Episodes Of Financial Instability Research Articles

Capital Adequacy and Liquidity of Global Financial Institutions: A Study of Reforms after the Great Recession

The global financial crises of 2007-2009 was followed by the Great Recession which was the worst since the Great Depression of 1930s. The crises left significant adverse effects on global growth and employment. Policymakers of affected countries responded differently to the outcomes of these crises. The central banks, including US Federal Reserve Bank and Bank of England, provided ample liquidity for the financial institutions and lowered the interest rate to near zero. The policymakers and regulators realized that capital inadequacy and insufficient liquidity of financial institutions were the main problems preventing the financial firms to protect themselves against major financial crises. In addition, lack of guidelines for compensations encourages managers to take the extra risks. The US Federal Reserve Bank took the initiative, in cooperation with international central banks to introduce rules and regulations to safeguard the financial systems against another major crisis. It is not guaranteed that another episode of financial instability will not happen again. However, with existing regulations on financial institutions in force, the severity of the crises on the whole global financial system may possibly become weaker. This is a conjecture we explore here.

Sources and Implications of Resource Misallocation: New Evidence from Firm-Level Marginal Products and User Costs

Using micro-data on firm-specific borrowing costs and wages, we demonstrate that distortions in firms’ policies can be empirically measured using firm-level gaps between marginal revenue products and user costs (MRP-cost gaps). We estimate MRP-cost gaps for 4.7 million firm-year observations in Italy between 1997 and 2013: their variation is closely related to the extent of credit and labor market frictions. Using the MRP-cost gaps, we assess the scope of input misallocation in Italy, and its impact on aggregate output and total factor productivity (TFP). The Italian corporate sector could produce 6% to 8% more output by reallocating resources toward higher-value users. Output losses from misallocation are larger (i) during episodes of financial instability, (ii) in non-manufacturing industries, (iii) in areas with less developed institutions and (iv) among high-risk firms. We highlight an important gain/risk tradeoff: gains from reallocation might come at the expense of increasing aggregate financial fragility, because maximizing reallocation gains requires a transfer of resource from large, old, and low-risk firms toward small, young, and high-risk firms.

The financial crisis in the eurozone: a balance-of-payments crisis with a single currency?

In a pegged exchange-rate system, a balance-of-payments crisis happens when there is serious mistrust of whether a debtor country holds sufficient international reserves to monetise a capital withdrawal at the ongoing exchange-rate parity. In the eurozone (EZ), doubts that banks and governments of peripheral countries could settle debts when they matured led to a massive capital outflow after the fall of Lehman Brothers and, especially, the first Greek sovereign-debt crisis. This has led some authors to hold that the situation in the EZ is a balance-of-payments (BoP) crisis.However, the European Central Bank (ECB) offset massive financial capital withdrawals with a huge inflow of reserves to the EZ periphery, making the international reserves constraint irrelevant. This invalidated the BoP view in other authors’ opinion, who pointed out bad bank behaviour and a poor initial institutional design as the alternative root cause for the current mess. This position is known as the monetary sovereign (MS) view.In this paper, we provide a brief overview of the debate between both sides, with Cesaratto, as a representative for the BoP view, and Lavoie, De Grauwe and Wray, for the MS view, and discuss whether a reconciliation between these two positions can be possible. We step into the discussion to offer two additional arguments in favour of the second view: (i) A currency union requires a single monetary policy, as opposed to a fixed exchange-rate regime; TARGET2 balances combined with refinancing operations are an essential ingredient of monetary policy implementation. (ii) The current situation is more easily understood as another episode of financial instability after banks have granted huge amounts of credit (which they refinanced abroad). The situation got even worse because governments supporting troubled banks in their respective jurisdictions lacked a lender of last resort.

Desigualdad, inflación, ciclos y crisis en Chile

En este artículo se analizan los efectos de fluctuaciones macroeconómicas, así como episodios de inestabilidad financiera e inflacionaria, sobre indicadores de desigualdad en Chile para el período 1960-2014. La relación entre los episodios de crisis y fluctuaciones sobre los niveles de desigualdad se estima a partir de un estudio de eventos y de estimaciones econométricas, donde indicadores de desigualdad se relacionan con distintas variables macroeconómicas y de desempeño educacional. Las principales conclusiones son que, las crisis bancarias e inflacionarias, así como períodos de contracción severa del ciclo, tienden a aumentar los niveles de desigualdad en Chile.

