EXAMINATION QUESTION PAPER: May, 2013
Module code: EC5004
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Section A
Answer One Question from this section.
- "Critically discuss the role played by income and wealth inequality inthe financial crisis of 2007-8". (25 marks)
The financial crisis of 2007-08 also known as the Great Recession is a systematic banking crisis that started in the collapse of the subprime mortgage market in the United States (that triggered the crisis in the US shadow banking system) which eventually spread to the banking sector of the global economy. Generally, the crisis is characterized by large scale defaults in debts by the households as well as drastic fall in output.
Kumhof et al. (2012) argued in their paper that increasing income inequality has been both a consequence and a cause of domestic financial market liberalization. The rise in income in the financial sector in the United States was noted by Philippon (2008) and Philippon and Reshef (2009) as a result of financial liberalization; eventually, greater income inequality result to further liberalization of the financial markets as observed by Rajan (2010) as politicians and the government in general actively facilitates financing (mortgage, credit) for low and middle income households.
Most authors who studied the Great Recession have observed that during the pre-crisis period, there have been an increased in the savings of the top executives (increased share in the total income at the very top) and increased in the borrowing activities of the low and middle income earners. Such increased saving and borrowing activities of both groups significantly fuelled the demand for more financial intermediation. As a result, there was the increase in the size of the financial sector particularly the shadow banking system.
Kumhof and Rancière (2011) pointed out that the sharp increase in income and wealth inequality coupled by the rise in debt-to-income ratios among the lower and middle income households eventually became unsustainable triggered the financial crisis. Using a dynamic stochastic general equilibrium model, they showed that income inequality can endogenously result to a crisis. They emphasized that the resulting financial crisis was due to a shock in the relative bargaining power over income of investors and workers. The two groups comprise the types of households in the model: the investors who value both assets holdings and consumption and represent the upper 5 percent in the distribution of income; and the workers who have risk aversion to drops in consumption and represent the lower 95 percent in the income distribution. The key mechanism in the Kumhof- Rancière model is that the investors use a large portion of their increased income to buy financial assets backed by loans to workers. In this manner, investors enable workers to limit the drop in their consumption following their loss of income. However, such activity leads to the persistently rising debt-to-income ratios of workers that eventually cause financial fragility. The rising indebtedness of households that become unsustainably high was perceived to as the key factor that contributed to eventually triggering the crisis.
- Describe the nature of what has come to be called the ‘shadow banking system’ and critically discuss its role in the financial crisis.(25 marks)
The most significant feature of the 2007/08 financial crisis involves the interaction between the traditional banks and other financial institutions, in which the activities are mostly observed in the over-the-counter markets. Typically, for banks to increase the volume of their operations, they use different ways to transfer the risks (credit) off from their balance sheets without setting aside the capital coefficients required by Basel Agreements. These include creation of SIVs, acquisition of protection in the derivatives market from credit risks, and issuance of credit securities with returns that depends on the borrower’s amortization fee. And traditional banks are only able to do such activities because of the presence of risk-taking agents who act as the counterparty to take the risk for a return that is very high at the time. These agents comprise the shadow banking system. The shadow banking system pertains to the unregulated activities (e.g., credit default swaps) of a collection of financial institutions including hedge funds, money-market mutual funds, investment banks, commercial banks, off-the-balance-sheet entities, finance companies, ABCs or asset-backed conduits, and SIVs (structured investment vehicles). These institutions facilitate the creation of credit in the global financial system. One of the features of shadow banks is the relatively high leverage; some of the intermediaries like the investment banks were levered between 25 to 30 that is equivalent to approximately 3 to 4 percent capital-to-asset ratio. This implies that a relatively small decrease in the value of asset eventually eliminates their capital.
Generally, the shadow banking system operates as banks but in unregulated manner, raising resources in the short term, investing in long term and illiquid assets, and operating with very high leverage. But unlike the traditional banks, shadow banks do not maintain reserves of capital (do not have reserve requirement), do not have access to last resort credit lines of the central bank, do not have access to rediscount operations or even deposit insurance. This nature of the shadow banking system made these institutions prone to asset imbalance as well as investors’ run.
