Potential and Possible Consequences of Systemic Financial Crisis - Essay Example

Running Head: Financial Crisis Potential and Possible Consequences of Systemic Financial Crisis of the of the A) Introduction Financial crisis, like any crisis situation, is the instability and uncertainty found in the money and capital markets. Systemic financial crisis is primarily due to the systemic risks inherent in the investment and trade activities of these financial markets. Such risks are pre-existent and their serious and critical effects come into play only if these are triggered by an external event(s), which may include economic downturn, exchange rate changes, global or international financial crisis, a central corporate or institutional collapse or even a major market player’s personal financial downturn or insolvency. Such events in turn intimidate the disturbance in the whole mechanism of the financial sector and agitate the smooth functioning of all the firms and investment processes of this sector. Such crisis, if it is of massive scale, disrupts the lending and borrowing capacity of the market players, thus paralysing the economy as a whole. This paper intends to draw attention to this type of crisis, indicating its potential causes and consequences, using both theoretical as well as empirical approaches. Towards the end of each concept, an attempt to identify the ways to gauge investments in a way that those do not lead, or even fall prey to systemic financial crisis will be made. B) Theories of Financial Crisis The paper now outlines the principal theoretical approaches to financial crisis. The first two sections cover, respectively, the concept of contagious runs on financial institutions and markets, and the aspects of financial regulation, which seek to protect against such events. I then assess two traditional views of financial crisis, which attempt to explain exclusively the totality of financial crises, namely the financial fragility and monetarist approaches. These are followed by more recent paradigms, which seek to clarify the mechanisms involved in crises, namely uncertainty, credit rationing, asymmetric information/agency costs, and aspects of the dynamics of dealership markets. B-1) Concept of Contagious Runs B-1.1) Bank Runs It is important to begin with an argument of contagious runs, since they are the principal identifying factor for crises. Of all the types of risks to banks, the focus here is on liquidity risk, which is the inability to obtain funding to finance operations, though it may be linked to interest-rate and credit risk. Although most of the analysis covers banks, these concepts can also be applied to other financial institutions and even securities markets. Any event, however extraneous, but including runs on or insolvency of other banks can according to Diamond and Dybvig (1983), provoke such runs. Such an effect might be particularly potent for banks, which are creditors of the bank in distress. Runs are also likely when the equity of banks is a small proportion of balance-sheet totals, as depositors fears of moral hazard increase, assuming managers actions cannot be perfectly monitored (L. J. White 1989). And, more generally, in the presence of asymmetric information, which arises from banks creation of non-marketable assets, runs may be triggered by any event that makes depositors change their beliefs about banks riskiness. These might include leading indicators of recession, or a decline in net worth of a particular class of borrowers. Runs may be particularly likely when such bad news follows a phase of speedy growth in credit, when the leverage of banks and borrowers is most extended (Calomiris and Gorton, 1991). It may also involve failure of other, particularly large, institutions where there is a suspicion that balance sheets are similarly weak and un-diversified. Again, the non-marketable nature of bank assets means a bank cannot easily prove otherwise. Payments system failure may provoke runs on banks unable to settle their accounts. Finally, outstanding contingent guarantees that banks may issue (e.g. back-up lines of credit) may aggravate effects of liquidity problems, since beneficiaries may exercise their claims at the same time as banks are in difficulty. Runs can lead to economic disruption in various ways. To the extent that these are externalities, the bank concerned does not take them into account in its own portfolio decisions, and they thus constitute an a priori basis for public intervention. First, there is interruption of production as banks call loans; hence assets are prematurely liquidated, while optimal risk sharing is disturbed. Such effects are particularly severe for those agents in the non-financial sector who have relationships with failing banks, and/or can only obtain credit from banks due to the latters unique role as monitors and evaluators of loan contracts (i.e. those lacking reputation or too small to pay the fixed costs of capital market). The effects are of course magnified if failure provokes contagion to other banks or more generalized panics. As noted, contagious runs on banks may be provoked by any failure, because when there is uncertainty over the value of non-marketable assets (i.e. loans) public perception of the health of the system is influenced by failures at individual banks. Effects of bank failures are further aggravated if there is also closure of securities markets, as then even agents having