An Overview of the Crisis: Causes, Consequences, and Solutions*
Franklin Allen(University of Pennsylvania)
Elene Carletti(European University Institute)

What caused the crisis? Initially many thought that it was due to incentive problems in the U.S. mortgage industry. However, after the large economic meltdown following Lehman Brothers’ bankruptcy in September 2008, it seems that much more was going on. We argue that there was a bubble in real estate prices in the United States and a number of other countries. The main causes of the bubble were loose monetary policy, particularly by the United States Federal Reserve, and global imbalances. The combination of cheap credit together with the easy availability of funds contributed to create the bubble. Many other factors such as subprime mortgages, weak regulatory structures, and high leverage in the banking sector exacerbated the effects of the crisis. We consider possible reforms aimed at minimizing the occurrence of future crises in the governance structure of central banks, measures to reduce global imbalances, and changes in banking regulation.*Presented at the conference on Global Market Integration and Financial Crises at HKUST, July 12–13, 2009. We are grateful to the participants and particularly to our discussant Susan Wachter for very helpful comments and suggestions. We are also grateful to the Sloan Foundation for financial support.

keywords:

Credit Default Swaps and the Stability of the Banking Sector*
Frank Heyde(Department of Mathematics, Martin-Luther-University)
Ulrike Neyer(Department of Economics, Heinrich-Heine-University)

This paper considers credit default swaps (CDSs) used for the transfer of credit risk within the banking sector. The banks’ motive to conclude these CDS contracts is to improve the diversification of their credit risk. It is shown that these CDSs reduce the stability of the banking sector in a recession. However, during a boom or in periods of moderate economic up- or downturn, they may reduce this stability. The main reasons behind these negative impacts are firstly, that banks are induced to increase their investment in an illiquid, risky credit portfolio, and secondly, that these CDSs may create a possible channel of contagion.

*We would like to thank especially Franklin Allen, Diemo Dietrich, Falko Fecht, Achim Hauck, and Rüdiger Pohl for helpful comments and suggestions.

keywords:

Sophistication in Risk Management, Bank Equity, and Stability*
Hans Gersbach(CER-ETH ? Center of Economic Research, at ETH Zurich and CEPR)
Jan Wenzelburger(Centre for Economic Research, Keele University)

We investigate the question of whether sophistication in risk management fosters banking stability. We compare a simple banking system that uses an average rating with a sophisticated banking system in which banks are able to assess the default risk of entrepreneurs individually. Both banking systems compete for deposits, loans, and bank equity. While a sophisticated system rewards entrepreneurs with low default risks with low loan interest rates, a simple system acquires more bank equity and finances more entrepreneurs. Expected repayments in a simple system are always higher and its default risk may be lower. As an economy with a sophisticated banking system invests its funds more efficiently, there is a trade-off between efficiency and stability of a banking system.

*We would like to thank Johannes Becker, Noemi Hummel, David de Meza, Theresa Fahrenberger, Charles Kahn, Jean-Charles Rochet, Gilles Saint-Paul, Eva Terberger-Stoy, Jean Tirole, and seminar participants in Heidelberg, Keele, and Toulouse for valuable suggestions.

keywords:

Financial Market Crises and Natural Resource Production
James R. Brown(Department of Finance, Iowa State University)
Lauren C. Lax(Department of Economics, Yale University)
Bruce C. Petersen(Department of Economics, Washington University in St. Louis)

During a financial crisis, the loss of access to world capital markets may force heavily indebted countries to accelerate their production of exhaustible resources. Few studies consider the impact that financial crises have on real behavior, and no existing studies appear to consider the impact a crisis might have on resource production. We find that four major state-owned enterprises in Brazil, Chile and Mexico substantially expanded their production and world market share of copper, iron ore and oil during the 1980s’ international financial crisis. There was also a very large expansion, followed by a sharp contraction, of production of tin in Brazil and silver in Mexico. In contrast, Indonesia – a major resource producer who did not succumb to the 1980s’ financial crisis – did not accelerate production during the 1980s’ crisis, and resource production in the United States sharply contracted during this period. Our study provides new insights into why the prices of natural resources are so volatile and highlights a previously unexplored reason for financial contagion: one country’s efforts to service its debt can drive down resource prices and revenues to other indebted resource producers.

keywords:

Trade Credit, Bank Credit and Financial Crisis*
Inessa Love(Development Research Group, The World Bank)
Rida Zaidi(Fitch Ratings)

This paper examines trade credit behavior in a sample of small and medium enterprises in four East Asian countries before and after the financial crisis of 1998. We use a unique dataset that contains detailed data on trade credit amount and contract terms along with data on access to finance. We find that after the crisis, firms constrained in bank finance receive less trade credit in terms of percent of inputs bought on credit and shorter time of repayment. They also reduce credit extension to their customers in terms of quantity and length of time, due to a smaller pool of available finance. Discount terms rise on both receivables and payables. Our evidence does not support the hypothesis that trade credit can substitute for bank credit in times of the crisis, and instead suggests that liquidity shocks are propagated along the supply chains.

*This paper’s findings, interpretations and conclusions are entirely those of the authors and do not necessarily represent the views of The World Bank and its Executive Directors or the countries they represent. The views expressed in this paper also remain those of the respective authors and do not necessarily reflect those of the Fitch Group or any of its affiliated entities (“Fitch”). Fitch is not responsible, in any way, for the views expressed in this paper and Fitch shall have no liability to any person or entity therefore.

keywords: