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Lecture 1 Financial Crises and their Causes Professor Roman Matousek Kent Business School Kent University Anhui Univer

Lecture 1 Financial Crises and their Causes Professor Roman Matousek Kent Business School Kent University Anhui University of Finance &Economics Bengbu 12-14 May 2014. Learning Objectives. To compare and contrast different types of financial c rises.

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Lecture 1 Financial Crises and their Causes Professor Roman Matousek Kent Business School Kent University Anhui Univer

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  1. Lecture 1 Financial Crises and their Causes Professor Roman Matousek Kent Business School Kent University Anhui University of Finance &Economics Bengbu 12-14 May 2014
  2. Learning Objectives To compare and contrast different types of financial crises. To critically evaluate potential causes of financial crises. To apply this knowledge into the current economic environment.
  3. Introduction: Financial crises & Terminology Definition A full-scale financial crisis is triggered by a sharp fall in the prices of a large set of assets that banks and other financial institutions own, or that make up their borrowers' financial reserves. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults
  4. Con’t Financial Crises can have domestic or external origins, and stem from private or public sectors. They come in different shapes and sizes, evolve over time into different forms, and can rapidly spread across borders. They often require immediate and comprehensive policy responses. They call for major changes in financial sector and fiscal policies, and can necessitate global coordination of policies. (like in the case of current Global Financial Crisis – GFC)
  5. Mishkin’s (2001)definition of a financial crisis: A financial crisis is a disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that financial markets are unable to efficiently channel funds to those who have the most productive investment opportunities.
  6. Types of Financial Crises Currency crises. Sudden stops (in capital flows). Debt crises. Banking crises. You can have different classifications Currency Crises Banking Crises International crises
  7. Average number of financial crises over decades
  8. How to Explain Financial Crises and their Forms Financial crises have common elements, they do come in many forms. A financial crisis is often associated with one or more of the following phenomena: substantial changes in credit volume and asset prices; severe disruptions in financial intermediation and the supply of external financing to various actors in the economy; large scale balance sheet problems (of firms, households, financial intermediaries and sovereigns); large scale government support (in the form of liquidity support and recapitalization). Thus, financial crises are typically multidimensional events and can be hard to characterize using a single indicator.
  9. Con’t Factors driving crises: i) Fundamental factors—macroeconomic imbalances & internal or external shocks—are well defined and observed. But no rigorous answers as exact causes of crises. ii) “Irrational” factors – like runs on banks, contagion and spillovers among financial markets, limits to arbitrage during times of stress, emergence of asset busts, credit crunches, and firesales, and other aspects related to financial turmoil. The idea of “animal spirits” an attempt to explain crises.
  10. What happens around financial crises Asset Price Booms and Busts Credit Booms and Busts And what’s the impact of Asset Price and Credit Busts?
  11. Asset Price Booms and Busts Sharp increases in asset prices, sometimes called bubbles, and often followed by crashes have been around for centuries. Asset prices sometimes seem to deviate from what fundamentals would suggest and exhibit patterns different than predictions of standard models with perfect financial markets. A bubble, an extreme form of such deviation, can be defined as “the part of a grossly upward asset price movement that is unexplainable based on fundamentals” . Patterns of exuberant increases in asset prices, often followed by crashes.
  12. Con’t Some asset price bubbles and crashes are well known. Such historical cases include: The Dutch Tulip Mania from 1634 to 1637, the French Mississippi Bubble in 1719-20, and the South Sea Bubble in the United Kingdom in 1720. During some of these periods, certain asset prices increased very rapidly in a short period of time, followed by sharp corrections. These cases are extreme, but not unique. In the recent financial crisis, for example, house prices in a number of countries have followed this inverse U-shape pattern.
  13. How to Explain Asset Price Bubbles? Individual rational behaviour can lead to collective mispricing, which in turn can result in bubbles. These explanations consider asset price bubbles as agents’ “justified” expectations about future returns. Under rational expectations, the asset price does not need to equal its fundamental value, leading to “rational” bubbles. Thus, observed prices, while exhibiting extremely large fluctuations, are not necessarily excessive or irrational. For example, to explain the internet “bubble” of the late 1990s.
  14. Con’t Micro distortions and macro factors can lead to bubbles as well. Fund managers who are rewarded on the upside more than on the downside bias their portfolios towards risky assets, which may trigger a bubble. Other microeconomic factors (e.g., interest rate deductibility for household mortgages and corporate debt) can add to this, possibly leading to bubbles.
  15. Con’t Investors’ behaviour can also drive asset prices away from fundamentals, at least temporarily. Mechanisms, such as herding among financial market players, informational cascades, and market sentiment, can affect asset prices. The phenomenon of contagion – spillovers beyond what “fundamentals” suggest – may have similar roots. Empirical work confirms some of these channels.
  16. Con’t Busts following bubbles can be triggered by small shocks. Asset prices may experience small declines, whether due to changes in fundamental values or sentiment. Changes in international financial and economic conditions, for example, may drive prices down. A drop in prices can trigger a fire sale, as financial institutions experiencing a decline in asset values struggle to attract short-term financing. Such “sudden stops” can lead to a cascade of forced sales and liquidations of assets, and further declines in prices, with consequences for the real economy. Relationships among financial intermediaries are multiple and complex. Information asymmetries are prevalent among intermediaries and in financial markets. These problems can easily lead to financial turmoil.
  17. Credit Booms and Busts A rapid increase in credit is another common thread running through the narratives of events prior to financial crises. Leverage buildupsand greater risk-taking through rapid credit expansion, in concert with increases in asset prices, often precede Both distant past and more recent crises episodes typically witnessed a period of significant growth in credit (and external financing), followed by busts in credit markets along with sharp corrections in asset prices.
  18. Con’t The patterns before the East Asian financial crisis in the late-1990s resembled those of the earlier ones in Nordic countries Banking systems collapsed following periods of rapid credit growth related to investment in real estate. The experience of the United States in the late 1920s and early 1930s exhibits some features similar to the run-up to the recent global financial crisis with, beside rapid growth in asset prices and land speculation, a sharp increase in (household) leverage.
  19. Conclusion Asset Price and Credit Boom and Busts are quite complex. There is still not convincing theory that would help to explain these movements. In fact to predict Financial crises is hard and economists are unable to do it. During a briefing by academics at the London School of Economics on the turmoil on the international markets the Queen asked: "Why did nobody notice it?“
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