unload the bonds, which causes their prices to plummet Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Banks hold this debt then face a big hole on the asset side of their balance sheets, which leads to huge decline in their net worth With less capital, these institutions have fewer resources to lend and lending declines This decline is even worse if the decline in bank capital leads to a bank panic in which many banks fail at the same time Severe fiscal imbalances lead to a weakening of the banking system, which leads to a worsening of adverse selection and moral hazard problems, and reduces lending Additional factors: Rise in interest rates is when high-risk firms are most willing to pay the high interest rates, so adverse selection problem become more severe\ High interest rates, reduce firm's cash flows, forcing them to seek funds in external capital markets in which asymmetric information problems are greater ○ Ei high interest rates = increased adverse selection and moral hazard Asset price declines in the stock market leads to a decrease of the firm's net worth and so increase adverse selection There is less collateral for lenders to seize, which leads to increased moral hazard because owners of the firm have less to lose when they engage in risky activities ○ Ei asset price decline = worsen adverse selection, moral hazard problems, and lending directly and indirectly by causing deterioration in banks’ balance sheets from asset write- downs Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Stage 2: currency crisis When a currency is fixed against another currency (normally the currency of an advanced economy) it may become subject to speculative attack ○ This is where speculators engaged in large -scale sales of the currency As the currency sales flood the market, supply far surpass demand, the value of the currency collapses, and a currency crisis ensues High interest rates abroad, increases the uncertainty, and falling asset prices all play a role Deterioration of bank balance sheets and severe fiscal imbalances, are the two key factors that trigger the speculative attacks and plunge the economy into full-sale, downward spiral or currency crisis, financial crisis and meltdown Deterioration of Bank Balance Sheets Triggers currency crisis When banks and other financial institutions are in trouble, governments have few options Defending their currencies by raising interest rates should encourage capital inflows, but if the government raises interest rates, banks must pay more to obtain funds The increase in costs decreases bank profitability which may lead them to insolvency Thus, when banking system is in trouble, the government and the central bank are now stuck between a rock and a hard place: If they raise interest rates too much, they will destroy their weakened banks and further weaken their economy If they do not, they will not be able to maintain the value of their currency Speculators in the market for foreign currency will recognize the troubles in a countries financial sector and will know when the foreign government’s ability to raise interest rates and defend the currency is likely to become so costly that the government will give up and allow its currency to depreciate They will seize an almost sure-thing bet because they know that the currency can only go downward in value Speculators will then engage in a feeding frenzy and will sell the currency in anticipation of its declines, which will provide them with huge profits These savings rapidly use up the countries reserves of foreign currency because the country will have to sell its reserves to buy the domestic currency and keep it from falling in value Once the country has exhausted its holdings of foreign-currency reserves, the cycle will end Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 The government no longer has the resources to intervene in the foreign exchange market and must let the value of the domestic currency fall - the gov must allow a devaluation Severe fiscal imbalances trigger currency crisis: Severe fiscal imbalances can lead to a deterioration of bank balance sheets and so can indirectly help produce a currency crisis. Fiscal imbalances can also directly trigger a currency crisis ○ When gov budget deficits spin out of control, foreign and domestic investors begin to suspect that the country may not be able to pay back its government debt and so will start pulling money out of the country and selling domestic currency When people recognize the fiscal situation is out of control it results in a speculative attack against the currency, which eventually results in its collapse Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Stage 3: Full-fledged financial crisis Emerging market economies dominate many debt contracts in foreign currency leading to a currency mismatch ○ An unanticipated depreciation or devaluation of the domestic currency in an emerging market country increases the debt burden of domestic firms in terms of the domestic currency The depreciation of the domestic currency increases the value of debt relative to assets, and the firms’ net worth declines. The decline in net worth then increases the adverse selection and moral hazard problems and decreases lending which will be followed by a decline in investment and economic activity. The institutional structure of debt markets in emerging market countries interacts with currency devaluations to propel the economies into full-fledged financial crises. A currency crisis, with its resulting depreciation of the domestic currency, leads to deterioration of firms’ bank balance sheets and sharply increases adverse selection and moral hazard problems. ○ This can also lead to higher inflation The central banks in most emerging market countries, in contrast to those in advanced countries, have little credibility as inflation fighters. ○ Thus, a sharp depreciation of the currency after a currency crisis leads to immediate upward pressure on import prices. A dramatic rise in both actual and expected inflation is likely to follow, which will cause domestic interest rates to increase The resulting increase in interest payments causes reductions in firms cash flows, which leads to increases asymmetric information problems The increase in adverse selection and moral hazard problems then leads to a reduction in investment and economic activity Further deterioration occurs The collapse in economic activity and the deterioration of cash flow and firm and household balance sheets mean that many debtors are no longer able to pay off their debts, resulting in substantial losses for banks Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 The sharp increase in the value of their foreign-foreign-currency-denominated liabilities