Financial Crisis: What is it?

The term financial crisis is used to describe a situation in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, financial crises were associated with banking panics and many recessions coincided with these panics. Situations like stock market crashes, bursting of financial bubbles, currency crises, and sovereign defaults are often referred to as financial crises.

There are many theories offered by several economists about how financial crises develop and how they could be prevented. But even today, the economists have not reached a consensus.

From time to time the world has witnessed a financial crisis. More recently two situations that have taken the form of financial crises are the Sovereign Debt Crisis and the 2008 Housing Bubble crisis.

There is a consensus among various economists that there are many similarities across crises episodes. Some of these similarities are rapid increase in asset prices; credit boom; a dramatic expansion in marginal loans; and failure in regulation and supervision of such developments. All these factors when combined increase the risk of a situation known as a financial crisis.

Rapid Increase in Asset Prices: This is a very common factor across most of the financial crises till date. Prior to the 2008 crisis there was a meteoric increase in the house prices in the US, UK, Iceland, Ireland, Spain, and all other markets that eventually faced the brunt of this crisis. Now this increase in prices was similar to previous banking crises in advanced economies. These booms in the prices are generally the result of rising credit.

Credit Boom: The rapid expansion of credit play a large role in the run-up to the crises. While historically not all credit booms end up in a crisis, but they only increase the probability of a crisis. Credit boom occurs because. There are various factors that can cause a credit boom. Financial reforms, surges in capital inflows, lagged GDP growth and other domestic factors are some of the triggers that can cause a credit boom.

Marginal Loans and Systematic Risk: Credit booms and rapid growth in financial markets are usually associated with a deterioration in lending standards. They lead to the creation of marginal assets which are good till the time economic conditions are favorable. The problem arises when the economic conditions start to become hostile rather than friendly.

Ineffective Regulation and Supervision: When reforms and financial liberalization are not properly regularized the probability of a crisis occurring is very high. If we look at all the crises till now there is a common trend of insufficient prevention and early intervention mechanisms.

Let us now understand the effects or consequences of a financial crisis.

Usually recessions are associated with financial crises. These recessions tend to be unusually severe and their recoveries are very slow. The recent crises have taken a very heavy toll on the world’s economy. These recessions result in much larger declines in real economic activity. Globally synchronized recessions are often long and deep, and recoveries from these recessions are generally weak.

So now that we understand what financial crises are, in my next few posts I will try to explain the causes for the 2008 Housing Bubble Crisis and the Sovereign Debt Crisis.