This study presentation looks at the causes and consequences of different types of financial crisis. It also focuses on the Hyman Minsky theory of financial instability in a capitalist economic system.

1. Financial Crises
Financial Economics

2. Economics of Financial Crises

3. Types of Financial Crisis
• Currency crisis when a fixed exchange rate regime
collapses or a currency goes into a free fall
• Balance of Payments (BoP) or external debt crisis
• Sovereign debt crisis
• Banking crisis
• Corporate debt crisis
• Household debt crisis
• Broad financial crisis that combines many elements of the
above crises (Argentina 2001 for example)

4. What is a Financial Crisis?
• “A disturbance to financial markets, associated typically
with falling asset prices and insolvency amongst debtors
and intermediaries, which ramifies through the financial
system, disrupting the market’s capacity to allocate
capital.”– (Eichengreen and Portes 1987)
• “Bank runs, sharp increases in default rates accompanied
by large losses of capital that result in public intervention,
bankruptcy or forced merger of financial institutions.”
(Schularick and Taylor, 2012)

5. Distinction between Solvency and Liquidity Crises
• Insolvency crisis:
• An agent (such as business, individual or a bank) is insolvent
when its debt relative to its income is so high that it will not be
able to pay back its debt and the interest on it (i.e. there is an
unsustainable debt)
• May require some form(s) of debt restructuring / debt relief to
lower default risk
• Illiquidity crisis:
• An agent is solvent but illiquid when its debt is not
unsustainable but it has large amounts of this debt coming to
maturity (i.e. short term debt) and it is not able to roll it over
(this creates liquidity crisis, rollover/run crisis)
• Illiquidity can lead to insolvency as illiquidity can trigger
default
• In a liquidity crisis, international institutions may step in to
provide emergency funds as a “lender of last resort”

6. Root Causes of The Great Recession of 2008-09
US housing and
mortgage bust
Liquidity and credit
crunch spread to all
credit and financial
markets
Economy wide
recession in the US
Recession in most
advanced
economies
Banking crisis led to
sovereign debt
crisis
Great Recession of
2008-09 bottomed
out in late 2009
But long period of
slow growth in
countries burdened
by debt

7. Non-Performing Bank Loans in the United States
Share of non-performing loans held by banks in the United States from 1995 to 2015
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
'95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15
Shareofnon-performingloansintotalloans
Non-performing debts are debts on which
creditors have not made payments in more
than 90 days. If a bank decides to write-off
these debts, it creates damage on their
balance sheets

8. Root Causes of The Great Recession of 2008-09
0
50
100
150
200
250
'91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11 '13 '15
Indexvalue
• Years of low interest rates
• Lax supervision and
regulation of the financial
system – regulatory failure
• Excessive risk taking and
leverage of the banks –
especially sub prime lending
• Global current account
imbalances and global
savings glut
• Irrational exuberance and
animal spirits leading to
financial bubbles
• Distorted incentives of credit
rating agencies
US House Price Index 1991-2015

9. Aspects of the Sub-Prime Lending Crisis
Mortgage delinquency rates for subprime conventional loans in USA from 2000 to 2014
11.9%
10.8%
19.9%
25.5% 25.9%
23%
20.6% 21%
19.1%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
2000 2005 2008 2009 2010 2011 2012 2013 2014
Delinquencyrates

10. Are Financial Crises Becoming More Frequent?
• Recent developed markets crises
1. US housing and sub-prime crisis in 2006-2008
2. Global Financial Crisis (GFC) of 2008-2009
3. Sovereign debt crises and economic crisis in the
Eurozone (2010-2013): Greece, Ireland, Portugal, Spain,
Italy, Cyprus, Slovenia. Grexit Risk.
• Recent emerging market crises:
1. Mexico (1994), East Asia (1997-98), Russia (1998), Brazil
(1999), Turkey and Argentina (2001)
2. EM mini-crisis in 2013-15 and China’s 2015 turmoil

11. Economic and Social Risks from Financial Instability
Taxpayers
(Bailout costs)
Depositors
(Risk of lost
savings)
Creditors
(Unpaid
debts)
Shareholders
(Lost equity)
Employees
(Lost jobs)
Government
(increased
deficit)

12. Financial Crisis and Contagion Effects
Sub prime
mortgages
Mortgage
companies
Lenders &
Home
builders
Financial
markets
US economy
Global
economy
Key origins of the 2007-2009 financial crisis
• Sub-prime lending – lending to high risk
home-buyers
• Financial innovation e.g. credit default
swaps and collateralized debt obligations
• Asset price bubble – especially in housing –
banks lent out too much
• Regulatory capture – e.g. failure of the
credit ratings agencies