after the devaluation creates more problems for banks ○ Thus, the bank balance sheets are squeezed from both sides- the value of their assets falls as the value of their liabilities rises Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Application: Crisis in South Korea, 1997-1998 Financial liberalization and globalization mismanaged Government removed many restrictive regulations on financial institutions to liberalize the country's financial markets, and embarked on financial globalization ○ Lead to a lending boom in which bank crit to private nonfinancial business sector accelerated sharply Because of weak bank regulation supervision and a lack of expertise in screening and monitoring borrowers at banking institutions, losses on loans began to mount, causing an erosion of banks’ net worth There was rapid increasing external debt especially ST debt in South Korea in years prior to crisis Perversion of financial liberalization and globalization Process: Chaebols and the South Korea crisis Large family-owned conglomerates (chaebols) dominated the economy ○ They were politically powerful and deemed too big to fail They knew they would receive direct government assistance if they got into trouble, BUT if their bets paid off, they would keep all profits ○ Because of this bank kept lending them money Chaebols encouraged government to open the financial market to foreign capital in order to get the desired funds Because Chaebols were not allowed to on commercial banks it was still uncertain that they would get all the bank loans they needed Merchant banking systems were wholesale financial institutions that engaged in underwriting securities leasing, and ST lending to the corporate sector The chaebols convinced the government to turn financial companies into merchant banks ○ These banks channeled massive amount of funds to chaebols, where it flowed into unproductive investments When loans went sour, the stage was set for disastrous financial crisis Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Stock market decline and failure of firms increase uncertainty Experienced negative shocks to export prices that shock the chaebol already-thin profit margins and the firms that were tied to them Uncertainty caused by such bankruptcies and the deteriorating conditions of financial and nonfinancial balance sheets Adverse selection and moral hazard problems worsen, and the economy contracts Increase in uncertainty and a decrease in net worth resulting from a stock market decline will exacerbate asymmetric information problems (hard to screen out good and bad borrowers) The decline in net worth decreases the value of firms’ collateral and increases their incentives to make risky investments because there is less equity to lose if investments are unsuccessful Increase in uncertainty and stock market decline before South Korea crisis, along with the deterioration in banks’ balance sheets, worsened adverse selection and moral hazard problems ○ Lending declined and economy weakened - got South Korea ready for the next stage - full-fledged financial crisis and a depression Currency crisis ensues Weakened balance sheets and increased exposure of the economy top sudden stops in capital inflows caused by large amount of ST external borrowing - speculative attack on South Korea’s currency was inevitable South Korean central bank could no longer defend the currency by raising interest rates because this action would sink (the already weekend) banks Speculators pulled out of the South Korean currency, leading to a speculative attack Final stage: Currency Crisis Triggers Full-Fledged Financial crisis 50% decrease in value of the won increases the value of foreign debt by 50% Increased adverse selection & moral hazard Deterioration of banks' balance sheets GDP declines by 6% - caused a sharp increase in unemployment Inflation increases spurred by increases in import prices and weakened the credibility of the bank of South Korea as an inflation fighter The bank pursued tight monetary policy in line with recommendations from the international Monetary Fund Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 High interest rates = drop in cash flow ○ Firms now had to obtain external funds and increased adverse selection and moral hazard problems in credit markets Increase in asymmetric information problems in the credit markets, along with the direct effect of higher interest rates on investment decisions ○ This led to further contraction of investment spending, providing another reason the falling economic activity Recovery Commences Government responded aggressively to the crisis by implementing a series of financial reforms that helps restore confidence in the financial system Markets began to recover which stimulated lending - economy began to recover Global: China and the “Noncrisis” in 1997–1998 China was not affected by the 1997-98 crisis in East Asia. Why? Two key factors: ○ Slower, more restricted financial liberalization in China ○ No currency instability Renminbi pegged to the dollar and not convertible for capital account transactions Impact of the crisis on China's subsequent economic policies ○ Vindicated the policy of “controlled liberalization” ○ Encouraged the country to accumulate foreign exchange reserves Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Application: Argentine Crisis, 2001 - 2002 Severe fiscal imbalances No lending boom, banks had sounder balance sheets Provinces spent beyond their means and then call on the federal government to assume responsibility for tier debt = Gov Budget is in a DEFICIT A recession worsened the situation and led to declining tax revenues and a widening gap between Gov expenditures and taxes Growing fiscal imbalances led the government to ask banks to buy public debt Bank balance sheets deteriorate, while investors (foreign and domestic) do not regain trust in Argentina's ability to repay debt Adverse selection and moral hazard problems worsen Deterioration of bank balance sheets and the loss of deposits led the banks to cut back on their lending ○ Adverse selection and moral hazard worsened and lending declined Weakening of the economy and deterioration of bank balance sheets set the stage to a bank panic Bank panic begins Negotiations between central gov and provinces on the fiscal situation broke down = tax revenues continued falling and the economy suffered Default on gov bonds was inevitable ○ Resulted in a full-fledged bank panic Gov was forced to close banks temporarily and impose a restriction called corralito, under which depositors could withdraw only $250 in cash per week ○ This was devastating for the poor, who were highly dependent on the cash to conduct their daily transactions Currency crisis ensues Bank panic