1

Over the module we will consider.

Lecture ONE FINANCIAL AND BANKING CRISES:
AN INTRODUCTION
Lecture TWO WHAT CAUSES FINANCIAL CRISES?
Lecture THREE THE WHY AND HOW OF BANK BAILOUTS
Lecture FOUR WHY REGULATE?
Lecture FIVE CAPITAL RATIOS
Lecture SIX INSTITUTIONAL STRUCTURES OF
REGULATION
Lecture SEVEN MONETARY POLICY AFTER A
BANKING CRISIS?
Lecture EIGHT HETERODOX MACROECONOMICS
AND FINANCIAL CRISIS
2
Teaching Plan of Dr. Zaw
every Monday Morning Classes
Week Date Topics
First 9 October 2017 Chapter 1
Second 16 October 2017 Chapter 2
Third 23 October 2017 Chapter 3
Fourth 30 October 2017 Presentation
Fifth 6 November 2017 Presentation
Sixth 13 November 2017 (Public Holiday) Chapter 4
Assignment submission Deadline
Seventh 20 November 2017 Chapter 5
Eighth 27 November 2017 Chapter 6
Ninth 4 December 2017 Chapter 7
Tenth 11 December 2017 Chapter 8
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 MBF Programme
The Module Structure
Section. Chapter and Web-Ex Session Topics Addressed
Lecture No.
Section 1: 1 Session 1: Introduction
Financial and Why banks are important
Banking Crises The frequency of financial crises
What Are We Symptoms and features financial and banking
Regulating? crisis
The costs of financial crisis
2 The causes of Financial Crises
3 Bank bail outs
Section 2: 4 Session 2: Why and how we regulate banks.
Prudential
5 Why and How Capital Ratios
Regulation
6 Should We Institutional arrangements for prudential
regulation
Regulate Banks?

Section 3: 7 Session 3: Monetary Policy Responses to Financial Crisis

Macroeconomic
How We Should
responses to 8 Heterodox macroeconomics and financial
financial crisis. Respond to crisis
Financial Crisis? Financial crisis case studies.
4
Financial Crises and Regulations
Attendance: 10 marks

Presentation marks: 20 marks

Mid term or Assignment: 20 marks

Final exams: 50 marks

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 Module aims
This module aims to provide:
a theoretical and historical approach to explaining why banks and
financial markets are inherently vulnerable to crises,
to analyse the role of policy makers and institutions and
examine the role of monetary policy, bank supervision and regulation
in mitigating or exacerbating crises.
At the end of the module you should be able to
understand:
the main theoretical models in which asymmetric information
and coordination failures create a role for intermediaries and
produce problems such as bank runs, asset price bubbles and
herding. Different policy options for dealing with
financial/banking crises will also be outlined.
6
The approach adopted within these
sessions.
Financial crises and banking regulation
are highly complex and opinionated areas
of discussion and debate.
Many issues are not fully agreed and
critical discussion of different questions
is essential.
These sessions will consider key
topics/questions/issues raised and try to draw
out a critical discussion of these topics.
.
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 Assignment
The module will be assessed through one course work
assignment, one group presentation and final exam.

The first course work assignment is as follows:

a) Identify and describe two distinct financial crises

within the last two hundred years. (750 words)

b) For each crisis, provide a description of the

immediate and underlying causes of the crisis.
(750 words)
 Assignment
1. The due date for the Financial Crises and Bank
Regulation assignment is the 13 November 2017.
2. The word limit for this assignment is 1,500 which does
not include referencing, Tables or appendices.
3. Assignments are to be submitted via email to
drzawwinthein@gmail.com, only one submission
attempt is possible.
4. Assignments should be submitted by midnight local
time
5. Assignment must be submitted in Microsoft Word
2007 or PDF Format
6. Assignment must be headed by Name, Roll Number,
Group number and Batch number
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Group Presentation

10
 Reading for the module
The consequences of the Global Financial Crisis
(Oxford) (Wyn Grant & Graham K. Wilson)

The fundamental principles of Financial Regulation

(Markus Brunnermeier, Andrew Crockett, Charles
Goodhart, Avinash D. Persaud and Hyun Shin)

