Global Financial Crisis Causes and Consequences
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Global Financial Crisis Causes and Consequences
- 1. Global Financial CrisisBy Mohit Rajput (12216014) Nikil Singla (12216015)
- 3. What is Financial Crisis? • Financial crisis a situations in which some financial institutions or assets suddenly lose a large part of their nominal value or simply it’s value drops rapidly . • Lower asset prices observed when more savings are withdraw or a rapid string of sell offs . • The crisis can cause the economy to go into a recession or depression.
- 4. Association Results in a loss of paper wealth but do not necessarily result in changes in the real economy Financial crises are associated with • banking panics • recessions • stock market crashes • bursting of other financial bubbles • currency crises • sovereign defaults
- 5. Types of Financial Crisis Types of Financial Crisis Speculative bubbles and crashes International financial crises Wider economic crisis Banking Crisis
- 7. Speculative bubbles and crashes • One factor that contributes to a bubble is the presence of buyers who purchase an asset based solely on the expectation that they can later resell it at a higher price, rather than calculating the income it will generate in the future. • 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 predict 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.
- 8. Examples of bubbles • the Dutch tulip mania • the Wall Street Crash of 1929 • the Japanese property bubble of the 1980s • the crash of the dot-com bubble in 2000–2001 • the now-deflating United States housing bubble
- 9. Speculative bubbles and crashes • One factor that contributes to a bubble is the presence of buyers who purchase an asset based solely on the expectation that they can later resell it at a higher price, rather than calculating the income it will generate in the future. • 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 predict 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.
- 12. International financial crises • Because of a speculative attack country that maintains a fixed exchange rate is suddenly to devalue its currency, this is called a currency crisis or balance of payments crisis. • When a country fails to pay back its sovereign debt, this is called a sovereign 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 stop in capital inflows or a sudden increase in capital flight.
- 13. Examples of International financial crises • Several currencies that formed part of the European Exchange Rate Mechanism suffered crises in 1992–93 and were forced to devalue or withdraw from the mechanism. • Another round of currency crises took place in Asia in 1997–98. • Many Latin American countries defaulted on their debt in the early 1980s. • The 1998 Russian financial crisis resulted in a devaluation of the ruble and default on Russian government bonds.
- 14. 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 debt, this is called a sovereign 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 stop in capital inflows or a sudden increase in capital flight.
- 17. Wider economic crisis • Negative GDP growth lasting two or more quarters is called a recession. • An especially prolonged or severe recession may be called a depression, • While a long period of slow but not necessarily negative growth is sometimes called economic stagnation. • Financial crises are caused by recessions and that even where a financial crisis is the initial shock that sets off a recession, other factors may be more important in prolonging the recession.
- 18. Examples of Wider economic crisis • The subprime mortgage crisis and the bursting of other real estate bubbles around the world also led to recession in the U.S. and a number of other countries in late 2008 and 2009.
- 19. Wider economic crisis • Negative GDP growth lasting two or more quarters is called a recession. An especially prolonged or severe recession may be called a depression, while a long period of slow but not necessarily negative growth is sometimes called economic stagnation. • Many recessions have been caused in large part by financial crises. • Financial crises are caused by recessions and that even where a financial crisis is the initial shock that sets off a recession, other factors may be more important in prolonging the recession.
- 21. Banking Crisis
- 22. Banking Crisis • When a bank suffers a sudden rush of withdrawals by depositors, this is called a bank run. • An event in which bank runs are widespread is called a systemic banking crisis or banking panic. • Wide-scale selling of an investment, causing a sharp decline in price. • In most instances of panic selling, investors just want to get out of the investment, with little regard for the price at which they sell
- 23. Examples of Banking Crisis • Examples of bank runs include the run on the Bank of the United States in 1931 and the run on Northern Rock in 2007. Banking crises generally occur after periods of risky lending and resulting loan defaults.
- 24. 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 (see fractional-reserve banking), it is difficult for them to quickly pay back all deposits if these are suddenly demanded, so a run renders the bank insolvent, causing customers to lose their deposits, to the extent that they are not covered by deposit insurance. • An event in which bank runs are widespread is called a systemic banking crisis or banking panic.
