-AGENTS -INSTRUMENTS-MARKETS-INSTITUTIONSFinancial System

- AGENTS

- INSTRUMENTS - MARKETS

- INSTITUTIONS

Financial System

Borrowers (net Lenders) Lenders

(net savers)

Financial System

• Instruments

• Institutions

• Markets

K K I

tY

Flows of Funds Through the Financial System

Global Financial Crisis : Lessons for Macroeconomics

The crisis is profoundly changing our thinking with respect to the way that macroeconomists do their research and teaching.

Many defects of existing, standard macroeconomic models need to be remedied. It is not enough to model the real side of the economy and ignore the financial sector.

Deeper thinking will be needed to integrate finance and macroeconomics.

Economists will need to think carefully about what drives the demand for money and other safe assets when markets fail, and how to understand and incorporate rival views of crises, such as irrational herding, limits to arbitrage, imperfect information,

moral hazard, and so forth.

Feenstra and Taylor, Int. Macro

The financial system is not jus a veil

• Imperfect information

– Financial contracts are set in a context of imperfect information

• Losses are possible

• Asymmetric information

– The borrower knows more than the lender

 The lender may respond restricting the availability of credit

Memo

Agenda

I. Information failures II. The role of banks

III. Financial accelerator

IV. The credit channel

V. Financial crises

I. Information failures

in credit markets

Information failures in credit markets

1. The interest rate in a risky asset

Lender’s risk hypothesis

• One peso loan at the interest rate

– Probability of repayment = p

– With (1-p) the bank looses the principal

• Opportunity cost

– Safe asset at the risk-free rate,

• Arbitrage condition (/competition among banks)

  ^{(1 )}  ¹

 ^{ 1  0}  ¹

 ⁰

E B  p    r   r     p     r   

p r  r



 1

1

r

In financial contracts, the expected return typically differs from the

contractual return

r

Information failures in credit markets

1. The interest rate in a risky asset

2. Bubbles

Tulipmania

Price index for (“future”) contracts in the market for tulip bulbs, in the Netherlands 1634-37

Are bubbles consistent with Rational

Expectations?

• Short selling had been banned since 1610

– That is, the seller was supposed to have a bulb

• Still, speculation caused the price of future tulips to increase at an increasing rate

– In 1637, the average price of a single flower exceeded the annual income of a skilled worker.

• In February 1637 the market collapsed.

Prices of real state vs GDP deflators

100 150 200 250 300

1995 1998 2001 2004 2007

1995=100

Portugal Espana GDP def. PT GDP Def. Esp.

Fonte: Confidencial Imobiliário; Ministerio de Vivienda (Espanha)

Real estate prices

Valuing stocks

• Arbitrage: return equal to dividend and capital gain:

• We assume that (NPG condition)

1 1

t t t

f

t

a a

r a

 

  



   

2 2

1

1 1 1 2 3

2 3

1

1 1 1 1 1

t t

t

t t f t t t

t

f f f f f

a a r

a r r r r r

 



    

   

     

     

    

 

lim 0

1

t T T

f

a



r 



The value of the asset shall not increase infinitely ahead of the interest rate.

Otherwise, there would be infinite borrowing

Ever-expanding bubble

Bubble: When the price of an asset starts increasing over time, departing from its fundamental

– Assume that the asset has no intrinsic value:

– The anticipation of ever-increasing prices would still satisfy the arbitrage condition

1

t t

f

t

a a

r a







t 0, t

  

 ¹ 

t T t f

a

 a  r

Bursting bubble

•

The bubble has the probability (1-p) of bursting each period, and the probability p of going on

•

A risk neutral investor will be willing to hold the asset if:

•

To compensate for the probability of a crash, the expected return in case of no crash must be higher than the risk free rate

•

The closer to collapse, the greater has to be the “promised” return in order to keep risk neutral investors in

 Bubbles can be the result of rational decisions

 Still, they can lead to wealth effects and overspending during booms and create a lot of damage when they burst

 

t t

E a a pa a

r a a

   

  _t ¹ 1 _f

t t

a r

a p

 



Wealth Effects

• An important component of consumers ’ lifetime resources is their financial wealth

– Common stocks – Real estate

• Consumers ’ balance sheets affect spending and borrowing decisions

– When asset prices rise, wealth increases, thereby increasing the lifetime resources of consumers

– Households respond, consuming more and borrowing more

FIGURE 11-18 (3 of 3)

The Crisis and Recession in the United States These charts show key U.S. economic trends from 2003 through 2010.