The Financial Crisis Inquiry Report (USA official

government edition)

11
 Today we will consider:
Introduction and Module Outline.
Why are Banks Important?
The Frequency of Financial and
Banking Crises
Different Types of Financial Crisis
The Increasing Importance of Financial
and Banking Crises
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 Intermediation and intermediaries
In this module we are interested in bank-like financial
intermediaries i.e. firms with the following
characteristics:
Banks borrow from one group of agents and
lend to another group of agents
The lending and borrowing relationships are with large
numbers of agents using debt contracts
The claims issued to borrowers and to lenders have
different payoffs
Banks are often large, suggesting diversification
on each side of the balance sheet
A large portion of the liability side of the balance
sheet is demand deposits and securities 13
 What are private banks?
Banks are one group of financial institutions that
provide access to the financial markets.
A system without financial institutions would
not work very well for three reasons:
Individual transactions between saver-lenders and borrower-
spenders would be extremely expensive.
Lenders need to evaluate the creditworthiness of borrowers
and then monitor them to ensure that they dont abscond
with the funds and individuals are not equipped to do this.
Most borrowers want to borrow long term, while lenders favour
short term loans
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 Financial intermediation
This process entails four functions:
The pooling of risks, with each depositor of a bank having an
indirect claim on all the mortgages, business loans, or credit
card receivables owed to the bank rather than a claim on one
specific mortgage or loan.
Maturity transformation via balance sheet intermediation,
with banks lending at longer average maturities than they
borrow
Maturity transformation via the provision of market
liquidity, which gives the holder of a contractually long-term
asset the option of selling it immediately in a liquid market.
Risk return transformation via the creation of a different mix
of debt and equity investment options for savers than arise from
the liabilities of the borrower. 15
 The transformation of savings into
investment
Savings Investment

High, search, agreement and monitoring costs

Low
High liquidity
liquidity
Ultimate
Borrowers High Risk
Primary
(households
Investors Low Risk
and businesses)
(households)
Large
Small Quantity
Quantity
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 Why do banks exist?
We know (broadly) what financial intermediaries do, but
this is not the same as understanding why they exist. The
economics literature provides several reasons for their
existence:

Delegated Monitors
Consumption Smoothing
Information Producers
Liquidity Provision
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 Delegated monitors
Financial intermediaries act as delegated monitorsi.e.
they monitor borrowers on behalf of investors who lend to
the financial intermediary.
A monitor is needed because of information asymmetries.
Because banks handle the borrowers transactions account they
act as the firms book-keeper and have a greater comprehension of
the risks of lending than the depositor.
In undertaking this function banks provide economies of
scope or synergies between deposits and lending
businesses.
A financial intermediary can commit to repay depositors only
if it is an effective monitor.
Otherwise it will make losses on its assets and be unable to
redeem all deposits. 18
 Direct Finance Each Lenders Monitors its
Borrower Lender 1
N identical firms seek to borrow. Borrower 1
Each firm is monitored at cost K. Lender M
M investors or lenders are required for
Lender 1
each borrower. Borrower N
The total number of investors required is Lender M
NM so all loans provided.
Total cost of monitoring is NMK
Delegated Monitoring
When a bank emerges it can
monitor each borrower at a cost Borrower 1
Lender 1
NK.
Lender M
Lenders can monitor the banks
using a debt or deposit contract Bank
(cost C) Lender 1
Borrower N
Total cost under delegated
monitoring is NK + C Lender M

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 Information Producers
Financial intermediaries produce (costly) information
about potential investments that could not be produced
efficiently by securities markets.
If information about investment opportunities is not free, it may be
worthwhile to produce and sell it.
Information producers need to have credibility that the information is
reliable.
The information producer needs to know that information produced will
not be re-sold.
Financial intermediaries can overcome these problems: they solve
the reliability and appropriability problem in information
production.
This requires the intermediary (information producer) to have a
minimum amount of wealth at risk (i.e. to make a loan). The
information may be acquired over time through repeated
lendingcustomer relationship. 20
 Consumption Smoothing.
Satisfying consumption needs may require ending investments
unless consumers save via financial intermediationi.e.
intermediation provides insurance against shocks to a consumers
consumption path.