- 25. Banking Crisis
- 27. Causes and consequences of financial crisis Causes and consequences of financial crisis Strategic complementarities in financial markets Leverage Asset-liability mismatch Uncertainty and herd behaviour Regulatory failures Contagion Recessionary effects
- 28. Strategic complementarities in financial markets • In many cases investors have incentives to coordinate their choices. Economists call an incentive to mimic the strategies of others strategic complementarity. • It has been argued that if people or firms have a sufficiently strong incentive to do the same thing they expect others to do, then self-fulfilling prophecies may occur. For example, if investors expect the value of the yen to rise, this may cause its value to rise; if depositors expect a bank to fail this may cause it to fail. Therefore, financial crisis are sometimes viewed as a vicious circle in which investors shun some institution or asset because they expect others to do so.
- 29. Leverage • Leverage, which means borrowing to finance investments, is frequently cited as a contributor to financial crisis. • 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.
- 30. Asset-liability mismatch • It is 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 bank runs occur (when depositors panic and decide to withdraw their funds more quickly than the bank can get back the proceeds of its loans).
- 31. Uncertainty and herd behaviour • Many analyses of financial crises emphasize the role of investment mistakes caused by lack of knowledge or the imperfections of human reasoning. • If the first investors in a new class of assets profit from rising asset values as other investors learn about the innovation then still more others may follow their example, driving the price even higher as they rush to buy in hopes of similar profits. • If such "herd behavior" causes prices to spiral up far above the true value of the assets, a crash may become inevitable. If for any reason the price briefly falls, so that investors realize that further gains are not assured, then the spiral may go into reverse, with price decreases causing a rush of sales, reinforcing the decrease in prices.
- 32. Regulatory failures • Governments attempts to eliminate or mitigate financial crises by regulating the financial sector. • One major goal of regulation is transparency. • Another goal of regulation is making sure institutions have sufficient assets to meet their contractual obligations, through reserve requirements, capital requirements, 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. However, excessive regulation has also been cited as a possible cause of financial crises. • International regulatory convergence has been interpreted in terms of regulatory herding, deepening market herding and so increasing systemic risk. From this perspective, maintaining diverse regulatory regimes would be a safeguard.
- 33. Contagion • The likelihood that significant economic changes in one country will spread to other countries. Contagion can refer to the spread of either economic booms or economic crises throughout a geographic region. • Contagion refers to the idea that financial crises may spread from one institution to another, as when a bank run spreads from a few banks to many others, or from one country to another, as when currency crises, sovereign defaults, or stock market crashes spread across countries. • When the failure of one particular financial institution threatens the stability of many other institutions, this is called systemic risk.
- 34. Recessionary effects • Many factors contribute to an economy's fall into a recession, but the major cause is inflation. • In an inflationary environment, people tend to cut out leisure spending, reduce overall spending and begin to save more. But as individuals and businesses curtail expenditures in an effort to trim costs, this causes GDP to decline. Unemployment rates rise because companies lay off workers to cut costs. It is these combined factors that cause the economy to fall into a recession.
- 37. Then Global Financial Crisis ? • When the financial crisis happen at the global level • The global financial crisis of 2008 is the worst of its kind since the Great Depression • Began with failures of large financial institutions in the United States • Morgan Stanley, Goldman Sachs, Merrill Lynch, Deutsche Bank, Barclays.
- 38. • Global crisis resulting in a number of European bank failures •Commercial banks suffer a sudden rush with drywalls by depositors, this is called a bank run •Leads to downturns in stock markets and Unemployment around the world
- 39. Reasons of Global Financial crises : credit crises: It is a world wide Financial Fiasco involving terms you probably heard like 1.Sub Prime Mortgages 2.Collateralized Debt Obligation 3.Frozen Credit Market 4.Credit Default Swap
- 40. •Credit crises bring two people together ie Home owners and Investors •Home owners represent their mortgages and these mortgages represent houses and •Investors represent their money and money represent large institution like like pension funds ,Insurance Company •Together bring to a financial system ,commonly known as” WALL STREET “ •These banks in wall street are closely related to the houses on the main street, lets see how??
