1.

Asymmetric Information and Financial Crises –

Asymmetric information, also known as "information failure," occurs when one

party to an economic transaction possesses greater material knowledge than
the other party.

a.) Agency Theory:

The analysis of how asymmetric information problems can generate adverse
selection and moral hazard problems is called agency theory.

Agency theory is a principle that is used to explain and resolve issues in the
relationship between business principals and their agents. Most commonly, that
relationship is the one between shareholders, as principals, and company
executive, as agents.

An agency, in broad terms, is any relationship between two parties in which one,
the agent, represents the other, the principal, in day-to-day transactions. The
principal or principals have hired the agent to perform a service on their behalf.
Principals delegate decision-making authority to agents. Because many
decisions that affect the principal financially are made by the agent, differences
of opinion and even differences in priorities and interests can arise. This is
sometimes referred to as the principal-agent problem.

b.) Financial Crisis:

A financial crisis occurs when an increase in asymmetric information from a
disruption in the financial system.

2. Dynamics of Financial Crises in Advanced Economies—

a.) Stage One: Initiation of Financial Crisis:

i. Mismanagement of Financial Liberalization or Innovation.

The seeds of a financial crisis are often sown when countries engage in financial
liberalization, the elimination of restrictions on financial markets and institutions,
or the introduction of new types of loans or other financial products. In the long
run, financial liberalization promotes financial development and encourages a
well-run financial system that allocates capital efficiently. However, financial
liberalization has a dark side: in the short run, it can prompt financial institutions to
go on a lending spree, called a credit boom. Government safety nets such as
deposit insurance weaken market discipline and increase the moral hazard
incentive for banks to take on greater risk than they otherwise would. Banks can
make risky, high-interest loans, knowing that they’ll walk away with nice profits if
the loans are repaid, and leave the bill to the taxpayer if the loans go bad and
the bank goes under. Without proper monitoring, risk taking grows unchecked.
Eventually, this risk taking comes home to roost. Losses on loans begin to mount
and the drop in the value of the loans (on the asset side of the balance sheet)
falls relative to liabilities, thereby driving down the net worth (capital) of banks
and other financial institutions. With less capital, these financial institutions cut
back on their lending, a process called deleveraging. Furthermore, with less
capital, banks and other financial institutions become riskier, causing depositors
and other potential lenders to these institutions to pull out their funds. Fewer funds
mean fewer loans and a credit freeze. The lending boom turns into a lending
crash.

ii. Asset Price Boom and Bust.

Prices of assets such as shares and real estate can be driven well above their
fundamental economic values by investor psychology. The rise of asset prices
above their fundamental economic values is an asset-price bubble. When the
bubble bursts and asset prices realign with fundamental economic values,
stock prices tumble and companies see their net worth drop. Lenders look
askance at firms with little to lose (“skin in the game”) because those firms are
more likely to make risky investments, a problem of moral hazard. Lending
contracts as borrowers become less creditworthy from the fall in net worth

iii. Spikes in Interest Rates.

If increased demand for credit or a decline in the money supply market drives up
interest rates sufficiently, good credit risks are less likely to want to borrow while
bad credit risks are still willing to borrow. Because of the resulting increase in
adverse selection, lenders will no longer want to make loans.
Increases in interest rates also play a role in promoting a financial crisis through
their effect on cash flow, the difference between cash receipts and
expenditures. A firm with sufficient cash flow can finance its projects internally,
and there is no asymmetric information because it knows how good its own
projects are.

iv. Increase in Uncertainty.

b.) Stage Two: Banking Crisis

Deteriorating balance sheets and tougher business conditions lead some

financial institutions into insolvency, when net worth becomes negative. Unable
to pay off depositors or other creditors, some banks go out of business. If severe
enough, these factors can lead to a bank panic, in which multiple banks fail
simultaneously.

c.) Stage Three: Dept Deflation:

 A process called debt deflation occurs, in which a substantial unanticipated
decline in the price level sets in, leading to a further deterioration in firms’ net
worth because of the increased burden of indebtedness.

