This document discusses the financial crisis that began in 2007. It describes the initial conditions that led to the crisis, including risky subprime assets and complex financial products. It then explains two amplification mechanisms: runs on financial institutions due to bad assets, and declining capital ratios. These mechanisms strongly interacted and spread contagion across institutions, assets, and countries. The document analyzes the dynamics of the crisis in real time and discusses appropriate short-run policies to address liquidity and capital issues. It also notes ongoing financial and economic challenges.

1. The financial crisis: Initial conditions, basic
mechanisms, and appropriate policies.
Olivier Blanchard
Munich lecture, November 2008
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2. 1. Introduction
• Much too early to give a definitive assessment.
• Not too early to think about the basic mechanisms, and whether/how
we can prevent similar events in the future.
• A first pass, in the midst of the action. With thanks to the IMF team.
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3. The basic question: How could such a small trigger have such enormous effects
on world output?
¨
Initial Subprime Losses and Subsequent Declines in World GDP,
US Households Real Estate Wealth, and US Stock Market Capitalization
§
(in Billions US Dollars)
¦
¥
¤
£
¢
¡
© © 5 E I I I I
! quot; 3 4 9 4 $ $ C D 4 % 9 4 $ $ C P quot; 9 4 $ $ C P quot;
# # F © Q Q
$ $ $ % 1 ) ) 6 1 ) ( ) 7 quot; 4 % 8 9 @ A 4 G 3 ! 4 $ 2 0 ) 2 2 0 ) 6 3 ! 4 $ 2 0 ) 2
5 B H H
quot; ' ( ) 0 1 ) ) 2 9 4 $ A 4 quot; $ % 1 0 ) 2 1 0 ) 6 ( ) 0 ) 6
Source: IMF Global Financial Stability Report; World Economic Outlook November update and estimates; Federal Reserve Flow of
Funds Accounts; World Federation of Exchanges.
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4. Organization
• Initial conditions
• Two amplification mechanisms
• Interconnections and dynamics
• Implications for policy now and in the future
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5. Setting the stage: Initial conditions
• The trigger: The issuance of risky assets, with undervaluation of risk.
Subprime mortgages.
Causes? Large world demand for safe assets, and bad regulation.
• The determinants of amplification.
– Complexity and opacity of assets on balance sheets of financial
institutions, so low liquidity.
Causes? Better risk allocation, and bad regulation.
– Increased leverage (lower capital relative to assets).
Causes? Bad, and sometimes perverse regulation.
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6. A visual sense of the complexity. From mortgages to securities
Bought by
Bought by both ABCP
more risk-
low and high risk-
seeking
Residuals
seeking investors
investors
Loan
proceeds Lines of Banks provide liquidity ABCP Conduits
credit to lenders
/ SIVs buy ABS
Subprime Subprime Subprime and issue short-
Borrower Servicer Lender Banks provide credit term debt
Loan cash Banks
Loan cash Loan cash Securitization lines to conduits / SIVs
Subprime
flow flow flow Underwriting
Securitization
Structure Bam ks prov ide
financing to CDOs
Provide insurance on
Subprime BBB-
Insurers
CDOs, ABS and some
through Single A ABS are bought SIVs
bonds
Subprime AAA
by CDOs and
AA bonds
tranched into
CDO CDO
structured
debt equity
products, financed
Bought by less Bought by more
Bought by by issuing debt
risk-seeking risk-seeking
other
investors investors
CDOs
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7. Amplification mechanism 1. Runs
• Bad (or doubtful) assets on balance sheets
• Runs (not only by depositors, but by other investors)
• Need to sell assets.
• Not enough deep pocket investors to buy.
• Firesale prices. P EN P V .
• Worse balance sheets. More incentives to run, etc
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8. Amplification mechanism 2. Capital
• Bad (or doubtful) assets on balance sheets
• Decrease in capital ratio (Assets minus liabilities, over Assets)
• Need to sell assets (deleverage)
• Not enough deep pocket investors to buy.
• Firesale prices. P EN P V .