- 42. How its all stared : •Years ago investors are seating on their piles of money and wanted to invest to get more money. •Traditionally they can buy treasury bills or they can go to US Federal Reserve but US Federal decrease the interest rate to 1% to keep economy strong so investors didn't invest money because of less profit •But at this interest rate the Bank and Wall Street can borrowed money from Feds only at 1% ,which create abundance of cheap credit and so wall street get the tons of credit and grow tremendously rich and also pays back .
- 43. • Less interest rate make borrowing of money easy for banks, which make banks to go crazy with leverage •so the investors see it as a one piece on action and decide to invest in it the wall street has an idea to connect the House Buyer and the Investors through Mortgage
- 44. How It Works: •A Family wants house and have some down payment ,so they contact a Mortgage Broker .the Mortgage Broker connect the Family to lender with the mortgages which provide family a house . •so this process goes on and the demand and price of houses are going up fastly.
- 45. •one day the Lender got a call from Investment Bankers ,who want to buy the mortgages ,the lender sell all the mortgages with a nice profit so the investor banker borrowed a large amount of money to buy thousands of Mortgage. •Now the banker get the monthly payments from every Home owner and if any Home owner default on his mortgage ,the bank put the house on sale.
- 46. •Now the Banks did a Financial Research on this Mortgage concept and divide the whole thing in three slices .Safe ,Okay ,Risky putting all together called Collateralized Debt Obligation
- 47. •Now Banks sell these safe investments to investors who want safe investment ,okay and risky investments to the hedge funds and other banks who want to take the risk and thus get a large profit by selling this mortgages. •In this way the banks pay their debts ,as Investors are happy with this deal and are making more Profit then 1% Treasury Bills ,they want more Mortgages.
- 49. • Also if a home owner default on the mortgage the investors will get the house and values of Houses are increasing tremendously. •They want to make more profit ,so they have an idea and Start adding risk ie no down payments ,no proof of income ,no documents. $ FREE MONEY $ and introduce Sub Prime Mortgages.
- 51. Investing in a good home owner is called Prime Mortgages Investing in careless and irresponsible family is called sub prime mortgages
- 52. And This is the turning point in the investment •After taking risk ,every one is making profit by selling mortgages, Means they are transferring the risk from their hand to others . •Now surprisingly those irresponsible home owner default on their mortgage which is owned by the bankers ,as banks didn't get money so they put the house on the sale. No problem for Banks
- 53. •But more and more monthly payments are converting into selling houses •Now there are so much houses in the market for selling purpose such that the supply is more than demand so the price of houses start decreasing.
- 54. •Now Investment Banker calls investors to sell mortgages to them but they refuse because already buy thousands of houses to make more profit. • Lenders want to sell more Mortgages to Banker but they are also refusing and Broker losses his job
- 55. •And the whole financial system froze and every body get bankrupt and Unemployment spread every where. •Rate of unemployment hikes to 8.9% in the US: 539,000 lost •US GDP shrinks by 8.1% in the first quarter. •5000 businesses registered for bankruptcy in first quarter. •US Home Prices fall 14% in first quarter • This How the Global Financial Crises arises in 2008
- 56. Freddie Mac stock, 2007-2011 (in dollars and volume traded)
- 57. General Motors Corporation stock, 2007-2011 (in dollars and volume traded):
- 58. Citigroup, Inc. stock, 2007-2011 (in dollars and volume traded):
- 59. IMPACT ON INDIA: •India could not insulate itself from the adverse developments in the international financial markets, despite having a banking and financial system that had little to do with investments in subprime mortgages, whose failure had set off the chain of events causes global crisis. • Economic growth decelerated in 2008-09 to 6.7 percent. This represented a decline of 2.1 percent from the average growth rate of 8.8 percent in the previous five years
- 60. Impact On Real Estate: •In India One of the crisis is in the real estate. The crisis will hit the Indian real estate sector hard . The sector is witnessing a slump in demand because of the global economic slowdown. •The recession has forced the real estate players to restrict their expansion plans. Many on-going real estate projects are suffering due to lack of capital investment from foreign investors.
- 61. Impact On Stock Market: •The financial crises affected the stock markets even in India. prospect of economic slowdown have pulled down the stocks market. • Foreign institutional investors pulled near around $ 11 billion from India, dragging the capital market down with it. Stock prices have fallen by 60per cent. •India’s stock market index Sensex touched above 21,000 mark in the month ofJanuary,2008 and has plunged below 10,000 during October 2008.