3. The Great Depression

 In 1928 and 1929, prices doubled in the U.S. stock market. Federal Reserve
officials viewed the stock market boom as excessive speculation.
 When adverse shocks to the agricultural sector led to bank failures in agricultural
regions that then spread to the major banking centers.
 A sequence of bank panics followed from October 1930 until March 1933.
 The continuing decline in stock prices after mid-1930 and the increase in
uncertainty from the unsettled business conditions created by the economic
contraction worsened adverse selection and moral hazard problems in the
credit markets
 Lenders began charging businesses much higher interest rates to protect
themselves from credit losses. Risk premiums (also called credit spreads)
widened, with interest rates on corporate bonds.
 The ongoing deflation that started in 1930 eventually led to a 25% decline in the
price level. This deflation short-circuited the normal recovery process that occurs
in most recessions.
 The decline in net worth in the credit markets led to a prolonged economic
contraction in which unemployment rose to 25% of the labor force.

4. Financial Crisis 2007-2009

a.) Causes of the 2007–2009 Financial Crisis

i. Financial Innovation in the Mortgage

Advances in computer technology and new statistical techniques, known as data

mining led to enhanced, quantitative evaluation of the credit risk for a new class
of risky residential mortgages. Households with credit records could now be
assigned a numerical credit score, known as a FICO score that would predict how
likely they would be to on their loan payments. In addition, by lowering
transactions costs, computer technology enabled the bundling together of
smaller loans (like mortgages) into standard debt securities, a process known as
securitization. These factors made it possible for banks to offer subprime
mortgages to borrowers with less-than-stellar credit records. The ability to cheaply
bundle and quantify the default risk of the underlying high-risk mortgages in a
standardized debt security called mortgage-backed securities provided a new
source of financing for these mortgages. Financial innovation didn’t stop there.
Financial engineering, the development of new, sophisticated financial
instruments products, led to structured credit products that are derived from cash
 flows of underlying assets and tailored to particular risk characteristics that appeal
to investors with differing preferences.

ii. Agency Problems in the Mortgage Markets

The mortgage brokers that originated the loans often did not make a strong effort
to evaluate whether the borrower could pay off the loan, since they would quickly
sell the loans to investors in the form of security. This originate-to-distribute business
model was exposed to principal–agent problems, in which the mortgage brokers
acted as agents for investors (the principals) but did not often have the investors’
best interests at heart. Once the mortgage broker earns her fee, why should she
care if the borrower makes good on his payment? The more volume the broker
originates, the more she makes. Commercial and investment banks, who were
earning large fees by underwriting mortgage-backed securities and structured
credit products like CDOs, also had weak incentives to make sure that the ultimate
holders of the securities would be paid off. Large fees from writing financial
insurance contracts called credit default swaps. The structured products can get
so complicated that it can be hard to value the cash flows of the underlying assets
for a security or to determine who actually owns these assets. The increased
complexity of structured products can actually destroy information, thereby
worsening asymmetric information in the financial system and increasing the
severity of adverse selection and moral hazard problems.

iii. Asymmetric Information and Credit Rating Agencies

Credit rating agencies, who rate the quality of debt securities in terms of the
probability of default, were another contributor to asymmetric information in
financial markets. The rating agencies advised clients on how to structure complex
financial instruments, like CDOs, at the same time they were rating these identical
products. The rating agencies were thus subject to conflicts of interest because
the large fees they earned from advising clients on how to structure products that
they were rating meant that they did not have sufficient incentives to make sure
their ratings were accurate. The result was wildly inflated ratings that enabled the
sale of complex financial products that were far riskier than investors recognized.

b.) Effects of the 2007–2009 Financial Crisis

i. Residential Housing Prices

The subprime mortgage market took off after the recession ended in 2001. By
2007, it had become over a trillion-dollar market. The asset-price boom in
housing, which took off after the recession was over, also helped stimulate the
growth of the subprime market. The growth of the subprime mortgage market, in
turn, increased the demand for houses and so fueled the boom in housing
 prices, resulting in a housing price bubble. With housing prices falling after their
peak in 2006, the rot in the financial system began to be revealed.

ii. Deterioration in Financial Institutions’ Balance Sheets

The decline in U.S. housing prices led to rising defaults on mortgages. As a result,
the value of mortgage backed securities and CDOs collapsed, leading to ever-
larger write-downs at banks and other financial institutions.