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22
 Liquidity Provision.
The desire of economic agents to contract and
trade generates a need for a payments system
(otherwise agents would need to barter).
Economic agents who need to consume may face
trading losses if other agents know this and seek
to use that knowledge to make profits.
Financial intermediaries overcome the moral hazard
problem that prevents firms (consumers) with excess
liquidity lending to other firms (consumers) that
need liquidity.
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 What do banks really contribute?
How should we understand and measure the contribution the
financial sector makes to economic wellbeing? There are several
views we will discuss:

Generally the financial system is essential

to the conduct of modern life,
both for firms and households.

Yunus in his 2006 Nobel peace prize speech declared

access to credit is basic human right.
Payment systems are an essential element within the financial
infrastructure of any capitalist economy, enabling the
settlement of transactions in a systematic and timely manner.
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 What do banks really contribute?
Across the European Union in 2007 the percentage of
households using current account services was 87%, a figure
rising from 80% in 2003; a higher percentage than had
telephone services, both mobile and fixed line, or a gas supply
(European Commission 2009).
The financial system plays an active role in capital
accumulation when it performs the pooling function.
The pooling function delivers more efficient allocation of
capital and a higher level of income for any given level of
investment.
Maturity transformation allows depositors to smooth
consumption across time, while permitting society to fund
long-term investments.
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 Financial and banking crises
Financial and banking crises are major
disruptions to the financial system, typically
involving crashes in asset prices and failures
of financial institutions.
These crises has been defined as real crises (fuelled
by fear, that means payment will be unavailable at any
price, Schwartz 1986) and pseudo crises involving a
sharp readjustment of asset prices.
Real crises pose the greatest dangers to an economy
potentially having major implications the monetary
base and medium term economic prospects. 26
 The Frequency of Financial and Banking Crises
Financial and banking crises impact rich and poor
nations alike.
Financial crises have been a persistent occurrence throughout
history increasing in frequency during the last century.
Allen et al (2009) report the frequency of crises in recent
decades has been double that of the Bretton Woods Period
(1945-1971) and the Gold Standard Era (1880-1914).
Financial and banking crises are not random
events.
Historically real crises tend to occur with a seasonal
regularity in Spring and Autumn, moving with the
agricultural cycle (Wood 1999).
Crises tend to be linked with higher levels of banking activity.
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 The Frequency of Financial and Banking
Crises
Crises occur within cycles, happening more frequently
at the peak of the business cycle (Gorton 1988).
The economic cycle causes solvency risks as levels of
debt vary over the economic cycle. In good times more
debt can be profitable and in poorer times high leverage
can amplify other risks.
Crises re-occur regularly in certain nations indicating
path dependence of these events.
19 countries have experienced more than one banking
crisis (e.g., Argentina: 4; Mexico: 2; USA: 2) (Laeven
and Valencia 2008)

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 Bank Crisis affects all nations! Share of years in a banking crisis
since 1800 or Independence (Reinhart and Roggoff 2011.)
United Kingdom
Uruguay Turkey
Sweden
Peru Spain
Russia
Panama Romania
Portugal
Mexico Poland
Norway
Guatemala
The Netherlands
Italy
Ecudor
Hungary
Costa Rica Greece
Germany
Chile France
Finland
Brazil Denmark
Belgium
Argentina Austria
0 10 20 30 40 0 10 20 30 29 40
 Bank Crisis affects all nations!
Share of years in a banking crisis since 1800 or Independence
(Reinhart and Roggoff 2011.)
Thailand Zimbabwe
Taiwan Zambia
Sri Lanka Tunisia
Singapore South Africa
The Phillipines
Nigeria
New Zealand
Morocco
Myanmar
Mauritius
Malaysia
Kenya
Korea
Egypt
Japan
Indonesia Cote d'Ivore
India Central African
China Angola
Australia Algeria
0 10 20 30 40 0 10 20 30 30 40
 Economic theories of banking crises
There are many explanations as to why banking/financial
crises occur or are triggered.
Severe financial and banking crises rarely occur in
isolation and amplify current concerns within an
economy.
Laeven and Valencia (2008) report financial crises arise
from many sources both individually and in
combination. These include unsustainable
macroeconomic policies, excessive credit booms, large
capital inflows, policy paralysis and balance sheet
fragilities.
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 This has led to many types of crisis being defined.
Following Laeven and Valencia (2008) and others, we
divide financial crises into a number of categories:
A systemic banking crisis
A currency crisis where the currency depreciates by at least
30% in a year.
A sovereign debt crisis when a country needs to
default or restructure its national debt.
Asset-Price Crashes.
Increased capital mobility and financial liberalisation
Capital flow bonanzas
Monetary Policy
Bank runs

