LECTURE 3.

4: BANKING INDUSTRY: STRUCTURE -interest rate-risk increase demand for

AND COMPETITON assets and services reducing risk
- Central banks: gov institutions that have - 2 Financial Innovations
responsibility for the amount of money and - Adjustable-rate mortgages -
credit supplied to the economy as a whole mortgages loans on which interest
- State banks: state-chartered rates changes when a market
- National banks: federally chartered banks interest rate changes
- Dual banking system: state and national - Attractive Feature: issue with
working side by side lower initial interest rate
making them popular to
Financial Innovation and the Growth of the “Shadow households
Banking System” - Flexible mortgage with
- Traditional banking – is on the decline adjustable interest rates
- Granting loans (assets) funded by - Lower initial interest rates
deposits (liabilities) attractive to home buyers
- 1 entity engages in the process of - Interest rates can increase in
asset transformation to fund assets the future
purchases - Both fixed and flexible
- Shadow banking system - bank lending has mortgage were widespread
been replaced by lending via the securities - Financial Derivatives - hedge (protect
market which involved different financial themselves (FI) financial contracts that derive their
value from an underlying asset or assets
institutions - Feature contracts - sellers
- Securities market - divided into agrees to provide a certain
primary/secondary markets, buy and sell of standardized commodity to
stocks, bonds, and derivatives the buyer - specific date - on
- Financial innovation: agreed price
- earn higher profits 2. Responses to changes in Supply Condition:
- lower production costs Information Technology
- reduce transaction and distribution - Info Tech (2 effects)
cost - Lowered cost of processing financial
- A change in the financial environment will transactions
stimulate a search by financial institutions for - Seller - dec cost of
innovations that are likely to be profitable processing transactions -
- Change in Fin envi stimulates fin making them profitable to
innov create new financial products
- Financial environment changes (60s) – and services
stimulate the search for innovations, new - Easier for investors to acquire
products and services information
- Financial engineering - process of - Buyer: easier to acquire info
developing new products and - Bank Credit and Debit Cards
services - Credit: extend the purchaser a loan
3 Basic types of Financial Innovation that does not have to be paid off
1. Responses to changes in Demand immediately
Conditions : Interest -Rate Volatility - Debit: immediately deducted from
- Inflation led to higher interest rates the card holder’s main account
- Electronic Banking
 - ATM (Automated Teller Machine) - - Process of Securitization
get cash, make deposits, transfers - Loan Origination - Servicing -
cash, check balances Bundling - Distribution
- Home banking - linked banks - Step 1 loan origination – residential
computer to customer’s smartphone mortgage loan granted/serviced by a
etc FI A – collects the regular
- Virtual bank - no physical loc interest/principal payments
- Junk Bonds - started by Milken; only very - Step 2 FIA – sells mortgage loan to
well-established corporation, i.e., FI B which bundles the mortgage
- with good credit ratings, can raise loan with many mortgages ( new
funds by selling bonds financial product is created)
- “Fallen angels” - Step 3 FI B ( bundler) takes the
- As getting info became easier, regular interest/principals payments
buyers more willing to buy bonds of of the bundled new financial asset, a
less than well-established/new portfolio of mortgages, and pays
corporations , i.e., lower credit ratings them to third parties
- Commercial Market Paper - short term debt - Earn a fee per step
security issued by large banks and - Prominent role in the subprime
corporations mortgage market 2000
- Liquid, high quality, short-term assets - Subprime Mortgage Market
- New class of residential mortgages
Securitization and the Shadow Banking System offered to borrowers with
- Securitization less-than-stellar credit records
- Process of bundling small and - One factor leading to the 2008
otherwise illiquid financial assets into Global Financial Crisis
marketable capital market securities - Early 2000s – search for new growth
- Illiquid Fin Assets (residential engine
mortages, auto loans, credit card - New economy – ushered in by the
receivables) dot.com corporations
- Bundle small, illiquid financial assets - Candidate – less than prime creditor
- Fundamental building block of the in the housing market
shadow banking system - Greenspan, former Fed Chair, argued
- One of the most important for less regulation !
