Until now we have been assuming that there are only two financial assets, money and one period bonds. Hence, we have been assuming that there is only one interest rate.
The financial system is more complicated than that. There are many more financial instruments, more than one interest rates and many financial institutions.
Before the 2008 crisis, the financial system was relatively downplayed in macroeconomics. All interest rates were assumed to move together with the rate determined by monetary policy.
The financial crisis made it clear that this view is too simplistic. The financial system can be subject to short run crises with major macroeconomic implications.
In order to analyze such possibilities, one has to take a closer look at the role of financial markets, and in particular the role of financial intermediaries such as banks, and the role of risk.
Financial intermediaries stand between lenders-savers and borrowers-spenders and help transfer funds from one to the other. This is called indirect finance.
In fact, financial intermediation is the main route for moving funds from lenders to borrowers, and is mainly conducted by depository institutions (commercial banks, savings and loans associations, mutual savings banks and credit unions), by contractual savings institutions (life insurance companies, pension funds and government retirement funds), and by investment intermediaries (finance companies, mutual funds, hedge funds and investment banks).
Financial intermediation implies lower transaction costs because of specialization, economies of scale and the provision of liquidity services. In addition, because of the scale of their operations, financial intermediaries can reduce the risk of lending, by pooling different types of risk. Thus, they turn individually risky assets into safer composite assets, through diversification (“You should not put all your eggs in one basket”). By holding a larger and safer portfolio of risky assets, financial intermediaries are thus able to offer savers a safer menu of assets at a lower cost than if savers tried to do the same at a smaller scale.
Financial intermediation increases the efficiency of the financial system, but is not without risks.
For a start, although financial intermediation reduces problems of asymmetric information between borrowers and lenders, such problems remain. Intermediaries have better information about risks than their lenders and worse information than their borrowers. Hence, the need for government regulation to reduce the problems of asymmetric information.
In addition, financial markets are vulnerable to systemic risks. A negative systemic shock can destabilize them, especially as there is a discrepancy between the maturity structure of the liabilities and the assets of financial intermediaries. The liabilities of financial intermediaries such as banks are typically safe short term securities (e.g. checking accounts), while their assets are riskier and longer term (e.g. long term loans and bonds). If there is a shock that reduces the return of their assets and at the same time shakes the confidence of lenders-savers, leading them to withdraw their deposits, financial intermediaries may run into liquidity or solvency problems. Again, the possibility of such systemic risks creates the need for regulation.
In the absence of regulation, adverse shocks may lead to a destabilization of the financial system and a financial crisis.
Central to the risks of financial intermediation is the concept of leverage, which is defined as the ratio of total assets to capital. Leverage is nothing but the inverse of the capital ratio of a bank.
Financial intermediaries, such as banks are highly leveraged, because leverage increases profitability. Bank assets typically yield more than the cost of bank liabilities like deposits exactly because they are associated with longer maturities and higher risk. Therefore, higher leverage increases the risk of losses for the bank, which may lower the value of its assets below the value of its liabilities and make the bank insolvent. Thus, the higher the leverage ratio, the higher the risk of insolvency for the bank.
As a result, leverage makes banks and other financial intermediaries vulnerable to financial shocks and confidence crises. Because their assets are less liquid than their liabilities and carry higher risks, financial shocks can destabilize the banking system, causing bank failures and deleveraging. This reduces liquidity, increases the rate of return of risky assets and may have serious macroeconomic consequences.
In effect, through its liquidity effects and the rise in risk premia, a financial crisis causes a reduction in aggregate demand and may tilt an economy towards recession. This is what happened both in 1929, with the stock market crash and the wave of bank bankruptcies, and in 2007-2009 with the subprime and Lehman crisis.
To analyze the macroeconomic effects of a financial crisis, we must first extend our basic IS-LM framework to allow for investment to depend on risk adjusted real interest rates.
An increase in the risk premium, as a result of a financial crisis, increases risk adjusted real interest rates and reduces investment demand. This causes a recession, which may in itself result in bankruptcies and bank failures, which further reduce aggregate demand.
The appropriate response of monetary policy is to increase liquidity in order to reduce interest rates, and therefore reverse the effects of the financial crisis on aggregate demand. In addition, central banks may be required to act as lenders of last resort to the banking system, and bail out banks, in order to prevent deleveraging and bankruptcies and the further reduction in aggregate demand, output and employment.
The Great Depression of the 1930s and the Great Recession of 2007-09 provide important lessons of how a financial crisis develops and on what is the appropriate response of monetary policy.
Blanchard Ch. 6
Macroeconomics 