alternative sources of debt finance may find those sources closed. Meanwhile, as banks contract credit, the money supply may fall and real interest rates rise, thus discouraging spending and increasing pressure on fragile borrowers. Widespread bank failure is also likely to disturb the payments mechanism (Corrigan 1987; Folkerts-Landau 1991). Humphrey (1986) has shown that the failure of a major US bank might leave up to 50 banks with net settlement obligations at the end of the day in excess of their capital. Repetition of the experiment on a different day gave similar results for a comparable number of different banks, showing the unpredictable nature of this risk. All of these costs are additional to costs that may arise in any bankruptcy, such as costs of reorganization and social losses from breaking up unique bundles of assets. The way to counteract runs and panics is for the authorities to provide a safety net such as deposit insurance or lender-of-last-resort facilities, to remove fear of loss on the part of depositors, while inflicting capital adequacy standards and direct controls on risk-taking to avoid exploitation of the subsidy that such (mispriced) insurance provides. If deposit insurance is mispriced, due to inability of insurers to gauge the risk of individual banks, it provides a subsidy to equity holders, which is positively related to leverage and portfolio risk (Osterberg 1990). An important additional factor in protecting the wider economy from financial disruption is the automatic stabilizer: government expenditure rises relative to tax revenue in a downturn. It is suggested that the Diamond and Dybvig (1983) paradigm, although most closely related to commercial banks, can also apply to investment banks or non-financial companies, to the extent that they rely on short-term financing, have a mismatch between assets and liabilities, and that there is imperfect information about the quality of their assets. Suppliers of short-term credit may run from such institutions when rollover is due. Moreover, although the paradigm focuses on retail depositors (and hence recommends deposit insurance), it is equally if not more applicable to wholesale depositors who lack such protection. In theory, if information about bank-specific risks is perfect, such a run could not generalize in a wholesale market (such as that for certificates of deposit) where bank debt is traded, as risk would be correctly priced (Gorton 1989). But experience suggests that markets discriminate imperfectly among banks, and/or apply quantity rather than price rationing of credit in cases of heightened risk. Finally, runs are more likely when there are many than when there are few creditors; the latter can avoid free riders--and are also less likely to escape with their assets intact. Runs may generalize further to securities markets. Some discussion of market crashes is given below under the paradigms of rational expectations and of dealer market behaviour. A liquid asset market can be seen as providing optimal risk sharing from the security holders point of view. If uncertainties crop up over the future liquidity of the market, it is rational to sell first, before the disequilibria between sellers and buyers become too great, and market failure supervenes. Such losses of liquidity, especially in short-term debt markets, may have externalities similar to bank failures, e.g. if there is a class of creditor raising funds in such markets which does not have a clear alternative source of short-term funding. B-1.2) Financial Regulation against Systemic Risk The two central objectives that financial regulation serves are the protection of retail investors and protection against systemic risk. The need for investor protection arises from information asymmetry, particularly those between retail clients and financial intermediaries, given the fact that such transactions are often one-off (e.g. buying a life insurance policy) and involve a large proportion of wealth. Systemic risk arises from the tendency for failure of one financial intermediary to generalize to the system as a whole. A form of information asymmetry is also at the root of this problem, in that runs can occur for solvent institutions, leading them to collapse from lack of liquidity, when investors lack information about performance of their assets, as is a normal feature of banks holding non-marketable loans on their books. Retail investors may be particularly vulnerable in this context, as they may lack the information that runs are under way until it is too late. So, increasing disclosure of information may reduce the risk of runs. The implication of Diamond and Dybvig (1983) in a world without regulation is that banks would frequently be subject to runs, and systemic collapses would also occur at regular intervals. Banks would need to hold large amounts of capital to generate confidence, with deleterious effects on the cost of intermediation. There are several lines of defense against systemic risk. First, there are forms of public insurance of bank liabilities, namely the lender-of-last-resort and deposit insurance (the safety net). Second, there are forms of protection against bank failure which regulators can apply, implicitly providing protection for the insurer, namely capital requirements, direct controls on assets, checks on bank management, and on liquidity. Below is a brief discussion of each of these terms. The lender of last resort can