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Chapter 12
Financial Crises and Financial Regulation
Brief Chapter Summary and Learning Objectives
12.1 The Origins of Financial Crises (pages 350–359)
Explain what financial crises are and what causes them.
Because banks borrow from depositors short term and lend long term to households and firms,
banks have a maturity mismatch with the maturity of their liabilities exceeding the maturity of
their assets. This mismatch creates liquidity risk for banks.
Liquidity risk is a particular problem for banks if the government does not provide insurance for
deposits and if there is no central bank.
Governments have two main ways they can attempt to avoid bank panics: (1) A central bank can
act as a lender of last resort, and (2) the government can insure deposits.
A bank panic can lead to declines in production and employment, either causing a recession or
making an existing recession worse.
Though there are some benefits to having a fixed exchange rate, pegging can run into problems,
particularly if the pegged exchange rate ends up substantially above the equilibrium rate that
would prevail in the absence of the peg.
A sovereign debt crisis occurs when a country has difficulty making interest or principal
payments on its bonds, or when investors expect a country to have this difficulty in the future.
12.2 The Financial Crisis of the Great Depression (pages 360–365)
Understand the financial crisis that occurred during the Great Depression.
Though the Great Depression began in response to tight monetary policy, several factors helped
to increase the severity of the downturn during the period from the fall of 1929 to the fall of
1930 including the stock market crash in October 1929 and the passage of the Smoot-Hawley
Tariff Act in June 1930.
Many economists believe that the series of bank panics that began in the fall of 1930 greatly
contributed to the length and severity of the Great Depression.
The Federal Reserve, which Congress established in 1913 to end bank panics, did not intervene
to stabilize the banking system.
12.3 The Financial Crisis of 2007–2009 (pages 365–368)
Understand what caused the financial crisis of 2007–2009.
The financial crisis of 2007–2009 began with the bursting of the housing bubble, which led to a
credit crunch.
The collapse of Lehman Brothers set off a financial panic resulting in parts of the financial
system being frozen.
The Federal Reserve, the Treasury, the Congress, and President Bush responded to the crisis
with unprecedented government intervention designed to stabilize the financial systems
12.4 Financial Crises and Financial Regulation (pages 368–379)
Discuss the connection between financial crises and financial regulation.
There is a regular pattern relating financial crises and regulation: 1) crisis, 2) regulation, 3)
response to new regulations by financial firms, and 4) response by regulators.
Despite its shaky start as a lender of last resort during the Great Depression, the Fed has
performed this role well during most of the post-World War II period.
Over time, the perception arose that some large financial institutions were too big to fail,
because their failure would pose a systemic risk to the economy.
Regulating the minimum amount of capital that banks are required to hold reduces the potential
for moral hazard and the cost to the FDIC of bank failures.
Key Terms and Concepts
Bank panic The situation in which many banks
simultaneously experience runs.
Bank run The process by which depositors who
have lost confidence in a bank simultaneously
withdraw enough funds to force the bank to close.
Basel accord An international agreement about
bank capital requirements.
Contagion The process by which a run on one
bank spreads to other banks resulting in a bank
panic.
Debt-deflation process The process first
identified by Irving Fisher in which a cycle of
falling asset prices and falling prices of goods
and services can increase the severity of an
economic downturn.
Disintermediation The exit of savers and
borrowers from banks to financial markets.
Federal Deposit Insurance Corporation (FDIC)
A federal government agency established by
Congress in 1934 to insure deposits in commercial
banks.
Financial crisis A significant disruption in the
flow of funds from lenders to borrowers.
Insolvent The situation for a bank or another firm
of having a negative net worth because the firm’s
assets have less value than its liabilities.
Lender of last resort A central bank that acts as
the ultimate source of credit to the banking
system, making loans to solvent banks against
their good, but illiquid, loans.
Too-big-to-fail policy A policy under which the
federal government does not allow large financial
firms to fail for fear of damaging the financial
system.
Chapter Outline
Teaching Tips
Prior to 2007, most economists and policymakers believed that financial crises were a thing of the
past, at least where the United States was concerned. The events of 2007-2009 have led to a
greater interest in financial crises both within the profession and among students. One of the
objectives of this chapter is to provide students with background on the 2007-2009 financial crisis
by putting it in the context of other financial crises. Because many economists, policymakers,
and journalists have drawn analogies between the 2007-2009 crisis and the crisis of the 1930s, the
chapter devotes a section to the financial crisis of the Great Depression.
