Financial Crises in Advanced Economies PDF

12 Financial Crises in Advanced Economies Learning Objectives 12.1 Define the term Preview F financial crisis. inancial crises are major disruptions in financial mar...

12 Financial Crises in Advanced Economies Learning Objectives 12.1 Define the term Preview F financial crisis. inancial crises are major disruptions in financial markets characterized by sharp 12.2 Identify the key declines in asset prices and firm failures. In the United States, beginning in August features of the three 2007, defaults in the subprime mortgage market (by borrowers with weak credit stages of a financial records) sent a shudder through the financial markets, leading to the worst financial crisis crisis. since the Great Depression. In congressional testimony, Alan Greenspan, former chairman 12.3 Describe of the Fed, described the financial crisis as a “once-in-a-century credit tsunami.” Wall Street the causes and firms and commercial banks suffered hundreds of billions of dollars of losses. Households consequences of the and businesses found they had to pay higher rates on their borrowings—and it was much global financial crisis of harder to get credit. All over the world, stock markets crashed, with the U.S market falling 2007–2009. by over 50% from its peak. Many financial firms, including commercial banks, investment banks, and insurance companies, went belly up. A recession began in December 2007, and 12.4 Summarize the by the fall of 2008, the economy was in a tailspin. The recession, which ended in June short-term plans that 2009, was the most severe since World War II and is now known as the “Great Recession.” were put in place in In Europe, in the wake of the 2007–08 global financial crisis, the Eurozone (the response to the global area regrouping all European countries using the euro as their national currency) went financial crisis of through a severe crisis between late 2009 and 2012, known as the Eurozone debt crisis 2007–2009. (see the Global box). The crisis arose as bank bailouts and economic recession led to 12.5 Summarize the skyrocketing public (or sovereign) debt, with public average Eurozone members’ debt- long-term changes to to-GDP ratios increasing from 68.7% in 2008 to 89.7% in 2012. For peripheral mem- financial regulation that ber countries of the Eurozone, however, the deterioration of public finances went much occurred in response to faster and deeper: in Greece, for instance, the debt-to-GDP ratio went from 109% in the global financial crisis 2008 to 172% in 2011. At the same time, foreign investors started losing faith in of 2007–2009. Greece’s and other countries’ repayment capabilities—interest rates on debt securities 12.6 Identify how gaps issued by these countries increased fast, with large capital outflows from the ailing in financial regulation countries; the overall stability of the Eurozone was threatened, which led European may be addressed governments and European Union institutions to take action through, in particular, with future regulatory austerity packages. While the packages sought to restore healthier fiscal balances they changes. also worsened domestic demand in affected countries. Why did this global financial crisis occur? Why have financial crises been so prevalent throughout, and what insights do they provide on the financial crisis from 2007 to 2009? Why are financial crises almost always followed by severe contractions in economic activity, as occurred during the Great Recession? We will examine these questions in this chapter by developing a framework to understand the dynamics of financial crises. Building on Chapter 8, we make use of agency theory, the economic analysis of the effects of asymmetric information (adverse selection and moral hazard) 315 316 PART ! Financial Institutions Global The European Sovereign Debt Crisis The global financial crisis of 2007–2009 led not only austerity measures aimed at dramatically cutting gov- to a worldwide recession but also to a sovereign debt ernment spending and raising taxes, interest rates on crisis that still threatens to destabilize Europe today. Greek debt soared, eventually rising to nearly 40%, Up until 2007, all of the countries that had adopted and the debt-to-GDP ratio climbed to 160% of GDP the euro found their interest rates converging to very in 2012. Even with bailouts from other European low levels, but with the onset of the global finan- countries and liquidity support from the European cial crisis, several of these countries were hit very Central Bank, Greece was forced to write down the hard by the contraction in economic activity, which value of its debt held in private hands by more than reduced tax revenues at the same time that govern- half, and the country was subject to civil unrest, ment bailouts of failed financial institutions required with massive strikes and the resignation of the prime additional government outlays. The resulting surge minister. in budget deficits then led to fears that the govern- The sovereign debt crisis spread from Greece to ments of these hard-hit countries would default on Ireland, Portugal, Spain, and Italy. The governments their debt. The result was a surge in interest rates that of these countries were forced to embrace auster- threatened to spiral out of control.* ity measures to shore up their public finances while Greece was the first domino to fall in Europe. interest rates climbed to double-digit levels. Only In September 2009, with an economy weakened with a speech in July 2012 by Mario Draghi, the by reduced tax revenues and increased spending president of the European Central Bank, in which demands, the Greek government was projecting a he stated that the ECB was ready to do “whatever budget deficit for the year of 6% and a debt-to-GDP it takes” to save the euro, did the markets begin to ratio near 100%. However, when a new government calm down. Nonetheless, despite a sharp decline in was elected in October, it revealed that the budget interest rates in these countries, they experienced situation was far worse than anyone had imagined, severe recessions, with unemployment rates rising because the previous government had provided to double-digit levels and Spain’s unemployment misleading numbers about both the budget deficit, rate exceeding 25%. The stresses that the European which was at least double the 6% number, and the sovereign debt crisis produced for the eurozone, amount of government debt, which was ten percent- the countries that have adopted the euro, has raised age points higher than previously reported. Despite doubts about whether the euro will survive. *For a discussion of the dynamics of sovereign debt crises and case studies of the European debt crisis, see David Greenlaw, James D. Hamilton, Frederic S. Mishkin, and Peter Hooper, “Crunch Time: Fiscal Crises and the Role of Monetary Policy,” U.S. Monetary Policy Forum (Chicago: Chicago Booth Initiative on Global Markets, 2013). on financial markets, to see why financial crises occur and why they have such devas- tating effects on the economy. We then apply our analysis to explain the course of events that led to a number of past financial crises, including the global financial crisis from 2007 to 2009. "#." WHAT IS A FINANCIAL CRISIS? LO 12.1 Define the term financial crisis. In Chapter 8, we saw that a well-functioning financial system solves asymmetric infor- mation problems (moral hazard and adverse selection) so that capital is allocated to its most productive uses. These asymmetric information problems, which act as a barrier to  CHAPTER "# Financial Crises in Advanced Economies 317 efficient allocation of capital, are often described by economists as financial frictions. When financial frictions increase, financial markets are less capable of channeling funds efficiently from savers to households and firms with productive investment opportuni- ties, with the result that economic activity declines. A financial crisis occurs when information flows in financial markets experience a particularly large disruption, with the result that financial frictions increase sharply and financial markets stop function- ing. Then economic activity collapses. "#.