be defined as “an institution, usually the Central Bank, which has the ability to produce at its discretion currency or high powered money to support institutions facing liquidity difficulties; to create enough base money to offset public desire to switch into money during a crisis; and to delay legal insolvency of an institution, preventing fire sales and calling of loans.” (http://www.zen13767.zen.co.uk/imf%202003-4.pdf) The function may thus operate either via maintenance of liquidity in the system as a whole, or via help to individual banks, where the latter implicitly assumes that the authorities have a better judgment of the solvency of individual banks than the market has. Deposit insurance, as its name implies, provides a guarantee that certain types of bank liability are convertible into cash, thus removing the incentive for runs on solvent banks by uninformed depositors. In order to keep away from insuring all of the system, there are usually limits to coverage. But difficulties may arise; for example, in the case of large banks judged too big to fail, all depositors may be paid off; unlike the lender of last resort, deposit insurance cannot be used at the regulators discretion, which thus generates agency problems; and workable means of relating premiums to risk, and thus preventing an implicit subsidy to shareholders, have proved difficult to devise--instead there are flat fees related to the size of balance sheets (Kane 1986; Baltensperger and Dermine 1987; Acharya and Udell 1992). All of these may lead to severe moral-hazard problems; a response in most countries (but not the USA or Italy) has been to restrict deposit insurance coverage severely, so it effectively only becomes a partial protection for small retail depositors. This induces a degree of monitoring and market discipline by wholesale depositors. Although, the effectiveness of such monitoring is limited, especially given imperfect information. Note that both the lender of last resort and deposit insurance are assumed to be publicly provided, or at least co-coordinated, by the public sector. The difficulty of private provision rests on the inability of insurers to provide sufficient reserves to offer unconditional guarantees for the financial system as a whole, as well as on the difficulty of assessing the riskiness of banks portfolios. Since the public sector has the power to tax and to create money, it can offer unconditional guarantees, at least for nominal amounts. A system in which the lender of last resort and/or flat-rate deposit insurance operate as the sole forms of protection against systemic risk, would be vulnerable to excessive risk-taking by banks, imposing heavy burdens on the regulator. Such tendencies may be particularly marked in the absence of structural regulation limiting competition. Capital requirements and other types of prudential supervision seek to avoid these difficulties. Capital regulations, which require a minimum ratio of shareholders funds to liabilities or assets, can be seen as means of shifting the risks insured by the safety net back to shareholders, who are the first to bear losses incurred by the bank. A low capital ratio, in other words high leverage, enhances the likelihood of bankruptcy and raises agency costs for debt holders (in this case proxied by the lender of last resort/deposit insurer). A higher percentage of equity can reduce these risks. However, shareholders capital is not the first line of defense for a bank against defaults by borrowers. Correct pricing of risk, backed by adequate diversification, screening, and monitoring, should ensure that capital resources are never called upon. Capital requirements can be related to the riskiness of banks asset portfolios. This can be seen as a means of offsetting the mispricing of the safety net, by implicitly raising the premium on risky portfolios, as well as giving incentives for banks to price risk correctly. However, for this to be accurate, the authorities must correctly assess risk. UK banks are supervised for large exposures to individual borrowers (but not sectors), thus correcting the weakness of the risk-asset approach for failing to penalize un-diversified portfolios. UK supervisors also assess holdings of cash, future cash flows, and diversification of the deposit base; adequacy of provisions for bad and doubtful debts (including provisioning policy, systems for monitoring credit risk, arrears, and practices for taking and valuing security); systems for monitoring the banks condition and risks; and that the management be fit and proper. All of these provide backup for capital adequacy in protecting the safety net from the moral hazard it may generate. The description in this section has been largely of banking regulation; however, capital adequacy is also applied to non-depository institutions, notably investment banks, which can also be exposed to forms of runs and whose failure may generate systemic risk. Moreover, an increasing focus is applied to soundness of financial infrastructure such as payments and settlements systems, failures in which can generate or spread liquidity crises and systemic risk as much as failures of institutions (Corrigan 1987; Folkerts-Landau 1991). And securities markets themselves, notably for short- and long-term debt, are felt to warrant increasing attention, as their importance as a source of primary liquidity for borrowers increases (Goodhart and King 1987). B-2) Traditional