signaled that the Gov could no longer allow interest rates to remain high in order to prop up the value of the Peso and preserve the currency board ○ This was the arrangement in which the Argentine government fixed the value of one Peso to the U.S. dollar by agreeing to buy and sell pesos at the exchange rate Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Raising interest rates to preserve the currency board was no longer an option because it would have meant destroying the already weakened banks The public realized the peso would decline in value, so a speculative attack and people sold pesos for dollars. In addition, the government's dire fiscal position made it unable to pay back its debt, providing yet another reason for the investors to pull money out of the country, leaving further peso sales The government announces the suspension of external debt repayments And then government announces the end of the currency board Currency crisis triggers full-fledged financial crisis Free fall of the peso, and then stabilizing With the peso falling in value, all dollar-denominated debt tripled in peso terms ○ If they had to pay back their dollar debt, almost all firms would become insolvent Financial markets could to function because net worth would not be available to mitigate adverse selection and moral hazard problems There was terrible state of bank balance sheets and the run on the banks led to huge deposit outflows Lacking the resources to make new loan moral hazard and adverse selection worsened Foreigners were unable to lend and were pulling their money out of the country Financial flows halted which resulted in curtailment of lending = further economic contraction Sharp slowdown in the underground economy (large in Argentina and runs mostly on cash) The Argentine currency crashed after the successful speculative attack on the currency raised import prices, which then led to increase in inflation through higher import prices (like in South Korea), which was compounded by historically poor inflation performance in the country Higher interest payments led to a decline in the cash flow of both households and business, which now had to seek external funds to finance their investments Given the uncertainty, asymmetric information problems were particularly severe, and this meant that investment could not be funded Spending decreased further and the economy plummeted Recovery begins The financial crisis recedes, a boom in the demand for Argentina commodity exports encouraged the beginnings of the recovery Unemployment and inflation fell Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 When an Advanced Economy Is Like an Emerging Market Economy: The Icelandic Financial Crisis of 2008 The financial crisis and economic contraction in Iceland that started in 2008 followed the script o financial crisis in an emerging market economy, even though Iceland is a wealthy nation. Financial liberalization led to rising stock market values and currency mismatch. Foreign capital fled the country as a severe recession developed. Preventing emerging market financial crisis Beef up prudential regulation and supervision of banks To prevent crisis, governments must improve prudential regulation and supervision of banks to limit their risk taking ○ Banking sector sits at the root of financial crisis in emerging economies Regulators should ensure that banks hold ample capital to cushion losses from economic shocks and to give bank owners, who have more to lose, an incentive to pursue safer investments Prudential supervision can also help promote safer and sounder banking system be ensuring that banks have [proper risk management procedures in place including 1. Good risk management and monitoring systems 2. Policies to limit activities that present significant risks 3. Internal controls to prevent fraud or unauthorized activities by employees Regulation should ban commercial businesses from owning banks (chaebols) because they are likely to channel lending to themselves Prudential supervisors need adequate resources which can be a problem in emerging market countries Need more independent regulatory and supervisory agency to withstand political influence Encourage disclosure and market-based discipline The public sector will always struggle to control risk taking by financial institutions ○ They have incentives to hide information form bank supervisors in order to avoid restriction on their activities and can become adept and crafty at masking risk Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Supervisors may be corrupt or give into political pressure To eliminate these problems financial markets, need to discipline financial institutions from taking on too much risk Government regulations to promote disclosure by banking and other financial institutions of their balance sheet positions, therefore, are needed to encourage these institutions to hold more capital, because depositors and creditors will be unwilling to put their money into an institution that is thinly capitalized Regulations to promote disclosure of banks’ activities will also encourage depositors and creditors to pull their money out of institutions that are engaged in risky activities Limit currency mismatch A collapse in domestic currency causes debt denominated in foreign currencies to become particularly burdensome because it must be paid back in the more expensive currency ○ Therefore, causing a deteriorating in firms’ balance sheets Governments can limit this by implementing regulations or taxes that discourage the issuance by nonfinancial firms of debt denominated in foreign currencies Regulation of banks can limit bank borrowing in foreign currencies Moving to a flexible exchange rate regime can help discourage borrowing in foreign currencies because there is now more risk associated with doing so Monetary policy that promotes price stability also helps by making the domestic currency less subject to decreases in its value as a result of high inflation, thus making it more desirable for firms to borrow in domestic currency Sequence Financial Liberalization If not managed properly in emerging market economies it can be disastrous To avoid financial crises, policy makers need to put in place the proper institutional infrastructure before liberalizing their financial systems Crucial to avoiding financial crises is the implementation of the policies, which involve strong prudential regulation and supervision and limits on currency mismatch Because implementing these policies takes time, financial liberalization may have to be phased in, with some restrictions on credit issuance imposed along the way Downloaded by Mila Mohlathe ([email protected])  lOMoARcPSD|27073014 Downloaded by Mila Mohlathe ([email protected])