# DYNAMICS OF FINANCIAL CRISES LO 12.2 Identify the key features of the three stages of a financial crisis. As earth-shaking and headline-grabbing as the 2007–2009 financial crisis was, it was only one of a number of financial crises that have hit industrialized countries over the years. These experiences have helped economists uncover insights into present-day economic turmoil. Financial crises in advanced economies have progressed in two and sometimes three stages. To understand how these crises have unfolded, refer to Figure 1, which traces the stages and sequence of events in financial crises in advanced economies. Stage One: Initial Phase Financial crises can begin in two ways: credit boom and bust, or a general increase in uncertainty caused by failures of major financial institutions. Credit Boom and Bust The seeds of a financial crisis are often sown when an economy introduces new types of loans or other financial products, known as financial innovation, or when countries engage in financial liberalization, the elimination of restrictions on financial markets and institutions. In the long run, financial liber- alization promotes financial development and encourages a well-run financial system that allocates capital efficiently. However, financial liberalization has a dark side: In the short run, it can prompt financial institutions to go on a lending spree, called a credit boom. Unfortunately, lenders may not have the expertise, or the incentives, to manage risk appropriately in these new lines of business. Even with proper management, credit booms eventually outstrip the ability of institutions—and government regulators—to screen and monitor credit risks, leading to overly risky lending. As we learned in Chapter 10, government safety nets, such as deposit insurance, weaken market discipline and increase the moral hazard incentive for banks to take on greater risk than they otherwise would. Because lender-savers know that government- guaranteed insurance protects them from losses, they will supply even undisciplined banks with funds. Without proper monitoring, risk taking grows unchecked. Eventually, losses on loans begin to mount, and the value of the loans (on the asset side of the balance sheet) falls relative to liabilities, thereby driving down the net worth (capital) of banks and other financial institutions. With less capital, these vioutre prestiti ; financial institutions cut back on their lending to borrower-spenders, a process called deleveraging. Furthermore, with less capital, banks and other financial institutions become riskier, causing lender-savers and other potential lenders to these institutions to pull out their funds. Fewer funds mean fewer loans to fund productive investments and a credit freeze: The lending boom turns into a lending crash. 318 PART ! Financial Institutions Mini-lecture STAGE ONE Initial Phase Deterioration in Financial Asset-Price Increase in Institutions’ Balance Sheets Decline Uncertainty Adverse Selection and Moral Hazard Problems Worsen and Lending Contracts STAGE TWO Banking Crisis Economic Activity Declines Banking Crisis Adverse Selection and Moral Hazard Problems Worsen and Lending Contracts Economic Activity Declines STAGE THREE Debt Deflation Unanticipated Decline in Price Level Adverse Selection and Moral Hazard Problems Worsen and Lending Contracts Economic Activity Declines Factors Causing Financial Crises Consequences of Changes in Factors FIGURE " Sequence of Events in Financial Crises in Advanced Economies The solid arrows trace the sequence of events during a typical financial crisis; the dotted arrows show the additional set of events that occurs if the crisis develops into a debt deflation. The sections separated by the dashed horizontal lines show the different stages of a financial crisis. When financial institutions stop collecting information and making loans, financial frictions rise, limiting the financial system’s ability to address the asymmetric informa- tion problems of adverse selection and moral hazard (as shown in the arrow pointing from the first factor, “Deterioration in Financial Institutions’ Balance Sheets,” in the top  CHAPTER "# Financial Crises in Advanced Economies 319 row of Figure 1). As loans become scarce, borrower-spenders are no longer able to fund their productive investment opportunities and they decrease their spending, causing economic activity to contract. Asset-Price Boom and Bust Prices of assets such as equity shares and real estate can be driven by investor psychology (dubbed “irrational exuberance” by Alan Greenspan when he was chairman of the Federal Reserve) well above their funda- mental economic values, that is, their values based on realistic expectations of the assets’ future income streams. The rise of asset prices above their fundamental economic values is an asset-price bubble. Examples of asset-price bubbles are the tech stock market bubble of the late 1990s and the housing price bubble from 2002 to 2006 that we will discuss later in this chapter. Asset-price bubbles are often also driven by credit booms, in which the large increase in credit is used to fund purchases of assets, thereby driving up their price. When the bubble bursts and asset prices realign with fundamental economic val- ues, stock and real estate prices tumble, companies see their net worth (the difference between their assets and their liabilities) decline, and the value of collateral these com- panies can pledge drops. Now these companies have less at stake because they have less “skin in the game,” and 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 (as shown by the downward arrow pointing from the second factor, “Asset-Price Decline,” in the top row of Figure 1). The asset-price bust also causes a decline in the value of financial institutions’ assets, thereby causing a decline in the institutions’ net worth and hence a deterioration in their balance sheets (shown by the arrow from the second factor to the first factor in the top row of Figure 1), which causes them to deleverage, steepening the decline in economic activity. Increase in Uncertainty Financial crises have usually begun in periods of high uncertainty, such as just after the start of a recession, a crash in the stock market, or the failure of a major financial institution. In the United States, the crises began after the failure of Ohio Life Insurance and Trust Company in 1857; the Jay Cooke and Company in 1873; Grant and Ward in 1884; the Knickerbocker Trust Company in 1907; the Bank of the United States in 1930; and Bear Stearns, Lehman Brothers, and AIG in 2008. In the case of the Eurozone debt crisis, as seen in the Introduction and the Global box on the European sovereign debt crisis, the crisis started in the aftermath of the 2007–08 global financial crisis—in a context of financial fragility and increased uncertainty on all segments of the financial markets. With information hard to come by in a period of high uncertainty, financial frictions increase, reducing lending and economic activity (as shown by the arrow pointing from the last factor, “Increase in Uncertainty,” in the top row of Figure 1). Stage Two: Banking Crisis Deteriorating balance sheets and tougher business conditions lead some financial institutions into insolvency, which happens when their net worth becomes nega- tive. Unable to pay off depositors or other creditors, some banks go out of business. If severe enough, these factors can lead to a bank panic in which multiple banks fail simultaneously. The source of the contagion is asymmetric information. In a panic, 320 PART ! Financial Institutions depositors, fearing for the safety of their deposits (in the absence of or with limited amounts of deposit insurance) and not knowing the quality of banks’ loan portfolios, withdraw their deposits to the point that the banks fail. Uncertainty about the health of the banking system in general can lead to runs on banks, both good and bad, which forces banks to sell off assets quickly to raise the necessary funds. These fire sales of assets may cause their prices to decline so much that more banks become insolvent and the resulting contagion can then lead to multiple bank failures and a full-fledged bank panic. With fewer banks operating, information about the creditworthiness of bor- rower-spenders disappears. Increasingly severe adverse selection and moral hazard problems in financial markets deepen the financial crisis, causing declines in asset prices and the failure of firms throughout the economy that lack funds for productive investment opportunities. Figure 1 represents this progression in the stage two por- tion. Bank panics are frequent features of any financial crisis. In a 2009 far-reaching survey of financial crises throughout modern history, Carmen M. Reinhart and Ken- neth S.! Rogoff documented the high frequency of banking crises around the world since 1800. Drawing on Reinhart and Rogoff’s research for select countries, Table 1 shows (a) the number of documented banking crises since independence or 1800; (b) the number of banking crises since 1945, and (c) the share of years in a banking crisis since independence or 1800. While the average number of banking crises expe- rienced is high across the world’s main regions, both the number of crises and their cumulated length (shown in the fourth column of Table 1) significantly vary across countries. The most stable banking system in the sample in this Table being Russia, while the United States is the country that experienced the highest number of years in a banking crisis. TABLE " Banking Crises around the World Since 1800 Country Number of Banking Number of Banking Share of Years in a Crises since Independence Crises since 1945 Banking Crisis since or 1800 Independence or 1800 Argentina 9 4 8.8 Brazil 11 3 9.1 Canada 8 1 8.5 China 10 1 9.1 France 15 1 11.5 Germany 8 2 6.2 Japan 8 2 8.1 Russia 2 2 1.0 South Africa 6 2 6.3 United Kingdom 12 4 9.2 United States 13 2 13.0 Source: Adapated from Carmen Reinhart and Kenneth Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, 2009.  