Financial Crises and Aggregate Economic Activity Agency theory, our economic analysis of the effects of adverse selection and moral hazard, can help us understand financial crises, major disruptions in financial mar- kets that are characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms. Financial crises have been common in most coun- tries throughout modern history. The United States experienced major financial crises in 1819, 1837, 1857, 1873, 1884, 1893, 1907, and 1930–1933 but has not had a full-scale financial crisis since then. 6 Studying financial crises is worthwhile because they have led to severe economic downturns in the past and have the potential for doing so in the future. Financial crises occur when there is a disruption in the financial system that causes such a sharp increase in adverse selection and moral hazard problems in finan- cial markets that the markets are unable to channel funds efficiently from savers to people with productive investment opportunities. As a result of this inability of finan- cial markets to function efficiently, economic activity contracts sharply. To understand why banking and financial crises occur and, more specifically, how they lead to contractions in economic activity, we need to examine the factors that cause them. Five categories of factors can trigger financial crises: increases in interest rates, increases in uncertainty, asset market effects on balance sheets, problems in the banking sector, and government fiscal imbalances. Increases in Interest Rates. As we saw earlier, individuals and firms with the riskiest investment projects are exactly those who are willing to pay the highest interest rates. If market interest rates are driven up sufficiently because of increased demand for credit or because of a decline in the money supply, good credit risks are less likely to want to borrow while bad credit risks are still willing to borrow. Because of the result- ing increase in adverse selection, lenders will no longer want to make loans. The sub- stantial decline in lending will lead to a substantial decline in investment and aggregate economic activity. Increases in Uncertainty. A dramatic increase in uncertainty in financial markets, due perhaps to the failure of a prominent financial or nonfinancial institution, a recession, or a stock market crash, makes it harder for lenders to screen good from bad credit risks. The resulting inability of lenders to solve the adverse selection problem makes them less willing to lend, which leads to a decline in lending, investment, and aggre- gate economic activity. Asset Market Effects on Balance Sheets. The state of firms’ balance sheets has impor- tant implications for the severity of asymmetric information problems in the financial system. A sharp decline in the stock market is one factor that can cause a serious dete- rioration in firms’ balance sheets that can increase adverse selection and moral hazard Factors Causing Financial Crises CHAPTER 8 An Economic Analysis of Financial Structure 189 6 Although we in the United States have not experienced any financial crises since the Great Depression, we have had several close calls—the October 1987 stock market crash, for example. An important reason why we have escaped financial crises is the timely action of the Federal Reserve to prevent them during episodes like that of October 1987. We look at the issue of the Fed’s role in preventing financial crises in Chapter 17. problems in financial markets and provoke a financial crisis. A decline in the stock market means that the net worth of corporations has fallen, because share prices are the valuation of a corporation’s net worth. The decline in net worth as a result of a stock market decline makes lenders less willing to lend because, as we have seen, the net worth of a firm plays a role similar to that of collateral. When the value of collat- eral declines, it provides less protection to lenders, meaning that losses on loans are likely to be more severe. Because lenders are now less protected against the conse- quences of adverse selection, they decrease their lending, which in turn causes invest- ment and aggregate output to decline. In addition, the decline in corporate net worth as a result of a stock market decline increases moral hazard by providing incentives for borrowing firms to make risky investments, as they now have less to lose if their invest- ments go sour. The resulting increase in moral hazard makes lending less attractive— another reason why a stock market decline and resultant decline in net worth leads to decreased lending and economic activity. In economies in which inflation has been moderate, which characterizes most industrialized countries, many debt contracts are typically of fairly long maturity with fixed interest rates. In this institutional environment, unanticipated declines in the aggregate price level also decrease the net worth of firms. Because debt payments are contractually