Lehren aus der Krise – Notwendige Änderungen der Finanzmarktregeln und zur Begrenzung systemischer Risiken

Abstract The latest financial crisis has been caused by a mixture of state and market failure, argues Otmar Issing. To avoid future crises, more transparency is needed - not by gathering more information, but by gathering it systematically and thereby creating “intelligent transparency”. Furthermore, regulation has to be global, he states. The necessary institutions are in place: The International Monetary Fund, the Financial Stability Board and the Bank for International Settlements. Stephany Griffith-Jones and Stefano Pagliari point out, that containing “systemic risk” is one of the most important rationales for regulating financial markets. Our understanding of the sources of systemic risk has repeatedly been challenged by major episodes of financial instability. The crisis that started in the summer of 2007 has been no exception. They discuss how the latest global financial crisis urges analysts and regulators to rethink the origin of systemic risk beyond a narrow focus on the banking sector, beyond the “too big to fail problem”, and beyond a narrow micro-prudential focus. They focus on two regulatory principles: comprehensiveness and countercyclicality. Claudia Buch und Katja Neugebauer review the existing empirical evidence on whether the increase in cross-border activities has allowed banks to diversify risks and to what extent it has increased banks’ exposure to systemic risks.

Financial imbalances and gradualism

In the last years, in the major OECD economies, while inflation has become lower and more stable, episodes of financial instability and large cycles in asset prices have shown up with (often) non-negligible effects on economic activity. These facts should call for a larger concern with financial imbalances by the central bank. Adapting the model by Caplin and Leahy (1996)—where a central bank, which is uncertain about the state of the economy and its reaction to policy, seeks an optimal search strategy to influence private agents' responses—by substituting the central bank's price stability objective with a financial stability one, we find that the monetary authority should follow a less aggressive policy than the one suggested by the original model. However, initial conditions play a crucial role in determining the degree of gradualism by the policy maker with the policy becoming more and more aggressive as the initial interest rate shrinks.

Bank Crises and Investor Confidence

In addition to their direct effects, episodes of financial instability may decrease investor confidence. Measuring the impact of a crisis on investor confidence is complicated by the fact that it is difficult to disentangle the effects on investor confidence from coincident direct effects of the crisis. In order to isolate the effects of financial crises on investor confidence, we study the investment behavior of immigrants in the U.S. Our findings indicate that systemic banking crises have important effects on investor behavior. Immigrants who have experienced a banking crisis in their countries of origin are significantly less likely to have bank accounts in the U.S. This finding is robust to including important individual controls like wealth, education, income, and age. In addition, the effect of crises is robust to controlling for a variety of country of origin characteristics, including measures of financial and economic development and specifications with country of origin fixed effects.

Dream of the red financial supermarket: the gradual emergence of integrated financial services provision in China in the 21st century

While the current regulatory trend in the area of banking scope regulation favours integrated financial services provision, China continues to restrict commercial banks’ permissible range of business activities via its 1995 Commercial Bank Law. In this article, we propose an analytical framework that explicitly incorporates the sophistication-level constraint of a country's financial system into the regulatory trade-off calculation between banks’ need for new growth opportunities and an increased risk of financial instability. Applying this framework to China, we first discuss the episode of financial instability that led policy-makers to re-segment the financial industry in 1995 and then analyse the rationale behind China's recent, gradual movement back towards integrated financial services provision. While improved risk management capabilities mean that China may now be ready for a more liberal banking scope regulatory regime, we find that a financial crisis could still derail this important element of China's financial sector reform strategy.

The Basel Process, Financial Stability, and the Age of Turbulence

The Basel Process is a key element of the global financial system and a critical force that has been shaping the international financial architecture over the last 80 years. As such it plays an important role in co-ordinating the multilateral eorts of central banks, regulators, supervisors and market participants alike and is thus uniquely geared towards fostering and maintaining financial stability. Giving rise to current global financial turbulence, the recent subprime crisis has subjected the Basel Process to intense internal and external scrutiny. This episode of financial instability might yet prove be one of the most challenging tests for the Basel Process as authorities strive to improve their regulatory frameworks in search of incentives for prudent behaviour.

Distress Selling and Asset Market Feedback

This paper examines the process of distress selling and asset market feedback. It splits this process into several stages, in order to analyze what triggers distress selling, why asset prices fall, and how falling prices generate additional rounds of selling. This framework enables us to understand and compare models relevant to distress selling from diverse literatures. The paper also considers what policy options are available at each stage to mitigate the adverse economic consequences of distress selling and asset market feedback.

Financial Innovations and Veblen’s Theory of Financial Markets

The financial system in the 1980s was shaken by a wave of speculative finance facilitated by a massive accumulation of debt, a stock market crash, crises in the banking/thrifts sector, and episodes of price manipulation. These developments comported closely with Veblen's theory of financial markets presented in The Theory of Business Enterprise [1904]. But have repeated episodes of financial instability invalidated Veblen's later assessment in Absentee Ownership [1923] that the financial system had become virtually self-insured against crises? In this paper, we propose an interpretation of Veblen's theory of financial markets which incorporates both a tendency toward collusive stability and resurgent periods of financial instability. Within that context, we focus on the role of financial innovations. The current instability traces to a financial restructuring process often linked to a wave of financial innovations. Carter [1989, 781-786] explained how financial innovations generate an increasingly fragile financial structure. Lawson and Lawson [1990] argued that the standard view of financial innovations-as encouraged by regulations and high interest/inflation rates and