 Welcome back everyone. So this week we will discuss financial crises. We will look at the difference between financial crises and economic recessions and see if there's any kind of relationship between the two. Then we will discuss the reasons behind financial crises. So what are the causes of financial crises? And finally we'll look at two important notions, the two big to fail and moral hazard and we'll look at the kind of relationship that these two have together. First things first, when we're talking about financial crises, it's normally a period when a sudden decrease in asset value happens and because of that, this sudden decrease in asset value leads financial institutions to encounter particular challenges. These challenges are related to them being able to meet their obligations and because of this, we can identify a series of events here. So the very first pattern is that we have a period of growth. This growth is normally facilitated by increased access to borrowing and then after this period of growth, we have a sudden fall in the value of assets and because of this sudden fall of the value of assets, we have a decrease in borrowing and so because of this, we encounter a financial crisis. On the other hand, if we look at economic recession has different indicators to it. So basically we look at the GDP and the GDP here is a low GDP. So the indicators are very low. We experience a period of low liquidity and at the same time, because of these issues, we have a decrease unemployment rate. Of course, this will be accompanied by lower production levels and as well lower levels in terms of living standards. And at the same time, we will likely have a higher inflation rate. But it is important to look at what causes economic recession. Economic recession normally are caused by asset mismanagement, asset mismatch and at the same time, it could be because of sudden fall or sudden decline in the asset value. How can we predict financial, how can we predict economic recession? We have three main ways to look into it that give us an indication that yes, we are going to be experiencing an economic recession. First one is through the consumer confidence index, which is basically C-high. The other indicator is basically stock market value. Of course, stock market value could give us a great indication as to the direction that we're going through. So if there is an economic recession, stock market value is a good indicator for us. Finally, if we look at the yield curve would normally look inverted in this case. And so these are just some of the ways that we can try to predict economic recession. But now that we know what economic recession is and what financial crisis is, what is the relationship between the two? So financial crisis normally is a starting point. And because it is a starting point, it leads to an economic recession. And when you have a financial crisis led by an economic recession, one will normally amplify the effects of the other. And at the same time, it will prolong the impact of it. So in our case, if we look at financial crisis and economic recession and assuming that we have a financial crisis first that led to economic recession, economic recession will amplify and prolong the impact of the financial crisis. And this is something that was very much visible during the last, the great recession of 2008-2007. So we know what causes economic recession and we've seen what financial crises are. But it is also important for us to understand what are the causes of financial crises. And the very first thing that we need to look into is something that was referred to as systemic risk. Systemic risk is a situation when you have financial institutions or institutions in general, taking risk, a higher type of risk, because they know that there is a sort of protection that is awarded for them. And because of this, any risk that they take, this higher level of risk that they take could basically lead to instability or perhaps the instability of the institution itself and perhaps even could lead to the collapse of the industry and could threaten the economy. And so normally systemic risk is regarded as an inherent type of risk in financial institutions. And this comes because financial institutions normally are very much interconnected to one another and they are interdependent on one another. And again, in the crisis of 2008, we could see how financial institutions are very much interconnected and interdependent. And because of this, if we do experience a crisis, if we do experience a financial crisis because of a systemic risk in one country, this could likely also stretch to another country because of the interdependence of the financial institutions. Now, if we're looking at financial crisis and we'd like to identify some of the causes of financial crisis, one of the main examples of financial crisis is bank runs. Bank runs are normally when you have depositors, a group of depositors all going at once trying to withdraw their deposits from the financial institutions where they deposited their money at. And basically this indicates that these depositors have no trust anymore in the banking sector. And because of this, imagine if you have suddenly hundreds of thousands of depositors removing and withdrawing all their money from the banks that they deposited their money in, you could imagine the severity of such actions on the bank itself that they are withdrawing the money from and perhaps even on the industry, on the financial industry. Again, because of the interconnectedness of financial institutions with one another. Another cause of financial crises is what we refer to as currency crises. Here, the currency suddenly is devaluated. So the monetary value of a particular currency is decreased whenever we try to measure it with a foreign currency or maybe a group of other foreign currencies. And normally in these cases, what we refer to are currencies that are pegged to other currencies. Now, within next week's presentation, we will look at the different types of currencies out there. We will learn more about what pegged currency is and what is a floated currency looks like. And so these are things that we will discuss within next week. But for us to understand what a currency crisis is, normally when we have pegged currencies that are tied to an exchange rate of another foreign currency and suddenly the local currency that is pegged to a foreign currency loses its value or the value decreases all of a sudden, this could lead to a loss of trust in the national currency. It could also emanate from effective fiscal policies or unstable fiscal policies. And it could also happen that the pegged currency becomes unpegged all of a sudden. And because of this, this unpeggedness of the currency, it makes the currency becomes a free-floating currency. And in these cases, when we have a currency crisis, this could basically lead to a financial crisis in that country. Another cause