This lecture examines the mechanisms behind two central forms of financial instability: banking crises and currency crises. In Part 1, the focus was on asset bubbles and crashes. Here, the analysis shifts to the structure of balance sheets, strategic interaction, and systemic amplification mechanisms that transform local shocks into economy-wide crises.
- Apple: $LR = 1$ - RBS: $LR = 19$ This implies: - Apple becomes insolvent if asset value falls by 50%. - RBS becomes insolvent if asset value falls by roughly 5%. > [!abstract] Theoretical Interpretation > High leverage makes banks structurally fragile. Small shocks to asset values translate into disproportionately large changes in equity. This creates a convex amplification mechanism, where downside risk is magnified relative to ordinary firms. > [!info] Economic Intuition > If you only own £1 of a £20 house and borrow £19, a tiny drop in house value wipes you out. > [!tip] Exam Insight > When discussing banking fragility, always link **high leverage → thin equity buffer → systemic vulnerability**. --- ## 1.2 Bank Runs as a Coordination Game ![[ECON1016_CurrentEconIssues/ECON1016_images/Lecture 2, Part 2/Slide5.png]] Each depositor must decide whether to withdraw funds. Payoffs depend on what others do. | | Others Stay | Others Go | |---------------|------------|-----------| | **You Stay** | $(1+r)X$ | $0$ | | **You Go** | $X$ | $X$ or $0$ | There are two equilibria: 1. Everyone stays → bank survives. 2. Everyone withdraws → bank run. > [!abstract] Theoretical Interpretation > This is a multiple-equilibrium coordination game. Both equilibria are rational. Expectations determine outcomes. Hence, beliefs can be self-fulfilling. > [!info] Economic Intuition > If you believe others will panic, the safe action is to panic too. > [!definition] > <span class="ob-keyterm">Self-fulfilling prophecy</span>: When expectations about insolvency cause behaviour that makes insolvency occur. --- ## 1.3 Fire Sales and Information Asymmetry When facing withdrawals, banks must sell assets. However: - Loans are opaque. - Banks possess private information. - Buyers fear adverse selection. This forces asset sales below book value. > <span class="ob-mechanism">Liquidity shock → asset liquidation → discounted prices → equity erosion → insolvency</span> > [!warning] Common Mistake > Do not confuse insolvency with illiquidity. Illiquidity can trigger insolvency through fire-sale losses. --- ## 1.4 Contagion and Systemic Risk ![[ECON1016_CurrentEconIssues/ECON1016_images/Lecture 2, Part 2/Slide7.png]] Banks lend to each other through interbank markets. Revised balance sheet includes: - Loans to other banks - Deposits at other banks This creates a financial network. ### Contagion ![[ECON1016_CurrentEconIssues/ECON1016_images/Lecture 2, Part 2/Slide8.png]] If Bank A fails: - It cannot repay Bank B. - Bank B’s assets fall. - Bank B may become insolvent. This generates cascading failures. Additionally: - During crises, buyers disappear. - Asset prices collapse. - Fire sales intensify systemic losses. > [!abstract] Theoretical Interpretation > Interbank markets create network externalities. Individual bank risk becomes correlated through balance sheet interdependence. This transforms idiosyncratic shocks into systemic crises. > [!tip] Exam Insight > Use the phrase <span class="ob-exam">“network amplification of balance sheet shocks”</span> when analysing contagion. --- # 2. Currency Crises and Speculative Attacks ## 2.1 Exchange Rate Pegs ![[ECON1016_CurrentEconIssues/ECON1016_images/Lecture 2, Part 2/Slide10.png]] Under a fixed exchange rate: - The Central Bank commits to a peg. - If demand for domestic currency falls, - It uses foreign reserves to buy domestic currency. > [!definition] > <span class="ob-keyterm">Exchange rate peg</span>: A policy commitment to maintain a fixed exchange rate against another currency. > [!abstract] Theoretical Interpretation > Pegs serve as commitment devices to reduce exchange rate volatility and enhance credibility. However, credibility depends on reserve sufficiency. --- ## 2.2 Speculative Attack as a Coordination Game ![[ECON1016_CurrentEconIssues/ECON1016_images/Lecture 2, Part 2/Slide12.png]] Traders decide whether to: - Hold baht - Sell baht for dollars (cost $c$) If everyone sells: - Reserves exhausted - Peg collapses - Currency devalues - Each trader earns profit $v$ | | Others Hold | Others Sell | |---------------|------------|------------| | **Hold** | 0 | 0 | | **Sell** | $-c$ | $v$ | Again, two equilibria: - No attack. - Successful speculative attack. > [!abstract] Theoretical Interpretation > This mirrors the bank run model. Currency crises are also driven by strategic complementarities. Expectations determine whether the peg survives. > [!info] Economic Intuition > If you think everyone will dump the currency, you dump it first. > [!tip] Exam Insight > Emphasise that speculative attacks can occur even if fundamentals are not catastrophic. Limited reserves + coordination incentives are sufficient. --- # 3. Twin Crises and Balance Sheet Mismatches ## 3.1 Maturity Mismatch > [!definition] > <span class="ob-keyterm">Maturity mismatch</span>: Borrowing short-term while lending long-term. Banks: - Fund with deposits or short-term interbank loans. - Lend long-term (mortgages, business loans). This exposes them to rollover risk. --- ## 3.2 Currency Mismatch > [!definition] > <span class="ob-keyterm">Currency mismatch</span>: Borrowing in foreign currency while lending in domestic currency. If the domestic currency depreciates: - Foreign liabilities rise in domestic value. - Domestic assets remain fixed. - Equity collapses. > <span class="ob-mechanism">Depreciation → foreign debt burden increases → balance sheet deterioration → banking crisis</span> --- ## 3.3 Sudden Stops If foreign lenders withdraw funding: - Banks must liquidate domestic assets. - Convert proceeds into foreign currency. - Depreciation worsens repayment capacity. This links currency crises and banking crises. > [!abstract] Theoretical Interpretation > Twin crises arise because bank balance sheets embed both maturity and currency mismatches. Exchange rate depreciation directly impairs bank solvency when foreign-currency liabilities exceed foreign-currency assets. > [!tip] Exam Insight > When asked about twin crises, explicitly connect: > - Coordination games > - Balance sheet mismatches > - Network contagion > - Fire sales --- # 4. Integrated Mechanism of Financial Crises Financial crises share common structural features: 1. High leverage 2. Strategic complementarities 3. Information asymmetries 4. Network interconnections 5. Balance sheet mismatches > [!summary] > - Bank runs and speculative attacks are coordination failures. > - Leverage amplifies shocks. > - Fire sales convert liquidity problems into insolvency. > - Interbank networks create contagion. > - Currency depreciation can trigger banking collapse via mismatches. The overarching theme is that financial systems are fragile not merely because of shocks, but because of **structure, incentives, and expectations**. --- # Bibliography Diamond, D.W. and Dybvig, P.H. (1983) ‘Bank runs, deposit insurance, and liquidity’, *Journal of Political Economy*, 91(3), pp. 401–419. Krugman, P. (1979) ‘A model of balance-of-payments crises’, *Journal of Money, Credit and Banking*, 11(3), pp. 311–325. Obstfeld, M. (1996) ‘Models of currency crises with self-fulfilling features’, *European Economic Review*, 40(3–5), pp. 1037–1047.