CHAPTER "# Financial Crises in Advanced Economies 321 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. With the financial markets able to operate well again, the stage is set for an economic recovery. Stage Three: Debt Deflation If, however, the economic downturn leads to a sharp decline in the price level, the recov- ery process can be short-circuited. In stage three of Figure 1, 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. In economies with moderate inflation, which characterizes most advanced coun- tries, many debt contracts with fixed interest rates are typically of fairly long maturity, ten years or more. Because debt payments are contractually fixed in nominal terms, an unanticipated decline in the price level raises the value of borrowing firms’ and house- holds’ liabilities in real terms (increases the burden of the debt) but does not raise the real value of their assets. The borrowers’ net worth in real terms (the difference between assets and liabilities in real terms) thus declines. To better understand how this decline in net worth occurs, consider what happens if a firm in 2022 has assets of $100 million (in 2022 dollars) and $90 million of long-term liabilities, so that it has $10 million in net worth (the difference between the values of assets and liabilities). If the price level falls by 10% in 2023, the real value of the liabilities would rise to $99 million in 2022 dollars, while the real value of the assets would remain unchanged at $100 million. The result would be that real net worth in 2022 dollars would fall from $10 million to $1 million ($100 million minus $99 million). The substantial decline in the real net worth of borrowers caused by a sharp 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 most significant financial crisis that displayed debt deflation was the Great Depression, the worst eco- nomic contraction in the history of most advanced economies. A P P L I C AT I O N The Mother of All Financial Crises: The Great Depression With our framework for understanding financial crises in place, we are prepared to ana- lyze how a financial crisis unfolded during the Great Depression and how it led to the worst economic downturn in the history of most advanced industrial countries. The U.S. Stock Market Crash In 1928 and 1929, U.S. stock prices doubled. Federal Reserve officials viewed the stock market boom as caused by excessive speculation. To curb it, they pursued a tightening of monetary policy to raise interest rates in an effort to limit the rise in stock prices. The Fed got more than it bargained for when the stock market crashed in October 1929, fall- ing by 40% by the end of 1929, as shown in Figure 2. Worldwide Decline in Asset Prices The crash of the U.S. stock market in October 1929 quickly generated effects in other countries. Arbitrage and panic propagated downward trends in stock prices throughout advanced economies, as shown in Figure 3. 322 PART ! Financial Institutions FIGURE # Stock Prices 100 Industrial Average, September 1929 = 100) During the Great 90 Stock market peak Depression Period 80 Stock prices crashed Stock Prices (Dow-Jones in 1929, falling by 70 40% by the end of Stock market trough in December 1932 60 1929, and then at 10% of September 1929 peak value continued to fall to 50 only 10% of their 40 peak value by 1932. Source: Federal Reserve 30 Bank of St. Louis FRED 20 database: https://fred. stlouisfed.org/series/ 10 M1109BUSM293NNBR. 0 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 Although the stock market crash in the United States was a significant factor that led to this crisis, it was not its sole cause. As Charles Kindleberger put it in an influen- tial work, “the [1929–1931] depression was a worldwide phenomenon in origin and interaction rather than an American recession that [.!.!.] spilled abroad.”1 Worldwide commodity prices had been declining since the early 1920s. According to some accounts, the average U.S. price index for a selection of 30 basic commodities FIGURE ! Stock Price 600 Indexes in a Selected Number 500 of Advanced Economies, 400 Stock Prices 1929–1931 300 Source: Adapted from Kindleberger, 1986, 200 Table 6. 100 0 Jul-29 Oct-29 Jan-30 Apr-30 Jul-30 Oct-30 Jan-31 Apr-31 Jul-31 Oct-31 United States United Kingdom France Germany Canada 1 For further reading on the Great Depression and the global financial crisis, see Charles P. Kindleberger, The World in Depression, 1929–1939, (Berkeley, University of California Press, 1986).  CHAPTER "# Financial Crises in Advanced Economies 323 decreased from a peak of 231 in 1920 to a trough of 74 in 1932. The decline in commod- ity prices accelerated after the 1929 stock market crash. Wheat, for instance, went from $1.37 per bushel in September 1929 to $0.87 a year later—a 37% drop; over the same period, the price of coffee decreased from $0.22 per lb to $0.10 per lb—a 46% decline. Bank Failures The sharp drop in stock prices, together with the decline in commodity prices and—in some cases, such as Germany in the summer of 1931—a collapse of the currency’ exter- nal value, put a huge strain on banks’ balance sheets in most advanced industrial coun- tries. This triggered bank panics, with massive withdrawals from banks in the United States (1930–1933), Italy (1930–1931), Belgium (1931), Germany (1931), Switzerland (1931–1933), and Austria (1929–1930). Some countries, like France, were relatively spared from a full-fledged banking crisis—the country registered only two major bank failures in the early 1930s. Others, by contrast, saw banks failing by the hundreds, or by the thousands, such as in the United States, where 1,860 banks failed between August 1931 and January 1932 alone. As a result, several countries, including the United States and Germany, declared bank holidays. Economic Contraction and Debt Deflation The decline in asset prices, together with bank failures and panics, fed massive eco- nomic contraction, which worsened adverse selection and moral hazard problems in financial markets, further aggravating the economic downturn. World trade dropped: the total value of imports of the 75 largest economies decreased from $2,998 million in January 1929 to $992 million in January 1932. At that point, debt deflation kicked in. As Kindleberger put it, “new lending stopped because of falling prices, and prices kept falling because of no new lending.”2 Mass unemployment appeared in the United States, France, and the United Kingdom; in Germany, 6 million people were unemployed in 1932, which accounted for 25% of the workforce. The short-term consequences of the Great Depression were economic dislocation and impoverishment throughout most advanced industrial countries and economic duress in developing countries as well. The worldwide depression caused great hardship, with millions upon millions of people out of work, and the resulting discontent led to the rise of fascism and World War II. The consequences of the Great Depression financial crisis were disastrous. ◆ ⑨ "#.! THE GLOBAL FINANCIAL CRISIS OF !""#$!""% LO 12.3 Describe the causes and consequences of the global financial crisis of 2007–2009. For many years, most economists thought that financial crises of the type experienced during the Great Depression were a thing of the past for advanced countries. Unfortu- nately, the financial crisis that engulfed the world in 2007–2009 proved them wrong. 2 See Charles P. Kindleberger, The World in Depression, 1929–1939, (Berkeley, University of California Press, 1986). 