innovations due to IT improvements - Interest rates kept low for too long
- Lower costs to acquire info – easier - Demand for housing kept on
to sell securities increasing creating a housing bubble
- Lower transactions costs – easier for - Bubble ? Why? Demand was
FIs to collect payments supported by cheap credit
- Transform into marketable capital - A legend fell; his legacy diminished;
market securities ushered in the worst financial crisis
- How Shadow Banking System (SBS) Works? since the 1929 NYSE crash
- Securitization : involves different FI 3. Avoidance of Existing Regulations
working together - they comprise - Loophole mining – Kane : process of
SBS avoiding regulations
- Not done under 1 roof - Bcoz regulatory constraints imposed too
much/cost too much
 - burden: it becomes (un??)profitable to go - They make a demand for their bonds thru
around the rules eligible securities
- Regulations that have been the major force - Allowable alternative compliance
behind Financial Innovations - Eligible securities
- Reserve requirements - (i) Investment in bonds issued by
- Acts as tax on deposits - de DBP and the LBP
facto implicit tax - (ii) Other debt securities
- Tax = i x r - (iii) Paid subcriptions of preferred
- i (interest on assets shares of stock in accredited rural FIs
could have been - (iv) OR Philippine Crop Insurance
acquired - Opp Cost) Corporation
- Reserve Portfolio Innovations to Avoid Regulations
- Cash in vaults, - Money Market Funds
deposits w/CB (policy - issue shares that are redeemable at
on interest on fixed price by writing checks
reserves) - Not legally deposits that can earn
- Interest bearing, interest, not subj to RR or
highly liquid, low risk prohibitions on interest payments
securities - E.g negotiable CD - can sell to the
- Rose as interest rates market, highly liquid
rises - Sweep Accounts
- Regulation Q / Restrictions on - To avoid tax from RR
interest paid on deposits - Bal above a certain amount in
- Max limits on interest rates checking acc at the end of a day are
- Deposit rate ceilings swept out of the acc and invested
- If interest rates rose - overnight/to very shortly periods
depositors withdrew funds - securities that pay interest
put on higher yielding - Not chekable deposits, thus
securities not taxed
- Will cause “disintermediation” - Avoids Regulation Q since banks
- Loss of deposits that banks since banks can pay interest
could lend - Effect: the required reserves has
- Once market interest rates > been decreased so much it is no
ceilings longer binding; banks voluntarily
- Depositor withdrew funds hold more reserves that is required.
from banks , switch to interest Financial Innovation and the Decline of Tradition
bearing and /or higher Banking
yielding assets - Role of Traditional Banking : make long-term
- Constrains banks ability to loans and to fund by issuing short-term
earn profits deposits
- Incentive to innovate! - “Borrowing short & lending long”
E.g. Agri-Agra Law - Decline in cost advantages in acquiring
- All banks, public and private, to allocate at funds (liabilities)
least 25% of their total loanable funds for - Regulation Q – non payment of
agriculture and agrarian reform beneficiaries interest; interest rate ceilings on
savings and time deposits
 - 60’s – advantageous to bank : Major - Between 1929 Crash and the 208 Global
source of cheap funds Financial Crisis
- Disintermediation process - Most cases were in developing/emerging
- Conditions changed 80s: inflation led market economies
to higher interest rates - 1994 Mexican Crisis
- Cheap source of funds gone: - 1997 Asian Financial crisis
substitution to other financial assets - 2001 Argentina
with higher yields/interest payments - How and Why: Rapid growth , reduced
- Regulation Q abolished: allowed poverty , trade reform and trade
more competition but cost of funds - liberalization, financial liberalization to crisis
increased
- Decline in income advantages on uses of Stages of Financial Crisis
funds ( assets) [Developed Economies]
- Competition from junk bonds, STAGE 1: Initiation of a Financial Crisis
securitization, commercial papers - Credit Boom and Bust:
- Corporations can borrow/raise funds - Mismanagement of financial liberalization
from substitute financial assets - Financial innovation leading to asset price
issued by other FIs boom and bust
- Improvement of comp tech led to the - Asset-price boom and bust
