Financial Economics — Financial Crises: Leverage, Bank Runs, Currency Mismatch and Policy Responses

Financial Economics — A Financial Crisis Is a Problem of Amplification More Than of Losses

Not every fall in asset prices is a financial crisis. When high leverage, short-term funding, collateral prices and interconnectedness combine, a small loss is amplified into fire sales, a credit crunch and a real recession. To understand a crisis, look at balance sheets before price charts.

1. Leverage magnifies both gains and losses on equity

A financial institution with assets of 100, liabilities of 90 and equity of 10 has leverage of 10. If asset values fall 5%, assets become 95, and with liabilities unchanged, equity becomes 5. The asset loss is 5%, but the equity loss is 50%.

Selling assets in a hurry to meet regulatory ratios pushes prices down further and lowers the value of other institutions’ collateral too. This is the vicious circle of sales, falling prices and further sales.

2. Liquidity crises and insolvency differ, but one can turn into the other

Even a bank holding sound long-term loans can run short of means of payment if short-term deposits leave all at once. The central bank as lender of last resort eases temporary liquidity shortages. But supplying only liquidity to an institution whose assets are worth less than its liabilities can delay loss recognition and restructuring.

3. Currency mismatch turns an exchange-rate shock into a debt shock

When firms or governments borrow in dollars but earn in the domestic currency, a depreciation makes the domestic-currency value of their debt jump. If won/dollar rises from 1,000 to 1,400, a debt of 100 million dollars grows from 100 billion won to 140 billion won. For a borrower with no export revenue, a rise in the exchange rate is a fall in net worth.

Add a maturity mismatch, and an institution that funded long-term projects with short-term foreign-currency debt faces refinancing halts and a rising exchange rate at the same time. That is why one looks not only at the size of foreign reserves but also at short-term external debt, the currency composition of liquidity and hedging in the private sector.

4. The 2008 crisis is not explained by a fall in house prices alone

Losses on subprime mortgages spread through the financial system via securitization, high leverage, short-term wholesale funding and opaque over-the-counter derivatives. Falling collateral values triggered margin calls and fire sales, and institutions that could not gauge counterparty risk pulled back from money markets. The fall in credit supply spread to consumption, investment and employment.

5. Quantitative easing and fiscal rescues differ in purpose and in who bears losses

Quantitative easing is monetary policy in which the central bank buys long-term securities and other assets to change term premiums and financial conditions. It is not the same as recapitalization or fiscal rescue, which decide who bears the losses on bad assets. Expanding the central bank’s balance sheet does not in itself mean a rise in private net worth or a proportional rise in bank lending.

Check your understanding

If the assets of a bank with assets of 100, liabilities of 90 and equity of 10 fall 8%, what is its equity? With assets of 92 and liabilities of 90, equity is 2. An 8% asset loss becomes an 80% equity loss. Selling assets to meet regulatory ratios pushes prices down further, and the same calculation repeats.

The theory of asset prices, information and intermediation is in financial economics chapters 1–4. For derivative replication see financial engineering; for the corporate cost of capital see corporate finance.

References

• Bank for International Settlements, Basel Framework
• International Monetary Fund, Global Financial Stability Report
• Ben Bernanke, Essays on the Great Depression