324 PART ! Financial Institutions Causes of the 2007–2009 Financial Crisis It is important to note that, while originating in the United States’ financial markets, the 2007–2009 was global in nature, in at least two respects. First, beyond the specifi- cally financial causal factors identified below, some of the long-term roots of the crisis were related to global economic imbalances, and in particular the continuous inflows of capital into the U.S. financial markets from the rest of world, especially countries like India and China (see the Inside the Fed box). Second, while the financial troubles did originate in one specific segment of the U.S. financial market (the mortgage credit derivatives market), the crisis reached a systemic level by spreading quickly to other segments of the U.S. financial system and to other countries’ financial system. Non-U.S. banks and financial institutions’ exposure to U.S. derivatives markets, which resulted from the growing interdependence of financial markets associated with globalization, facilitated this contagion. We begin our look at the 2007–2009 financial crisis by examining three central factors: financial innovation in mortgage markets, agency problems in mortgage mar- kets, and the role of asymmetric information in the credit-rating process. Financial Innovation in the Mortgage Markets As we saw in Chapter 11, starting in the early 2000s, advances in information technology made it easier to securitize subprime mortgages, leading to an explosion in subprime mortgage-backed securities. Financial innovation didn’t stop there. Financial engineering, the develop- ment of new, sophisticated financial instruments, led to structured credit products FLSSI that paid out income streams from a collection of underlying assets, designed to have particular risk characteristics that appealed to investors with differing preferences. The most notorious of these products were collateralized debt obligations (CDOs). The!risks associated with financial innovation are not limited to the 2007–09 crisis and the mortgage market, however. For instance, credit default swaps (CDSs) played an important role in the 2009–2012 Eurozone debt crisis as well (both instruments are discussed in the FYI box, “Collateralized Debt Obligations and Credit Default Swaps”). Agency Problems in the Mortgage Markets The mortgage brokers who originated the mortgage loans often did not make a strong effort to evaluate whether a borrower could pay off the mortgage, since they planned to quickly sell (distribute) the loans to investors in the form of mortgage-backed securities. This originate-to-distribute business model was exposed to the principal–agent problem!of the type discussed in Chapter 8, in which the mortgage brokers acted as agents for investors (the principals) but did not have the investors’ best interests at heart. Once the mortgage broker earns his or her fee, why should the broker care if the borrower makes good on the payment? The more volume the broker originates, the more money the broker makes. Not surprisingly, adverse selection became a major problem. Risk-loving real-estate investors lined up to obtain loans to acquire houses that would be very profitable if housing prices went up, knowing they could “walk away” if housing prices went down. The principal–agent problem also created incentives for mortgage brokers to encour- age households to take on mortgages they could not afford or to commit fraud by fal- sifying information on borrowers’ mortgage applications in order to qualify them for mortgages. Compounding this problem was lax regulation of originators, who were not required to disclose information to borrowers that would have helped them assess whether they could afford the loans. The agency problems went even deeper. Commercial and investment banks, which were earning large fees by underwriting mortgage-backed securities and structured  CHAPTER "# Financial Crises in Advanced Economies 325 FYI Collateralized Debt Obligations (CDOs) and Credit Default Swaps The creation of a collateralized debt obligation Although financial engineering carries the potential involves a corporate entity called a special purpose benefit of creating products and services that match vehicle (SPV), which buys a collection of assets such investors’ risk appetites, it also has a dark side. Struc- as corporate bonds and loans, commercial real estate tured products like CDOs, CDO2s, and CDO3s can bonds, and mortgage-backed securities. The SPV get so complicated that it becomes hard to value the then separates the payment streams (cash flows) from cash flows of the underlying assets for a security or these assets into a number of buckets that are referred to determine who actually owns these assets. The to as tranches. The highest-rated tranches, called increased complexity of structured products can actu- super senior tranches, are the ones that are paid off ally reduce the amount of information in financial first and so have the least risk. The super senior CDO markets, thereby worsening asymmetric information is a bond that pays out these cash flows to investors, in the financial system and increasing the severity of and because it has the least risk, it also has the lowest adverse selection and moral hazard problems. interest rate. The next bucket of cash flows, known Credit default swaps (CDSs) are, like CDOs, deriva- as the senior tranche, is paid out next; the senior CDO tive financial instruments that fulfill similar functions has a little more risk and pays a higher interest rate. as CDOs, that is, insuring against certain types of finan- The next tranche of payment streams, the mezzanine cial risk, but are often used, like CDOs (and other tranche of the CDO, is paid out after the super senior derivative instruments as well) in a purely specula- and senior tranches and so it bears more risk and has tive manner. A CDS is a contract through which the an even higher interest rate. The lowest tranche of the seller commits himself/herself to compensate the buyer CDO is the equity tranche; this is the first set of cash (usually a creditor) in the event of a loan default (by a Cioe e flows that are not paid out if the underlying assets go debtor) or another negative credit event (contractually into default and stop making payments. This tranche defined). Like in most swap contracts, the buyer of the come se it has the highest risk and is often not traded. CDS makes regular payments to the seller, in exchange utilit If all of this sounds complicated, it is. Tranches for the seller’s payment in case of default. Like CDOs, buyer il seller also included CDO2s and CDO3s that sliced and again, economic agents who are not directly interested come una diced risk even further, paying out the cash flows in the underlying loan, for investment purposes, can piccola from CDOs to CDO2s and from CDO2s to CDO3s. a purchase CDSs. In this case, we speak of “naked CDSs.” banca Gi fa pag periodici in cambio da di un pagamento parte credit products like CDOs, also had weak incentives to make sure that the ultimate del seller holders of the securities would be paid off. Financial derivatives, financial instru- afunrefer ments whose payoffs are linked to (i.e., derived from) previously issued securities, in carbt also were an important source of excessive risk taking. Large fees from writing credit default swap (see the FYI box), also drove units of insurance companies, like the United States’ AIG, to write hundreds of billions of dollars’ worth of these risky contracts. Given the riskiness associated with such instruments, in December 2011 the European Parliament banned the use of `naked’ CDSs (see the FYI box) on the market for sovereign debt. Asymmetric Information and Credit-Rating Agencies Credit-rating agen- cies, who rate the quality of debt securities in terms of the probability of default, were another contributor to asymmetric information in financial markets. The rating agen- cies advised clients on how to structure complex financial instruments, like CDOs, while at the same time they were rating these identical products. The rating agencies were thus subject to conflicts of interest because the large fees they earned from advis- ing clients on how to structure products that they themselves were rating meant that 326 PART ! Financial Institutions they did not have sufficient incentives to make sure their 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 the 2007–2009 Financial Crisis The 2007–2009 financial crisis affected consumers and businesses alike in many countries. The impact of the crisis was most evident in five key areas: the U.S. residen- tial housing market, financial institutions’ balance sheets, the shadow banking system, debt markets, and the headline-grabbing failures of major firms in the global financial industry. Residential Housing Prices: Boom and Bust In the United States, the sub- prime mortgage market took off after the recession ended in 2001. By 2007, it had become over a trillion-dollar market. The development of the subprime mortgage mar- ket was encouraged by economists and politicians alike because it led to a “democra- tization of credit” and helped raise U.S. homeownership rates to the highest levels in history. This rapid increase in residential housing prices, together with easy mortgages, was experienced in other advanced economies as well, such as the United Kingdom, Ireland, and Spain. In Spain, a real estate boom, sustaining rapid economic growth and a decrease in unemployment during the same years, compounded the 2000s boom in residential housing prices. Figure 4 shows trends in Spanish residential housing prices between 2001 and 2015. Prices had been increasing since the mid-1990s. Residential housing prices peaked in spring of 2008, at an average of "2,101 per square meter; 2500 2000 Housing 1500 market peak 1000 500 0 Mar-01 Nov-01 Jul-02 Mar-03 Nov-03 Jul-04 Mar-05 Nov-05 Jul-06 Mar-07 Nov-07 Jul-08 Mar-09 Nov-09 Jul-10 Mar-11 Nov-11 Jul-12 Mar-13 Nov-13 Jul-14 FIGURE $ Residential Housing Prices in Spain Spanish residential housing prices boomed from the mid-1990s to early 2000s, peaking in 2008. Housing prices began declining rapidly after that, falling by 31% decline in six years subsequently and leading to defaults by subprime mortgage holders. Source: Bank of Spain, Financial Accounts.  