fixed in nominal terms, an unanticipated decline in the price level raises the value of firms’ liabilities in real terms (increases the burden of the debt) but does not raise the real value of firms’ assets. The result is that net worth in real terms (the difference between assets and liabilities in real terms) declines. A sharp drop in the price level therefore causes a substantial decline in real net worth and an increase in adverse selection and moral hazard problems facing lenders. An unanticipated decline in the aggregate price level thus leads to a drop in lending and economic activity. Because of uncertainty about the future value of the domestic currency in devel- oping countries (and in some industrialized countries), many nonfinancial firms, banks, and governments in these countries find it easier to issue debt denominated in foreign currencies. This can lead to a financial crisis in a similar fashion to an unan- ticipated decline in the price level. With debt contracts denominated in foreign cur- rency, when there is an unanticipated decline in the value of the domestic currency, the debt burden of domestic firms increases. Since assets are typically denominated in domestic currency, there is a resulting deterioration in firms’ balance sheets and a decline in net worth, which then increases adverse selection and moral hazard prob- lems along the lines just described. The increase in asymmetric information problems leads to a decline in investment and economic activity. Although we have seen that increases in interest rates have a direct effect on increasing adverse selection problems, increases in interest rates also play a role in promoting a financial crisis through their effect on both firms’ and households’ bal- ance sheets. A rise in interest rates and therefore in households’ and firms’ interest payments decreases firms’ cash flow, the difference between cash receipts and cash expenditures. The decline in cash flow causes a deterioration in the balance sheet because it decreases the liquidity of the household or firm and thus makes it harder for lenders to know whether the firm or household will be able to pay its bills. As a result, adverse selection and moral hazard problems become more severe for poten- tial lenders to these firms and households, leading to a decline in lending and eco- nomic activity. There is thus an additional reason why sharp increases in interest rates can be an important factor leading to financial crises. 190 PART III Financial Institutions Problems in the Banking Sector. Banks play a major role in financial markets because they are well positioned to engage in information-producing activities that facilitate productive investment for the economy. The state of banks’ balance sheets has an important effect on bank lending. If banks suffer a deterioration in their balance sheets and so have a substantial contraction in their capital, they will have fewer resources to lend, and bank lending will decline. The contraction in lending then leads to a decline in investment spending, which slows economic activity. If the deterioration in bank balance sheets is severe enough, banks will start to fail, and fear can spread from one bank to another, causing even healthy banks to go under. The multiple bank failures that result are known as a bank panic. The source of the contagion is again asymmetric information. In a panic, depositors, fearing for the safety of their deposits (in the absence of deposit insurance) and not knowing the quality of banks’ loan portfolios, withdraw their deposits to the point that the banks fail. The failure of a large number of banks in a short period of time means that there is a loss of information production in financial markets and hence a direct loss of financial intermediation by the banking sector. The decrease in bank lending during a financial crisis also decreases the supply of funds to borrowers, which leads to higher interest rates. The outcome of a bank panic is an increase in adverse selection and moral hazard problems in credit markets: These problems produce an even sharper decline in lending to facilitate productive investments that leads to an even more severe contraction in economic activity. Government Fiscal Imbalances. In emerging market countries (Argentina, Brazil, and Turkey are recent examples), government fiscal imbalances may create fears of default on the government debt. As a result, the government may have trouble getting peo- ple to buy its bonds and so it might force banks to purchase them. If the debt then declines in price—which, as we have seen in Chapter 6, will occur if a government default is likely—this can substantially weaken bank balance sheets and lead to a con- traction in lending for the reasons described earlier. Fears of default on the govern- ment debt can also spark a foreign exchange crisis in which the value of the domestic currency falls sharply because investors pull their money out of