Views of Financial Crisis B-2.1) Debt and Financial Fragility “This approach regards financial crises as an essential component of the turning-point of the business cycle” (Fisher, 1933), a response to previous excesses which can operate through a variety of financial markets. It extends the concepts developed in the earlier sections of this paper to the wider economy and the financial sector, and postulates both a direct link from financial fragility in the non- financial sector to financial crisis, and reverse causality to non- financial activity. Fisher (1932, 1933) attributed the downturn in the business cycle to over-indebtedness and deflation. “The earlier upswing is caused by an exogenous event leading to improved opportunities for profitable investment, called a displacement.” (Kindleberger, 1978) This leads to increased fixed investment, as well as speculation in asset markets for capital gain. “The process is debt-financed, mainly by bank loans, which increases deposits, the money supply, and the price level.” (http://research.stlouisfed.org/publications/review/98/09/9809dw.pdf) Velocity also increases, further fuelling the expansion. Increasing prices decrease the real value of outstanding debt, counterbalancing the rise in nominal debt, and promoting additional borrowing. This leads to a state of over-indebtedness, i.e. a degree of indebtedness that multiplies unduly the chances of being insolvent, or alternatively a state of indebtedness implying a negative present value of borrowers in a wide variety of states of nature. When agents have insufficient liquid assets to meet liabilities, a financial crisis can be triggered. Debtors incapable to recompense debts and refinance positions can be enforced by creditors to liquidate assets, that is distress selling. If this is widespread, and in the absence of lender-of-last-resort intervention by the monetary authorities, it triggers further crises and a deep depression; distress selling by the whole community leads to falling prices, bank deposits declining as loans are withdrawn. Deflation augments the real value of outstanding debt. Creditors see the nominal value of collateral declining with prices so they call loans; the real debt burden of borrowers increases and they continue to liquidate. Each individual hopes to be better off by liquidating but the community is worse off due to deflation. If the nominal interest rates at the time are sticky, real rates increase. Bank runs are triggered as fears for their solvency increase, especially as falling prices reduce companies net worth and profits and lead to loan default. Output and employment fall until bankruptcy has eliminated over-indebtedness. The process then repeats itself. Minsky (1977, 1982) elaborated Fishers approach, and introduced the concept of fragility, to attempt to clarify the problem of over-indebtedness during an upswing. “Fragility depends on; first, the combination of hedge, speculative, and Ponzi finance; second, the liquidity of portfolios; and third, the extent to which ongoing investment is debt-financed.” (http://cei.ier.hit-u.ac.jp/activities/seminars/papers/Stein.pdf) Hedge financing occurs when a units cash-flow commitments to debt servicing are such that cash receipts exceed cash payments over a long period; speculative financing entails cash-flow payments over a short period that exceed cash-flow receipts; Ponzi finance occurs when a unit has interest portions of its cash-payment commitments exceeding net income. A Ponzi unit has to increase its debt to meet outstanding commitments for long periods. For speculative and Ponzi units, a rise in the interest rate can entail negative net worth and insolvency. In the upswing, the demand for new investment leads to an excess demand for finance, which increases interest rates, though this is partly offset by monetary financial innovations (giving an elastic money supply and velocity), which increase the supply of finance for further investment. Higher interest rates generate fragility via an increase in debt finance, a shift from long- to short-term debt, a shift from hedge to speculative or Ponzi finance, and a drop in margins of safety for financial institutions. Additional rises in interest rates can cause a refinancing crisis with firms unable to roll over their debt, leading to Fishers distress selling cycle, unless the Central Bank intervenes. Minsky suggests that the cycle described is an intrinsic feature of capitalist economies, repeating itself as memories of previous problems fade. Bernanke (1983), in describing the Great Depression suggested that, given a heavy burden of debt on borrowers and a risk of bank runs, fragility can generalize itself by raising the real cost of intermediation between lenders and some classes of borrowers. He suggests that his theory is consistent with Fishers outline but, unlike Kindleberger and Minsky, retains the postulate of rational, market-constrained agents. Following the monitoring theories of intermediation, costs of intermediation include screening, monitoring, and accounting costs, as well as unexpected losses inflicted by defaulting borrowers. Meanwhile, most bank loans are non-marketable loans to idiosyncratic borrowers, unable to access bond markets. In a crisis, fear of runs may lead banks to desire rediscounted or liquid assets, including government securities, and pull out from their traditional loan markets, with an ensuing sharp decline in bank