growth of SBS and Securitization - Increase in Uncertainty
- Bank’s Responses STAGE 2: Banking Crisis
- 2 response STAGE 3: Debt Deflation
- Maintain traditional lending
activity by expanding into [Emerging Market Economies]
new and riskier areas of STAGE 1: Initial Phase
lending - Path A : Credit Boom and Bust
- Pursuing new off balance - Path B : Severe Fiscal Imbalances
sheet act that are more STAGE 2: Currency Crisis
profitable that will embrace STAGE 3: Full-Fledged Financial Crisis
SBS

LECTURE 3.5 FINANCIAL CRISIS IN EMERGING Emerging Market Economies

MARKET ECONOMIES - Early stage or market development
Financial fricition STAGE 1
- asymmetric information problems which act Path A: Credit Boom and Bust
as a barrier to efficient allocation of capital - There is a mismanagement of financial
- Inc FF, fin markets are less capable of liberalization and globalization
chanelling funds efficiently (from savers to - Most Common Path
HH to firms) - econ act declines - Financial Liberalizaton - eliminating
- asymmetric information working against the restrictions on FI and markets / in the real
efficient allocation of capital sector
Financial Crisis - BOP Current ACc - liberalized:
- Information flows in financial markets Selective Sectures
experience a praticulary large disruptions - - BOP Capital CC - Selective/full lib
FF increase sharply - fin markets top - Inflows/Outflows - capital (long term
functioning FDI - not problematic)
 - Inflow/Outflows - portfolio flows to obtain funds - inc cost, dec
(short term - problematic) profitability
- Finacial Globalization - opens up its econ to - If raise too much - destroy weakened
flows of K and Ffirms from other nations banks, further weaken econ
- In developed countries (Fin Lib) - If not raise - not be able to maintain
- Less developed Fin sys, more the currency
vulnerable to external shocks [one - Recessionary, higher cost of capital;
key diff to developed countries] increases adverse selection
- THE BOP current and capital - Banks become weaker with
accounts were open decreased profitability
- Financial systems – developed - Withs speculative attacks
- Emerging - weak credit culture = ineffective - Defending the currency can’t
screening and monitoring of borrows, lax last very long
gov supervision of banks - How much international
- Credit booms end in crashes reserves does the CB hold?
- Weak prudential regulation and - Until CH exhausted its
supervision to limit excessive holdings of for
risk-taking currency reserves
- Within the context of the principal-agent - CB takes the hit (loss)
problem defending the currency
- Powerful business interest – lured by - Speculators recognize trouble - will
high payoffs from financial lib give up, sell currency w/anticipation
- Politicians and prudential that it will depreciate - huge profits, -
supervisors(agents) is or should be to Gov must allow devaluation
protect voters/taxpayers (principals - They bets on depreciation
Path B: Severe Fiscal Imbalances - odds are biased in one
- Inappropriate financing of gov direction only
- Fiscal imbalances : poor revenue collection ( - Add more pressure on the
tax effort); non-productive fiscal currency to depreciate
expenditures; domestic /foreign debt fund - Demand increases ; supply
illiquid asset
white elephants ; increases debt servicing decreases
on a long term basis - Free fall of the currency
- Governments - need funds sometimes force - In 1997 , East Asian countries
banks to buy government debt !!! were in a competitive
- Government debt, usually bonds, loses devaluation cycle
value, banks lose / net worth decreases - Severe fiscal Imbalances
- Or just print money and extract seigniorage - Can directly trigger currency crisis
(inflation tax) - If gov deficits spin of out of control,
- Banking system weakened for and dom investors will suspect
that gov may not pay their debt - pull
STAGE 2: Currency Crisis (Weak Balance Sheet) out their money and sell dom
- Deterioration of bank balance sheets currency
- Raising interest rates to defend their In dev econ, it may become subj to a speculative
currency should encourage capital attack - where speculators engage in large scale
inflows, thus, banks must pay more sales of the currency
STAGE 3: Full-Fledged Financial Crisis - Loophole mining: NBFIs – merchant bank
- Currency mismatch - it takes more pesos to (underwrite securities, leasing, short term
pay back the dollarized debt lending, etc.