the country. The decline in the domestic currency’s value will then lead to the destruction of the bal- ance sheets of firms with large amounts of debt denominated in foreign currency. These balance sheet problems lead to an increase in adverse selection and moral haz- ard problems, a decline in lending, and a contraction of economic activity. CHAPTER 8 An Economic Analysis of Financial Structure 191 Financial Crises in the United States Application As mentioned, the United States has a long history of banking and financial crises, such crises having occurred every 20 years or so in the nineteenth and early twentieth centuries—in 1819, 1837, 1857, 1873, 1884, 1893, 1907, and 1930–1933. Our analysis of the factors that lead to a financial crisis can explain why these crises took place and why they were so damaging to the U.S. economy. 192 PART III Financial Institutions Study Guide To understand fully what took place in a U.S. financial crisis, make sure that you can state the reasons why each of the factors—increases in interest rates, increases in uncertainty, asset market effects on balance sheets, and problems in the banking sector—increases adverse selection and moral hazard prob- lems, which in turn lead to a decline in economic activity. To help you under- stand these crises, you might want to refer to Figure 3, a diagram that traces the sequence of events in a U.S. financial crisis. As shown in Figure 3, most financial crises in the United States have begun with a deterioration in banks’ balance sheets, a sharp rise in interest rates (frequently stemming from increases in interest rates abroad), a steep stock market decline, and an increase in uncertainty resulting from a failure of major financial or nonfinancial firms (the Ohio Life Insurance & Trust Company in 1857, the Northern Pacific Railroad and Jay Cooke & Company in 1873, Grant & Ward in 1884, the National Cordage Company in 1893, the Knickerbocker Trust Company in 1907, and the Bank of United States in 1930). During these crises, deterioration in banks’ balance sheets, the increase in uncertainty, the rise in interest rates, and the stock market decline increased the severity of adverse selection problems in credit markets; the stock market decline, the deterioration in banks’ balance sheets, and the rise in interest rates, which decreased firms’ cash flow, also increased moral haz- ard problems. The rise in adverse selection and moral hazard problems then made it less attractive for lenders to lend and led to a decline in investment and aggregate economic activity. Because of the worsening business conditions and uncertainty about their bank’s health (perhaps banks would go broke), depositors began to withdraw their funds from banks, which led to bank panics. The resulting decline in the number of banks raised interest rates even further and decreased the amount of financial intermediation by banks. Worsening of the problems created by adverse selection and moral hazard led to further eco- nomic contraction. Finally, there was a sorting out of firms that were insolvent (had a neg- ative net worth and hence were bankrupt) from healthy firms by bankruptcy proceedings. The same process occurred for banks, often with the help of public and private authorities. Once this sorting out was complete, uncer- tainty in financial markets declined, the stock market underwent a recovery, and interest rates fell. The overall result was that adverse selection and moral hazard problems diminished and the financial crisis subsided. With the financial markets able to operate well again, the stage was set for the recov- ery of the economy. If, however, the economic downturn led to a sharp decline in prices, the recovery process was short-circuited. In this situation, shown in Figure 3, a process called debt deflation occurred, in which a substantial decline in the price level set in, leading to a further deterioration in firms’ net worth because of the increased burden of indebtedness. When debt deflation set in, www.amatecon.com/gd /gdtimeline.html A time line of the Great Depression. CHAPTER 8 An Economic Analysis of Financial Structure 193 the adverse selection and moral hazard problems continued to increase so that lending, investment spending, and aggregate economic activity remained depressed for a long time. The most significant financial crisis that included debt deflation was the Great Depression, the worst economic contraction in U.S. history (see Box 3). FIGURE 3 Sequence of Events in U.S. Financial Crises The solid arrows trace the sequence of events in a typical financial crisis; the dotted arrows show the additional set of events that occur if the crisis develops into a debt deflation. Consequences of Changes in Factors Factors Causing Financial Crises Typical Financial Crisis Debt Deflation Increase in Interest Rates Increase in Uncertainty Stock Market Decline Unanticipated Decline in Price Level Bank Panic Economic Activity Declines