Financial Crisis

Definition of Financial CrisisA situation in which the supply of money is outpaced by the demand for

money. This means that liquidity is quickly evaporated because available money is withdrawn from banks (called a run), forcing banks either to sell other investments to make up for the shortfall or to collapse. –BusinessDictionary.com

Is “applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth; they do not directly result in changes in the real economy, may indirectly do so, notably if a recession or depression follows.” –Wikipedia

Many economists have offered theories about how financial crises develop and how they could be prevented. There is little consensus, however, and financial crises are still a regular occurrence around the world.

Factors of a Financial CrisesAsset Market Effects on Balance SheetsDeterioration of Financial Institutions’

Balance SheetsBanking CrisesIncreases in UncertaintyIncreasing Interest ratesGovernment Fiscal Imbalances

Asset Market effects on balance sheetsThere are several factors which contribute to financial

crises.Increases in interest rates, increases in uncertainty, asset

market effects on balance sheets and bank failures.

The increase in moral hazard diminishes lendingless economic activity

Firm’s net worth can be reduced by an error on a balance sheet (stock prices going down)

This leads to a decrease in lending (less collateral), which lead to borrowers taking higher risks (moral hazard)

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Deterioration of Financial Institutions Balance SheetsBanks play a major role in financial markets because,

of they are well positioned to engage in information-producing activities which produce productive investments for our economy.

The state of banks' balance sheet plays a very important part on lending.

If compromised, the banks' balance sheets would suffer substantial contractions in their capital.

Which would then lead to fewer resources to lend, and lending in all would decline.

Which then results in a decline in investment spending, slowing down economic activity.

Banking Crises and Increase in UncertaintyIf financial institutions' balance sheets are

deteriorated severely enough, they will begin to fail.

By definition a bank panic occurs when multiple banks fail simultaneously.

In a panic, depositors fearing for the safety of their money and without insuracnce or knowing a particular bank's loan portfolio will withdraw as quickly as possible. When this happens in a large amount, there is a loss of information production in financial markets and a bank;s financial intermediation.

Banking Crises and Increase in Uncertainty ContinuedWith a bank lending decrease, supplies of

funds available to borrowers decrease as well. Which then leads into higher interest rates.

With an increase in adverse selection, bank panics cause the inability of lenders to solve this selection process in credit markets.

With the inability to solve the adverse selection makes banks' less likely to lend, and then a decline in lending, investment, and aggregate activity occurs.

History: Great DepressionAs the economic depression of the 1930s got

worse and worse banks were failing at alarming rates. During the 1920s an average of 70 banks failed each year nationally. After the crash during the first 10 months of 1933, 744 banks failed.

In all, a total of 9000 banks failed during the 1930s. By, then depositors nation wide had lost $140 billion through bank failures...

Interest Rate IncreasesIncreases in interest rates also play a role in promoting

a financial crisis through an effect on cash flow. With this negative increase in interest rates, a firm

would have fewer internal funds and must raise funds from an external source.

Banks might not lend out to firms even if they have a good risk.

Resulting in a drop in cash flow, and again adverse selection and moral hazard problems become more severe. Impacting lending, investment, and overall economic activity.

Government Fiscal Imbalances Government imbalances may create fears of

default on government debt. These fears can spark a foreign exchange crisis in

which the value of the domestic currency falls sharply because investors pull their money out of the country.

The decline then leads to destruction of the balance sheets of firms with large amounts of debt. These balance sheets once again lead to an increase in adverse selection and moral hazard problems.