Information failures in credit markets

1. The interest rate in a risky asset 2. Bubbles

3. Asymmetric information

Asymmetric information

Each individual knows his circumstances but not those of other individuals

Borrowers have greater information about their default risk than do banks

- Adverse selection (occurs before the transaction takes place: If the lender cannot observe the risk characteristics of the borrower, he

cannot demand higher returns from riskier projects. He may, instead set an “average” interest rate, but this would change adversely the

composition of the pool)

- Moral hazard (after the transactions takes place, opportunistic agents may have incentive to engage in projects more risky than the lender would like, because in case of failure, the principal bears the cost.

Credit Rationing

As the interest rate on the loan increases, two types of effects occur

 adverse selection effect :

 The less risky borrowers drop out of the market;

 adverse incentive effect, or moral hazard effect:

 Borrowers are induced to choose projects for which the probability of default is higher (because riskier projects are associated with higher expected returns).

Hence, as the interest rate on the loan increases, the probability of repayment may decline.

Banks has less incentive to lend in such conditions and they may even stop lending completely

Credit Rationing

 Lending rates below market clearing levels

 Optimal response of the bank to asymmetric information

(

II. The role of banks

Borrowers Lenders

(net savers)

Direct Finance

Financial

Intermediaries:

• Insurance companies, Pension funds

• Banks

K K I

tY

Flows of Funds Through the Financial System

Brokers

Indirect Finance

Securities -Stocks - Bonds

• Deposits

• Contractual savings

• Loans

• Securities

Direct vs Indirect Finance

Direct finance:

• Borrowers obtain funds directly from lenders in financial markets by selling them securities.

– These transactions may be facilitated by brokers, which charge a fee for matching borrowers and lenders.

– Brokers are not financial intermediaries, because they do not take any risk in the transaction.

Indirect Finance:

• Mediated by institutions – financial intermediaries - that borrow funds from people who have saved and make loans to other people:

– Banks: accept deposits and make loans

– Other: insurance companies, pension funds, mutual funds and investment companies, finance companies,

– These institutions buy and sell assets at their own risk.

Why do we need banks?

In a world in which:

• Information is not freely available

• Agreements cannot be costless enforced

….Financial intermediation arises as an economic activity.

• Banks are specialized in mitigating asymmetric information problems in credit markets

• A central function of banks is to screen and monitor borrowers, thereby overcoming information and incentive problems.

• By developing expertise in gathering relevant information, as well as by maintaining ongoing relationships with customers, banks develop

"informational capital."

• Banks incur in searching costs, evaluation costs, contract design, and

contract enforcement costs. These costs do not depend on the size of the loan.

• Banks take opportunity of these economies of scale developing specific knowledge, buying equipment, and pooling together large quantities of assets and liabilities, diversifying risk.

Limits to banking

• Banks reduce transaction costs and allow “small” savers and borrowers to engage in financial transactions

– Most SMEs lack access to direct finance and rely on banks, which have the capability to monitor and screen their actions and activities.

• Banks do not have special advantages with borrowers that are too transparent.

– When information about borrowers becomes easier to acquire, the role of banks should decline

– Large corporations will find it cheaper to rely on Direct Financing

• They can afford the fixed cost of making its information publicly available (credit rating agencies, prospects) or to signal soundness (underwriters)

• Large loans are divided in small units and spread among many diversified portfolios

• Bank loans and funds raised in capital markets are not perfect substitutes:

they target different audiences.