Economic Activity Declines Economic Activity Declines Adverse Selection and Moral Hazard Problems Worsen Adverse Selection and Moral Hazard Problems Worsen Adverse Selection and Moral Hazard Problems Worsen Deterioration in Banks’ Balance Sheets 194 PART III Financial Institutions Box 3 Case Study of a Financial Crisis The Great Depression. Federal Reserve officials viewed the stock market boom of 1928 and 1929, dur- ing which stock prices doubled, as excessive specula- tion. To curb it, they pursued a tight monetary policy to raise interest rates. The Fed got more than it bargained for when the stock market crashed in October 1929. Although the 1929 crash had a great impact on the minds of a whole generation, most people forget that by the middle of 1930, more than half of the stock market decline had been reversed. What might have been a normal recession turned into something far different, however, with adverse shocks to the agri- cultural sector, a continuing decline in the stock mar- ket after the middle of 1930, and a sequence of bank collapses from October 1930 until March 1933 in which over one-third of the banks in the United States went out of business (events described in more detail in Chapter 18). The continuing decline in stock prices after mid- 1930 (by mid-1932 stocks had declined to 10% of their value at the 1929 peak) and the increase in uncertainty from the unsettled business conditions created by the economic contraction made adverse selection and moral hazard problems worse in the credit markets. The loss of one-third of the banks reduced the amount of financial intermediation. This intensified adverse selection and moral hazard prob- lems, thereby decreasing the ability of financial mar- kets to channel funds to firms with productive investment opportunities. As our analysis predicts, the amount of outstanding commercial loans fell by half from 1929 to 1933, and investment spending collapsed, declining by 90% from its 1929 level. The short-circuiting of the process that kept the economy from recovering quickly, which it does in most recessions, occurred because of a fall in the price level by 25% in the 1930–1933 period. This huge decline in prices triggered a debt deflation in which net worth fell because of the increased burden of indebtedness borne by firms. The decline in net worth and the resulting increase in adverse selection and moral hazard problems in the credit markets led to a prolonged economic contraction in which unem- ployment rose to 25% of the labor force. The finan- cial crisis in the Great Depression was the worst ever experienced in the United States, and it explains why this economic contraction was also the most severe one ever experienced by the nation.* *See Ben Bernanke, “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” American Economic Review 73 (1983): 257–276, for a discussion of the role of asymmetric information problems in the Great Depression period. Financial Crises in Emerging-Market Countries: Mexico, 1994–1995; East Asia, 1997–1998; and Argentina, 2001–2002 Application In recent years, many emerging-market countries have experienced financial crises, the most dramatic of which were the Mexican crisis, which started in December 1994; the East Asian crisis, which started in July 1997; and the Argentine crisis, which started in 2001. An important puzzle is how a devel- oping country can shift dramatically from a path of high growth before a financial crisis—as was true for Mexico and particularly the East Asian coun- tries of Thailand, Malaysia, Indonesia, the Philippines, and South Korea—to a sharp decline in economic activity. We can apply our asymmetric information CHAPTER 8 An Economic Analysis of Financial Structure 195 analysis of financial crises to explain this puzzle and to understand the Mexican, East Asian, and Argentine financial situations. 7 Because of the different institutional features of emerging-market coun- tries’ debt markets, the sequence of events in the Mexican, East Asian, and Argentine crises is different from that occurring in the United States in the nineteenth and twentieth centuries. Figure 4 diagrams the sequence of events that occurred in Mexico, East Asia, and Argentina. An important factor leading up to the financial crises in Mexico and East Asia was the deterioration in banks’ balance sheets because of increasing loan losses. When financial markets in these countries were deregulated in the early 1990s, a lending boom ensued in which bank credit to the private non- financial business sector accelerated sharply. Because of weak supervision by bank regulators and a lack of expertise in screening and monitoring borrow- ers at banking institutions, losses on the loans began to mount, causing an erosion of banks’ net worth (capital). As a result of this erosion, banks had fewer resources to lend, and this lack of lending eventually led to a contrac- tion in economic activity. Argentina also experienced a deterioration