• Lower capital ratio. More incentives to sell assets, etc
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9. The two mechanisms: Conceptually separate but strongly interacting
• Run on financial institution 1
• Cut credit to financial institution 2
– Sale of assets at depressed prices
Low capital, so further sales
– Or cut credit to financial institution 3
Examples. From US banks to Hungary. From subprimes to other assets.
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10. The dynamics in real time
• Increase in probability of insolvency.
• Increase in counterparty risk.
• Decrease in volume and maturity of interbank lending.
• Contagion across institutions. From direct exposure to subprime on-
wards.
• Contagion across countries. From the US to Europe, to emerging market
countries.
• Increasing effects on the ultimate borrowers: households and firms.
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11. Contagion across institutions, assets, and countries
Heat Map: Developments in Systemic Asset Classes
Emerging markets
Corporate credit
Prime RMBS
Commercial MBS
Money markets
Financial institutions
Subprime RMBS
Jan-07 Jul-07 Jan-08 Oct-08
Source: IMF, Global Financial Stability Report, October 2008
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12. Counterparty risk: Difference between the lending rate between banks and the
riskless rate
5.0
Ted Spreads: 3-month Libor Rate minus T-bill Rate
(in percent)
4.0
Sep 15, 2008
3.0 Lehman Files for Bank ruptcy
2.0
1.0
0.0
01/01/07 08/01/07 03/01/08 10/01/08
US Euro Japan UK
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13. Emerging market spreads
Emerging Markets Sovereign Srpeads - Composite Index
(1/2/06 - 11/12/08)
¥
¤
£
¢
¡
08
08
06
06
08
06
07
07
07
08
06
07
/
/
/
2/
2/
2/
2/
2/
2/
2/
2/
2/
/2
/2
/2
1/
4/
7/
1/
4/
1/
4/
7/
7/
10
10
10
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14. Bank lending standards
100
Bank Lending Standards
80
60
40
20
0
-20
-40
6/ 5
9/ 5
5
05
6/ 6
9/ 6
6
3/ 6
6/ 7
9/ 7
7
3/ 7
6/ 8
9/ 8
8
0
0
/0
/0
/0
/0
/0
/0
/0
/0
/0
/0
/0
/0
0/
0/
0/
30
30
30
30
30
30
30
30
30
30
30
30
/3
/3
/3
3/
3/
12
12
12
U.S.: CI loans U.S.: Mortgages
ECB: Large company loans ECB: Mortgages
Change in the Balance of Respondents Between “Tightened Considerably-Tightened Somewhat” and “Eased Somewhat-Eased
Considerably” in Percent of Respondents. Source: Haver Analytics.
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15. Financial policies for the short run
Need to dampen/eliminate the two amplification mechanisms.
• Runs: Provide liquidity to a broader set of institutions.
Done. Still problem with institutions, countries without access to lender
of last resort (Iceland).
• Capital.
– Buy bad assets. For two reasons: Clarify price. Move price closer
to EPDV.
– Increase capital.
Many institutions may still need recapitalization. So need to add
capital (buy shares).
• Second leg takes time to implement. May need guarantees for deposi-
tors, and for interbank claims. To start interbank lending.
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16. Basic financial architecture in place in advanced countries
• A crucial weekend in October, but:
• Problems with speed/scope of recapitalization
• Coherence across countries
• Still hidden land mines. for example: CDS positions.
• Problems in emerging market countries.
Sudden stops. Need access to international liquidity provision.
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17. Counterparty risk since September
Ted Spreads: 3-month Libor Rate
3-month Libor Rate
minus T-bill Rate
5.0
8.0
4.5
7.0
4.0
6.0
3.5
5.0 3.0
2.5
4.0
2.0
3.0
1.5
2.0
1.0
1.0 0.5
0.0
0.0
8/1 8/16 8/31 9/15 9/30 10/15 10/30
8/1 8/16 8/31 9/15 9/30 10/15 10/30
US Euro Japan UK US Euro Japan UK
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18. Sovereign spreads since September
3500
Sovereign CDS Spreads
(index 7/2/07=100)
3000
2500
2000
1500
1000
500
0
7/2/07 9/2/07 11/2/07 1/2/08 3/2/08 5/2/08 7/2/08 9/2/08 11/2/08
Current account deficit larger than 5% of 2007 GDP
Current account surplus, or small deficit
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19. From the financial crisis to the economic crisis
• Not a side show.