iii. Run on the Shadow Banking System

The sharp decline in the value of mortgages and other financial assets triggered
a run on the shadow banking system, comprising hedge funds, investment
banks, and other non-depository financial firms. These securities were funded
primarily by repurchase agreements (repos), which are short-term borrowing
which, in effect, use assets like mortgage-backed securities as collateral.

iv. Failure of High-Profile Firms

The impact of the financial crisis on firm balance sheets forced major players in
the financial markets to take drastic action such as Bear Stearns, the fifth-largest
investment bank sell itself to J.P. Morgan for less than 5% of what it was worth just
a year earlier.

c.) Height of the 2007–2009 Financial Crisis and the Decline of Aggregate
Demand
The financial crisis reached its peak in September 2008 after the House of
Representatives, voted down a $700 billion bailout package proposed by the Bush
administration. The unemployment rate shot up, going over the 10% level in late
2009.

5. Dynamics of Financial Crises in Emerging Market Economies

The dynamics of financial crises in emerging market economies-economies in an

early stage of market development that have recently opened up to the flow of
goods, services, and capital from the rest of the world. Only with some important
differences. They have many of the same elements as those found in advanced
countries like the US.

a.) Stage One: Initiation of Financial Crisis

In contrast to crises in advanced economies triggered by a number of different

factors, financial crises in emerging market countries develop along two basic paths.
One involving the mismanagement of financial liberalization or globalization. The
other involving severe fiscal imbalances.

Path A: Mismanagement of Financial Liberalization or Globalization

 i. As in the US, the seeds of a financial crisis in emerging market countries are often sown
when countries liberalize their financial systems by eliminating restrictions on financial
institutions and markets domestically and opening up their economies to flows of
capital and financial firms from other nations, a process called Financial globalization.
ii. Countries often start out with solid fiscal policy. For example, in the years before their
crises hit, the countries in East Asia had budget surpluses, and Mexico ran a budget
deficit of only 0.7% of GDP, a number to which most advanced countries would
aspire.
iii. Bank regulators in emerging market countries typically provide very weak supervision,
and banking institutions lack expertise in the screening and monitoring of borrowers.
This is often described by saying that emerging market financial systems have a weak
credit culture.
iv. The financial globalization process adds fuel to the fire because it allows domestic
banks to borrow abroad. The banks pay high interest rates to attract foreign capital
and so can rapidly increase their lending which starts producing high loan losses,
which then leads to a deterioration in bank balance sheets and banks cut back on
their lending.
v. Just as in advanced countries like the US, the lending boom ends in a lending crash.
In emerging market countries, banks play an even more important role in the financial
system than in advanced countries because securities markets and other financial
institutions are not as well developed. The decline in bank lending thus means that
there are really no other players to solve adverse selection and moral hazard
problems.
vi. The story told so far suggests that a lending boom and crash are inevitable outcomes
of financial liberalization and globalization in emerging market countries, but they
only occur when there is an institutional weakness that prevents the nation from
successfully handling the liberalization or globalization process. More specifically, if
prudential regulation and supervision to limit excessive risk taking were strong, the
lending boom and bust would not happen.
vii. Once financial markets have been liberalized, powerful business interests that own
banks will want to prevent the supervisors from doing their job properly & so they may
not act in the public interest. Also who contribute heavily to politicians campaigns are
often able to persuade politicians to weaken regulations that restrict their banks from
engaging in high-risk/high-payoff strategies. But, if the bank gets in trouble, the
government is likely to bail it out and the taxpayer foots the bill.
viii. The weak institutional environment in emerging market countries makes this
perversion of the financial liberalization process even worse. In emerging market
economies, business interests are far more powerful than they are in advanced
economies where a better-educated public and a free press monitor, politicians and
bureaucrats who are not acting in the public interest. Then the cost to the society of
the principal-agent problem we have been describing here is particularly high in
emerging market economies.