in bank balance sheets lead- ing up to its crisis, but the source of this deterioration was quite different. In contrast to Mexico and the East Asian crisis countries, Argentina had a well- supervised banking system, and a lending boom did not occur before the cri- sis. On the other hand, in 1998 Argentina entered a recession (you can find out more on why this occurred in Chapter 20) that led to some loan losses. However, it was the fiscal problems of the Argentine government that led to severe weakening of bank balance sheets. Again in contrast to Mexico and the East Asian countries before their crises, Argentina was running substantial budget deficits that could not be financed by foreign borrowing. To solve its fiscal problems, the Argentine government coerced banks into absorbing large amounts of government debt. When investors lost confidence in the ability of the Argentine government to repay this debt, the price of this debt plummeted, leaving big holes in commercial banks’ balance sheets. This weakening in bank balance sheets, as in Mexico and East Asia, helped lead to a contraction of economic activity. Consistent with the U.S. experience in the nineteenth and early twenti- eth centuries, another precipitating factor in the Mexican and Argentine (but not East Asian) financial crises was a rise in interest rates abroad. Before the Mexican crisis, in February 1994, and before the Argentine crisis, in mid- 1999, the Federal Reserve began a cycle of raising the federal funds rate to head off inflationary pressures. Although the monetary policy moves by the Fed were quite successful in keeping inflation in check in the United States, they put upward pressure on interest rates in both Mexico and Argentina. 7 This chapter does not examine two other recent crises, those in Brazil and Russia. Russia’s financial crisis in August 1998 can also be explained with the asymmetric information story here, but it is more appropriate to view it as a symptom of a wider breakdown in the economy—and this is why we do not focus on it here. The Brazilian crisis in January 1999 has features of a more traditional balance-of-payments crisis (see Chapter 20), rather than a financial crisis. 196 PART III Financial Institutions Increase in Interest Rates Increase in Uncertainty Deterioration in Banks’ Balance Sheets Fiscal Imbalances Stock Market Decline Banking Crisis Foreign Exchange Crisis Economic Activity Declines Economic Activity Declines Adverse Selection and Moral Hazard Problems Worsen Adverse Selection and Moral Hazard Problems Worsen Adverse Selection and Moral Hazard Problems Worsen Consequences of Changes in Factors Factors Causing Financial Crises FIGURE 4 Sequence of Events in the Mexican, East Asian, and Argentine Financial Crises The arrows trace the sequence of events during the financial crisis. The rise in interest rates in Mexico and Argentina directly added to increased adverse selection in their financial markets because, as discussed earlier, it was more likely that the parties willing to take on the most risk would seek loans. Also consistent with the U.S. experience in the nineteenth and early twentieth centuries, stock market declines and increases in uncertainty occurred prior to and contributed to full-blown crises in Mexico, Thailand, CHAPTER 8 An Economic Analysis of Financial Structure 197 South Korea, and Argentina. (The stock market declines in Malaysia, Indonesia, and the Philippines, on the other hand, occurred simultaneously with the onset of the crisis.) The Mexican economy was hit by political shocks in 1994 (specifically, the assassination of the ruling party’s presiden- tial candidate and an uprising in the southern state of Chiapas) that created uncertainty, while the ongoing recession increased uncertainty in Argentina. Right before their crises, Thailand and Korea experienced major failures of financial and nonfinancial firms that increased general uncertainty in finan- cial markets As we have seen, an increase in uncertainty and a decrease in net worth as a result of a stock market decline increase asymmetric information prob- lems. It becomes harder to screen out good from bad borrowers, and the decline in net worth decreases the value of firms’ collateral and increases their incentives to make risky investments because there is less equity to lose if the investments are unsuccessful. The increase in uncertainty and stock market declines that occurred before the crisis, along with the deterioration in banks’ balance sheets, worsened adverse selection and moral hazard problems (shown at the top of the diagram in Figure 4) and made the economies ripe for a serious financial crisis. At this point, full-blown speculative attacks developed in the foreign exchange market, plunging these countries into a full-scale crisis. With the Colosio assassination, the Chiapas uprising, and the growing weakness in the banking sector, the Mexican peso came under attack. Even though the Mexican