Perhaps most importantly, the chapter provides a framework for understanding how financial crises
lead to changes in regulations that, in turn, lead to innovations among financial firms, which then
lead to additional regulations. For example, the failure of the Fed to carry out its role as lender of
last resort in the early 1930s led Congress to set up the FDIC and enact restrictions on bank
competition. Banks responded with several innovations, including standby letters of credit,
negotiable certificates of deposit, and NOW accounts. Congress then responded to these
innovations by passing the Depository Institutions Deregulation and Monetary Control Act in
1980 and the Garn-St. Germain Act in 1982. Or, more recently, problems with inadequate capital
in the savings-and-loan and commercial banking systems led to the decision by the Unites States
to join the Basel accord, thereby raising capital requirements for U.S. banks. Banks responded by
setting up special investment vehicles (SIVs) to hold their most risky assets. Problems with SIVs
during the financial crisis led the United States and other countries to agree to further changes in
capital requirements. This regulatory pattern is a continuing feature of the financial system.
Understanding it helps students to better understand the ways in which the system evolves.
A Cloudy Crystal Ball on the Financial Crisis
We know now that the housing marketing led to the financial crisis of 2007–2009, but many
policymakers, business leaders, and economists failed to see the crisis developing.
12.1 The Origins of Financial Crises (pages 350–359)
Learning Objective: Explain what financial crises are and what causes them.
A. The Underlying Fragility of Commercial Banking
Because banks borrow from depositors short term and lend long term to households and firms,
banks have a maturity mismatch with the maturity of their liabilities exceeding the maturity of
their assets. Banks, therefore, face liquidity risk because they can have difficulty meeting their
depositors’ demands to withdraw their money. If a bank has made loans and bought securities
that have declined in value, it may be insolvent.
B. Bank Runs, Contagion, and Bank Panics
Liquidity risk is a particular problem for banks if the government does not provide insurance
for deposits and there is no central bank. The process by which simultaneous withdrawals by a
bank’s depositors results in the bank closing is called a bank run. Without a system of
government deposit insurance, bad news about one bank can snowball and affect other banks in
a process called contagion. If multiple banks experience runs, the result is a bank panic, which
may lead many, perhaps all, banks in the system to close. A bank panic feeds on a self-fulfilling
perception: If depositors believe that their banks are in trouble, the banks are in trouble.
C. Government Intervention to Stop Bank Panics
Governments have two main ways they can attempt to avoid bank panics:
1. A central bank can act as a lender of last resort. For example, the Fed was established to be an
ultimate source of credit to which banks could turn for loans during a panic.
2. The government can insure deposits. By reassuring depositors that they would receive their
money back even if their bank failed, deposit insurance effectively ended the era of commercial
bank panics in the United States.
D. Bank Panics and Recessions
A bank panic can lead to declines in production and employment, either causing a recession or
making an existing recession worse. Bank failures can directly affect the ability of households
and firms to spend by wiping out some of the wealth they hold as deposits. Typically, in a
panic, even banks that remain solvent will reduce their lending as they attempt to accumulate
reserves to meet deposit withdrawals. As the recession worsens, with the profitability of firms
declining and household incomes falling, more borrowers are likely to default on their loans,
and the prices of securities held by banks are likely to fall, further undermining the confidence
of depositors and leading to increased withdrawals, causing banks to further curtail lending.
E. Exchange-Rate Crises
Though there are some benefits to having a fixed exchange rate, pegging can run into problems,
particularly if the pegged exchange rate ends up substantially above the equilibrium rate that
would prevail in the absence of the peg. For instance, in the case of the South Korean won, the
central bank, which would be responsible for maintaining the peg, must use its previously
accumulated reserve of dollars to buy surplus won, or else the peg cannot be maintained.
Eventually, the central bank will exhaust its holding of dollars. To maintain the peg as long as
possible, steps must be taken to make the currency more attractive. Often the central bank
raises domestic interest rates, with the intention of attracting foreign investors to buy domestic
bonds, thereby raising the demand for the domestic currency, and, potentially, preserving the
peg. Unfortunately, higher domestic interest rates also discourage domestic firms from
engaging in real capital investment and domestic households from borrowing to finance
spending on houses and consumer durables. The result can be a recession.
F. Sovereign Debt Crises
A sovereign debt crisis occurs when a country has difficulty making interest or principal
payments on its bonds, or when investors expect a country to have this difficulty in the future.
Even if the government avoids default, it will probably have to pay much higher interest rates
when it issues bonds. Sovereign debt crises occur frequently and typically result from either of
two circumstances:
1. Chronic government budget deficits that eventually result in the interest payments paid on
government bonds taking up an unsustainably large fraction of government spending.