of a financial crisis is stock market crashes. And whenever we talk about a stock market crash here, what we're talking about is a sudden loss in the value of the stocks traded or the stock prices. And this sudden loss of value or decline in the stock prices basically wipes out a paper value, a significant paper value or paper wealth from the portfolios. And this is also another indicator of a financial crisis. Now, a third indicator or a third cause to financial crisis is the regulatory failure. Now, normally regulators intervene to try to protect consumers, to try to maintain the stability of the financial industry and to control inflation rates and to control how financial institutions are behaving in a particular country. Now, with that in mind, there are different approaches that different regulators put in place in order to ensure the stability of the financial sector on the one hand and on the other hand, the full protection of consumers. Now, some states in some countries opt for more of a lax type of regulatory approach or a less affair approach to regulating financial industry. And normally this is where we have problems occurring. And if the crisis of 2008 and indicator for us, it's that whenever you have a lax approach to regulation, whenever you give financial institutions a free flow to regulate themselves and to oversee themselves and their operations, most of the time you'll have financial institutions taking risks that they wouldn't necessarily take in normal situations. They become a little bit more free in taking these risks. And because of that, most sometimes what this would lead to is a crisis because of the uncalculated risk or the extra amount of risk that these financial institutions have taken. So when you have a lax regulatory approach accompanied with perhaps a lack of government, a proper government oversight, you will have financial institutions take trying to leverage their own to leverage themselves basically to capture gains and to capture some gains and even, as we said, take risks that they wouldn't necessarily take. Now, with this in mind, there are also other ways or other causes for financial crises. One of those is inflation crisis. And inflation crisis happens when you rapidly have rising inflation rates at an uncontrollable at an uncontrollable level. And this would basically lead to decreasing of the purchasing power. So this, again, is an indication that we have a financial crisis. Another one or another cause of a financial crisis is when you have sovereign debt crisis. And sovereign debt crisis is when a government or a state, a country basically is unable to meet its financial obligations towards the governments or financial institutions or other investors that it owes money to. So it is unable to repay the debt that it owes to these groups of investors. With the stock market crash, we've looked at stock market crash and we've seen how stock market crash could basically lead also to a financial crisis. Now, having seen the different causes of financial crises, there is an interesting notion that accompanies financial crisis normally. And this is something that we've seen being coined in 2008. And this is the notion of the too big to fail or the concept of too big to fail. And normally the concept of too big to fail comes along with moral hazard. And so what are these two different concepts? What is moral hazard and what is too big to fail? Basically, if we're talking about moral hazard, here we're talking about financial institutions or institutions in general that decide to take on risks they wouldn't normally take. And the reason they do so is because they have the protection from the consequences associated with taking that particular risk. Such protection could come from a contractual obligation between them and between another party who is willing to ensure them against these risks that they are taking. Now, here in this kind of relationship, we have one party that assumes a little more risk than the other. And so this party that is assuming risk is likely going to impact the second party who is ensuring against that risk negatively. And so when we have moral hazard here, it comes as a result of post-contractual asymmetric of information. And a good example of that is if we are talking about borrowing and lending. So in the case of borrowing and lending, if a borrower defaults on paying their loans, what we have here is the fact that the borrowers think that if I default on my loan, that's absolutely okay because in the end, it will be covered. The lender is going to bear all the losses and they will take charge of it. So there isn't any risk in that case for me as a borrower. So this is a situation where the actions of one party would negatively impact the second party. So now that we know what moral hazard is, we are in a better position to understand what too big to fail is and what it entails. So the notion of too big to fail is basically when we allow larger institutions, when we try to protect large institutions from collapsing. So here governments normally would bail out these large financial institutions because if they were to collapse, their collapse could lead to a collapse of an industry in general. And so saving these institutions becomes much cheaper than allowing them to collapse because if they were to collapse, they might lead to a collapse in an economy. So they might lead to a financial crisis or even lead to an economic recession. And so the act of saving these institutions becomes a necessity. If we are then talking about the relationship between financial institutions and the too big to fail notion or concept, here we can see that when we have large financial institutions that normally take risk that they wouldn't take, they do this because they know that the government will come, it will intervene and it will try to save them and protect them. Now the government, the protection that is awarded by governments are normally emanating from taxpayers money. So whatever kind of bailing out or bail out agreement that would be drawn out between the government and between the collapsing institution, it would be done and facilitated through the taxpayers money. And what we can see here, we can see a direct relationship between the too big to fail notion and the moral hazard concept. It is because we have the concept of moral hazard, we needed to introduce a too big to fail notion. We needed to introduce a mechanism to protect these institutions in the first place. So with this in mind, the homework for us to do for this week is to try to make a little bit of a research and figure out whether too big to fail concept is also applied beyond financial institutions. Do you think that too big to fail concept is only limited to financial institutions or does it also extend beyond the financial industry in the financial sector? What are your thoughts? With this, I'll leave you to do your homework and I'll see you next week.