Financial Crises, Regulation and Growth

Article excerpt

The paper discusses the effects on growth of a systemic banking crisis as a result of debt defaults. These effects will come from the impact of credit rationing on consumption and credit and from the impacts of a significant rise in the spread between lending and borrowing rates for both producers and consumers. The analysis uses the dynamic stochastic general equilibrium version of the National Institute global model. The paper also investigates the impact on output of a permanent, regulation induced, rise in margins in the financial sector, taking into account the impacts of regulation on equity market valuations.

Keywords: Financial crises: financial market spreads; forward looking consumers; dynamic stochastic general equilibrium models

JEL Classifications: E17; E44

Introduction

A financial crisis has been building since the summer of 2007. It has been driven largely by defaults on US housing loans to consumers and the subsequent collapse of liquidity in interbank funding markets. These have been of a sufficiently large scale as to bring the stability of the banking sector into question. Financial crises are relatively common events, but not often on the scale we are currently witnessing. They often follow periods of financial innovation or deregulation, as borrowers and lenders find themselves in situations where it is hard to evaluate the prices of new types of risk. The globalisation of financial markets has meant that the newly created assets and risks associated with them are shared across banks throughout the world and a number of European banks have suffered major losses as a result of purchasing high-yield high-risk securitised mortgage backed assets originating in the United States.

The paper investigates the impacts of widespread credit rationing and a significant rise in the spread between lending and borrowing rates for both producers and consumers in a rational expectations dynamic general equilibrium version of the widely used NiGEM model.

Credit rationing is a ubiquitous result of financial crises, and it reduces consumption and investment, as Barrell, Davis and Pomerantz (2006) discuss. Quantity rationing of this form may reflect increased asymmetry in information and increased risk aversion on the part of banks. An increase in spreads increases price rationing and can also help banks wishing to rebuild their capital after a crisis. In either case they represent the immediate impacts of a crisis in the banking sector. The paper also investigates the impact on output of a permanent, regulation induced, rise in margins in the financial sector, taking into account the impacts of regulation on equity market valuations.

The current crisis has developed following a wave of complex financial innovations and a period of international financial integration. Innovation and integration should help manage risk, with risk sharing leading to increases in welfare and the reduction in the investment risk premium producing higher output. However, complex innovations seem to have been hiding risk rather than managing it. Financial innovation resulted in lending to increasingly risky borrowers, while the lender could shift risk (the originate and distribute model) completely. Poor quality US loans were bundled and sold on but were difficult to value by conventional means. Because barriers to the movement of financial capital have largely been removed, markets spread risk to other countries where the poor quality of US borrowing and bankruptcy regulation was not fully understood.

Most mortgages in the US are non-recourse loans, as Ellis (2008) discusses. Although they are secured on property, there is no personal liability. Non-recourse loan default does not require that bankruptcy takes place, but even when it does there are still problems for lenders as it remains difficult to recapture the full value of loans. (1) Bankrupts, and those who default on their own homes, are allowed to keep housing equity up to $125,000 or more if they receive below median income. …