central bank intervened in the foreign exchange market and raised interest rates sharply, it was unable to stem the attack and was forced to devalue the peso on December 20, 1994. In the case of Thailand, concerns about the large current account deficit and weakness in the Thai financial system, cul- minating with the failure of a major finance company, Finance One, led to a successful speculative attack that forced the Thai central bank to allow the baht to float downward in July 1997. Soon thereafter, speculative attacks developed against the other countries in the region, leading to the collapse of the Philippine peso, the Indonesian rupiah, the Malaysian ringgit, and the South Korean won. In Argentina, a full-scale banking panic began in October–November 2001. This, along with realization that the government was going to default on its debt, also led to a speculative attack on the Argentine peso, resulting in its collapse on January 6, 2002. The institutional structure of debt markets in Mexico and East Asia now interacted with the currency devaluations to propel the economies into full- fledged financial crises. Because so many firms in these countries had debt denominated in foreign currencies like the dollar and the yen, depreciation of their currencies resulted in increases in their indebtedness in domestic currency terms, even though the value of their assets remained unchanged. When the peso lost half its value by March 1995 and the Thai, Philippine, Malaysian, and South Korean currencies lost between a third and half of their value by the beginning of 1998, firms’ balance sheets took a big negative hit, causing a dramatic increase in adverse selection and moral hazard problems. This negative shock was especially severe for Indonesia and Argentina, which saw the value of their currencies fall by over 70%, resulting in insolvency for firms with substantial amounts of debt denominated in foreign currencies. 198 PART III Financial Institutions The collapse of currencies also led to a rise in actual and expected inflation in these countries, and market interest rates rose sky-high (to around 100% in Mexico and Argentina). The resulting increase in interest payments caused reductions in households’ and firms’ cash flow, which led to further deterioration in their balance sheets. A feature of debt markets in emerging-market countries, like those in Mexico, East Asia, and Argentina is that debt contracts have very short durations, typically less than one month. Thus the rise in short-term interest rates in these countries meant that the effect on cash flow and hence on balance sheets was substantial. As our asymmetric information analysis suggests, this deterioration in house- holds’ and firms’ balance sheets increased adverse selection and moral haz- ard problems in the credit markets, making domestic and foreign lenders even less willing to lend. Consistent with the theory of financial crises outlined in this chapter, the sharp decline in lending helped lead to a collapse of economic activity, with real GDP growth falling sharply. As shown in Figure 4, further deterioration in the economy occurred because the collapse in economic activity and the deterioration in the cash flow and balance sheets of both firms and households led to worsening bank- ing crises. The problems of firms and households meant that many of them were no longer able to pay off their debts, resulting in substantial losses for the banks. Even more problematic for the banks was that they had many short-term liabilities denominated in foreign currencies, and the sharp increase in the value of these liabilities after the devaluation lead to a further deterioration in the banks’ balance sheets. Under these circumstances, the banking system would have collapsed in the absence of a government safety net—as it did in the United States during the Great Depression—but with the assistance of the International Monetary Fund, these countries were in some cases able to protect depositors and avoid a bank panic. However, given the loss of bank capital and the need for the government to intervene to prop up the banks, the banks’ ability to lend was nevertheless sharply curtailed. As we have seen, a banking crisis of this type hinders the ability of the banks to lend and also makes adverse selection and moral hazard problems worse in finan- cial markets, because banks are less capable of playing their traditional finan- cial intermediation role. The banking crisis, along with other factors that increased adverse selection and moral hazard problems in the credit markets of Mexico, East Asia, and Argentina, explains the collapse of lending and hence economic activity in the aftermath of the crisis. In the aftermath of their crises, Mexico began to recover in 1996, while the crisis countries in East Asia saw the glimmer of recovery in 1999. Argentina was still in a severe depression in 2003. In all these countries, the economic hardship caused by the financial crises was tremendous. Unemployment rose sharply, poverty increased substantially, and even the social fabric of the society was stretched thin. For example, Mexico City and Buenos Aires have become crime-ridden, while Indonesia has experienced waves of ethnic violence. [...]