Path B: Severe Fiscal Imbalances

 i. The second path is government fiscal imbalances that entail substantial budget
deficits that governments need to finance. The recent financial crisis in Argentina in
2001–2002 is of this type, other recent crises for example in Russia in 1998, Ecuador in
1999, and Turkey in 2001, also have some elements of this type of crisis.
ii. When Willie Sutton, a famous bank robber, was asked why he robbed banks, he
answered, “Because that’s where the money is.” Governments in emerging market
countries have the same attitude. When they face large fiscal imbalances and
cannot finance their debt, they often force banks to purchase government debt.
Now the banks that are holding this debt have a big hole on the asset side of their
balance sheets, with a huge decline in their net worth.
iii. With less capital, these institutions will have less resources to lend and lending will
decline. The situation can even be worse if the decline in bank capital leads to a bank
panic in which many banks fail at the same time. The result of severe fiscal imbalances
is therefore a weakening of the banking system which leads to a worsening of adverse
selection and moral hazard problems.
iv. directly and also indirectly by causing a deterioration in banks’ balance sheets from
asset write-downs.

b.) Stage Two: Currency Crisis

Deterioration of Bank Balance Sheets Triggers Currency Crises

When banks and other financial institutions are in trouble, governments have a limited
number of options. Defending their currencies by raising interest rates should
encourage capital inflows. If the government raises interest rates, banks must pay
more to obtain funds. This increase in costs decreases bank profitability, which may
lead them to insolvency. Thus, when the banking system is in trouble, the government
and central bank are now between a rock and a hard place: If they raise interest
rates too much, they will destroy their already weakened banks and further weaken
their economy. It they don’t, they can’t maintain the value of their currency.
Speculators in the market for foreign currency recognize the troubles in a country’s
financial sector and realize when the government’s ability to raise interest rates and
defend the currency is so costly that the government is likely to give up and allow the
currency to depreciate. They will seize an almost sure thing bet because the currency
can only go downward in value. Once the country’s central bank has exhausted, it
has no longer has the resources to intervene in the foreign exchange market and
must let the value of the domestic currency fall: that is, the government must allow a
devaluation.

Severe Fiscal Imbalances Trigger Currency Crises

We have seen that severe fiscal imbalances can lead to a deterioration of bank
balance sheets, and so can help produce a currency crisis along the lines described
immediately above. Fiscal imbalances can also directly trigger a currency crisis. When
government budget deficits spin out of control, foreign and domestic investors begin
to suspect that the country may not be able to pay back its government debt and
so will start pulling money out of the country and selling the domestic currency.
Recognition that the fiscal situation is out of control thus results in a speculative attack
against the currency, which eventually results in its collapse.

c.) Stage Two: Full-fledged Crisis

Emerging market economies denominate many debt contracts in foreign currency

(dollars) leading to currency mismatch, in contrast to most advanced economies that
typically denominated debt in domestic currency. An unanticipated depreciation or
devaluation of the domestic currency (for example, pesos) in emerging. The collapse
of a currency also can lead to higher inflation. The central banks in most emerging
market countries, in contrast to those in advanced countries, have little credibility as
inflation fighters. Thus, a sharp depreciation of the currency after a currency crisis
leads to immediate upward pressure on import prices. A dramatic rise in both actual
and expected inflation will likely follow. This asymmetric information analysis suggests
that the resulting increase in adverse selection and moral hazard problems leads to a
reduction in investment and economic activity. Under these circumstances, the
banking system will often suffer a banking crisis in which many banks are likely to fail
(as in the United States during the Great Depression). The banking crisis and the
contributing factors in the credit markets explain a further worsening of adverse
selection and moral hazard problems and a further collapse of lending and
economic activity in the aftermath of the crisis.

6. Financial Crisis in Mexico, East Asia And Argentina

 1994- Mexican crisis
 July 1997- East Asian crisis
 2001- Argentine crisis
 1990- Financial markets in these countries were liberalized and opened to foreign
capital markets
 Consistent with the U.S. experience in the nineteenth and early twentieth
centuries, another precipitating factor in the Mexican and Argentine (but not
East Asian) financial crises was a rise in interest rates abroad.
 mid-1999- The Federal Reserve began a cycle of raising the federal funds rate to
head off inflationary pressures.
 1994- The Mexican economy was hit by political shocks that created uncertainty,
while the ongoing recession increased uncertainty in Argentina
 20 December 1994-The Mexican central bank forced to devalue the peso
 July 1997- Thai central bank was forced to allow the baht to depreciate
 October–November 2001- A full-scale banking panic began in Argentina
 March 1995 -Peso lost half its value
 1998- Thai, Philippine, Malaysian, and South Korean currencies lost between one-
third and one-half of their value