32
 Systematic banking crisis
A systemic banking crisis is defined as a default
on borrowing by a large number of a nations
banks, financial institutions or firms
A systematic banking crisis develops when a
large number of banks default or many
financial institutions simultaneously cannot
honour their contracts.
Subsequently the level of non-performing loans rises
and the capital in a banking system is exhausted.
This may be associated with a fall in asset prices or
a slowdown or reversal in capital flows. 33
 Asset-Price Crashes.
Asset price crashes typically occur when an
asset-price bubble pops.
During a bubble asset prices rise far above the
present value of expected income from the assets.
Bubbles pop as at some point sentiment shifts:
people worry and start selling,
prices fall;
declining prices shake confidence,
a vicious circle of selling and panic emerges.
These equity and housing price cycles are frequently linked
with banking crises.
For example the real estate bubble in 2005 in the USA is seen as a key cause of
the 2007 crisis, the Japanese banking crisis of 1992 was linked to a real estate
and stock market boom and cases also exist in Norway (1987), Spain
(1977), Finland and Sweden (1991). 34
An example of an asset price boom:
Japanese asset prices (source BoE 2012)

35
 Increased capital mobility and
financial liberalisation
Financial liberalisation and increased capital
may also engender or trigger banking crises.
Kaminsky and Reinhart (1999) considered 26 banking crises
since 1970 and reported 18 of these crises were linked to
financial liberalisation in the previous 5 years.
It is reported:
That it is unusual for financial liberalisation to go
smoothly.
The probability of a banking crisis conditional on
financial liberalisation is significantly higher than the
unconditional probability of a banking crisis.

36
 Capital flow bonanzas
Reinhart and Reinhart (2009) examined 81 nations between 1960-
2006 and reported whether a sustained capital inflow into an
economy prior to a banking crisis was critical in determining
whether a banking crisis actually occurred.
The probability of a banking crisis conditional on a cash
flow bonanza is significantly higher than the unconditional
probability of banking crisis (without a capital bonanza).
This effect is most marked for lower and medium income nations
rather than higher income nations which may be able to manage
such capital flows within more developed financial markets.
Overall 61% of nations have a higher propensity for banking
crisis if this event is preceded by a cash bonanza.
This finding would be higher if we considered post 2007 data.
37
From Reinhart and Reinhart (2009)

38
 Institutional Factors
Calomiris and Haber (2014) argue the institutional framework within
which banks operate is critical to whether a banking system is prone to
banking crisis or otherwise. Banks can be fragile by design.

"Institutions are the rules of the game in a society or more formally

are the humanly devised constraints that shape human
interaction." (North 1990)
Institutions are the building blocks from which the particular form and
nature of societies economies are developed. This perspective involves
the concept of path dependence the history of a nation will
influence its present.

Calomiris and Haber argue banks require certain property rights such as
the enforcement of credit contracts, to thrive. These rights can only be
provided by strong governments which bankers can convince to act in
their interests.
The fragility of the banking system or otherwise is therefore an outcome
of a political process the Game of Bank Bargains.
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 Capital Flight
In the last 20 years, financial crises have hit many
emerging market economies, including Mexico in
1994, East Asian countries 1997-98, Russia in 1998;
Ecuador in 1999, and Argentina in 2001.
These crises have an additional key element
capital flight.