- 62. Impact on India’s export •With the US and several European countries slipping under the full blown recession, Indian exports ran into difficult times, since October. •Manufacturing sectors like leather, textile, gems and jewellery have been hit hard because of the slump in the demand in the US and Europe. Indian exports fell by 9.9 per cent in November2008, •when the impact of declining consumer demand in the US and other major global market, with negative growth for the second month, running and widening monthly trade deficit over $10 billions
- 63. Impact on India’s handloom sector, jewellery export and tourism : •Reduction in demand in the OECD(Organization for Economic Cooperation and Development) countries affected the Indian gems and jewellery industry, handloom and tourism sectors. Around 50,000 artisans employed in jewellery industry lost their jobs as a result of the global economic meltdown. • Further, the crisis had affected the Rs. 3000 crores handloom industry and volume of handloom exports dropped by 4.6 per cent in 2007- 08,creating widespread unemployment in this sector. •Indian tourism sector was also badly affected as the number of tourist flowing from Europe and USA has decreased sharply.
- 64. Indicator Period 2007-08 2008-09 Growth, per cent Real GDP Growth April-December 9.0 6.9 Industrial production April-February 8.8 2.8 Services April-December 10.5 9.7 Exports April-March 28.4 6.4 Imports April-March 40.2 17.9 GFD/GDP April-March 2.7 6.0 Stock Market (BSE Sensex) April-March 16,569 12,366 Rs.per US$ April-March 40.24 45.92 Key Macro Indicators:
- 65. India’s Response to the crisis : • Fiscal Responsibility and Budget Management Act 2003 - (FRBMA) is an Indian legislation enacted by the Parliament of India to institutionalise financial discipline, reduce India's fiscal deficit, improve macroeconomic management and the overall management of the public funds by moving towards a balanced budget •Additional support to exporters. RBI’S MEASURES: •Reduced the policy interests rates aggressively and rapidly •Expanded and liberalized the refinance facilities for export credit
- 66. Lessons From the Great Depression: • Constant changes in policy; this merely creates uncertainty and delays private sector recovery •Avoid Trade restriction • Avoid high volatility in monetary policy •Manage capital flow volatility
- 67. Thank You
Editor's Notes
- A speculative bubble exists in the event of large, sustained overpricing of �some class of assets. One factor that frequently contributes to a bubble is the presence of buyers who purchase an asset based solely on the expectation that they can later resell it at a higher price, rather than calculating the income it will generate in the future. 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 predict 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 (or purported bubbles) and crashes in stock prices and other asset prices include the Dutch tulip mania, the Wall Street Crash of 1929, the Japanese property bubble of the 1980s, the crash of the dot-com bubble in 2000–2001, and the now-deflating United States housing bubble. The 2000s sparked a real estate bubble where housing prices were increasing significantly as an asset good.
- A speculative bubble exists in the event of large, sustained overpricing of �some class of assets. One factor that frequently contributes to a bubble is the presence of buyers who purchase an asset based solely on the expectation that they can later resell it at a higher price, rather than calculating the income it will generate in the future. 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 predict 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.
- 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 debt, this is called a sovereign 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 stop in capital inflows or a sudden increase in capital flight.
- Several currencies that formed part of the European Exchange Rate Mechanism suffered crises in 1992–93 and were forced to devalue or withdraw from the mechanism. Another round of currency crises took place in Asia in 1997–98. Many Latin American countries defaulted on their debt in the early 1980s. The 1998 Russian financial crisis resulted in a devaluation of the ruble and default on Russian government bonds.
- 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 debt, this is called a sovereign 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 stop in capital inflows or a sudden increase in capital flight.