CHAPTER "# Financial Crises in Advanced Economies 327 Inside the Fed Was the Fed to Blame for the Housing Price Bubble? Some economists—most prominently, John Taylor of the culprits were the proliferation of new mortgage Stanford University—have argued that the low inter- products that lowered mortgage payments, a relax- est rate policy of the Federal Reserve in the 2003– ation of lending standards that brought more buyers 2006 period caused the housing price bubble.* Taylor into the housing market, and capital inflows from argues that the low federal funds rate led to low mort- countries such as China and India. Bernanke’s speech gage rates that stimulated housing demand and was very controversial, and the debate over whether encouraged the issuance of subprime mortgages, both monetary policy was to blame for the housing price of which led to rising housing prices and a bubble. bubble continues to this day. In a speech given in January 2010, then-Federal Reserve Chairman Ben Bernanke countered this *John Taylor, “Housing and Monetary Policy,” in Federal Reserve Bank of Kan- sas City, Housing, Housing Finance and Monetary Policy (Kansas City: Federal argument.† He concluded that monetary policy was Reserve Bank of Kansas City, 2007), 463–476. not to blame for the housing price bubble. First, he † Ben S. Bernanke, “Monetary Policy and the Housing Bubble,” speech given at the annual meeting of the American Economic Association, Atlanta, Georgia, said, it is not at all clear that the federal funds rate January 3, 2010; http://www.federalreserve.gov/newsevents/speech/ was too low during the 2003–2006 period. Rather, bernanke20100103a.htm. they rapidly declined hereafter, falling below "1,900 per square meter by the summer of 2009, and reaching a trough of "1,455 per square meter in the fall of 2014—a 31% decline in six years. High housing prices meant that subprime borrowers could refi- nance their houses with even larger loans when their homes appreciated in value. With housing prices rising, subprime borrowers were also unlikely to default because they could always sell their house to pay off the loan, making investors happy because the securities backed by cash flows from subprime mortgages had high returns. The growth of the subprime mortgage market, in turn, increased the demand for houses and so fueled the boom in housing prices, resulting in a housing-price bubble. Further stimulus for the inflated housing market came from low interest rates on residential mortgages, particularly in the United States and Europe. In particular, several economists blamed the easy monetary policy pursued by the U.S. Federal Reserve for paving the way for the house price bubble (see “Inside the Fed” box). Increased bor- rowing predicated upon increasing housing prices translated into increasing household indebtedness (see Figure 5). In the latter, total household debt as a percentage of national income almost doubled between 2000 and 2007, reaching a peak of 154.4% in 2007. As housing prices rose and profitability for mortgage originators and lenders grew higher, the underwriting standards for subprime mortgages fell lower and lower. High- risk borrowers were able to obtain mortgages, and the amount of the mortgage relative to the value of the house, the loan-to-value ratio (LTV), rose. Eventually, the housing price bubble burst. With housing prices falling in many countries, the weaknesses of the finan- cial system began to reveal themselves. The decline in housing prices led many subprime borrowers to find that their mortgages were “underwater”—that is, the value of the house was below the amount of the mortgage. When this happened, struggling homeowners had tremendous incentives to walk away from their homes and just send the keys back to the lender. Defaults on mortgages shot up sharply, eventually leading to foreclosures on millions of mortgages. The downfall from the crisis was particularly acute in the United States, where excess housing supply was larger than in other countries, mortgage lending standards had been 328 PART ! Financial Institutions 180.0 160.0 140.0 Percentage Increase 120.0 100.0 80.0 60.0 40.0 20.0 0.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 FIGURE % Total Spanish Household Debt as a Percentage of National Income Total household debt almost doubled between 2000 and 2007, reaching a peak of 154.4% in 2007. Source: Bank of Spain, Financial Accounts. eased more significantly, and households were financially more vulnerable to falling hous- ing prices.3 However, in some countries the housing market crisis was compounded by weakened currencies. For instance, in Ireland a small but significant chunk of mortgage loans were denominated in foreign currencies (especially in Swiss franc, CHF, and yen, ¥). When the Icelandic currency, the krona, devalued from 54.5/CHF to over 103/CHF between December 2007 and October 2008, the value of mortgage debt denominated in for- eign currencies doubled. Overall, the Icelandic residential mortgage debt-to-GDP ratio increased from 75.5% at the end of 2006 to 129% at the end of 2008.4 Deterioration of Financial Institutions’ Balance Sheets The decline in housing prices led to rising defaults on mortgages. As a result, the values of mortgage- backed securities and CDOs collapsed, leaving banks and other financial institutions holding those securities with a lower value of assets and thus a lower net worth. With weakened balance sheets, these banks and other financial institutions began to delever- age, selling off assets and restricting the availability of credit to both households and businesses. With no one else able to step in to collect information and make loans, the reduction in bank lending meant that financial frictions increased in financial markets. Run on the Shadow Banking System The sharp decline in the values of mort- gages and other financial assets triggered a run on the shadow banking system, composed of hedge funds, investment banks, and other nondepository financial firms, which are not as 3 See L. Ellis, The Housing Meltdown: Why Did It Happen in the United States? BIS Working Papers No. 259, Basel: BIS, 36. 4 Kathleen Scanlon, Jens Lunde, and Christine M. E. Whitehead, Responding to the Housing and Financial Crises: Mortgage Lending, Mortgage Products and Government Policies, International Journal of Housing Policy, 11(1), pp.!23–49.  CHAPTER "# Financial Crises in Advanced Economies 329 tightly regulated as banks. Funds from shadow banks flowed through the financial system and for many years supported the issuance of low-interest-rate mortgages and auto loans. These securities were funded primarily by repurchase agreements (repos), short-term borrowing that, in effect, uses assets like mortgage-backed securities as col- lateral. Rising concern about the quality of a financial institution’s balance sheet led lenders to require larger amounts of collateral, known as haircuts. For example, if a borrower took out a $100 million loan in a repo agreement, the borrower might have to post $105 million of mortgage-backed securities as collateral, for a haircut of 5%. Rising defaults on mortgages caused the values of mortgage-backed securities to fall, which then led to a rise in haircuts. At the start of the crisis, haircuts were close to zero, but eventually they rose to nearly 50%.5 The result was that financial institu- tions could borrow only half as much with the same amount of collateral. Thus, to raise funds, financial institutions had to engage in fire sales and sell off their assets very rapidly. Because selling assets quickly requires lowering their price, the fire sales led to a further decline in financial institutions’ asset values. This decline lowered the value of collateral further, raising haircuts and thereby forcing financial institutions to scramble even more for liquidity. The result was similar to the run on the banking system that occurred during the Great Depression, causing massive deleveraging that resulted in a restriction of lending and a decline in economic activity. The decline in asset prices in the stock market and large drops in residential house prices, along with the fire sales resulting from the run on the shadow banking system, weakened both firms’ and households’ balance sheets in many countries. The result- ing decline in lending meant that both consumption expenditure and investment fell, causing the economy to contract.6 Failures of small and large financial institutions were also multiple in European countries: in the United Kingdom, Northern Rock, a medium-size financial institution specialized