The Financial System: Opportunities and Dangers

The Financial System: Opportunities and Dangers Chapter 20 of Macroeconomics, 8thedition, by N. Gregory Mankiw ECO62Udayan Roy

The Financial System • The financial system is the collection of institutions that facilitate the flow of funds between lenders and borrowers.

The Financial System: Saving • When people earn income, they typically don’t want to consume their entire income all at once. • But they may have no idea what to do with the unconsumed income. • This unconsumed income is called saving

The Financial System: Investment • On the other hand, there are people who may wish to spend money on various potentially valuable projects but either have no money of their own or may wish to spend their personal funds on projects other than their own • The money that these people need for their spending plans is called investment

The Financial System Makes Saving Equal Investment • The financial system makes it easier for lenders (those who have the saving funds) and borrowers (those who need funds for investment) to find each other • Both groups benefit when the financial system does its job well • When the financial system fails, both groups suffer

What does the financial system do? • The financial system serves multiple purposes: • It helps entrepreneurs find the money needed to turn business ideas into reality • It helps entrepreneurs pursue business projects without having to personally carry too much of the risks associated with their projects • It helps to protect lenders from irresponsible borrowers • It helps to foster economic growth by channeling savings to the most valuable projects and cutting off funds for the less valuable projects

Financing Investment • The financial system helps entrepreneurs find the money needed to turn business ideas into reality • The money may take the form of • Debt finance (the entrepreneur sells bonds), and • Equity finance (the entrepreneur sells stocks)

Financing Investment • The flow of funds takes place through • Financial markets • Stock market, bond market • Financial intermediaries • Banks, mutual funds, pension funds, insurance companies

Sharing Risk • The financial system helps entrepreneurs pursue business projects without having to personally carry too much of the risks associated with their projects • The financial system also enables savers to diversify—that is, lend their money to a variety of borrowers—thereby reducing the risks of lending

Sharing Risk • Suppose it is your dream to start a restaurant. • Even if you have enough savings of your own to pay for the restaurant, it might still be better to share the risks—and the rewards—of the restaurant venture with others • And others may wish to share the risks of your restaurant venture if they believe that the returns would be good

Sharing Risk • The financial system—that is, the financial markets and financial intermediaries—may put you in touch with other investors • They would provide you money to get your restaurant started in return for part ownership • This is equity finance • This way you would not have to carry the full risk of your restaurant on your own shoulders

Sharing Risk • Even if you are not an entrepreneur, the financial system can help you use your savings to acquire ownership of a diversified portfolio of business enterprises • This will help you keep your idiosyncratic risks low • But systemic risks may remain

Dealing With Asymmetric Information • The financial system helps to protect lenders from irresponsible borrowers

Dealing With Asymmetric Information • Borrowers can hide crucial information—about their abilities and their plans—from potential lenders • As a result, trusting lenders can get ripped off • If that happens often enough, all lending would eventually end and the financial system would be unable to do what it is supposed to do

Dealing With Asymmetric Information • The financial system—especially financial intermediaries, such as banks, and watchdogs, such as government regulators and the courts—can help lenders by • ensuring that lenders get adequate information about potential borrowers • keeping a watchful eye on borrowers to ensure that they do nothing stupid or reckless with borrowed money • punishing dishonest treatment of lenders

Dealing With Asymmetric Information • When entrepreneurs hide information about themselves or the projects for which they are seeking money, lenders face the problem of adverse selection • When entrepreneurs hide information about how hard they would work to make their projects successful, lenders face the problem of moral hazard

Dealing With Asymmetric Information • Why would an entrepreneur borrow money for his/her project? • has no personal funds • has enough personal funds, but wants to diversify risks • knows something negative about the project that he/she is hiding from lenders (adverse selection) • has no intention to work hard for the project (moral hazard)

Dealing With Asymmetric Information • A lender can partially avoid the problems of adverse selection and moral hazard by lending money to an intermediary, such as a bank, and letting the bank deal with the borrower • The bank may have the resources to dig up hidden information about the borrower and the project • The bank may be able to ensure that the borrower will work hard to make the project a success

Dealing With Asymmetric Information • In some cases, asymmetric information may hurt an honest borrower • An entrepreneur may be honest and hard working, but may be unable to convince potential lenders that she is hard working • Here too, bank finance may be the solution • A bank may be willing to lend money to this borrower because the bank has resources to monitor the borrower, who in this case happens to be genuinely hard working

Dealing With Asymmetric Information • Government regulators and the law enforcement system have obviously important roles to play in dealing with adverse selection and moral hazard

Fostering Economic Growth • The financial system helps to foster economic growth by channeling savings to the most valuable projects and cutting off funds for the less valuable projects • When asymmetric information is not a problem, a market for loanable funds in which people are free to lend and borrow should ensure the success of economically valuable projects and the failure of economically wasteful projects

Fostering Economic Growth • For example, if in a well-functioning loanable funds market the equilibrium interest rate is 4%, then • the projects that can earn profits higher than 4% will succeed, and • the projects that cannot do so will fail • In this way, a free market will automatically allocate funds so as to foster economic growth

Case Study: Microfinance • In poor countries, financial markets are undeveloped, primarily because of asymmetric information problems and weak or nonexistent government efforts to deal with asymmetric information • In 1976, Muhammad Yunus, and economics professor in Bangladesh, started Grameen Bank to remedy the situation

Case Study: Microfinance • The Bank was successful in enabling entrepreneurs get the money to build small-scale businesses and improve their lives • Grameen Bank and Prof. Yunus were awarded the Nobel Peace Prize in 2006 • How did Grameen Bank succeed in solving the problem of asymmetric information?