- Negative GDP growth lasting two or more quarters is called a recession. An especially prolonged or severe recession may be called a depression, while a long period of slow but not necessarily negative growth is sometimes called economic stagnation. Some economists argue 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 subprime mortgage crisis and the bursting of other real estate bubbles around the world also led to recession in the U.S. and a number of other countries in late 2008 and 2009. Some economists argue that financial crises are caused by recessions instead of the other way around, and that even where a financial crisis is the initial shock that sets off a recession, other factors may be more important in prolonging the recession. In particular, Milton Friedman and Anna Schwartz argued that the initial economic decline associated with the crash of 1929 and the bank panics of the 1930s would not have turned into a prolonged depression if it had not been reinforced by monetary policy mistakes on the part of the Federal Reserve,[10] a position supported by Ben Bernanke.[11
- Negative GDP growth lasting two or more quarters is called a recession. An especially prolonged or severe recession may be called a depression, while a long period of slow but not necessarily negative growth is sometimes called economic stagnation. Some economists argue 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 subprime mortgage crisis and the bursting of other real estate bubbles around the world also led to recession in the U.S. and a number of other countries in late 2008 and 2009. Some economists argue that financial crises are caused by recessions instead of the other way around, and that even where a financial crisis is the initial shock that sets off a recession, other factors may be more important in prolonging the recession. In particular, Milton Friedman and Anna Schwartz argued that the initial economic decline associated with the crash of 1929 and the bank panics of the 1930s would not have turned into a prolonged depression if it had not been reinforced by monetary policy mistakes on the part of the Federal Reserve,[10] a position supported by Ben Bernanke.[11
- 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 (see fractional-reserve banking), it is difficult for them to quickly pay back all deposits if these are suddenly demanded, so a run renders the bank insolvent, causing customers to lose their deposits, to the extent that they are not covered by deposit insurance. An event in which bank runs are widespread is called a systemic banking crisis or banking panic. [3] Examples of bank runs include the run on the Bank of the United States in 1931 and the run on Northern Rock in 2007. Banking crises generally occur after periods of risky lending and resulting loan defaults.[4]
- 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 (see fractional-reserve banking), it is difficult for them to quickly pay back all deposits if these are suddenly demanded, so a run renders the bank insolvent, causing customers to lose their deposits, to the extent that they are not covered by deposit insurance. An event in which bank runs are widespread is called a systemic banking crisis or banking panic. [3] Examples of bank runs include the run on the Bank of the United States in 1931 and the run on Northern Rock in 2007. Banking crises generally occur after periods of risky lending and resulting loan defaults.[4]
- 2 Causes and consequences of financial crisis 2.1 Strategic complementarities in financial markets 2.2 Leverage 2.3 Asset-liability mismatch 2.4 Uncertainty and herd behavior 2.5 Regulatory failures 2.6 Contagion 2.7 Recessionary effects
- Causes and consequences of financial crisis 2.1 Strategic complementarities in financial markets 2.2 Leverage 2.3 Asset-liability mismatch 2.4 Uncertainty and herd behavior 2.5 Regulatory failures 2.6 Contagion 2.7 Recessionary effects
- Strategic complementarities in financial markets[edit] Main articles: Strategic complementarity and Self-fulfilling prophecy It is often observed that successful investment requires each investor in a financial market to guess what other investors will do. George Soros has called this need to guess the intentions of others 'reflexivity'.[12] Similarly, John Maynard Keynes compared financial markets to a beauty contest game in which each participant tries to predict which model other participants will consider most beautiful.[13] Circularity and self-fulfilling prophecies may be exaggerated when reliable information is not available because of opaque disclosures or a lack of disclosure.[14] 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. Likewise, a depositor in IndyMac Bank who expects other depositors to withdraw their funds may expect the bank to fail, and therefore has an incentive to withdraw too. Economists call an incentive to mimic the strategies of others strategic complementarity.[15] It has been argued that if people or firms have a sufficiently strong incentive to do the same thing they expect others to do, then self-fulfilling prophecies may occur.[16] For example, if investors expect the value of the yen to rise, this may cause its value to rise; if depositors expect a bank to fail this may cause it to fail.[17] Therefore, financial crises are sometimes viewed as a vicious circle in which investors shun some institution or asset because they expect others to do so.[18]
- Leverage[edit] Main article: Leverage (finance) Leverage, which means borrowing to finance investments, is frequently cited as a contributor to financial crises.[14] 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 (see 'Contagion' below). The average degree of leverage in the economy often rises prior to a financial crisis[citation needed]. For example, borrowing to finance investment in the stock market ("margin buying") became increasingly common prior to the Wall Street Crash of 1929. In addition, some scholars have argued that financial institutions can contribute to fragility by hiding leverage, and thereby contributing to underpricing of risk.[14]