Claessens et al. (2012) showed how the two economically most important shadow banking activities: securitization and collateral intermediation, have contributed to the 2007/08 financial crisis. These functions that are considered as ‘bank-like’ functions involve risk and maturity transformation and can, like banks, be unstable. The authors identified the failure of the securitization and distressed dealer banks as the cause of the financial crisis.
The securitization process is the key function of the shadow banking system. It is a process that involves the repackaging of cash flows from loans in order to create an almost fully safe and liquid asset, as would be perceived by market participants. Repackaging is somewhat equivalent to transferring the risk and involves the following steps: (1) risky long-term loans are slices into complementary and safe portions. The portion of safe assets is then funded in the short-term money markets with the added protection from banks through liquidity lines. These assets are the ABCPs or the asset-backed commercial papers, which were regarded as money-like (short-term, liquid and safe) by market participants before the crisis period. The returns in this asset exceeded the returns on short term government debt.
Accordingly, there were two sources of demand for money-like assets prior to the crisis. As noted by Pozsar (2011), the demand came from the corporations and asset management complex that faced the scarcity of safe investment. Likewise, Gorton and Metrick (2011) and Greenlaw et al. (2008) observed that banks used securitized assets for regulatory arbitrage (to minimize capital charges) and as collateral to attract repurchase agreement (or ‘repo’) funding.
The findings of the study of Claessens et al. (2012) indicated that the crisis showed some fundamental flaws in secularization process. Importantly, the perception of safety led to an ignorance of ‘tail risks’. In effect, the claims that were initially considered as safe turned to be risky. As the market were dried up of funding, banks unexpectedly faced exposures on their liquidity lines; this caused a run on monetary fund that in turn put the other banks at risk, that resulted to the collapse of interbank markets, and eventually to the economy-wide credit freeze borrowers.
Supporting collateral-based operations is another key function of the shadow banking. The collateral-based operations consist of hedging, lending of securities, and secured funding. The use of collateral aids with counterpart risks and serves as lubricant in the financial intermediation transactions. The shadow banking system intensively reuse the collateral to support large volume of financial transactions. The collateral-based operations are facilitated by dealer banks (the systematically important financial institutions) whose failures are believed to trigger financial crisis. According to Duffie (2010), dealer banks are exposed to significant credit and liquidity risks, creating financial stability risks.
References
Kumhof, et al. (2012). Income Inequality and Current Account Imbalances. IMF Working paper WP/12/08
Kumhof, Michael and Romain Rancière. (2011). Inequality, Leverage and Crises. http://www.stanford.edu/~kumhof/ilc_dec_2010.pdf
Rajan, R. (2010), Fault Lines: How Hidden Fractures Still Threaten the World Economy , Princeton: Princeton University Press
Philippon, T. (2008), “The Evolution of the U.S. Financial Industry from 1860 to 2007”, Working Paper, New York University.
Claessens, Stijn, Zoltan Pozsar, Lev Ratnovski, and Manmohan Singh (2012), “Shadow Banking: Economics and Policy”, IMF Staff Discussion Note, 12/12.
Duffie, Darrell (2010) “The Failure Mechanics of Dealer Banks”, Journal of Economic Perspectives, 24(1), 51–72.
Greenlaw, David, Jan Hatzius, Anil K Kashyap and Hyun Song Shin (2008, “Leveraged Losses: Lessons from the Mortgage Market Meltdown,” US Monetary Policy Forum Report, 2 February.
Perotti, Enrico (2010), “Systemic liquidity risk and bankruptcy exceptions”, VoxEU.org, 13 October.
Pozsar, Zoltan (2011), “Institutional Cash Pools and the Triffin Dilemma of the US Banking System”, IMF Working Paper, 11/190.
Tarullo, Daniel (2012), “Shadow Banking After the Financial Crisis”, Speech at the Federal Reserve Bank of San Francisco Conference on Challenges in Global Finance, 12 June.