credit to those most dependent on it. Such an effect will be worsened as insolvencies grow, while solvent agents collateral value deteriorates and (owing to deflation) real debt burdens increase. Given banks advantages in credit supply such as accumulated information, expertise, and customer relationships, their withdrawal sharply impairs financial efficiency, even if other channels of credit seek to substitute. Following the commitment paradigm, borrowers who have good records with their relationship banks will face higher prices or lower quantities of credit from outside lenders; following the monitoring paradigm, inability to convey private information credibly to other lenders and markets may lead to an inability to raise credit at all. Such an effect is likely to reduce aggregate demand, worsening the downturn; and once costs of intermediation have raised it may be a protracted period before they are reduced again. A parallel pattern may arise for international lending. B-2.2) Monetarist Approach Monetarists identify financial crises with banking panics, which may cause monetary contraction or may worsen effects of prior monetary contraction on economic activity. For example, Friedman and Schwartz (1963) noted that of six major contractions in the US over 1867-1960, four were associated with major banking or monetary disturbances, although none have occurred since 1933. Banking panics were held to arise out of public loss of confidence in banks abilities to convert deposits into currency. This loss was often caused by the failure of an important institution. Given fractional reserves, attempts by the public to increase its cash holdings can only be met by a multiple contraction of deposits, unless there is a suspension of convertibility of deposits into currency or intervention of the authorities (e.g. open-market operations). A panic may lead to widespread bank failures, unless the Central Bank acts to expand the money supply. This is because sound banks are forced into insolvency by falls in the value of their assets caused by attempts to respond to the scramble for liquidity. Failures in turn affect economic activity and lead to deflation via reductions in the money stock, as the deposit/currency and deposit/reserve ratios fall. Bank failures in this paradigm may have macroeconomic causes. For example, according to Schwartz (1987), financial instability tends to arise from inflation. Changing relative prices may clearly cause localized difficulties e.g. in commodities markets. But general inflation is also considered damaging. Besides the fact that it may cause interest-rate instability, it also distorts lenders perceptions of credit and interest-rate risk, both in up and downswings of price movements, contributing to excessive lending in one case and inadequate intermediation in the other. An asset portfolio, which requires fixed rates of money payments, might be distributed across low-risk assets ex-ante (i.e. ex-ante risk pricing is accurate), but an unexpected reversal of inflation could increase riskiness of bank assets and lead to insolvencies; ex-post quality of assets differs from ex-ante. This means a stable price level is the best way to avoid financial instability. Of course, the introduction of deposit insurance does much to alleviate the dangers of bank panics, as it removes the publics fear for its ability to convert deposits into currency. But without a stable price level, moral hazard may be severe. International transmission from the monetarist point of view occurs via the price-specie-flow mechanism for fixed exchange rates. In their view, countries with flexible rates could avoid contagion. Cagan (1965) again suggested that panics were caused by failures of major institutions and declines in public confidence in banks, which led to contractions in the money supply. He noted the inverted pyramid of credit resting on New York prior to 1914, the absence of emergency reserves provided by a Central Bank (and inadequacy of private clearing houses as lenders of last resort), and sharp outflows of money forcing banks rapidly to contract credit. He noted that crises did not tend to cause economic downturns, as they tended to follow peaks in activity, though the attendant monetary contraction could aggravate the downturn. In addition, some panics occurred without severe downturns, some severe downturns without panics, proving that panics were neither necessary nor sufficient for a severe contraction. The policy prescriptions of the monetarists are for a stable and predictable path for the money supply, but for readiness on the part of the authorities to expand the money supply in the case of crisis. Deposit insurance or a credible and precommitted lender of last resort is seen as essential to avoid runs or panics. Monetarists do not rule out asset price bubbles, although they do not see a necessary connection with the business cycle. Rather, they deny that loss of wealth associated with asset-market crashes, non-financial bankruptcies, and failures of individual banks are financial crises. Instead, ‘financial crisis’ is reserved for a shift to money that leads to widespread runs on banks. Monetarists go on to suggest that recent periods of financial instability have been pseudo financial crises, because a crisis would not have supervened even in the absence of lender-of-last-resort assistance (which in the event was just a bailout that was inefficient and/or led to