Lenders (net savers)

Direct Finance

Financial

Intermediaries:

• Insurance companies, Pension funds

• Banks

K K I

tY

Flows of Funds Through the Financial System

Brokers

• Deposits

• Contractual savings

Indirect Finance

Securities -Stocks - Bonds

Transparent

• Governments

• Corporations

Borrowers

Opaque

• SMEs

• Households

• Loans

• Securities

• Financial crises occur when a large disruption to information flows in the financial system causes a dramatic increase in adverse selection and moral hazard making impossible for markets to channel efficiently the funds from savers to borrowers.

Frederic Mishkin The Economics of Money, Banking, and the Financial Markets

What is a Financial Crisis?

Lenders (net savers)

Direct Finance

Financial

Intermediaries:

• Insurance companies, Pension funds

• Banks

K K I

tY

Brokers

• Deposits

• Contractual savings

Indirect Finance

Securities -Stocks - Bonds

Transparent

• Governments

• Corporations

Borrowers

Opaque

• SMEs

• Households

Credit crunch

• Because of moral hazard and adverse selection, banks use non-price rationing devices as part of the loan approval process

– Security checks, credit risk evaluation, collateral requirements.

• A credit crunch is a sudden reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from

banks.

– The volume of credit is reduced through these rationing devices, because the bank internalized the fact that raising lending rates may have adverse

selection effects.

• A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates.

– In such situations, the relationship between credit availability and interest rates changes.

– Credit becomes less available at any given official interest rate.

• Borrowing constraints: the IS curve moves to the left

III. The financial

accelerator

Memo

• Frictionless finance

–

Investment and consumption decouple from the business cycle

• Individuals borrow in bad times and pay back in good times

• In reality the availability of credit varies along the business cycle

–

Cheap and abundant during upturns.

–

Restrictive during downturns



The financial system can amplify the business cycle

The financial accelerator

1. The unconstrained Firm

Firms: Two period

• At the end of period 2 all debts owed, or owing must be paid off

• The two-period budget constraint equals:

 

1

1

L   r L    p I  Q

 

2

1

0

L   r L    Q 

0 1  r

I

I

1  r

2 1

K K

z F p

Unrestricted credit

• The firm choose the optimal investment level

• Any fall in savings (internally generated funds) will be ofset by new borrowing

• If Q1 declines, the firm can borrow to keep the optimal investment

* *

1 0 1 1 1

K F

L  L  p I  S

The financial accelerator

1. The unconstrained Firm

2. Collateral in advance constraint

No precommitment

• What if the borrower cannot pre-commit to repay the loan?

• In the absence of pre-commitment, the

borrower could be better off by not paying the debt.

– But rational creditors would anticipate this and refused to lend to begin with

• To solve this problem, the lender can request

a collateral

Collateral-in-advance constraints

• Monitoring the activities of the borrower is expensive.

• To mitigate the risk of default, banks require collaterals.

– The ability of a borrower to post collateral reduces the lender's risks and aligns the borrower's incentives with those of the lender.

– The availability of collateral facilitates credit extension.





1

1

L q T

 ^ r ^

     

T = Collateralizable asset

= Reflects the ability of the bank to enforce the collateral in courts (rule of law)

If =0 , there is no credit at all (ability to enforce is essential to ensure the availability of credit)

0 1  r

0 1  r

L1

L1





1

1

L q T

r

 



Collateral in advance constraint

Supply of credit

The supply of funds is infinitely elastic until meeting the borrowing constraint, and then it becomes vertical.

