Financial Crisis


By

Shailly Garg
Student
NSB, NIILM School of Business
New Delhi
 


Introduction

financial crises  is a sudden wide-scale drop in the value of financial assets, or in the financial institutions managing those assets (and often in both). A financial crisis may be triggered by a variety of factors, but the situation is typically aggravated by negative investor sentiment – fear or panic. A financial crisis often sparks a vicious circle where an initial decline sparks fears by investors that other investors will pull their money out, leading to redemptions and increasing declines. The global credit crunch of 2008 is an example of a financial crisis that resulted in such severe runs on the banks and other markets that investment banks such as Bear Stearns and Lehman Brothers, who have been around for more than 100 years, were bankrupted.

Types of financial crisis

Banking crisis

When a bank suffers a sudden rush of withdrawals by depositors, this is called a bank run. Since banks lend out most of the cash they receive in deposits, it is difficult for them to quickly pay back all deposits if these are suddenly demanded, so a run may leave the bank in bankruptcy, causing many depositors to lose their savings unless they are covered by deposit insurance. A situation in which bank runs are widespread is called a  systemic banking crisis or just a banking panic. A situation without widespread bank runs, but in which banks are reluctant to lend, because they worry that they have insufficient funds available, is often called a credit crunch. In this way, the banks become an accelerator of a financial crisis.

Examples of bank runs include the run on the bank of united states in 1931 and the run on Northern rock in 2007. The collapse of Bear stearns in 2008 has also sometimes been called a bank run, even though Bear Stearns was an investment bank rather than a commercial bank.

Speculative bubbles and crashes

Economists say that a financial asset exhibits a bubble when its price exceeds the present value of the future income that would be received by owning it to maturity If most market participants buy the asset primarily in hopes of selling it later at a higher price, instead of buying it for the income it will generate, this could be evidence that a bubble is present. If there is a bubble, there is also a risk of a crash in asset prices: market participants will go on buying only as long as they expect others to buy, and when many decide to sell the price will fall. However, it is difficult to tell in practice whether an asset's price actually equals its fundamental value, so it is hard to detect bubbles reliably. Some economists insist that bubbles never or almost never occur.

Well-known examples of bubbles and crashes in stock prices and other asset prices include the Dutch tulip mania, the wall street crash of 1929, the crash of the dot-com bubble in 2000-2001.

International financial crises

When a country that maintains a fixed exchange rate is suddenly forced to devalue its currency because of a speculative attack, this is called a  currency crisis or balance of payments crisis. When a country fails to pay back its sovereign attack, this is called asovereign default. While devaluation and default could both be voluntary decisions of the government, they are often perceived to be the involuntary results of a change in investor sentiment that leads to a sudden stock in capital inflows or a sudden increase in capital flight.

Wider economic crises

Negative GDP growth lasting two or more quarters is called a recession. An especially prolonged recession may be called a depression, while a long period of slow but not necessarily negative growth is sometimes called economic stagnation.

Since these phenomena affect much more than the financial system, they are not usually considered financial crises per se. But some economists have argued that many recessions have been caused in large part by financial crises. One important example is the Great depression, which was preceded in many countries by bank runs and stock market crashes. The sub prime and the bursting of other real estate bubbles around the world has led to recession in the U.S. and a number of other countries in late 2008 and 2009.

Nonetheless, some economists argue that financial crises are caused by recessions instead of the other way around. Also, even if a financial crisis is the initial shock that sets off a recession, other factors may be more important in prolonging the recession.

Causes and consequences of financial crises

Strategic complementarities in financial markets

It is often observed that successful investment requires each investor in a financial market to guess what other investors will do. George sorrows has called this need to guess the intentions of others 'reflexivity'. Similarly, John Maynard keynes compared financial markets to a beauty contest games in which each participant tries to predict which model other participants will consider most beautiful.

Furthermore, in many cases investors have incentives to coordinate their choices. For example, someone who thinks other investors want to buy lots of Japanese yen may expect the yen to rise in value, and therefore has an incentive to buy yen too.