inflation). On the other hand, the monetarists insist on the need for a credible and committed safety net for the financial system to prevent panics, and assert that this has been effective in the UK since 1866 and the USA since 1933. So a great deal rests on the judgement that this commitment would have effectively prevented crises even if it had not been operational in the recent episodes. Recent work on financial instability has tended to reflect a synthesis of financial fragility and monetarist views, emphasizing rising vulnerability of debtors but also runs on banks or financial markets, and potential for contagion and systemic risk. B-3) Recent Paradigms B-3.1) Uncertainty Economic uncertainty, as opposed to risk, was suggested by Knight (1921) to be central to economic activity. Meltzer (1982) pointed out its importance in understanding financial crises. “Uncertainty pertains to future events not susceptible to being reduced to objective probabilities, and also provides opportunities for profits in competitive markets.” (http://mercury.soas.ac.uk/economics/workpap/adobe/wp123.pdf) These aspects are discussed in turn below. Meltzer notes that events not susceptible to probability analysis and they are not included in rational-expectations models of decision-making. Rational-expectations models have not in his view provided a basis for reliable predictions concerning behaviour of macroeconomic financial prices, nor have they provided convincing explanations of financial crises. “In the real world, uncertainty reflects the changing economic environment, in which the random element is not well represented by stationary probability distribution. Therefore, the future is not knowable either precisely or probabilistically (inferring from past data). Davis notes that uncertainty may be more or less ignored or, alternatively, subjective ex-ante probabilities may be applied, together with a risk premium to cover unspecified adverse events, because there is no precise economic theory as to how decisions are made under uncertainty. In each case, people tend to watch others and do not deviate widely from the norm in terms of factors taken into account and weights given to them. When the crowd is wrong ex-post, there is the making of a financial crisis.” (http://mercury.soas.ac.uk/economics/workpap/adobe/wp123.pdf) Herding may be rationalized to some extent in finance if all (large) banks, expect to be rescued in a systemic crisis, whereas one bank going alone in a different direction would be allowed to go bankrupt. (Price, 1987) In terms of opportunity for profit, uncertainty rooted in change was suggested by Knight to be its major source in competitive markets. If all probabilities were known and risks diversified, profits would be bid away. Innovating and seeking opportunities where there is uneven information and uncertainty earn profits. These processes increasingly characterize financial markets. Whether the process leads to crisis depends on the form of the destruction. It may not if innovators take market share from inefficient firms, risks are correctly priced, and firms are adequately capitalized, or indeed if innovation facilitates dispersion of risk to those best able to bear it. But it may, if deteriorating balance-sheet quality follows the innovation process, for example, via risk concentration, or if financial intermediaries fail to understand the properties of financial innovations, and hence under-price risk. These more adverse patterns are quite likely to obtain initially, when behaviour of innovations over the cycle is not yet known, and competition tends to narrow margins. Uncertainty is likely to be increased by this innovation process, and hence it may be greatest in unregulated markets like the euro markets where innovation is untrammelled by restrictions on product design. When uncertainty is reduced in one area and profits are competed away, innovation may recur, exposing the market to new uncertainties. An increased level of uncertainty may lead to a loss of confidence and hence runs and panics on financial institutions or collapse of liquidity in securities markets. Confidence increases as innovators receive profits and their practices are emulated. Adverse surprises, given uncertainty and imperfect information, may trigger shifts in confidence and hence runs which affect markets more than comes out to be defensible by their inherent significance, because they lead to a rethinking of decision processes as well as to decisions themselves. This helps explain the wide variety of proximate causes of financial crises. Policy recommendations based on the lessons of the uncertainty approach (Shafer 1986) include reduction of uncertainty by avoidance of unstable macroeconomic policy (and also micro--for example, sudden changes in the level of assistance to particular sectors such as agriculture). To check risky behaviour of financial institutions that can lead to crisis if uncertainty worsens it is argued that supervisors and markets may need greater influence over intermediaries. As well as acting through traditional capital adequacy and asset-quality examination, supervisors should have greater power to reorganize financial firms which are acting in an unsafe manner, though such a policy is of course difficult to implement at a suitably early stage. The power of markets to check (via high costs of credit) any risky behaviour of financial institutions can be increased by more