... taking on risks at their expense The need for banks and other financial institutions to engage in screening and monitoring explains why they spend so much money on auditing and information-collecting activities Long-Term Customer Relationships An additional way for banks and other financial institutions to obtain information about their borrowers is through long-term customer relationships, another... the market value of the liabilities falls by 10% ( 5% 2 years), a decline of $9 million on the $90 million of liabilities The net result is that the net worth (the market value of the assets minus the liabilities) has declined by $6 million, or 6% of the total original asset value Similarly, a 5-percentage-point decline in interest rates increases the net worth of the First National Bank by 6% of the. .. with the stronger recovery of the economy in 1993, helped by a low-interest-rate policy at the Federal Reserve, did these complaints subside CHAPTER 9 Banking and the Management of Financial Institutions 217 As seen in the earlier discussion of general principles of asset management, banks and also other financial institutions must make successful loans that are paid back in full (and so subject the institution... profits by selling loans for an amount slightly greater than the amount of the original loan Because the high interest rate on these loans makes them attractive, institutions are willing to buy them, even though the higher price means that they earn a slightly lower interest rate than the original interest rate on the loan, usually on the order of 0.15 percentage point Generation of Fee Income Another type... sensitivity Alternatively, you could lengthen the duration of the liabilities By this adjustment of the banks assets and liabilities, the banks income will be less affected by interest-rate swings One problem with eliminating the First National Banks interest-rate risk by altering the balance sheet is that doing so might be very costly in the short run The bank may be locked in to assets and liabilities of... you will repay the loan Since more borrowers repay their loans if the loan amounts are small, financial institutions ration credit by providing borrowers with smaller loans than they seek With the increased volatility of interest rates that occurred in the 1980s, banks and other financial institutions became more concerned about their exposure to interestrate risk, the riskiness of earnings and returns... and interest-rate swaps Banks engaged in international banking also conduct transactions in the foreign exchange market All transactions in these markets are off-balance-sheet activities because they do not have a direct effect on the banks balance sheet Although bank trading in these markets is often directed toward reducing risk or facilitating other bank business, banks also try to outguess the. .. firm receiving a loan must keep in a checking account at the lending bank 220 PART III Financial Institutions Besides serving as collateral, compensating balances help increase the likelihood that a loan will be paid off They do this by helping the bank monitor the borrower and consequently reduce moral hazard Specifically, by requiring the borrower to use a checking account at the bank, the bank can... reduce the banks capital by paying out higher dividends to its stockholders, thereby reducing the banks retained earnings (3) You can keep bank capital constant but increase the banks assets by acquiring new funds say, by issuing CDs and then seeking out loan business or purchasing more securities with these new funds Because you think that it would enhance your position with the 216 PART III Financial Institutions... associated with changes in CHAPTER 9 Banking and the Management of Financial Institutions 221 interest rates To see what interest-rate risk is all about, lets again take a look at the First National Bank, which has the following balance sheet: Assets Rate-sensitive assets Variable-rate and short-term loans Short-term securities Fixed-rate assets Reserves Long-term loans Long-term securities Liabilities . sheets, the increase in uncertainty, the rise in interest rates, and the stock market decline increased the severity of adverse selection problems in credit markets; the stock market decline, the. in which over one-third of the banks in the United States went out of business (events described in more detail in Chapter 18). The continuing decline in stock prices after mid- 1930 (by mid-1932. Soon thereafter, speculative attacks developed against the other countries in the region, leading to the collapse of the Philippine peso, the Indonesian rupiah, the Malaysian ringgit, and the South