Definition of Financial Crisis • A 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 This means that liquidity is quickly evaporated because available money is withdrawn from banks (called a run), forcing banks either to sell other investments to make up for the shortfall or to collapse.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 Crises • Asset Market Effects on Balance Sheets • Deterioration of Financial Institutions’ Balance Sheets • Banking Crises • Increases in Uncertainty • Increasing Interest rates • Government Fiscal Imbalances
Asset Market effects on balance sheets • There 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) • http://www.slidefinder.net/F/Financial_Crises/5965800
Deterioration of Financial Institutions Balance Sheets • Banks 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 Uncertainty • If 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 Continued • With 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 Depression • As 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 Increases • Increases 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 Crises • The Three stages • Stage One: Initiation • Stage Two: Bank Panics • Stage Three: Debt Deflation
Stage One: Initiation • Mismanagement of Financial Liberation/Innovation • Asset Price booms and busts • Spikes in interest rates, • General increase in Uncertainty when banks fail
Mismanagement of Financial Liberalization/Innovation • Elimination of restrictions on markets or institutions • New financial markets/institutions are created • Ex. Subprime residential mortgages • Good in the long run because it stimulates financial development • Bad when management begins taking on too much risk • Result: 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’d • Government creates a safety net which leads to Moral hazard • Banks will only win on high risk or the government loses • Too much risk-taking eventually leads to losses and banks net-worth (capital) falls • Leads to a cutback on lending or “deleveraging”
Asset Price Boom and Bust • Assets, stocks and real estate prices get driven up by what investors incorrectly think they are worth • Result is an asset price bubble • A price bubble can be driven up by credit booms if credit is used to purchase assets • The bubble bursts and prices fall to correct levels causing everyone to lose • Banks again will “deleverage”
Spikes in interest rates • 1800’s most of U.S. crises were precipitated by increases in Interest Rates • This could be seen usually in London • Bank panics would lead to a need for liquidity • In turn interest rates would spike; sometimes 100 percentage points in a day • Leads to a decline in cash flows and lending, leads to adverse selection and moral hazard
Increase in Uncertainty • Always a factor in financial crises • Rise once a recession has started • Failure of major institutions • Ohio Life Insurance and Trust Company 1857 • Jay Cooke and Co. 1873 • Grant and Ward 1884 • Bank of the United States 1930 • Again leads to drop in lending, increasing adverse selection and moral hazard
What Happens • Because 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 sheets • With financial Institutions’ balance sheets deteriorating, lending declines • Which leads to a decline in investment spending • Which slows economic activity
Banking Crisis • With Institutions, even healthy ones, starting to fail • A 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 Rates • With 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 lend • This declines lending • Investment • Aggregate economic activity
Some Examples of this Happening • Panic of 1819; First major financial crisis in the United States • Panic 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 Depression • Began “Black Tuesday” with the Wall Street Crash of October, 1929 • It 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 Explanations • High consumer debt • Ill-regulated markets that permitted overoptimistic loans by banks and investors • Lack of high growth new industries • Growing wealth inequality • This all reduced spending, lowered production and lowered confidence
Stage Three: Debt Deflation • Unanticipated Decline in Price Level • Adverse selection and moral hazard becomes more severe • Economic activity declines
The Great Depression • Sharp Asset price increase due to a credit boom • Increased interest rates • Increased uncertainty leads to bank crises • Debt Deflation