disclosure and the limitation of depositor protection to retail depositors (by imposition of a low threshold). B-3.2) Credit Rationing Paradigms of credit rationing suggest financial crises are characterized by abrupt increases in rationing. In order to further expand on the theories drawing attention towards the element of uncertainty as described in the preceding section, it is logical to distinguish between systemic risks and financial crisis. The financial crisis is increasingly dependent on uncertainty, whereas systemic risks can be explained by the example of such events as recession. Normally it is believed that pricing of risk is made in precise and accurate manner in the event of recession. The rationale for this is that unreasonable results occur so repeatedly that the market intermediary tends to be over-confident (this does, however, assume a suitably long time horizon). However, for financial crises and other uncertain events there is no such presumption. B-3.3) Asymmetric-information and Dynamics of Dealer Markets Asymmetric-information and agency-cost theory, is not applied to structural change in the financial system, although, agency costs per se are important components of the transmission mechanism outlined here from heightened competition to instability. Dynamics of dealer markets discuss behaviour of secondary markets in response to changes in relative information, rather than competitive conditions among intermediaries per se (although their withdrawal can help destabilize the market). In sum, extant theories of financial crisis tend to suggest a potential importance for changing industrial structure and levels of competition, but generally do not specify them explicitly. Most of the theories are consistent with a steady-state financial system, subjective to various cyclical, monetary, or other (largely exogenous) shocks. C) Valuation of Investments in Capital Markets It is imperative to value the stocks prior to investing money in them, so that the accuracy of their market prices may be determined in comparison to their real value. Not all the share/stock prices that appear on the stock exchange listings are justifiably determined. Many a time stocks are over or under priced, pertaining to different reasons including the demand and supply factors of those stocks. It is this gap that can be exploited by investors in order to make money out of their investments. Analysis is made for different firms operating in various sectors in order to establish the accuracy of stock prices as well as helping investors make sound and profitable investments. A number of tools are used to carry out the valuation of stocks and investments in the capital market. The most important ones that are extensively used are discussed below. C-1) Price Earnings Ratio (P/E) It is the ratio of a stock’s price to its earnings per share and is also referred to as the P/E multiple. Price earnings ratio that is based on a firm’s financial statements and that reported in newspaper stock listings is not the same as the price earnings multiple that emerges from a discounted dividend model. The numerator is the same, that is the market price of the sock, but the denominator is different. The P/E ratio uses the most recent past accounting earnings, while P/E multiple predicted by valuation models uses expected future economic earnings. Many security analysts pay careful attention to the accounting P/E ratio in the belief that among low P/E stocks they are more likely to find bargains than with high P/E stocks. The idea is that one can acquire a claim on a dollar of earnings more cheaply if the P/E ratio is low. For example, of the P/E ratio is 8, one pays $8 per share per $1 of current earnings, while if the P/E ratio is 12, and one must pay $12 for a claim on $1 of current earnings. However, the current earnings may differ substantially from future earnings. The higher P/E stock still may be a bargain relative to the low P/E stock if its earnings and dividends are expected to grow at a faster rate. The point is that ownership of the stock conveys the right to future earnings as well as to current earnings. An exclusive focus on the commonly reported accounting P/E ratio can be shortsighted because by its nature it ignores future growth in earnings. C-2) Replacement Cost and Tobin’s q Replacement cost of a firm’s assets is essentially the cost to replace that firm’s assets. This balance sheet concept is of interest in valuing a firm. “Some analysts believe the market value of the firm cannot get too far above its replacement cost because, if it did, competitors would try to replicate the firm. The competitive pressure of other similar firms entering the same industry would drive down the market value of all firms until they came into equality with replacement cost.” (http://people.brandeis.edu/~yanzp/Study%20Notes/Investments_BKM.pdf) Economists vastly rely upon this idea, and there from comes the concept of Tobin’s q. According to this concept, the market price of the assets of a firm can be divided by its replacement cost; in order to obtain a number knows as its Tobin’s q. The economist James Tobin who also received Nobel Prize for his contribution initially proposed this. This number is likely to be around 1 in the long run; however this number may go considerably higher or lower than 1 taken for too long time phases. Despite the fact that analysts may derive highly valuable and helpful information