in mortgage lending and highly levered, succumbed to a bank run in mid-September 2007, the first such event occurring in Great Britain since the early nineteenth century. Soon, larger banks such as HBOS had to be rescued by a massive government bailout. Similarly, Iceland, Ireland, and Spain all suffered systemic banking crises during 2007–2009. Global Financial Markets Although the problem originated in the United States, the wake-up call for the financial crisis came from Europe, a sign of how extensive the globalization of financial markets had become. After Fitch and Standard & Poor’s announced ratings downgrades on mortgage-backed securities and CDOs totaling more than $10 billion, on August 7, 2007, a French investment house, BNP Paribas, sus- pended redemption of shares held in some of its money market funds, which had sus- tained large losses. The run on the shadow banking system began, only to become worse and worse over time. Despite huge injections of liquidity into the financial sys- tem by the European Central Bank and the Federal Reserve, banks began to horde cash and were unwilling to lend to each other. The drying up of credit led to the first major bank failure in the United Kingdom in over 100 years when Northern Rock, which had relied on short-term borrowing in the repo market rather than deposits for its funding, collapsed in September 2007. A string of other European financial institutions then 5 See Gary Gorton and Andrew Metrick, “Securitized Banking and the Run on Repo,” Journal of Financial Economics 104, no. 3 (2012): 425–51. 6 This period was also characterized by a substantial supply shock that occurred when oil and other commod- ity prices rose sharply until the summer of 2008, but then fell precipitously thereafter.!We discuss the aggregate demand and supply analysis of the impact of this supply shock in Chapter 23. 330 PART ! Financial Institutions failed as well. Particularly hard hit were countries like Greece, Ireland, Portugal, and Spain. The resulting crisis in markets for government-issued (sovereign) debt in Europe is described in the Global box, “The European Sovereign Debt Crisis.” Failure of High-Profile Firms The impact of the financial crisis on firms’ balance sheets forced major players in the financial markets to take drastic action. In March 2008, Bear Stearns, the fifth-largest investment bank in the United States, which had invested heavily in subprime-related securities, had a run on its repo funding and was forced to sell itself to J.P. Morgan for less than one-tenth of its worth just a year earlier. To broker the deal, the Federal Reserve had to take over $30 billion of Bear Stearns’s hard-to-value assets. In July, Fannie Mae and Freddie Mac, the two privately owned, government-sponsored enterprises that together insured over $5 trillion of mortgages or mortgage-backed assets, were propped up by the U.S. Treasury and the Federal Reserve after suffering substantial losses from their holdings of subprime securities. In early September 2008, Fannie Mae and Freddy Mac were put into conservatorship (in effect, run by the government). On Monday, September 15, 2008, after suffering losses in the subprime market, Lehman Brothers, the fourth-largest investment bank by asset size with over $600 billion in assets and 25,000 employees, filed for bankruptcy, making it the largest bankruptcy fil- ing in U.S. history. The day before, Merrill Lynch, the third largest investment bank, which had also suffered large losses on its holdings of subprime securities, announced its sale to Bank of America for a price 60% below its value a year earlier. On Tuesday, September!16, AIG, an insurance giant with assets of over $1 trillion, suffered an extreme liquidity crisis when its credit rating was downgraded. It had written over $400 billion of insurance con- tracts (credit default swaps) that had to make payouts on possible losses from subprime mortgage securities. The Federal Reserve then stepped in with an $85!billion loan to keep AIG afloat (with total government loans later increased to $173 billion). Given its global nature, the 2007–09 financial crisis generated multiple failures of non- U.S. financial institutions as well. In Great Britain, in addition to Northern Rock, several other large financial institutions nearly collapsed before the government took action to rescue them: Royal Bank of Scotland (RBS), Lloyds, and HBoS. Several large banking enti- ties, such as Bradford & Bingley, disappeared and foreign financial institutions acquired their remnants. In the Netherlands, ABN AMRO, the country’s second biggest bank, was acquired in December 2007 by a consortium of European banks led by Great Britain’s Royal Bank of Scotland (RBS) with Belgium’s Fortis and Spain’s Santander. Given RBS’ and Fortis’ exposure to ailing U.S. derivative markets, the debt taken up to finance the large acquisition brought RBS and Fortis to the edge of bankruptcy. While the governments of Great Britain and Belgium rescued the banks, RBS and Fortis were forced to withdraw from ABN Amro, which was re-established with the help of the Dutch government. Similarly, large financial institutions went bankrupt in Portugal (BPN, November 2008), Ireland (Anglo Irish Bank, January 2009), Germany, Spain, and Italy. Perhaps the most spectacular failure linked to the 2007–2009 crisis occurred in Iceland, a tiny economy where three of the largest privately-owned commercial banks (Landsbanki, Kaupthing, and Glitnir) failed contemporaneously in October 2008, in the midst of a severe currency crisis. Height of the 2007–2009 Financial Crisis The financial crisis reached its peak in September 2008 after the House of Representa- tives, fearing the wrath of constituents who were angry about the Wall Street bailout, voted down a $700 billion dollar bailout package proposed by the Bush administration.  CHAPTER "# Financial Crises in Advanced Economies 331 The Emergency Economic Stabilization Act was finally passed nearly a week later. The stock market crash accelerated, with the week beginning October 6, 2008, showing the worst weekly decline in U.S. history. Credit spreads went through the roof over the next three weeks, with the spread between Baa corporate bonds (just above investment grade) and U.S. Treasury bonds going to over 5.5 percentage points (550 basis points), as illustrated by Figure 6. The impaired financial markets and surging interest rates faced by borrower- spenders led to sharp declines in consumer spending and investment. Real GDP declined sharply, falling at a - 1.3% annual rate in the third quarter of 2008 and then at a - 5.4% and - 6.4% annual rate in the next two quarters. The unemployment rate shot up, going over the 10% level in late 2009. The recession that started in December 2007 became the worst economic contraction in the United States since World War II and, as a result, is now referred to as the “Great Recession.” In several countries, the 2007–09 crisis had immediate, far-reaching political effects: in Iceland, following the collapse of the three major banks and a currency cri- sis, the government resigned in January 2009. Voters throughout Europe sanctioned incumbent governments; in Great Britain, the Labour government lost the 2010 general elections to the Conservative Party. In a way, the aftermath of the 2007–09 follows a general trend. Three German economists who observed the political consequences of economic and financial crises over a 150-year period characterized this trend—frequent street protests, increased fragmentation, and polarization of politics.7 6% Baa-U.S. Treasury Spread (percent) Credit spread peak 4% 2% 0% 2002 2003 2004 2005 2006 2007 2008 2009 FIGURE & Credit Spreads and the 2007–2009 Financial Crisis Credit spreads (the difference between rates on Baa corporate bonds and U.S. Treasury bonds) rose by more than 4 percentage points (400 basis points) during the crisis. Debate over the bailout package and the stock market crash caused credit spreads to peak in December 2008. Source: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/BAA10Y. 7 For further discussion on the consequences of the crisis, see Manuel Funke, Moritz Schularick, and Christoph Trebesch, Going to Extremes: Politics after Financial Crises, 1870–2014, CEPR Discussion Paper No. 10884, 2015. A summary of their paper is available at https://voxeu.org/article/political-aftermath-financial-crises-going-extremes. 