- Debt burden in terms of domestic currency - Finance companies, some owned by
increases (net worth decreases). chaebols, were allowed to convert to
- Increase in expected and actual inflation Merchant Banks (MB)
reduces firms’ cash flow. - MBs – allowed to borrow in international
- “Twin crisis” - concurrent currency crisis & markets ( in foreign currency)Early 1997,
Fin crisis series of negative shocks to the external
- Collapse of currency can lead to high position of (already weakened) chaebols
inflation - First high-profile bankruptcy of Hanbo (14th
- Sharp depreciation of currency after largest);
currency crisis leads to immediate upward - 5 more followed (among largest 30)
pressure on import prises - inflation likely to - Decrease in chaebols' net worth
follow - dom interest rate inc - inc Asymm - Sharp decline in stock market values ( next
info problems slide)
- Banks more likely to fail: - Adverse selection and moral hazard
- Individuals are less likely to payoff problems worsen, and the economy
debts (value of assets fall) contracts
- Debt denominated in foreign
currency increases (value of liabilities Note: need liquidity to solve fin crisis
increase)
- Final stage: currency crisis triggers
Application: Crisis in South Korea (19977-98) full-fledged financial crisis
Fin Lib and Globalization Mismanaged - 50% decrease in value of the won
- Removed many restrictive regulations on increases the value of foreign debt
financial institutions by 50%
- Opened BOP capital account to capital flows - Increased adverse selection & moral
- Encouraged government to accelerate hazard
financial liberalization - Deterioration of banks' balance
- Demand for credit – very high from sheets
Chaebols - GDP declines by 6
- Domestic supply: not enough despite - Economic impact of the crisis
savings was 30% of GDP - Declining GDP causes a sharp
- I > S; enter foreign debt increase in unemployment
- Demand – which sector(s) did the loans go - Inflation increases spurred by
to? increases in import prices
- Credit boom – driven by external debt - Central bank increases interest
/borrowing , mostly in short term debt rates…
- Loan losses start to increase ? Weak bank - ...Which worsen the balance sheet of
regulation & supervision; lack of banks and firms
screening/monitoring expertise - Severe socio-economic
- To grow, more credit is needed consequences
- Chaebols not allowed to own banks - Recovery
 - Aggressive policy by South Korean - Lost of confidence/trust: Deposit withdrawals
government to restore financial reach US$1 billion/day in Nov
stability - Restrictions on withdrawals aggravated
- In particular, overhaul of social unrest
financial regulation Currency board in place
- Financial markets stabilize in - Arrangement: the government fixed one
1998–99 peso/ U.S. dollar
Application: the Argentine Financial Crisis (2001-02) - Agree to buy and sell pesos at the fixed rate
Severe fiscal imbalances Bank panic doubts the ability of the government to
- Adverse selection and moral hazard keep interest rates high to preserve the currency
problems worsen board (Using high interest rate policy to defend
- Bank panic begins currency)
- Currency crisis ensues - Speculative attacks against the peso multiply
- Currency crisis triggers full-fledged financial - In December, 2001, external debt
crisis repayments suspended for at least 60 days
- Recovery begins - In January 2002, end of the currency board
- Contrast with Mexico (1995) and East Asian Full fledged crisis
crisis (1997) - Free fall of the peso, stabilizing at 25% of its
- No lending boom, banks had sounder value by the end of 2001
balance sheets - Rapid increase in capital outflows and
- Growing fiscal imbalances decline in lending
- Local governments (provinces) control public - Increase in inflation through higher import
spending prices (like in South Korea), compounded by
- Federal Government (National) responsible historically poor inflation performance in the
for raising revenue country
- Government perennial deficit present all year - GDP decreases, dramatic increases in
- Recession in 1998: tax revenues declined unemployment and poverty
- Domestic/foreign buyers of government - Worst crisis in Argentina's history
bonds –not enough Recovery
- Government coerced banks to buy public - Financial recovery in 2002 together with
debt boom in demand for Argentinian exports
- Bank balance sheets deteriorate - Growth resumes at fast pace in 2003: +10%
- Loss of confidence: Argentina Government’s annual rate
ability to repay debt ??
- Value of debt plummeted ( ?) Preventing emerging market financial crisis
- Real GDP growth declined during the crisis - China not affected by the 1997-98 crisis in
by more than 15% East Asia. Why?
Adverse selection and moral hazard problems - Two key factors:
worsen - Slower, more restricted financial
- By 2001, banks start losing deposits, reduce liberalization in China
lending, increasing adverse selection and - No currency instability
moral hazard - Renminbi pegged to the
Bank panic begins dollar and not convertible for
- Doubts over sustainability of fiscal capital account transactions
imbalances continued making default real
Application: China (Non-crisis in 1997 & 1998)
- Impact of the crisis on China's subsequent
economic policies
- Vindicated the policy of “controlled
liberalization”
- Encouraged the country to
accumulate foreign exchange
reserves
Preventing emerging market financial crisis
- Beef up prudential regulation and
supervision of banks
- Encourage disclosure and
market-based discipline
- Limit currency mismatch
- Flexible exchange rate ?
- Portfolio inflows/outflows –change
expectations
- Odds are biased in one direction
only
- Implement taxes and/or regulation
- Tobin Tax –argued/proposed 1974 for a tax
on purchases of inancial instruments
denominated in a foreign currency to allow
some autonomy in setting domestic
stabilization policies 1/
- Regulating bank’s borrowings in foreign
currency
- Sequence financial liberalization
- Establish/create proper institutional
infrastructure BEFORE liberalizing
their financial systems
- Implementing policies takes time,
- Financial liberalization
–implementation should be gradual