2. A severe recession that increases government spending and reduces tax revenues, resulting
in soaring budget deficits.
Teaching Tips
In the Making the Connection, Why Was the Severity of the 2007–2009 Recession so Difficult to Predict?,
which begins on page 355, the authors cite the work of Reinhart and Rogoff, who provide an explanation of
why recessions caused by financial crises tend to be deeper and longer than average recessions. Have students
think about and discuss why financial crises have an effect that extends beyond the financial system. In
particular, ask them to discuss why the recovery from a recession caused by a financial crisis is generally
slower than the recovery following a typical recession..
12.2 The Financial Crisis of the Great Depression (pages 360–365)
Learning Objective: Understand the financial crisis that occurred during the Great Depression.
A. The Start of the Great Depression
Although many people think the Great Depression started with the famous stock market crash
of October 1929, the National Bureau of Economic Research (NBER) dates the Depression as
starting two months earlier, in August 1929. By 1928, the Federal Reserve had become
concerned by the rapid increases in stock prices shown in the Figure 12.4 on page 361 of the text.
As the Federal Reserve increased interest rates to reduce what it saw as a speculative bubble in
stock prices, growth in the U.S. economy slowed during early 1929, and the economy eventually
entered a recession. Several factors helped to increase the severity of the downturn during the
period from the fall of 1929 to the fall of 1930, including the stock market crash in October
1929 and the passage of the Smoot-Hawley Tariff Act in 1930.
B. The Bank Panics of the Early 1930s
Many economists believe that the series of bank panics that began in the fall of 1930 greatly
contributed to the length and severity of the Great Depression. The bank panics fed a
debt-deflation process—as banks were forced to sell assets, the prices of those assets declined,
causing other banks and investors holding the assets to suffer declines in net worth, leading to
additional bank failures and to investors going bankrupt. In addition, as the economic downturn
worsened, the price level fell with two negative effects:
1. Real interest rates rose.
2. The real value of debts increased.
C. The Failure of Federal Reserve Policy during the Great Depression
The Federal Reserve, which Congress established in 1913 to end bank panics, did not intervene
to stabilize the banking system. Economists have pointed to four possible explanations for this lack
of intervention:
1. No one was in charge of the Federal Reserve because authority within the system was much
more divided than is true today.
2. The Fed was reluctant to rescue insolvent banks.
3. The Fed failed to recognize the difference between nominal and real interest rates.
4. The Fed wanted to “purge speculative excess” by allowing the price level to fall and weak
banks to fail in order to prepare the way for a recovery.
Teaching Tips
Ask students to review the four reasons cited as to failure of the Federal Reserve during the Great Depression.
Have students discuss whether the lessons of the Great Depression help shaped the Fed’s response to the
financial crisis of 2007–2009.
12.3 The Financial Crisis of 2007–2009 (pages 365–368)
Learning Objective: Understand what caused the Financial Crisis of 2007–2009.
A. The Housing Bubble Bursts
After rising rapidly between 2000 and 2005, sales and prices of new homes began to decline in
2006, causing some homeowners to have trouble paying their loans. When lenders foreclosed
on some of these loans, the lenders sold the homes, causing housing prices to decline further.
Mortgage lenders that had concentrated on making subprime loans suffered heavy losses, and
some went out of business. Banks and other lenders tightened their lending requirements,
resulting in a credit crunch, which further depressed the housing market. As a result, spending
declined on housing-related products and homeowners had a more difficult time borrowing
against the value of their homes.
B. Bank Runs at Bear Stearns and Lehman Brothers
In the fall of 2007 and the spring of 2008, credit conditions worsened. Many lenders became
reluctant to lend to financial firms for more than very short terms and often insisted on
government bonds as collateral. Here are three key events that occurred during 2008:
Lenders became concerned that Bear Stearns’ investments in mortgage-backed securities had
declined in value to the extent that the investment bank was insolvent. With the aid of the
Federal Reserve, JP Morgan Chase took over Bear Stearns in March.
On September 15, Lehman Brothers investment bank filed for bankruptcy protection after the
Treasury and Federal Reserve declined to commit the funds necessary to entice a private buyer
to purchase the firm.
On September 16, Reserve Primary Fund, a large money market mutual fund, announced that
because it had suffered heavy losses on its holdings of Lehman Brothers commercial paper, it
would “break the buck” by allowing the price of shares in the fund to fall to $0.97. This
announcement led to a run on money market mutual funds as investors cashed in their shares.