332 PART ! Financial Institutions A P P L I C AT I O N Could the Coronavirus Pandemic Have Led to a Financial Crisis? The coronavirus pandemic in 2020 had the potential to trigger a financial crisis as seri- ous as the 2007–2009 global financial crisis. With the start of the lockdown of the U.S. economy in March 2020, the stock market crashed, falling by more than a third, unem- ployment skyrocketed, and many otherwise healthy firms now faced the prospect of being unable to pay their bills or pay back their loans. The framework we laid out in our discus- sion of Figure 1 can be used to analyze how the coronavirus pandemic provided the seeds for another financial crisis, 12 years after the previous one, and why it didn’t become the next financial crisis. All the factors that potentially lead to a financial crisis, shown in the first row of Figure 1, came into play when the pandemic became severe in March 2020. The lock- down dealt a serious blow to the income of both businesses and households, making it more likely that they would be unable to pay back their loans. A severe deterioration in financial institutions balance sheets thus became a real possibility, which could have led to severe restrictions on lending. The stock market crash resulted in more than a 35% decline in stock prices, and the sharp decline in income of a multitude of busi- nesses produced a sharp drop in the net worth of firms, which would increase both adverse selection and moral hazard. The high degree of uncertainty about the spread of the virus and how long it would disrupt the economy increased the asymmetry of information, making it harder to assess credit risks. The seeds of a financial crisis were then planted, and indeed, credit spreads, such as the Baa-Treasury spread doubled, shooting up from 2 percentage points in Febru- ary to a peak of 4.3 percentage points on March 23, 2020. Although the coronavi- rus pandemic had the potential to trigger a full-fledged financial crisis in the United States, this did not occur. The reason was the massive response by both the U.S. federal government and the Federal Reserve. Both the Federal Reserve and the federal government reacted with unprecedented speed once the World Health Organization (WHO) announced that the spread of the coronavirus could now be classified as a pandemic on March 11, 2020. On March 15, the Federal Reserve not only slashed its policy rate (federal funds rate) to zero but also embarked on large-scale programs to stabilize the financial markets!(see Chapter 16). After earlier legislation to provide money for public health measures, on March 27, the Congress passed the largest rescue package in U.S. history, the CARES (Coronavirus Aid, Relief, and Economic Security) Act. This massive $2 trillion package provided loans and grants to small businesses and large corporations, aid to state governments, increases in unemploy- ment insurance, and direct payments of $1,200 to most taxpayers, with an additional $500 per child. The coronavirus pandemic had the potential to unleash another financial crisis, with disastrous effects on the U.S. economy. However, the combination of Federal Reserve and U.S. government policies helped shore up businesses, and the Baa-Treasury spread began to decline. As of this writing, the impact of the coronavirus pandemic on the U.S. economy is still uncertain, but the likelihood of a financial crisis has decreased substantially. ◆  CHAPTER "# Financial Crises in Advanced Economies 333 "#.$ GOVERNMENT INTERVENTION AND THE RECOVERY LO 12.4 Summarize the short-term plans that were put in place in response to the global financial crisis of 2007–2009. In the wake of the global financial crisis that led to a severe drop in international trade, the rise in unemployment levels and the slump in commodity prices left no country immune from the ripple effects of the credit crunch. Governments of different coun- tries carried out short-term emergency plans to rescue their respective economies and put in place long-term policies to reform their entire financial system. Short-Term Responses and Recovery For most governments, the immediate short-term response to the global recession was to draw up emergency plans to avoid deflationary spirals, that is, to stop lower prices from causing ever-decreasing demand and output. In addition to the expansionary monetary policy, bailout plans were extended, and stimulus packages were provided. 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. Various large banks were rescued in 2008–2009, including the Goldman Sachs Group, Royal Bank of Scotland and Halifax Bank of Scotland, Citi- group, Merrill Lynch (rescued by Bank of America), and Morgan Stanley (by the Bank of Tokyo-Mitsubishi). The total bailout bill was highest in the United States. Many state-owned Sovereign Wealth Funds (SWFs) went bankrupt. An example is the SWF of Dubai that got $10 billion in bailout from the investment firm Dubai World in 2009. Fiscal Stimulus Spending Generally speaking, to boost their individual econ- omies, most governments used fiscal stimulus packages that combined government expenditure and tax cuts. While fiscal stimulus differed from one country to the other, most nations tried to adhere to a benchmark of 2% of GDP, which was mainly financed by deficit spending, that is, public debt and borrowings from central banks and inter- national institutions. The success of these stimuli differed from country to country. At the forefront of the crisis, U.S. stimulus packages of 2008 and 2009 amounted to 3% of its GDP. Gradually the funds were able to jump-start banks, boost domes- tic demand, and create jobs, making the United States of America the first nation to emerge out of the crisis. On an equally positive note, throughout 2008–2010, Australia implemented two successful stimulus packages of AUD $52 billion ($63.5 billion), which boosted con- sumption and lowered unemployment in the country. As one of the hardest hit nations, Japan’s consecutive stimulus packages, total- ing $568 billion, were among the highest during the crisis. However, the fact that these packages were injected in small amounts into many sectors rendered them quite ineffective. European nations showed moderate success. While most rescue plans were under- taken individually, there was limited coordination at the European Union (EU) level. The EU fiscal stimulus plan totaled "200 billion ("170 billion in national plans and "30!billion in the EU-wide plan). Britain’s stimulus efforts, measuring 1.6% of its GDP, mainly con- centrated on reducing sales taxes and pumping liquidity into the hands of the public 334 PART ! Financial Institutions Global Latvia’s Different and Controversial Response: Expansionary Contraction After gaining independence from the USSR in 1991, the IMF and other international organizations, the Latvia’s stabilization policies and fiscal programs population adamantly took a political decision to keep enabled it to join the European Union (EU) in 2004 the currency pegged and adopt a severe austerity pro- and the Eurozone in 2014. Central elements of gram. Latvians voluntarily endured the layoff of 25% Latvia’s economic policies were a low budget deficit of state workers, 40% salary cuts, and huge social and a fixed exchange rate against the Euro. During expenditure reductions. The strong nationalistic this period, while double-digit growth rates attracted stance, which stood in extreme contrast to the mass huge capital inflows, the economy was overheated rebellions of Spain, Greece, and Portugal, prompted with consumer credit, real-estate loans, high wages, international organizations and Nordic donors to and real-estate speculation. As foreign banks held finance Latvia’s needs. After a massive contraction 60% of assets, the Latvian banking sector was highly of over 25%, the country’s GDP started to grow to affected by the global crisis. In 2007, after its col- its near pre-crisis levels. Where some may consider lapse, Parex Bank, the country’s second-largest bank, Latvia a successful model of painful expansionary was nationalized by the government. Latvia needed contraction, others consider it inapplicable to other "7.5!billion, or 37% of its GDP, to recapitalize banks nations as it was a politically motivated decision to and to meet external financing requirements. Defying access the Eurozone. through the banking sector. Germany and France didn’t provide any fiscal stimulus in 2008, but in 2009 enacted tax cuts and introduced fiscal stimuli equivalent to 1.5% and 0.7% of their GDP, respectively. Some other Eastern European nations followed different contractive fiscal policies. The case of Latvia, discussed in the Global box “Latvia’s Dif- ferent and Controversial Response: Expansionary Contraction,” is interesting since the country followed a different path of fiscal austerity, giving rise to a heated debate. "#.