THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 232

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PA R T I I I

Financial Institutions
Financial crises in Canada have progressed in two and sometimes three stages.
To help you understand how these crises have unfolded, refer to Figure 9-1, a diagram that identifies the stages and sequence of events in Canadian financial crises.

Stage One:
Initiation of
Financial
Crisis

There are several possible ways that financial crises start: mismanagement of financial liberalization or innovation, asset price booms and busts, spikes in interest
rates, or a general increase in uncertainty when there are failures of major financial institutions (see the top row of Figure 9-1).
The seeds
of a financial crisis are often sown when countries engage in financial liberalization, the elimination of restrictions on financial markets and institutions, or
when major financial innovations are introduced to the marketplace, as occurred
recently with subprime residential mortgages. Financial innovation or liberalization is highly beneficial in the long run because it facilitates the process of financial development discussed in the previous chapter, which leads to a more
efficient financial system that can allocate capital better. However, financial liberalization or innovation has a dark side: if managed improperly, it can lead financial institutions to take on excessive risk. With restrictions lifted or new financial
products introduced, financial institutions frequently go on a lending spree, often
called a credit boom, and expand their lending at a rapid pace. Unfortunately,
the managers of these financial institutions may not have the expertise to manage
risk appropriately in these new lines of business. Even if the required managerial
expertise is initially present, the rapid growth of credit will likely outstrip the information resources available to these institutions, leading to overly risky lending.
As we will discuss in Chapter 10, most governments try to prevent bank panics and encourage banks to keep on lending during bad times by providing a government safety net. If depositors and other providers of funds to banks are
protected from losses, they will keep on supplying banks with funds so banks can
continue to lend and will not fail. However, there is a catch: The government
safety net weakens market discipline for the bank. With a safety net, depositors
know that they will not lose anything if a bank fails. Thus, the bank can still
acquire funds even if it takes on excessive risk. The government safety net therefore increases the moral hazard incentive for banks to take on greater risk than

they otherwise would, because if their risky, high-interest loans pay off, the banks
make a lot of money; if they don t and the bank fails, taxpayers pay most of the
bill for the safety net that protects the banks depositors. In other words, banks can
play the game of heads, I win: tails, the taxpayer loses.
The presence of a government safety net requires regulation and government
supervision of the financial system to prevent excessive risk taking. However, new
lines of business and rapid credit growth stretch the resources of the government s
supervisory agencies. Financial supervisors find themselves without the expertise
or the additional resources needed to appropriately monitor the new lending activities. Without this monitoring, risk-taking can explode.
Eventually, this risk-taking comes home to roost. Losses on loans begin to
mount and the drop in the value of the loans (on the asset side of the balance
sheet) falls relative to liabilities, thereby driving down the net worth (capital) of
banks and other financial institutions. With less capital, these financial institutions
cut back on their lending, a process that is called deleveraging. Furthermore, with
less capital, banks and other financial institutions become riskier, causing depositors and other potential lenders to these institutions to pull out their funds. Fewer

MISMANAGEMENT OF FINANCIAL LIBERALIZATION/INNOVATION