0

1

0

1r

1  r

L1

L1





1

1

L q T

r

 



Collateral in advance constraint

Supply of credit

'

1 r1

When the interest rate increases, the borrowing constraint becomes tighter

'

L1

1

0 1  r

0 1  r

L1

L1

Collateral in advance constraint

Supply of credit When the price of collateral (or the rule of law) declines, the borrowing constraint gets tighter

'

L1

1

 1



L q T

r

 



Firms: Maximization problem

ST ^{1 1 1 1 0}

1

I

S L L

p  

    

 

1

2 1

1 1 1

1

I

z F I MaxV p I

   r



1 1

L  L

2 1 1 0

1

1 1 0 1 1

1

1

£ 1

F K

F

z F S L L

S L L p L L

r 

 

   

  

 

   

         

1

£ 0 L

 



£ 0



 



£ 0

 

 



  

2

1 1

1 1

K K

z F r

p   

1 1

L  L

1 1 0

L L



 = Marginal benefit of one more unit of loan (shadow price of borrowed funds)

0 1  r

I

I

1  r

2 1

K K

z F p

Not binding

• The firm choose the optimal investment level

• Dividends policy irrelevant

 

2

1 1

1

K K

z F r

p  

*

1 1 1 0 1

1

1 _F

I I K S L L

p  

     

0 1  r

0

I

1  r

1

1  r

2 1

K K

z F p

I

I

Binding constraint

• If the constraint is binding investment will be suboptimal

*

1 1 0 1 1

1

1 _F

I K S L L I

p  

     

External Finance Premium=

2

1 1

K 1

K

z F r

p  

The financial accelerator

1. The Rationed Firm

2. Collateral in advance constraint

3. Economic downturns

Economic downturns

•

Fall in production

•

Higher interest rates on floating debt

•

Lower asset prices

•

Loan-to-value ratios decrease

• The availability of credit declines.

 Persistent effects

• Future output declines

 Propagation across industries

• Demand for intermediate inputs

1 1 0 0 1

S

 Q  r L  

*

1 1 1 0 1

1

1

I

S L L I

p  

     





1

1

L q T

r

 



0

1  r

1  r

1‘ 1 1 r

'

I

I

' I

z₂F_K p^K

1 1 0

1 _F

I K S L L

p  

    

1  r

Tighter borrowing constraints

Higher External Finance Premium

An initial shock with no intrinsic persistence can lead to persistent

fluctuations in the

economy, because next year output is affected.

The Financial accelerator

The financial system may exacerbate the economic impact of recessions

• Macroeconomic cycles lead to swings on the cash flows and balance sheet positions of firms, causing swings in the external finance premium

– During recessions, the value of collaterals declines

– At the same time, firms have less earnings and borrowing needs increase.

• On the other hand, banks may require higher collateral (lower loan to value) because of higher risk perception.

• This mechanism tends to aggravate the severity of macroeconomic shocks

– Persistence effect: Short-lived economic shocks may have long-lasting effects:

higher external finance premiums reduce investment impacting on future output and net worth, even after the original shock has dissipated.

– Propagation effect: Lower investment by some firms impacts on the cash flows of other firms

The Crisis and Recession in the United States These charts show key U.S. economic trends from 2003 through 2010.

I

1r1

1

1‘

I

I

'

z₂F_K p^K

1  r

'

1r1

Monetary tightening

• When the interest rate increases, the current value of the collateral decreases and thereby the maximum

availability of credit





1 1 0

1

1

1

F K

I S L q T

p  r

 

     





 









III. The credit

channel

Transmission Mechanisms of Monetary Policy

• Traditional mechanism

– Interest rate channel:

• Open market operations change the interbank money market interest rate, which in turn influence the long term bond yields through the term structure of interest rates.

• Changes in yields, in turn, influence the real return on

investments

Puzzle

• Empirical studies reveal that investment and

consumer spending respond little to bond yields.

• However, monetary policy impacts very significantly on output.

• This contradiction led economists to search for

channels other than the interest rate on bonds,

through which the monetary policy may impact

on aggregate demand

Transmission Mechanisms of Monetary Policy

In addition to bond prices, two other asset prices

receive substantial attention as channels for monetary policy effects:

– Asset prices:

• When stock prices rise, the value of financial wealth increases, thereby increasing the lifetime wealth of consumers, and consumption should rise.