% STABILIZING THE GLOBAL FINANCIAL SYSTEM: LONG&TERM RESPONSES LO 12.5 Summarize the long-term changes to financial regulation that occurred in response to the global financial crisis of 2007–2009. The extent of spillover effects from the affected zones to the previously risk-averse financial markets has revealed an interconnectedness and contagiousness between financial markets, which necessitates a globally binding and wide-ranging regulatory framework. Thus, in addition to the individual emergency, national bailout packages extended to rescue national economies and financial sectors, global leaders simultane- ously rushed to build a more stable and robust global financial system. Global Financial Regulatory Framework The construction of a global financial framework that is resilient to shocks requires reducing the hazardous effect of financial instruments and reigning in of financial institutions’ risk-taking activities. This involves a combination of national and global  CHAPTER "# Financial Crises in Advanced Economies 335 strategies. At the national level, countries have to implement sound macroeconomic policies, enhance their financial infrastructure, develop financial education and con- sumer protection rules, and enact macro- and microprudential regulations. At the inter- national level, proactive and globally binding supervision strategies must be designed, financial market discipline must be enforced, and systemic risk must be managed. But to produce a more globally effective outreach and synchronized effect, international cooperation is a must. Policy Areas at the National Level The first of many national-level policy areas is a sound monetary policy. We have discussed how central banks sometimes target price stability through a combination of changes in policy rates and the spread (or corridor) between bank deposits and lending rates. Ever since the crisis, central banks have also supported financial systems, pro- vided exceptional liquidity, and influenced credit spreads by using their balance sheet. However, regulators are requesting monetary authorities to include financial stability in their mandate in addition to price stability. This can be done by building up emergency liquidity and foreign exchange reserve buffers and by paying interest to banks and financial institutions for holding legal reserve requirements, especially at times of finan- cial distress. As we shall see in Chapter 16, monetary policy architects must be able to design appropriate exit strategies from costly quantitative and credit-easing assistance. The second area, fiscal policy, must no longer be solely concerned with growth and counter-cyclicality goals, but it must reduce fiscal debt levels so that additional debt can be taken on in times of stress. What is more, fiscal agents must build up fiscal buffers during periods of economic health that can be used at times of financial distress without the need to unsettle financial markets or use taxpayers’ money. This necessitates levying additional taxes on the financial sector to be used exclusively as discretionary stimulus, capital injections, and bank rescue packages at stressful times. However, at regular times, these funds could act as deposit insurance and debt guarantees. The third area of national polity concerns the strengthening of the financial infrastructure. This is an arena where individuals and institutions plan, negotiate, and perform financial transactions. The development of a solid financial infrastructure 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 opportuni- ties, reduce transaction costs, enhance information and knowledge, and hence assist with increasing capital formation. To build a reliable financial infrastructure, a num- ber of areas need buttressing. Strengthening the legal framework—in terms of effective conflict resolution mechanisms and bankruptcy codes—will lubricate the flow of funds that would have otherwise been trapped awaiting legal arbitration. In addition to this, many irresponsible, fraudulent, or erroneous activities could be detected early on and avoided under sound accounting and auditing practice, an obligatory national code of corporate governance, and internal audit. Strong customer-deposit insurance schemes, liquidity arrangements, and safety net facilities would help increase trust in the entire financial sector, and this trust cannot be established in the absence of a reliable informa- tion infrastructure. In order to enable swift settlement of funds, improvements would need to include provisions for modern trading platforms, state-of-art communication, technology networks, and reliable clearing houses. Public registries and obligatory dis- closure laws are the foundation work of a reliable information infrastructure. Equally important are accurate public statistical agencies, private financial research centers, competent financial analysts, credit bureaus, and reliable rating agencies. 336 PART ! Financial Institutions The fourth national policy area is consumer protection. As discussed in Chapter 10, the growing sophistication of financial markets—rapid development of new products, financial innovations becoming interminable, and intense technological advances—has left many consumers unable to unfold the complexity of financial instruments. More- over, there have been situations in which irresponsible bankers had lured their cus- tomers into buying financial instruments without adequately explaining the extent of the risk they may face or the high fees they may be charged. The fact that this had caused substantial losses to customers in the midst of the financial crisis reduced the faith placed in financial institutions, often there was less than complete participation by customers in financial markets. One of the most scandalous financial frauds is the LIBOR scandal, where various notable banks in London manipulated the LIBOR inter- est rates to boost their profits. Hence, enhancing disclosure rubrics and avoiding cus- tomer abuse will help in rebuilding confidence in financial systems. The fifth national policy area is the enactment of microprudential and macroprudential policies. While microprudential policy aims to reduce risk expo- sure of individual financial institutions, macroprudential policy looks to reduce sys- temic risk exposure of the entire financial sector. Undoubtedly, every central bank will always act as a “lender of the last resort” in the event of market problems, but the global financial crisis has proved that a central bank’s support may not be adequate in cases of severe fragility of the financial sys- tem. Prior to the crisis, globally designed regulations were confined to microprudential supervision, which focuses on the safety and soundness of individual financial institu- tions with little regard to how individual bank actions affects the entire financial system. As mentioned in earlier chapters, microprudential supervision looks at each individual financial institution separately and assesses the riskiness of its activities while gauging whether it complies with disclosure requirements and satisfies capital ratios. We have seen in Chapter 10 how Basel 2 rules have prompted banks to hold adequate capital to cover credit, market, and operational risk exposures. In case of non-compliance, regula- tors force financial institutions to engage in prompt corrective actions and to raise their capital to avoid penalties that could go all the way to shutting down the institutions. However, many banks increasingly shifted problems off their balance sheets, expos- ing themselves to harsh liquidity crunches and highly leveraged positions. The new reputation risk has installed a sentiment of distrust in banks per se and in the finan- cial system at large. Consequently, the Basel Committee on Banking Supervision has introduced Basel 3 following the global financial crisis, to be phased in over a period ranging from 2013 to 2019. The primary concern of microprudential regulation under Basel 3 is to introduce three types of buffers. First, more capital buffers were imposed since previous buffers proved insufficient to help banks recover. Second, new liquidity buffers were introduced to enable banks to withstand the drying up of money markets during periods of liquidity crunch. Third, the drastic asset sales at artificially depressed invesie levels during the crisis prompted the need to make banks less leveraged. -borrow fund to buy an More importantly, since the rapidly growing shadow banking system had escaped overall supervision until the meltdown in 2008, their capital requirements were incom- mensurate with the immense risk exposures that they undertook. As such, all financial institutions, even those that do not accept traditional bank deposits, have come under increasing scrutiny. Further, subsequent to the subprime crisis, unlisted derivatives and financial instruments have come under global financial regulations. In addition to individual bank problems, the global financial crisis unmasked serious inadequacies and substantial systemic risks that are inherent in the existing financial sys- tem, making macroprudential supervision an essential component of the financial reform process. First, the risks and losses caused by problematic financial institutions were  CHAPTER "# Financial Crises in Advanced Economies 337 FYI The LIBOR Scandal The “London Interbank Offered Rate” is derived major banks had been colluding with each other from the rates that major banks charge each other to manipulate the LIBOR since 2