Many parts of the financial system became frozen as trading in securitized loans largely
stopped, and large firms as well as small ones had difficulty arranging for even short-term
loans.
C. The Federal Government’s Extraordinary Response to the Financial Crisis
The Federal Reserve, the Treasury, the Congress, and then President Bush responded to the crisis
with unprecedented government intervention including:
Reducing the federal funds rate to near zero,
Effectively nationalizing Fannie Mae and Freddie Mac,
Introducting a $50 billion plan to insure money market deposits,
Introducting the commercial paper funding facility, and
Creating the Troubled Asset Relief Program (TARP).
Whether these initiatives may have unintended negative consequences in the long run remains to
be seen. But most economists and policymakers believe that they served the purpose of
stabilizing the financial system during the fall of 2008 and the spring of 2009. Also helping to
stabilize the system was a stress test administered by the Treasury to 19 large financial firms
during early 2009, which assured many investors that the firms would need to raise less than $100
billion to have the resources to withstand the crisis.
12.4 Financial Crises and Financial Regulation (pages 368–379)
Learning Objective: Discuss the connection between financial crises and financial regulation.
New government financial regulations typically occur in response to a crisis. Looking at different
types of regulations that the government has enacted over the years, we can see that there is a
regular pattern:
1. A crisis in the financial system occurs.
2. The government responds to the crisis by adopting new regulations.
3. Financial firms respond to the new regulations
4. Government regulators adapt policies as financial firms try to evade regulations
.
A. Lender of Last Resort
After the Fed failed its first test during the Great Depression, Congress reorganized the Fed,
helping to centralize decision making by having the chair of the board also chair the FOMC.
Despite its shaky start as a lender of last resort during the Great Depression, the Fed has
performed this role well during most of the post-World War II period. Over time, the perception
arose that some large financial institutions were too big to fail, because failure would pose a
systemic risk to the economy. The Dodd-Frank Act of 2010 allows the Fed, FDIC, and Treasury
to seize and “wind down” large financial firms, which means that the firms’ assets are to be
sold off in a way that will not destabilize financial markets. Whether the act has actually put an
end to the “too-big-to-fail” policy remains to be seen, as the new law left important details for
regulators to implement.
B. Reducing Bank Instability
One way that Congress attempted to increase stability in the banking system following the
Great Depression was by reducing competition. Regulation Q prohibited paying interest on
demand deposits and restricted interest paid on time and savings deposits. Congress believed
such regulation would increase the profitability of banks, thereby discouraging banks from
making risky investments. However, in the long run, anticompetitive regulations do not
promote bank stability because they create incentives for unregulated financial institutions and
markets to compete with banks by offering close substitutes for bank deposits and loans. For
example, the development of money market mutual funds provided depositors with a way of
earning higher interest rates and also provided borrowers with a greater ability to raise funds by
selling commercial paper. The exit of savers and borrowers from banks to financial markets is
known as distintermediation, which costs banks lost revenue from not having savers’ funds to
loan. To circumvent Regulation Q, banks developed new financial instruments for savers.
Regulatory changes in the early 1980s phased out regulation Q, formally allowing new
financial instruments including bank money market deposit accounts.
C. Capital Requirements
One way the federal government attempts to promote stability in the banking system is by
sending examiners from the FDIC, the Fed, and the Office of the Comptroller of the Currency
to banks to check that they are following regulations. After an examination, a bank receives a
grade in the form of a CAMELS rating based on the following:
Capital adequacy
Asset quality
Management
Earnings
Liquidity
Sensitivity to market risk
Of the CAMELS categories, along with asset quality, capital adequacy has typically received
the most attention. Regulating the minimum amount of capital that banks are required to hold
reduces the potential for moral hazard and the cost to the FDIC of bank failures. Under the
Basel accord, developed by the Bank for International Settlements, bank assets are grouped into
four categories based on their degree of risk. Bank regulators determine a bank’s capital
adequacy by calculating two ratios: the bank’s Tier 1 capital relative to its risk-adjusted assets
and the bank’s total capital (Tier 1 plus Tier 2) relative to its risk-adjusted assets.
D. The 2007–2009 Financial Crisis and the Pattern of Crisis and Response
The financial crisis of 2007–2009 has followed the pattern of crisis and response. The financial
crisis, which began with the housing bubble, has led to major regulatory changes. If history is a
guide, we can be certain that financial firms will respond with innovations intended to reduce
the effect of the new rules on their activities.