Case Study: Microfinance • Loans were given to groups rather than individuals • All members of the group that took a loan would be responsible for timely repayment • A group would only admit members that the other members knew to be sound • In this way, the group lending idea helped solve the asymmetric information problem

Case Study: Microfinance • Moreover, Grameen Bank gives loans in small amounts that are repaid—and renewed—after short intervals • Therefore, a continuing relationship develops between the bank’s loan officers and the borrowers • Moreover, as small amounts are loaned out at any given time, losses are low

Somehow the pipes get clogged Financial crisis

Financial Crisis • A financial crisis is a major disruption of the economy’s ability to make money flow between lenders and borrowers • Examples: • Great Depression 1930s • Great Recession 2008-09

Six Common Features • Although each financial crisis is unique, most financial crises share certain common elements • Asset-price booms and busts • Insolvencies in financial institutions • Falling confidence • Credit crunch • Recession • A vicious circle

Asset-price booms and busts • Financial crises are often preceded by a period of euphoria, called a speculative bubble, during which the prices of assets rise above their fundamental values • The fundamental value of an asset is the price that would prevail if people relied only on objective analyses of the cash flows the asset will generate

Asset-price booms and busts • If people start buying assets not for the expected cash flows from the asset but because they hope to sell the asset later at a higher price, an asset’s price can rise above its fundamental value • However, such speculative bubbles inevitably crash when euphoria ends and doubts set in

Asset-price booms and busts • In the Great Recession of 2008-09, a speculative bubble developed in home prices

Asset-price booms and busts • Banks fueled the boom because they failed to do their job of identifying irresponsible borrowers and not giving them loans. • Why? • Banks assumed that home prices would keep rising. • Under that assumption, it would not matter if a borrower defaulted. • The bank would simply take the house the defaulter had bought and sell it off at a higher price, thereby making a profit.

Recap: Six Common Features • Although each financial crisis is unique, most financial crises share certain common elements • Asset-price booms and busts • Insolvencies in financial institutions • Falling confidence • Credit crunch • Recession • A vicious circle

Insolvencies in financial institutions • Eventually, home prices stopped rising and then started to fall • Borrowers then owed more money than the value of the house they’d bought with the loan • Such borrowers stopped repaying their loans • Mortgage loans are “non-recourse” • Better to just return the house keys to the bank

Insolvencies in financial institutions • Of course, banks could take the homes (collateral) and sell them • But then banks would lose money because home prices had fallen • When banks’ assets (the homes) lose value, their Capital (owners’ equity) turns negative • See Ch. 4 • At that point, the bank is insolvent

Insolvencies in financial institutions • Many financial institutions turned insolvent • Financial institutions have assets and liabilities • Assets are what others owe them • Liabilities are what they owe others • When the value of assets falls below the value of liabilities, the financial institution is insolvent • When a financial institution becomes insolvent, it is forced to stop operations • When financial institutions stop operations, the economy suffers

Insolvencies in financial institutions • Suppose you and your friends decide to start a bank • You and your friends put $1,000 of your own money in the business. • This is called capital • You borrow $39,000. • These are your liabilities • You lend $40,000. • That is, you buy $40,000 in assets • Your leverage ratio = assets/capital = 40

Insolvencies in financial institutions • Suppose your assets then increase in value by $400 • a mere +1% • The return on your capital is +40%!!! • This is the magic of leverage

Insolvencies in financial institutions • But the magic of leverage cuts both ways • If your assets decrease in value by $1,000 (or, a mere -2.5%), you will lose all your capital (or, a loss of -100%)

Insolvencies in financial institutions • The heavy reliance on leverage by financial institutions at the time of the Great Recession meant that many such institutions became insolvent when home prices began to fall

Falling confidence • Some bank deposits are insured by the government • But not all • As banks and other financial institutions faced the threat of insolvency, many lenders withdrew their deposits (a run) • This reduced the ability of businesses to get loans for business projects

Falling confidence • Troubled financial institutions also had to sell their assets (loans) at fire sale prices to increase their cash reserves • Banks use short-term deposits to give long-term loans • When short-term deposits dry up for troubled banks, they are forced to sell their long-term loans (to less troubled financial institutions) at fire sale prices

Falling confidence • But the fire sale of assets reduces asset prices • And, as we saw before, this fall in asset prices can make many financial institutions, that are otherwise healthy, insolvent • In this way, trouble spreads like infectious disease

Falling confidence • Moreover, if the number of financial institutions is small, each will have lots of financial dealings with the others • In that case, if one institution becomes insolvent, the others would also be hurt and may themselves become insolvent

The Financial System: Opportunities and Dangers