13. How a Financial Crisis Hits Business Investment
• Financial crises eventually feed through into the real
economy and usually cause a fall in business investment
1. Higher cost of credit – commercial banks become more risk
averse and may raise interest rates on higher risk loans
2. Falling asset prices weaken bank balance sheets and mean
they have less money to lend out. Banks restrict credit to
rebuild capital
3. A desire to maintain higher lending of bank liquidity causes
a fall in lending to new and small businesses which can
hamper entrepreneurial activity
4. The fall in asset prices causes a fall in consumer spending /
aggregate demand and economic confidence – businesses
less likely to invest when spare capacity is growing
5. Fall in share prices hits the ability of listed companies to
raise extra capital to fund their investment plans

14. Impact on Share Prices of Previous Financial Crises
Source: http://www.risk.jbs.cam.ac.uk
Multiple financial crises often happen simultaneously. For example, the Global Financial
Crisis in 2008 was initially focused on the housing market (an asset price bubble) but then
spread into the wider banking system and onto government debt problems

15. Economic Policy Response to the Global Crisis in 2008
• The credit crunch and the collapse of Lehman led to a
steep fall in global real output and an even bigger decline
in the volume of world trade
• There were well-founded fears that the world economy
was at risk of another depression similar to the 1930s
• Macroeconomic policy in many countries responded:
1. Large conventional/unconventional monetary easing
involving deep cuts in policy interest rates and
quantitative easing
2. Massive fiscal stimulus for a while – especially in China
and (to a lesser extent) in the USA
3. Backstop and bailout of the private sector (financial
system, households, corporations) - including (in the UK)
bail-outs and nationalization of some banks

16. Adair Turner on Banking and Financial Crises
• “Modern financial systems left to themselves inevitably
create debt in excessive quantities. In particular, the type
of debt that does not fund new capital investment but
rather the purchase of already existing assets, above all
real estate.”
• “Banks do not only “take deposits from households and
lend money to business,” but they also “create credit,
money and purchasing power.”
• “Debt can be dangerous, even if all bankers are as honest,
responsible and professional as possible, and even if each
individual loan seems in itself socially useful and
economically sustainable.”

17. Credit and the Upswing of Asset Price Cycles
Increased
asset
prices
High bank
profits and
confidence
Relaxation
of credit
risks
Increased
lender
supply of
credit
Expansion
of credit
supply
When asset prices such as
property prices are rising,
many people will have the
expectation of future asset
price increases.
This then increases the
borrower demand for credit
at a time when commercial
banks are more willing to
lend to borrowers because of
the expectation of higher
profits
Expectations / sentiment
become crucial in explaining
asset price cycles
Big danger of upswing: Cycles of over-supply and over-demand

18. Credit and the Downswing of Asset Price Cycles
Falling asset
prices
Rising non-
performing
loans
Growing bad
debts hits
profits and
reserves
Decreased
lender
supply of
credit
Falling
demand for
assets
• When asset prices start
falling, lenders will tighten
up their lending criteria
and the supply of loans
contracts
• In a systemic credit
crunch, the financial
markets may stop or
severely limit lending to
each other.
• A rise in bad debts / loan
defaults hits the profits
and reserves of the banks
• In a severe crisis banks
may fail because of
insolvency and a loss of
liquidity
Big dangers of downswing: Bankruptcy, default, debt overhang

19. Hyman Minsky's Financial Instability Hypothesis
• Argues that the financial system is inherently unstable
• Take an economy currently experiencing a phase of strong
growth (“tranquil period”) but with debts from previous cycles
• Strong growth phase increases profits of the banks
• Rising incomes and employment makes debt more serviceable
• Lending criteria considered prudent in the past are relaxed
• Increase in supply of credit increases the leverage of the
banking system
• Credit boom drives economic growth and asset prices
• Rising debt-to-GDP ratio increases the risks for an economy if
there is an external shock
• Small increases in bad debts can make the system unstable

20. Hyman Minsky's Financial Instability Hypothesis
• Over periods of prolonged
economic prosperity and high
optimism about future
prospects, financial institutions
invest more in ever-riskier assets
in search of higher returns, which
can make the economic system
more vulnerable in the case that
default materializes.
• When bad economic news
eventually happens, the financial
system risks being too highly
leveraged and is at risk of
systemic collapse as asset prices
start falling and real incomes and
jobs contract.