Capital flight is a sharp fall in the demand for a

countrys assets.
This can result in a large-scale net outflow of capital, a real
exchange rate depreciation, a fall in the supply of loans and
higher real interest rates.
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 Costs of financial crisis
Financial crises inflict direct and indirect
costs on the economy.
The direct costs include equity and
creditor losses from bank (and other
financial institution) failures.
The indirect costs include a chain of events
that plunges the economy into recession
and have two key parts:
Lending and spending.
A vicious cycle
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 A vicious circle.
If a crisis causes an economic recession, the
recession can then exacerbate the crisis.
Because of feedback, a crisis can trigger a vicious
cycle of falling output and worsening financial
problems.
Asset prices are likely to fall further as stock prices fall because
the recession reduces expected profits and lower demand for real
estate pushes down house prices.
Recession worsens banking problems:
Banks lose revenue because recession reduces the
demand for loans and loan defaults increase as firms go
bankrupt.
This makes further bank panics and bank failures more
likely. 42
 Linkages in a banking crash
F
Asset-price Output
crashes
A
E
B Aggregate
F Lending
expenditure
C D

Bank failures
from liquidity
and/or
G
insolvencies
A Wealth Uncertainty
B Net worth and collateral of borrowers
C Fewer banks, banks more cautious
D Firms and consumers cant finance spending
E Spending determines output in the short run
F Recession leads to firm earnings demands for real estate
G Recession leads to bank revenue loan defaults

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 Economic effects of financial crises

Laeven and Valencia (2008)

Banking crises have large fiscal costs and output losses
Fiscal Costs (% of GDP)
Argentina 75%, Chile 36%, China 18%, Korea 31%, Mexico 20%.
Output losses
Argentina 73%, Chile 92%, China 37%, Finland 59%.

Reinhart and Rogoff (2009) - Banking crises leads to average:

Asset market collapses average 35% over 6 years
Equity market collapse 55% over 3 years
Output falls by 9%
Unemployment rises by 7%
44
 Average duration of recessions

IMF World Economic Outlook (April 2009).

(a)From peak to trough in output levels. Sample includes recessions in 21 advanced economies
since 1960.
(b)Big five includes Finland (199093), Japan (1993), Norway (1988), Spain (197879) and Sweden
(199093) 45
 Trust and uncertainty in banking crises
Financial and banking crises also have notable effects on
economic confidence and trust.
While neoclassical economics does not account for trust and confidence, the
degree of trust to transact with others can decline after a financial crisis
(Sapienza and Zingales 2012).
Some commentators (e.g. Guiso et al 2004, 2008) even argue trust can reduce
the level of public participation in future investment activity.

An associated concern is the level of uncertainty; a concept not

widely considered within economics.
After banking crises uncertainty as to the level of asset prices can emerge.
As many banking crises are preceded by asset price bubbles, the popping of
asset bubbles and resulting fall in asset prices affects other asset markets
unrelated to the bubble market.
In such circumstances the prices of commodities and currencies may become more
variable and volatile, making long term financial decision making challenging for
firms and individuals (Allen and Carletti 2010). 46
 Lastly, .. Personal Insolvency
can rise during crisis periods
0.4%

0.3%

0.2%

0.1%

0.0%
1985

1989
1991
1993

1997
1999
2001

2005
2007
2009

2013
1987

1995

2003

2011
Recession Individual Insolvency rate
Bankruptcy Rate DRO Rate
IVA Rate

47
 Review Questions
Why is banking important for an economy?

What are the key characteristics of financial

crises?

How frequent are financial crises?

What are the costs of financial crises?

Why are we concerned with financial and banking

crisis? 48
In the next lecture we will consider WHAT
CAUSES FINANCIAL CRISES?

This will include:

Structural Explanations: Solvency and

Liquidity Concerns.
Inter-bank relationships

Human Nature: Mania and operational

explanations
49
Any Questions?

50