- Asset-liability mismatch[edit] Main article: 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 bank runs occur (when depositors panic and decide to withdraw their funds more quickly than the bank can get back the proceeds of its loans).[17] Likewise, Bear Stearns failed in 2007–08 because it was unable to renew the short-term debt it used to finance long-term investments in mortgage securities. In an international context, many emerging market governments are unable to sell bonds denominated in their own currencies, and therefore sell bonds denominated in US dollars instead. This generates a mismatch between the currency denomination of their liabilities (their bonds) and their assets (their local tax revenues), so that they run a risk of sovereign default due to fluctuations in exchange rates.[19]
- Uncertainty and herd behavior[edit] Main articles: Economic psychology 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 'œcopathy'.[20] 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.[21][22] 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,[23] and the Crash of 1929, which followed the introduction of new electrical and transportation technologies.[24] 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.[25] Unfamiliarity with recent technical and financial innovations may help explain how investors sometimes grossly overestimate asset values. Also, if the first investors in a new class of assets (for example, stock in "dot com" companies) profit from rising asset values as other investors learn about the innovation (in our example, as others learn about the potential of the Internet), then still more others may follow their example, driving the price even higher as they rush to buy in hopes of similar profits. If such "herd behavior" causes prices to spiral up far above the true value of the assets, a crash may become inevitable. If for any reason the price briefly falls, so that investors realize that further gains are not assured, then the spiral may go into reverse, with price decreases causing a rush of sales, reinforcing the decrease in prices.
- Regulatory failures[edit] Main articles: Financial regulation and Bank regulation 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 requirements, 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 former Managing Director of the International Monetary Fund, Dominique Strauss-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'.[26]Likewise, the New York Times singled out the deregulation of credit default swaps as a cause of the crisis.[27] However, excessive regulation has also been cited as a possible cause of financial crises. In particular, the Basel II Accord has been criticized for requiring banks to increase their capital when risks rise, which might cause them to decrease lending precisely when capital is scarce, potentially aggravating a financial crisis.[28] International regulatory convergence has been interpreted in terms of regulatory herding, deepening market herding (discussed above) and so increasing systemic risk.[29] From this perspective, maintaining diverse regulatory regimes would be a safeguard. 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 embezzled 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 Albanian Lottery Uprising of 1997, and the collapse of Madoff Investment Securities in 2008. Many rogue traders that have caused large losses at financial institutions have been accused of acting fraudulently in order to hide their trades. Fraud in mortgage financing has also been cited as one possible cause of the 2008 subprime mortgage crisis; government officials stated on September 23, 2008 that the FBI was looking into possible fraud by mortgage financing companies Fannie Mae and Freddie Mac, Lehman Brothers, and insurer American International Group.[30] Likewise it has been argued that many financial companies failed in the recent crisis because their managers failed to carry out their fiduciary duties.[31]
- Contagion[edit] Main articles: Financial contagion and Systemic risk Contagion refers to the idea that financial crises may spread from one institution to another, as when a bank run spreads from a few banks to many others, or from one country to another, as when currency crises, sovereign defaults, or stock market crashes spread across countries. When the failure of one particular financial institution threatens the stability of many other institutions, this is called systemic risk.[32] One widely-cited example of contagion was the spread of the Thai crisis in 1997 to other countries like South Korea. However, economists often debate whether observing crises in many countries around the same time is truly caused by contagion from one market to another, or whether it is instead caused by similar underlying problems that would have affected each country individually even in the absence of international linkages.
- Recessionary effects[edit] Some financial crises have little effect outside of the financial sector, like the Wall Street crash of 1987, but other crises are believed to have played a role in decreasing growth in the rest of the economy. There are many theories why a financial crisis could have a recessionary effect on the rest of the economy. These theoretical ideas include the 'financial accelerator', 'flight to quality' and 'flight to liquidity', and the Kiyotaki-Moore model. Some 'third generation' models of currency crises explore how currency crises and banking crises together can cause recessions.[33]