ECS3701 Assignment 2 Semester 1 & 2 2021

QUESTION 2 Differentiate between the main factors in the initiation of financial crises between the advanced and emerging market economies. Financial crises in advanced economies can begin in several ways: mismanagement of financial liberalization/ innovation, asset-price booms and busts, or a general increase in uncertainty caused by failures of major financial institutions. Mismanagement of Financial Innovation/Liberalization The elimination of restrictions on financial markets and institutions, or when new innovations are introduced. Often there is a lack of understanding of the changing situations which leads ultimately to banks taking greater risks and then having to face the consequences of bad debts arising from these risks. When this occurs banks are forced to restrict lending (deleveraging) and this puts pressure on the economy, leading to a severe decrease in economic activity. Lending boom becomes a lending crash Asset price booms and busts Irrational expectations” tend to drive asset prices above the real value of these assets. Assetprice bubbles (tech stock market 1990s, house prices 2007) are often driven by credit booms, where the large increase in credit is used to fund purchases of assets, thereby driving up their price. When “reality” eventually prevails, the assets are largely devalued and the consequences for an economy can be devastating. Increase in uncertainty During periods of uncertainty (after a recession, stock market crash or failure of major financial institution) accurate information is harder to obtain and consequently the problems of adverse selection and moral hazard increase, financial frictions increase, lending declines and economic activity decreases. Crises in emerging market countries develop along two basic paths: either the mismanagement of financial liberalization and globalization, or severe fiscal imbalances. Mismanagement of financial liberalization/globalization. The opening up of economies to flows of capital and financial firms from other nations is called globalization. Problems arise when institutional weakness (fiscal imbalances, ineffective screening and monitoring of borrowers and lax government supervision of banks) prevents a country from successfully handling the liberalization or globalization process. Only when prudent regulation and supervision are strong, the lending boom and bust that often follows the opening up the emerging market economies will not occur. Severe fiscal imbalances. Governments that run up high deficits often persuade or even force the banks to purchase government debt (bonds). When investors lose confidence in the ability of the government to repay the bonds, the price of the bonds plummets and this means that banks that are holding such bonds have a serious decrease in the value of their assets. With less capital, lending will decline and a worsening of adverse selection and moral hazard problems will occur. Some additional factors: rise in interest rates from events abroad which are most likely to be agreed to by riskier firms. The loans that are made therefore become high risk.