Dynamics of a Financial CrisesThe Three stages

Stage One: InitiationStage Two: Bank PanicsStage Three: Debt Deflation

Stage One: InitiationMismanagement of Financial

Liberation/InnovationAsset Price booms and bustsSpikes in interest rates,General increase in Uncertainty when banks

fail

Mismanagement of Financial Liberalization/InnovationElimination of restrictions on markets or

institutionsNew financial markets/institutions are created

Ex. Subprime residential mortgagesGood in the long run because it stimulates

financial developmentBad when management begins taking on too

much riskResult: Credit boom where banks lend too much

and they can’t keep enough information or they have no experience

Mismanagement of Financial Liberalization/Innovation Cont’dGovernment creates a safety net which leads

to Moral hazardBanks will only win on high risk or the

government losesToo much risk-taking eventually leads to

losses and banks net-worth (capital) fallsLeads to a cutback on lending or

“deleveraging”

Asset Price Boom and BustAssets, stocks and real estate prices get

driven up by what investors incorrectly think they are worth

Result is an asset price bubbleA price bubble can be driven up by credit

booms if credit is used to purchase assetsThe bubble bursts and prices fall to correct

levels causing everyone to loseBanks again will “deleverage”

Spikes in interest rates1800’s most of U.S. crises were precipitated

by increases in Interest RatesThis could be seen usually in LondonBank panics would lead to a need for liquidityIn turn interest rates would spike; sometimes

100 percentage points in a dayLeads to a decline in cash flows and lending,

leads to adverse selection and moral hazard

Increase in UncertaintyAlways a factor in financial crisesRise once a recession has startedFailure of major institutions

Ohio Life Insurance and Trust Company 1857Jay Cooke and Co. 1873Grant and Ward 1884Bank of the United States 1930

Again leads to drop in lending, increasing adverse selection and moral hazard

Stage Two: Banking Crisis

What HappensBecause of worsening conditions in business

and uncertainty, depositors begin to withdraw funds from banks’

With less banks, there is a loss in domestic currency, the debt burden of domestic firms increase

Asset Write-Downs, which the asset price declines which leads to a write-down value of the assets side of the balance sheet

Deterioration of Financial Institutions’ balance sheetsWith financial Institutions’ balance sheets

deteriorating, lending declinesWhich leads to a decline in investment

spendingWhich slows economic activity

Banking CrisisWith Institutions, even healthy ones, starting

to failA Bank Panic occurs when multiple banks

fail simultaneously.Depositors, because of fear and uncertainty,

start to remove their deposits until the point that the bank fails

Increases in Uncertainty and Interest RatesWith an increase of uncertainty due to a

stock market crash, recession, ect. Resulting in lenders inability to solve adverse

selection problem make them less willing to lendThis declines lendingInvestmentAggregate economic activity

Some Examples of this HappeningPanic of 1819; First major financial crisis in the

United StatesPanic of 1837; the following 5 years was in

depression, with failure of banks and record high unemployment levels

Panic of 1857; After the Mexican-American war and increase in inflation due to gold. Banks began to lend to much money

Panic of 1873; Depression followed and lasted until 1879

Panic of 1884; Gold reserves in Europe depleted and NYC national banks halted investments

Continue….Panic of 1893; caused by railroad

overbuilding and shaky railroad financing which set off a series of bank failures

Panic of 1907; also know as Bankers’ Panic, occurred when the New York Stock Exchange fell close to 50% from its peak the previous year

The Great DepressionBegan “Black Tuesday” with the Wall Street

Crash of October, 1929It was a decade of high unemployment,

poverty, low profits, deflation, plunging farm incomes, and lost opportunities for economic growth and personal advancement

Causes are uncertain and controversial, the net effect was a sudden and general loss of confidence in economic future

Usual ExplanationsHigh consumer debtIll-regulated markets that permitted

overoptimistic loans by banks and investorsLack of high growth new industriesGrowing wealth inequality

This all reduced spending, lowered production and lowered confidence

Stage Three: Debt DeflationUnanticipated Decline in Price LevelAdverse selection and moral hazard becomes

more severeEconomic activity declines

The Great DepressionSharp Asset price increase due to a credit

boomIncreased interest ratesIncreased uncertainty leads to bank crisesDebt Deflation