What makes an Economy Vulnerable to a Financial Crisis?

How does the financial sector work? How risky or risk-free It is? Practice of mortgage is a Long-term commitment to the bank, while Savers Deposits are Short-term.

Welcome back to the Diabolic System of Money in Banking series of articles. In this part-1, we studied how a financial economy works and how banks create money. And then in part two, we'll learn how an adverse shock is endogenously amplified through the liquidity spiral and the disinflation spiral. then in part three, we introduce monetary policy and macro Prudential policy.

So, In this article, you will learn about money creation by banks, liquidity spirals, and the debt disinflation spiral, as well as the paradox of prudence. You will study macro Prudential policy and monetary policy contrasting the money view with the credit view you will become familiar with monetary dominance, fiscal dominance, and financial dominance. In addition, you will be exposed to various stability concepts and to the diabolic or Doom loop between banking and sovereign risk.

 This article is based on the topics where is to redirect, the theory of money, and re-distributive monetary policy, in which studies interaction between monetary policy, financial regulation, and fiscal policy to explain how the financial sector works, and What makes an economy vulnerable to a financial crisis?  

How does the Financial Sector work? & How Banks Create Money?

Let's start by setting up a simple economy with the financial sector. In our simple economy, there's a bank and someone we call in who might want to buy a house. He goes to the bank and takes out a mortgage, it's a million dollars. The bank in which the consumer mortgage will credit the input for $1 million as deposit as soon as the mortgage is agreed upon. 

This creates a credit on the asset side of the bank's balance sheet and deposits on the liability side of the bank's balance sheet. When the Emperor finally buys a house and makes a payment to the seller, he transfers his deposit to the seller of the house. As long as the seller holds the deposit essentially through the bank lends funds to the Emperor. Notice that after the purchase of the house to credit, the mortgage to the end program is risky to the bank, while the saver's deposit is supposedly risk-free. 

It is noted that the mortgage is a long term commitment to the bank, while savers deposits are short term. 

For these reasons, the bank faces two risks.

-    First, on the Asset side, there's a possibility that the Emperor does not pay back his debt. The bank faces credit or default risk represented carefully by the fluctuating curve. 

-    Second, the bank faces liquidity funding risk or run risk, which stems from the fact that the candidate is long term, while deposits are short time. 

Suddenly all savers with total deposits, the bank will not be able to repay them. In order to cover default risk, the bank should have an equity cushion to protect the depositor's savers 

In our example, in order to fed off liquidity ran the risk. Some of these funds are invested in safe assets, for example, preserves. The bank's balance sheet now has his serves on the asset side. In addition to credit on the liability side, it has the equity of the bank, in addition to savers, own deposits, I owe us against the bank. 

Of course, the bank has many employers on the asset side, and many savers deposit holders on the liability side. Granted, these risky loans to the end forced to not default all at the same time. The risks of each impose partially offset each other The bank diversifies risk across various inputs and putting various credits together into a single portfolio, which is like merging the fluctuating curves into single one fluctuations are largely averaged out. 

Also, notice that also the bank runs many forms of credit, the bank issued standardized IOU in the form of deposits. So, on the asset side, there are long term assets that are risky and illiquid. While on the liability side, they're standardized deposits. io use issued by the bank, the latter which are much more liquid. In a sense, liquid deposits are one of the outputs of the bank's production function. These standardized deposits are used inside money that is created by the banking sector.

Since they are short term, they're readily available. Due to the protection from the equity of the bank, the default probabilities are low, there is credit risk is limited, hence, as little as symmetric information about the value of desire use.

Because of this, it is easy to net our use across the whole financial system, and hence it serves as a means of payment. Now, let's add the government with the central bank. The reserves that we have introduced earlier on the asset side of the bank's balance sheet are provided by the government more precisely by the Central Bank. Putting the picture together with the banks, we can now see that savers have the option to hold either inside money in form of standardized deposits on us or outside money in form of physical cash issued by the Central Bank. In addition, savers can also directly lent to importers. However, direct lending is riskier for two reasons.

 Firstly, savers cannot diversify as well as banks. Secondly, banks are better at enforcing repayment from inputs. Therefore, direct lending is much riskier compared to holding inside money. In addition, as mentioned before, standardization of insert money allows some netting, which is not the case for direct lending claims. 

Since the default risk might differ from employer to employer, to sum up, part one of this article series illustrated how the banks create money in normal times. In part two, Explaining how thefinancial economy copes with an adverse shock?. And that even such a small shock takes a large scale crisis, then manage that crisis, and further discussion about how to be able to prevent it, and who should be in charge of it? We focus on two spirals, the liquidity spiral and the disinflation spiral. We will also introduce the paradox of prudence.