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Lecture 3

Global Financial Crisis: Origin and Consequences

Professor Roman MatousekKent Business School

Kent University

Anhui University of Finance &EconomicsBengbu

12-14 May 2014

Recommended Reading

• Matthews, K., Thompson, J., (2005). The Economics of Banking, John Wiley & Sons, Ch 12.

• Buckley, A. (2011), Financial Crisis: Causes; Context and Consequences, Pearson, Ch 8.

• Kob, R. W. (2011). The Financial Crisis of our Time, Oxford University Press, New York

• Kindleberger, C.P., Aliber, R. Z., (2011). Manias, Panics, and Crashes: A History of Financial Crises, 6th Ed. Palgrave, New York.

Global Financial Crisis: What Happened and Why

1. What caused the crisis?2. Why did markets stop working properly?3. Why did the crisis spread so globally?4. Why and how should central banks and

governments intervene?5. How to restore market discipline?6. How should financial regulation be reformed?7. Why did the lender of last resort acted too late?

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Financial Crises and Aggregate Economic Activity

• Factors Causing Financial Crises– Problems in the Banking Sector– Government Fiscal Imbalances

• Most U.S. financial crises have begun with a deterioration in banks’ balance sheets.

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What has happened?

• USA, UK, Japan and other economies have been facing economic recession (the technical definition of a recession: two consecutive quarters of negative growth in terms of real GDP).

• The banking systems have been severely paralysed. • DEFLATION fears • In the early stage of the crisis depreciation of GBP

against US$ & EURO• US$ restored its power as a global currency

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What’s different about this crisis?

• A Global Crisis - origin in USA & fast crisis spillovers into Europe, Japan.

• The crisis is unprecedented in severity of credit contraction (credit crunch & capital crunch).

• In May-June, 2007, the Bank of England did not foresee the gravity of today’s situation.

• The roots are in banking rather than in securities market or foreign exchange.

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What are the possible triggers?

• The Failure of Lehman Brothers triggered the Global Crisis (A big mistake by US authority). September 15, 2008 - the defining date of the global crisis.

• Historically low interest rates.• Savings glut.• Excessive liquidity creation by Central Banks.• Globalisation of financial markets.• Deregulation process.• Innovation process in financial markets.

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Consequences

• High leveraging by banks, companies, households.• Over the last two decades innovation in financial

industry became a driving force of banks profitability - off balance sheet activities (misprice risk)

• Financial Innovation has expanded and regulators got lost in the complexity of financial innovations.

• Securitisation Process (Collateral Debt Obligations - CDOs), Credit default swaps.

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Should We Blaim Securitisation?• IF YOU asked regulators in 2008 which financial

instrument they most wished had never been invented, odds were that they angrily splurted a three-letter acronym linked to securitisation. The practice of bundling up income streams such as credit-card and car-loan repayments, repackaging them as securities and selling them on in “tranches” with varying levels of risk once seemed like enlightened financial management. Not so after many a CDO, CLO, ABS, MBS and others (see table) turned out to be infested with worthless American subprime mortgages.

(The Economist Jan 11th 2014)14 14

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The Current State of Banking Sector

• The Failure of Lehman Brothers triggered the Global Crisis (A big mistake by US authority??- discuss).

• The global financial market is currently frozen.• Investment and Commercial Banks in USA, UK and

EUROPE bailed out by Governments.• A Partial Nationalisation of Banking Industry in US

& UK!!!

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What are possible remedies?

1. A Global Consolidation and Recapitalisation of the banking system.

2. Monetary stimulus.

3. Fiscal stimulus.

The current situation asks to take all three steps simultaneously!

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Quantitative Easing

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Con’t

• The Fed is engaged in aggressive quantitative and qualitative easing. 

• The Bank of England is engaged in reluctant quantitative and qualitative easing. 

• The ECB has done less quantitative easing (proportionally) than the Bank of England or the Fed, but has engaged in quite a bit of qualitative easing – not by buying risky and illiquid private securities outright, but by accepting them as collateral in repos and at the discount window (its marginal lending facility).

• Before this crisis is over, the two largest European central banks will engage in both quantitative and qualitative easing on a much larger scale. 25

Limitations of Monetary Policy

• Liquidity Trap - When a cut in interest rates fail to stimulate economic activity.

• One tool - interest rates for too many objectives, eg. Inflation and growth• Interest rates vs the exchange rate• Interest rates different impacts on different economic agents.

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What about fiscal stimulus?

Keynesian’s say yes? But really?What are options:• Direct & indirect tax cuts• Investment into infrastructure• Government lifeline credits to collapsing companiesi) A problem is that the money has to be paid back one day. ii) the current crisis different from the Great Depression in the

1930s.

Fiscal Stimulus

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What can we expect

• A gradual consolidation in the banking (financial) sector.

• A protracted period of economic contraction.• A further government interventions.• In 2009, economists assumed that 2010 - 2011 will be

a turning point. However, a further development highly unpredictable even 6 years after the crisis.

• A question about the trajectory of this crisis remains unclear - J or L or V or W shapes?

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