• When stock prices rise, the market value of firms becomes high relative to the replacement cost of capital (Tobin q), boosting investment.

– Exchange rate channel

• (under float): fall in interest rate gives rise to an excess demand for foreign bonds, causing the exchange rate to depreciate boosting exports.

The Credit Channel

• The credit channel focuses on the way in which

monetary policy impacts on creditworthiness of agents, and by then, on economic activity.

– Changes in the availability of credit alter the private sector ability to consume and invest, reinforcing the interest rate channel.

• The credit view, proposes that two types of monetary transmission channels arise as a result of financial frictions in credit markets:

– those that operate through effects on firms’ and households’ balance sheets and

– those that operate through effects on bank lending

The bank lending channel

• As a result of financial market frictions, banks play a key role in the transmission process of monetary policy.

• The theory of the bank-lending channel holds that monetary policy works in part by affecting the supply of loans offered by banks.

– Because of moral hazard and adverse selection, banks use non-price rationing devices as part of the loan approval process

– When monetary policy is tightened (bank’ reserves decline), the volume of credit is reduced through these rationing devices, because the bank

internalizes the fact that raising lending rates may have adverse selection effects.

• While the open market tends to increase the interest rate on bonds, it may also be reducing credit availability to SMEs and the public, causing a direct fall in consumption and investment that is not captured by the interest rate channel.

The balance sheet channel

• Changes in interest rates engineered by the central bank affect the

values of the assets and the cash flows of potential borrowers and thus their creditworthiness

• A tightening of monetary policy, by increasing the real interest rate, reduces spending through:

– Lower asset prices and then reducing the value of the firm collateral – Higher interest spending on past (floating) loans, and hence less

liquidity

– Lower demand for output and hence less revenue

 In case the collateral constraint is binding, the ability of the firm to buy inputs will decrease

• A tightening of monetary policy that reduces the net worth and liquidity of borrowers would increase the effective cost of credit by more than the change in risk-free rates and thus would intensify the effect of monetary policy.

The Link Between Monetary Policy and Aggregate

Demand: Monetary Transmission Mechanisms

Agenda

I. Information failures

II. Financial accelerator

III. The credit channel

IV. Financial crises

Factors Causing Financial Crises

•

Deterioration in Financial Institutions ’ Balance Sheets

•

Banking Crisis

– Loss of information production and disintermediation.

•

Increases in Uncertainty

•

Increases in Interest Rates

– Increases adverse selection problem – Increases need for borrowed funds.

•

Government Fiscal Imbalances

– Create fears of default on government debt.

– Investors might pull their money out of the country.

APPLICATION The Mother of All Financial Crises: The Great Depression

How did the financial crisis unfold along 1929-1933?

• The value of financial assets relative to the amount of debt declined sharply,

increasing the likelihood of financial distress

• This event was brought on by:

– Stock market crash – Bank panics

– Debt deflation

Because of the decline in the price level in that period, the level of real debt consumers owed also increased sharply (by over 20%)

Credit Spreads During the Great Depression

Bernanke on the Great Depression

•

“In the 1930s, declining output and falling prices (which increased real debt burdens) led to widespread financial distress among borrowers, lessening their capacity to pledge collateral or to otherwise retain significant equity interests in their proposed investments”.

•

“Borrowers' cash flows and liquidity were also impaired, which likewise increased the risks to lenders”.

•

Overall, the decline in the financial health of potential

borrowers during the Depression decade further impeded

the efficient allocation of credit.

Application: The Great Recession

• The rising level of subprime mortgage defaults led to a decline in the value of mortgage-backed securities

• This led to large losses on the balance sheets of financial institutions

• With weaker balance sheets, banks began to deleverage and cut back on their lending

• With no one else to collect information and make loans, adverse selection and moral hazard problems increased in

credit markets, leading to a slowdown of the economy.

(The decline in the stock market and housing prices also weakened the

economy, because it lowered household wealth)