Direct effects: Credit growth, stock prices, exchange rates
Indirect effects, through confidence, and wait and see
• A Keynesian recession
Worsens the financial crisis
Back to fiscal and monetary policy (in addition to financial policies)
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20. Decrease in stock prices
500
120
Equity Markets in Emerging Economies
Equity Markets in Advanced Economies
450
110 (Index 2001=100; national currency)
(March 2000 = 100; national currency)
400
100
350
90
300
80
250
70
200
60
150
50
100
40
50
30
0
Fe 03
Ja 06
Ju 0 5
Ma 01
8
Oc 1
Oc 08
A u 00
A u 07
Ma 00
Ma 07
No 5
D e 02
S e 04
Ju 2
A p 04
t -0
r -0
r-0
0
n-
l-
t-
v-
r-
n-
n-
y-
g-
b-
g-
Fe 3
Ja 6
Ju 5
Ma 01
8
Oc 1
Oc 8
c-
p-
Au 0
Au 7
Ma 0
Ma 7
No 5
D e 02
S e 04
Ju 2
Ap 4
l- 0
0
0
t -0
r -0
r -0
0
0
0
0
r-0
0
0
Ja
n-
t-
v-
n-
n-
y-
g-
b-
g-
c-
p-
Ja
ASIA LATIN AMERICA EASTERN EUROPE
WILSHIRE 5000 DJ EURO STOXX TOPIX
Source: Bloomberg and IMF staff estimates.
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21. Decrease in confidence
65 5
170
150
60 0
130
55 -5
110
50 -10
90
45
-15
Euro area 70
United States
40
-20
EU (right scale)
Emerging economies
50
U.S. (left scale)
35
-25
30
M0
Ju 5
M7
De 2
Fe 3
M 01
No 5
Ja 6
8
Oc 1
02
Se 4
Ap 4
Oc 8
Au 0
07
0
0
0
-0
l0
r-0
0
t-0
-0
0
0
-0
0
g-
v-
g-
-
t-
n-
c-
b-
p-
n-
n-
Fe 3
De -02
M -01
Ja 06
No -05
8
O 01
Ju 2
Se 04
Ap 04
O 08
M 00
Ju 05
M 07
Au -00
Au 07
ar
ar
ay
l0
-0
Ju
0
Au
-
n-
Ja
-
c-
b-
p-
-
g-
v-
g-
n-
ct
r
ct
ar
ar
ay
n
Ja
Manufacturing PMIs Consumer Confidence
(Values greater than 50 indicate expansion) (United States, 1985 = 100; Euro Area, percent balance)
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22. Growth forecasts
8
Real and Potential GDP Forecasted Growth Rates 7
for 2009; in percent
6
5.2
5
4
3
2
1
0
-0.2
-0.4 -1
-0.7
-2
United States Euro Area Japan Emerging Developing
Economies
Real GDP Potential GDP
Nr. 22

23. Looking forward. How to avoid a repeat?
• Back to the trigger and the two mechanisms:
• To limit the build up of systemic risk.
Broader regulation and monitoring systemic risk.
Limit leverage.
More transparent pricing and tracing of assets. Centralized trading
rather than over the counter.
• For runs: Broader liquidity provision.
Across institutions, in exchange for regulation,
Across countries, for runs on claims in foreign currency.
• For capital: Procyclical capital ratios.
A public fund to purchase illiquid assets at EN P V − x?
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24. The international dimension
• Need to coordinate regulation, national policies. Ireland and unilateral
guarantees.
• Need to monitor risk at a global level.
Exposure of Austria and Belgium to Hungary, of France to Belgium.
Exposure of emerging markets to sudden stops.
• Need to organize multilateral liquidity provision. Swaps, and the new
IMF facility.
• Need for burden sharing rules if recapitalization. National approaches
have large spillovers.
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