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The Financial Crisis - Part 1PSCI4193 - IPE - Week #10IntroductionWe’ve been there before (well, the Japanese did)... or not?Eery similaritiesWhat happened in JapanWhat’s happening nowJapan’s ‘Lost Decade’How did Japan’s ‘Lost Decade’ came into existence?Remember: Japan was at the top of its game. Rich. Advanced. Productive. Ready to take over as global superpowerHow did the crisis unfold?123The Japanese Finance Connection“By 1990, seventeen of the world’s forty largest banks were Japanese”“each of the six keiretsu banks was four times larger than the biggest American bank, Citibank”The financial sector had tight connection with the production sectorKeiretsu owned many corporation directlyImplicationsThey produced the loans used to drive up real estate and stock pricesThe Japanese central bank made money very cheap (relatively for the period) - much cheaper than anywhere else in the worldEconomic bubble!Japan Land Price Index, six major urban centers027.55582.51101985 1990 200035.1105.134.6456Japan Avg. Economic Growth012341980-1990 1990-20091.48%3.96%1980-1990 1990-2009Failed (Keynesian) policyJapan’s central bank kept interest rates extremely lowDeficit spendingUnsuccessful stimuli-8-6-4-2021990 2008-8%1.9%Budget Surplus/Deficit over nominal GDPGlossaryFinancial derivatives: a contractual relationship established by two (or more) parties where payment is based on (or "derived" from) some agreed-upon benchmark.Most common derivatives: options, forwards, futures, swapsOver-the-counter trading: trade financial instruments directly between two partiesUnder the lens: Credit-Default Swaps (CDS), Collateralized Debt Obligations789Introduction - 2008Understanding the CrisisBackground and frameworkThe unfolding of the crisisHow countries dealt with itImplications for the futureFramework1.Bad Bets2.Excessive Leverage3.Domino effects4.21st-Century bank runsPolicy Areas1.housing policy;2.capital regulation for banks;3.industry structure and competition;4.autonomous financial innovation (not driven by capital regulation);5.monetary policy.101112Bad BetsThe speculative investments that drove the housing bubbleExcessive LeverageNot enough capital to cover eventual lossesDomino EffectsLosses triggered a chain reaction13141521st Century Bank Runs“Mutually incompatible contingency plans”All together nowThe elements of the crisis had to be present all togetherWhy? What are the connectionsPolicy MatrixPolicy AreaBad BetsLeverageDomino EffectBank RunsHousing PolicyCapital RegulationIndustry StructureInnovationMonetary PolicyHigh WeightNo weightNo WeightNo WeightVery High WeightVery High WeightVery High WeightVery High WeightNo WeightVery Low WeightLowWeightLow WeightLow WeightLow WeightLow WeightLow WeightLow WeightLow WeightNo WeightNo Weight161718Capital RegulationCapital regulations distorted mortgage finance away from traditional lending and toward securitization.Rating agencies failed to do their jobs properly (and so did risk desks)Bad rating steered banks toward making bad debtsMacro-level causesLax banking/financial regulationGovernment policyGovernment involvement in the housing marketMicro-level causesIncentives to downplay the risksRisk desks vs. commercial desksShort-term horizon in financial firmsAccounting standardsPressure for high returns (and expectations for them)Moral Hazard192021The way outBusiness as usual: recapitalize the banks, inject money into the system (what we’re doing now)Rein in the banks (the Volcker option): reinforce regulation, limit leverage, exposure, risky activitiesLet them fail: let the banks take the hit, the market will adjust accordinglyThe way forwardEven more money pumped into the


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CU-Boulder PSCI 4193 - The Financial Crisis

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