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Financial Crises: Why They Occur and
What to Do about Them







E. Maskin

Institute for Advanced Study









•        current financial crisis only latest in long sequence

•        history of financial crisis in U.S. goes back to 19th
century

•        probably crises will continue in future

–        each crisis somewhat different from predecessors

–        even if we fix mortgage loan market in U.S.(where current crisis started), something new will happen

–        even if anticipated, not all crisis may be preventable

•        however, can do much better at limiting crises









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Today’s topics





•                Why does credit market have repeated crises and other markets do not?

•        Why does credit market require substantial ex post
intervention        (and others do not)?

•        What can be done ex ante to prevent/limit crises?











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To understand what caused this crisis (and other crises)
should first eliminate factors that were not causes

•        irrationality

- on part of bankers

- on part of borrowers

•        panic

•        greed

•        lack of ethics

•        overconsumption in U.S./ oversaving in China

•        opaqueness of derivatives

•        bankers’ bonuses

•        banks too big to fail


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Why is credit market different?
(1)        credit lifeblood for rest of economy
−        if crisis in market for rice, won’t bring down market for automobiles
−        if credit market doesn’t work, enterprises in all markets will have trouble investing and meeting payrolls
(2)        small shock to credit market often magnified
−        if some rice growers fail, won’t cause other growers to fail
−        if some banks fail, may well cause other banks to go under
(3)        credit market not self-correcting
−        if some rice growers fail, others will step into breach no outside intervention needed
−        if some banks fail, credit market can get “stuck” - - no banks willing to lend








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Elaboration on points 2 and 3

•        Suppose flood wipes out rice crop in Yunan

•        What will happen?

–        immediate effect is fall in overall rice output

–        but demand hasn’t changed - - less rice to go around

–        so price of rice will be bid up

–        induces other rice suppliers in Yangtze River Valley to grow and sell more











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•        So rice market “self-correcting”

–        crop failure hurts consumers in short run - - higher prices
–        but high prices induce suppliers to expand output
–        so effect of drought mitigated in long run
•        Government intervention not needed

•        Government interference in rice market likely to make things worse
•        Suppose puts cap on rice price or taxes “windfall”
profits

–        discourages expansion of output that can make up for crop failure
–        this creates rice shortage or black market in rice




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•        Credit market is just the opposite
•        Suppose a few banks get into trouble
–        made risky subprime mortgage loans
–        borrowers can’t repay loans
–        banks highly leveraged – don’t have enough capital to maintain other operations
•        these banks have other borrowers
–        have to call loans in on these borrowers
–        so borrowers have to scale back activities that depended on these loans
–        thus will have harder time repaying loans from other banks
•        so these other banks now get into trouble
–        have to call in loans from their borrowers
–        refuse to make new loans
•        what started as local problem (subprime mortgage lending) spreads to
entire credit market (systemic risk)
•        initial problem not self-correcting (as in rice market)
–        gets aggravated
–        end up with credit crunch
–        not due to panic, but to rational responses by bankers and borrowers


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•        in economics terminology,        bank exerts an externality on
other banks by being highly leveraged and making risky loans

–        externality: effect your actions have on others that you don’t take into account

–        when bank highly leveraged and makes risky loans,        puts other banks in jeopardy

–        but doesn’t factor this effect in when leverages itself and makes loans (not harmed by it)

–        not irrational or unethical or overly greedy

•        markets with significant externalities often don’t work well on own

–        take clean air, for example







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•        Why isn’t there a market for clean air?

•        in fact, there is such a market, but so limited we hardly see it
•        suppose laundry next door to steel plant
–        smoke from steel plant interferes with laundry
–        laundry may offer to pay steel plant to reduce smoke (so market for smoke reduction exists)
–        but smoke doesn’t just affect laundry - - affects many other enterprises
–        by paying for reduction, laundry confers benefit on other enterprises (externality)
–        laundry doesn’t take this into account
–        so likely to underpay for reduction - - smoke not reduced as much as should be

•        solution: government imposes cap or fine on smoke emissions by steel plant


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Need two solutions for credit market

•        ex post : after banks get into trouble

•        ex ante : to prevent crisis in first place

























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Ex post solution for credit market:

If some banks get into trouble,

•        government can bail them out

– infuse with capital so can continue to lend

•        but bailout important primarily for other
banks that would be hurt if bailed-out banks failed











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Bailout policy comes at cost:

•        if banks anticipate being bailed out when get in trouble

–        have incentive to take on highly risky loans, e.g., subprime mortgage loans (moral hazard)

•        so ex post solution to financial crisis actually makes crisis more likely!

•        so also need ex ante solution :

regulation

– constraints        on what banks can do










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Actually, two reasons why regulation needed

•        prospect of bailouts induces banks to make too-risky loans (moral hazard)

•                bank ignores externality imposed on other banks by too-risky loans and leverage - - undervalues cost of these loans and leverage



















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Principal forms of regulation

•        minimum standards for loans

- borrowers must be sufficiently credit worthy

•        limits on leverage / capital requirements

- given lending,        need minimum capital level

- limiting leverage limits bank’s liquidity

- another way of accomplishing same thing :

increasing interest rate
- leverage limitations        ↔        monetary policy








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•        restrictions on derivatives

- derivatives allow risks to be shared with others

- risk-sharing useful

- however, encourages riskier lending

- so, because of externality, should restrict derivative trading

•        regulation of bankers’ bonuses

- many complaints about these bonuses

- however, bonuses per se not problem

- problem : rewarding bankers for success without punishing failure –
encourages risky lending

- solution : bankers must return bonuses (or other punishment) if loans fail








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•        regulating size of banks

- problem with big banks not

too big too fail

- several small banks failing has same effect as one big bank failing
•        problem with big banks :

because of externality

- bank takes too much risk

- in particular, doesn’t diversify sufficiently

- so too likely to fail

- small banks also too likely to fail

- but several small banks less like to fail than one big bank, because each does
something different


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•        Have argued that can understand current financial crisis without
appealing to

- irrationality

- panic

- greed

- lack of ethics

- opaqueness of derivatives

- bonuses

- too big to fail

•        Crisis brought on by

- externality (one bank’s risk-taking affects other banks )

- moral hazard (prospect of bailouts)

•        Solution

- bailouts

- regulation
needed to correct externality
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moral hazard created by bailouts






•        Well-designed regulation/bailout package

–        can prevent many crises from getting started - - rules against subprime loans would have prevented this one

–        can resolve them if do occur

–        historically, regulation worked from 1940~1980

•        Can’t hope to prevent credit crises completely and still allow for creativity

–        can’t anticipate all possible innovations by banks

–        so can’t have rules that prevent only harmful innovations

•        But can do a lot better than we’ve done this time






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