Week 8 :Readings compiled
by S.A.M
Summary: Anatomy of a Financial Crisis – Frederic S. Mishkin
Mishkin outlines a financial crisis as a situation where financial markets cannot efficiently channel funds from savers
to borrowers, disrupting economic activity. The key stages and elements of a typical financial crisis include:
1. Initiation of Crisis
Triggered by factors like macroeconomic shocks, financial liberalization, or rising interest rates.
These shocks undermine financial institutions or borrowers' balance sheets, increasing the risk of default.
2. Banking Crisis
Banks become vulnerable due to deteriorating asset quality.
Bank runs and failures occur as confidence erodes.
Reduced lending worsens the economic downturn.
3. Debt Deflation
Deflation increases the real burden of debt, leading to more defaults.
Asset prices collapse, further weakening financial institutions.
4. Policy Responses
Mishkin emphasizes the role of central banks and regulators in crisis management.
Effective responses include providing liquidity, deposit insurance, and restoring confidence.
Key Themes
Asymmetric information plays a crucial role: it worsens during crises, leading to adverse selection and moral
hazard.
Crises often follow a boom-bust pattern, where financial innovation and optimism give way to collapse when risks
are mispriced.
The importance of institutional structures (like regulatory frameworks) in either preventing or exacerbating crises.
a) Definition of a Financial Crisis within the Asymmetric Information Framework (3 marks)
Mishkin defines a financial crisis as a disruption to financial markets that impairs the ability of the financial system to efficiently channel funds from savers to borrowers. This
disruption is primarily due to asymmetric information problems—namely adverse selection and moral hazard—which worsen during crises and prevent financial intermediaries
from functioning effectively.
b) Primary Factors That Worsen Adverse Selection and Moral Hazard (5 marks)
Mishkin identifies several factors that contribute to a deterioration of asymmetric information problems in credit markets:
Deterioration of Balance Sheets: When firms and households experience losses in asset value, their net worth falls. This increases adverse
selection as lenders can no longer distinguish good from bad borrowers, and moral hazard rises because low net worth borrowers have
less to lose from risky behavior.
Increases in Interest Rates: High interest rates may lead to adverse selection by driving out low-risk borrowers, leaving riskier borrowers in
the market.
Bank Failures and Panics: When banks fail or experience runs, they can no longer perform their role in monitoring borrowers, increasing
both adverse selection and moral hazard.
Decline in Lending Due to Uncertainty: Loss of confidence and lack of information transparency (e.g., during sudden market downturns)
amplify the information asymmetry.
Asset Price Declines: Falling asset prices reduce the collateral value of assets, making it harder for borrowers to secure loans and
increasing lenders’ risk, further deepening information problems.
Summary of "Behind the 2008 Capital Market Collapse" by C-René Dominique
Main Thesis:
C-René Dominique argues that the 2008 financial crisis was not solely the result of greed or unethical
behavior in financial institutions. Rather, its fundamental causes were the dominance of neo-liberal ideology
—which emphasizes deregulation and minimal government intervention—and the widespread reliance on
flawed economic theories, particularly those concerning risk assessment in market economies.
Key Arguments
1. Mechanics of the Crisis
The crisis unfolded when financial institutions in the United States repackaged non-viable mortgage debts
into complex investment instruments, which were widely purchased by global banks. To manage risk, these
institutions utilized credit default swaps (CDSs), contracts designed to insure against default. However, the
enormous scale of the CDS market (valued at approximately $55 trillion) and a lack of transparency led
to widespread panic when defaults began to materialize. This panic caused the global credit markets to
freeze, as banks became unsure of each other's solvency.
2. The Role of Neo-Liberalism
Dominique criticizes neo-liberal economic policy, which stems from neo-classical assumptions that markets
are efficient and self-correcting. This ideology led to widespread deregulation, privatization, and reduced
government oversight. Institutions such as the IMF and World Bank, under the banner of the "Washington
Consensus," promoted these policies worldwide. The removal of key regulations—such as the repeal of the
Glass-Steagall Act and the enactment of the Commodity Futures Modernization Act—contributed
significantly to the speculative behavior that precipitated the crisis.
3. Flawed Theories of Risk
Dominique emphasizes that modern risk assessment tools used by financial engineers or "quants" are
based on unrealistic assumptions. These include beliefs in Gaussian distributions and linear systems, which
fail to capture the true behavior of complex market economies. He argues that such economies are non-
linear, chaotic, and fractal in nature, which makes objective risk quantification impossible. As a result,
traditional models misrepresent economic uncertainty and contribute to systemic failures.
Fractal Nature of Market Economies
The paper introduces the concept that economic systems are fractal, meaning they exhibit self-similar
patterns at various scales and operate under rules of creative destruction. Equilibrium in such systems is
rarely, if ever, attained, and market behavior is in a state of constant fluctuation. Therefore, models that
assume equilibrium or rely on linear relationships are fundamentally flawed.
Policy Recommendations
Governments must regulate hybrid financial instruments and establish formal clearinghouses for derivatives.
Neo-liberal ideology should be re-evaluated; market systems require regulation and government stabilization
to function effectively.
Long-term forecasts in fractal and chaotic systems such as the economy are inherently unreliable.
Public funds should not be used indiscriminately to rescue private institutions; instead, companies should be
allowed to restructure through bankruptcy when necessary.
A small Tobin tax on speculative financial transactions should be considered.
Legislations that contributed to deregulation and speculative excesses should be repealed or reformed.
Conclusion:
The 2008 financial crisis serves as a cautionary tale about the dangers of deregulation, the
misapplication of economic theory, and overreliance on flawed models of risk. Dominique calls for a shift in
both ideology and methodology to prevent future collapses and to align economic policy with the complex
realities of modern financial systems.
