Financial Instability: Conduction Mechanism, Causes And Countermeasures

The financial crisis in2008ended almost ten years of global macroeconomic stability. What is obvious in both the2008U.S. financial crisis and2011European sovereignty debt crisis is the fragility of the financial systems in developed markets. The crises have demonstrated that financial instability could threaten growth of real economy (as in European sovereignty debt crisis) and if without proper policy response could lead to great recession (as in2008U.S. financial crisis). What is the transmission channel between financial instability and real economy? What are the causes of financial instability in developed countries? What should be the policy response towards financial instability? These questions not only have significance by themselves but also have important implications for the ongoing financial sector reform in China.This dissertation has six chapters. Chapter Three-Financial Instability and Financial Deleveraging-explains the root cause of financial instability:high leverage, high interconnectedness and maturity mismatch by constructing a balance sheet model of financial system. It also elaborates on the feedback mechanism in a financial deleveraging process. Such deleveraging process could induce severe shocks to real economy if policy-makers do not intervene. With this chapter as the core section, Chapter Two reviews relevant literatures on the transmission channel between financial system and real economy. Chapter Four explains the specific reasons that lead to the pre-crisis instability of financial system in U.S., namely securitization, collateral financing and rehypothecation. Chapter Five focuses on European sovereignty debt crisis and introduces the concept of liquidity crisis and solvency crisis which sets the framework to explain European Central Bank (ECB) policy options and the cost-benefit analysis. Chapter Six explains the impact of the ongoing financial sector reform on the banking system and put forward suggestions for policy makers to avoid financial instability while reforming the system.