Leverage

Leverage, which means borrowing to finance investments, is frequently cited as a contributor to financial crises. When a financial institution (or an individual) only invests its own money, it can, in the very worst case, lose its own money. But when it borrows in order to invest more, it can potentially earn more from its investment, but it can also lose more than all it has. Therefore leverage magnifies the potential returns from investment, but also creates a risk of bankruptcy. Since bankruptcy means that a firm fails to honor all its promised payments to other firms, it may spread financial troubles from one firm to another.

Asset-liability mismatch

Another factor believed to contribute to financial crises is asset-liability mismatch, a situation in which the risks associated with an institution's debts and assets are not appropriately aligned. For example, commercial banks offer deposit accounts which can be withdrawn at any time and they use the proceeds to make long-term loans to businesses and homeowners. The mismatch between the banks' short-term liabilities (its deposits) and its long-term assets (its loans) is seen as one of the reasons bankruns occur (when depositors panic and decide to withdraw their funds more quickly than the bank can get back the proceeds of its loans). Likewise, Bear Sterns failed in 2007-08 because it was unable to renew the short-term debt it used to finance long-term investments in mortgage securities.

Uncertainty and herd behavior

Many analyses of financial crises emphasize the role of investment mistakes caused by lack of knowledge or the imperfections of human reasoning. Behavioral finance studies errors in economic and quantitative reasoning. Psychologist Torbjorn K A Eliazonhas also analyzed failures of economic reasoning in his concept of 'ścopathy'.

Historians, notably Charles P. Kindleberger, have pointed out that crises often follow soon after major financial or technical innovations that present investors with new types of financial opportunities, which he called "displacements" of investors' expectations. Early examples include the South Sea Bubble and Mississippi Bubble of 1720, which occurred when the notion of investment in shares of company stock was itself new and unfamiliar, and the Crash of 1929, which followed the introduction of new electrical and transportation technologies. More recently, many financial crises followed changes in the investment environment brought about by financial deregulation, and the crash of the dot com bubble in 2001 arguably began with "irrational exuberance" about Internet technology.

Regulatory failures

Governments have attempted to eliminate or mitigate financial crises by regulating the financial sector. One major goal of regulation is transparency making institutions' financial situations publicly known by requiring regular reporting under standardized accounting procedures. Another goal of regulation is making sure institutions have sufficient assets to meet their contractual obligations, through reserve requirements, capital requirement, and other limits on leverage.

Some financial crises have been blamed on insufficient regulation, and have led to changes in regulation in order to avoid a repeat. For example, the Managing Director of the IMF, Dominique stauss-kahn, has blamed the financial crisis of 2008 on 'regulatory failure to guard against excessive risk-taking in the financial system, especially in the US'. Likewise, the New York Times singled out the deregulation of credit defaults swaps as a cause of the crisis.

Fraud

Fraud has played a role in the collapse of some financial institutions, when companies have attracted depositors with misleading claims about their investment strategies, or have embezzeled the resulting income. Examples include charles ponzi's scam in early 20th century Boston, the collapse of the MMM investment fund in Russia in 1994, the scams that led to the Albanion lottery uprising of 1997, and the collapse of Madoff investment securities in 2008.

Global Financial Crisis

The global financial crisis, brewing for a while, really started to show its effects in the middle of 2007 and into 2008. Around the world stock markets have fallen, large financial institutions have collapsed or been bought out, and governments in even the wealthiest nations have had to come up with rescue packages to bail out their financial systems.

A Crisis So Severe, The World Financial System Is Affected

A collapse of the US sub-prime mortgage market and the reversal of the housing boom in other industrialized economies have had a ripple effect around the world. Furthermore, other weaknesses in the global financial system have surfaced. Some financial products and instruments have become so complex and twisted, that as things start to unravel, trust in the whole system started to fail.

While there are many technical explanations of how the sub-prime mortgage crisis came about, the mainstream British comedians, John Bird and John Fortune, describe the mind set of the investment banking community in this satirical interview, explaining it in a way that sometimes only comedians can.

Refrences:

www.en.wikipedia.org
www.globalissues.org
www.economywatch.com
 


Shailly Garg
Student
NSB, NIILM School of Business
New Delhi
 

Source: E-mail August 25, 2010

 

           

 

Occasional Papers Main Page