Les crises financières

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Financial intermediaries accept funds from savers and direct them to investors. For example, banks accept deposits from households and make loans to firms. Other examples: mutual funds, pension funds, and insurance companies

- What functions does the financial system perform?

Financing Investment: The financial system helps channel funds from Savers and households with income they do not need to spend immediately To investors—firms that need funds to finance investment projects.

It should enable the transmission of resources from savers to the best investment opportunity many people are risk averse: they dislike uncertainty. Investors can share the risk that their projects will fail with the savers who provide the funds.

The financial system allows people to share risks: Savers can reduce risk through diversification: providing funds to many different investors with uncorrelated assets. Diversification can reduce idiosyncratic risks, risks that differ across individual businesses. Diversification cannot reduce systematic risks, which affect most/all businesses.

Dealing with Asymmetric Information: Asymmetric information: One party has access to some information about the transaction that the other party does not have.

Two key problems that create frictions in the flow of credit from lenders to borrowers. When these frictions are strong, a financial crisis occurs. Adverse selection and moral hazard are both examples of market failure situations, due to asymmetric information between buyers and sellers (or lenders and borrowers) in a market.

Adverse selection: it describes a situation where the two parties to a transaction have different pieces of knowledge about the quality of the good or service been traded. When there is adverse selection, people who know they have a higher risk of defaulting on their loan are more likely to borrow than the typical investor .

Moral hazard: it seen, after the deal was done. One of the parties to the deal may be more careless because he/she does not need to pay the full cost of a damage. The idea here is the inability of the insurance provider to control and monitor increased risk-taking behavior that creates the potential for market failure.

For credit to flow efficiently the borrower has to maintain have enough at stake in the success of the project and so does not have strong incentive to divert resources. Limit on credit that can be amplifier with bad economic conditions leading to crisis.

The financial system helps mitigate the effects of asymmetric information:

Fostering Economic Growth: Firms with lucrative investment projects are willing to pay higher interest rates to attract funds than firms with less desirable projects. The financial system helps channel funds to projects with the highest expected returns relative to their risk. Government helps facilitate this function: by providing quality, legal institutions like.

- Defining Financial Crises:

A financial crisis marks a severe disruption of the normal functions of the financial systems, thereby hurting the normal functioning of the real economy. This situation is characterize by sharp declines in asset prices and firm failures.

Different types of financial crises:

- Banking crises

- National currency and single currency area crises

- Credit frictions and Market freezes

- Asset bubbles: booms and Busts

- Sovereign Debt Crises

Dynamics of financial crises: When a financial crisis occurs financial frictions increase sharply and financial markets stop functioning. Asset Markets Effects on Balance Sheets when Stock market decline that Decreases net worth of corporations. →Unanticipated decline in the price level → unanticipated decline in the value of the domestic currency → Increases debt denominated in foreign currencies and decreases net worth-→ Deterioration in Financial Institutions’ Balance Sheets. → Increases in Uncertainty → Increases in Interest Rates. →Government Fiscal Imbalances.

- Dynamics of Financial Crises in Advanced Economies: → Stage One: Initiation of Financial Crisis

→ Stage One: Initiation of Financial Crisis → Stage three: Debt Deflation.

The Mother of All Financial Crises: The Great Depression:

- How did a financial crisis unfold during the Great Depression and how it led to the worst economic downturn in U.S. history?

This event was brought on by : Stock market crash - Bank panics - Continuing decline in stock prices - Debt deflation

- Application: The Global Financial Crisis of 2007-2009

The causes of this crises: → Financial innovations emerge in the mortgage markets , → Housing price bubble forms, → Agency problems arise, → Crisis spreads globally, → Banks’ balance sheets deteriorate, → High-profile firms fail, →

- APPLICATION Financial Crises in Mexico, 1994–1995; East Asia, 1997–1998; and Argentina, 2001–2002

Mexico: Financial liberalization in the early 1990s:→ Lending boom, coupled with weak supervision and lack of expertise. Also Banks accumulated losses and their net worth declined. → Rise in interest rates abroad. →Uncertainty increased (political instability). →Domestic currency devaluated on December 20, 1994. →Rise in actual and expected inflation.

East Asia: the same effects that is mention before in the case of Mexico, just Uncertainty increased (stock market declines and failure of prominent firms). →Domestic currencies devaluated by 1997.

Argentina: Government forced banks to absorb large amounts of debt due to fiscal imbalances. →Rise in interest rates abroad. →Uncertainty increased (ongoing recession). →Domestic currency devaluated on January 6, 2002. →Rise in actual and expected inflation.

- What is the trilemma in international finance?

In most nations, economic policy makers would like to achieve these three goals:

- Make the country’s economy open to international flows of capital.

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