21. • Bank and investors over-optimistic, herd behaviour
• Failure to understand tail-end risks (or "Black Swan events")
Irrational exuberance
• Senior bank executives did not understand complex financial instruments such as CDOs
• Executives unaware of the scale of leveraged, risky trading
Principal agent problem
• Deposit insurance, provision of central bank liquidity, and bail-outs made it rational for
banks to take on excessive risk
• Asymmetry of risk: Gains to private investors, losses absorbed by the public sector
Moral hazard
• Would having more women as traders / executives helped to avoid the financial crisis?
Labour market discrimination
Banking Crisis and Aspects of Market Failure

22. Convention and Unconventional Monetary PoliciesConventional
• Interest Rates
• Money supply
• Currency policy
Unconventional
• ZIRP (Zero Interest Rate
Policy)
• QE (Quantitative
Easing)
• CE (credit easing)
• FG (Forward
Guidance),
• Negative Interest
Rates,
• Liquidity Support of
Banks and Non-Banks

23. Side-Effects of the Macro Policy Response Post 2008
• Ultra-low interest rates and quantitative easing:
1. Surge in demand for assets – rising house prices (again)
2. Increase in demand for commodities
3. Limited reductions in private sector debt
4. Continued survival of zombie businesses
5. Issues about how and when to exit from QE and near-
zero interest rates – dependency on low interest rates?
• Big rise in fiscal deficits and national debt
• How and how fast to reduce fiscal deficits and debts
that may be unsustainable?
• How to deal with the moral hazard that bailouts of the
financial system may have induced?
• Decisions on when/whether to reverse nationalisation

24. Keynesian v Austrian Perspectives on Policy Response
• Provide strong monetary & fiscal stimulus – public sector spending
needed when private sector demand is weak
• Focus in particular on labour-intensive infrastructure projects
• Bailout the private sector to prevent catastrophic job losses
• Key is to support animal spirits and prevent a collapse in demand
Keynesian approach
• Avoid bail-outs as they lead to moral hazard and the survival of
zombie businesses which ultimately constrains long run growth
• Fast-forward structural economic / market reforms to promote
competition and raise productivity
• Against counter-cyclical macro stimulus - especially ultra-low
interest rates as this "distorts" the allocation of capital
Austrian approach

25. Keynesian Ideas
An understanding of Keynesian ideas can be helpful in evaluating
macroeconomic stability in terms of prices, jobs and incomes
• Keynesians believe that free markets are
volatile and not always self-correcting in
the event of an economic shock
• The free-market system is prone to
lengthy periods of recession & depression
• The volatility of aggregate demand (AD =
C+I+G+X-M) can be explained in part by
changes in consumer and business
sentiment – known as animal spirits
• In a world of stagnation or depression,
direct state intervention may be essential
to restore confidence and lift demand.
John Maynard Keynes
was born in 1883.
Educated at Eton College
and Cambridge University
- where he later taught.
He died aged 63 in 1946

26. The Importance of (Keynesian) Animal Spirits
John Maynard Keynes coined the notion of animal spirits which
refers to the driving force that gets people going in the economy
• Animal spirits refers to a mix of confidence, trust, mood and
expectations
• Animal spirits can fluctuate quickly as populations of people and
the business community change their thinking
• When confidence is low, individuals save more, businesses save
more too and, because demand and profits are lower than
expected, they cut back on production and perhaps postpone or
cancel capital investment projects. Economic activity suffers.
• Higher saving and reduced investment both have the effect of
reducing demand and incomes in the circular flow causing an
economic contraction – this is called the “paradox of thrift”

27. Keynesian Approaches to Managing Demand
Keynesian economists tend to favour the active use of fiscal policy
as the may way of managing demand and economic activity
Counter
cyclical
policies
Targeted tax
changes
Government
capital
spending
Government
borrowing
can pay for
itself
Active measures
to inject extra
demand can drag
an economy out
of a recession
Tax cuts for lower
income groups
with higher
propensity to
spend boosts AD
Depending on the
size of the fiscal
multiplier –
borrowing will
create more tax
revenues
Keynesians favour
labour-intensive
projects such as
new transport
infrastructure
projects and
house-building

28. Strategies for Avoiding Future Financial Crises
Floating exchange rates rather than
fixed ones that could collapse
Build up foreign currency reserves to
avoid liquidity runs on banks
Better regulated banks and financial
systems
Take steps to reduce public and private
sector debt to reduce solvency risks
Structural reforms to improve
competitiveness of real economy

29. Financial Crises
Financial Economics

30. Legacy of Recession: Hysteresis v Creative Destruction
Here are two competing views about the effects of a recession
When an economy is
disabled by recession
there is a big risk of a
permanent loss of
national output
Loss of productive
capacity due to low
capital investment +
many business closures
High rates of structural
unemployment may
cause a shrinking labour
force perhaps through
outward migration
Hysteresis
Recessions can cast a
dark shadow but
capitalist market
economies usually
bounce back eventually
Recessions prompt the
emergence of new
business models and an
increase in start-ups
New technologies can
act as a catalyst for
renewed economic
growth and investment
Creative
Destruction