from a firm’s balance sheet regarding its replacement costs and more, it is extremely important advisable that future expected cash flows for that firm is considered in order to establish quality assessment of the firm’s value. C-3) Efficient Market Hypothesis The efficient market hypothesis holds the notion that typically speaking fundamental analysis brings little value. This is for the fact that any firm’s earnings and industry information are freely accessible to everyone, and therefore every analyst has hands on such information. As such it is inconceivable that the assessment and valuation of a particular firm’s prospects, made by different analysts would vary. D) Conclusion The successful evaluation of common stocks requires the use of more than one tool or philosophy. Today, the globalization of markets and greater than before unpredictability in intraday prices has all created complexity in analyzing investments. Thus I conclude that the best method for obtaining thorough knowledge of a stock appears to be with a combination of fundamental and technical considerations. Such means would result in sound investments hence preventing from falling prey to the harmful consequences of systemic financial crisis. References Acharya S., and Udell G. F. ( 1992), Monitoring Financial Institutions, Working Paper No. S-92-3, Salomon Center, New York Univ. Baltensperger E., and Dermine J. ( 1987), "The Role of Public Policy in Ensuring Financial Stability: A Cross-Country, Comparative Perspective", in R. Portes and A. Swoboda (eds.), Threats to International Financial Stability, Cambridge Univ. Press, Cambridge. Bordo Micheal D., and Wheelock David C. “Price Stability and Financial Stability:The Historical Record” http://research.stlouisfed.org/publications/review/98/09/9809dw.pdf Accessed December 14, 2006. Cagan P. ( 1965), Determinants and Effects of Changes in the Stock of Money 1875-1960, Studies in Business Cycles, 13, NBER, Columbia Univ. Press, New York. CalomirisC. W., and Gorton G. ( 1991), "The Origins of Banking Panics, Models, Facts and Bank Regulation", in R. G. Hubbard (ed.), Financial Markets and Financial Crises, NBER, Univ. of Chicago Press, Chicago. Corrigan E. G. ( 1987), "Financial Structure: A Long View", in Annual Report, Federal Reserve Bank of New York. Davis E. Philip “Liquidity Management in Banking Crisis” (http://www.zen13767.zen.co.uk/imf%202003-4.pdf) Accessed December 14, 2006. Diamond and Dybvig P. ( 1983), "Bank Runs, Deposit Insurance and Liquidity", Journal of Political Economy, 91: 401-19. Fisher I., “The Debt Deflation Theory of Great Depressions”, Econometrica, Vol.1, No.4, 1933, pp 337-57 Folkerts-Landau D. J ( 1991), "Systematic Financial Risk in Payments Systems", in Determinants and Systemic Consequences of International Capital Flows, IMF Occasional Paper. Goodhart and King M. A. ( 1987), "Financial Stability and the Lender of Last Resort Function", mimeo, Financial Markets Group, London School of Economics. Gorton G. ( 1989), "Self-Regulating Bank Coalitions", mimeo, Wharton School, Univ. of Pennsylvania, Philadelphia. Humphrey D. B. ( 1986), "Payments Finality and the Risk of Settlement Failure", in A. Saunders and L. J. White (eds.), Technology and the Regulation of Financial Markets, D. C. Heath, Lexington, Mass. Kane E. J. ( 1986). "Appearance and Reality in Deposit Insurance: The Case for Reform", Journal of Banking and Finance, 10: 175-88. Kindleberger C. P. ( 1978), Manias, Panics and Crashes, A History of Financial Crises, Basic Books, New York. Knight F. H. ( 1921), Risk, Uncertainty and Profit, Boston; No. 16 in series of reprints of scarce texts in economics, LSE, London Machiko Nissanke (2002) “Financial Globalisation and Economic Development: Toward an Institutional Foundation” http://cei.ier.hit-u.ac.jp/activities/seminars/papers/Stein.pdf Accessed December 14, 2006. Meltzer A. H. ( 1982), "Rational Expectations, Risk, Uncertainty, and Market Responses", in P. Wachtel (ed.), Crisis in the Economic and Financial Structure, Salomon Bros. series on Financial Institutions and Markets, Lexington Books, Lexington, Mass. Minsky H. P. ( 1977), "A Theory of Systemic Fragility", in E. I. Altman and A. W. Sametz (eds.), Financial Crises, Wiley, New York. ----- ( 1982), "The Financial Instability Hypothesis, Capitalist Processes and the Behaviour of the Economy", in C. P. Kindleberger and J.-P. Laffargue (eds.), Financial Crises, Theory, History and Policy, Cambridge Univ. Press. Osterberg W. P. ( 1990), "Bank Capital Requirements and Leverage: A Review of the Literature", Federal Reserve Bank of Cleveland, Economic Review (Quarter 4), 2-12. Price L. D. D. ( 1987), "Discussion of Contagion Effects in the Interbank Market", in R. Portes and A. Swoboda (eds.), Threats to International Financial Stability, Cambridge Univ. Press. Schwartz A. J. ( 1987), "The Lender of Last Resort and the Federal Safety Net", Journal of Financial Services Research, 1: 77-111. Shafer J. R. ( 1986), "Managing Crises in the Emerging Financial Landscape", OECD Economic Studies, 8: 56-77. White L. J. ( 1989), "The Reform of Federal Deposit Insurance", Journal of Economic Perspectives, 3: 11-29. Yasushi Suzuki “Bank Rents and Uncertainty” http://mercury.soas.ac.uk/economics/workpap/adobe/wp123.pdf Accessed December 14, 2006. Zhipeng Yan “Study notes of Bodie, Kane and Marcus” http://people.brandeis.edu/~yanzp/Study%20Notes/Investments_BKM.pdf Accessed December 06. Read More