Financial Crisis. MarketCheese

A financial crisis is characterized by a sharp decline in the value of financial instruments. Economists associate a financial crisis with a loss of stability in financial markets and financial sector institutions, money circulation, international finance, state, municipal and corporate finance. It is the situation in which an economic system faces a panic, there is a panic selling in the markets, investors go completely to cash and remove funds from a bank account as they are afraid of losing capital.

Main causes of Financial Crisis

There are many reasons why a financial crisis may occur in a financial institution, the economy of a country, or a world economy. Many scientists claim that the behavior of most investors is affected by the absence of information about an economic future and they tend to imitate the actions of other investors. The imitation results in banking crises. If depositors have no reliable information on the condition of a particular bank, they can turn to cash withdrawal after hearing rumors about the possible failure of a bank or simply seeing a queue of depositors lined up. Interestingly, it may be one of the reasons for a bank failure.

The imitation can cause banking and currency crises, speculative bubbles, as well as liquidity crises.

Many researchers who have studied a financial crisis, believe that an important cause of financial turmoil is the behavioral choices that are made when individuals deal with new, untested phenomena.

In addition, many financial organizations may be on the verge of bankruptcy and may force partners to violate the law.

The concept of contagion in the world of investment and finance describes the situation in which a financial crisis can spread out from one organization to another or even from one country to another. So, when one bank is not able to meet the obligations, it may lead to distrust in all banks. Another example is when a currency crisis or a state default spreads out and results in other crises within the country and even abroad. Contagion arises due to the closer relationships between companies in a developed economy.

The economic shock brought on by the phenomena stated above may even result in the severe economic downturn.

Examples

It is impossible to avoid financial crises as they are cyclical processes that repeat after a certain period of time. The most notable financial crises are mentioned below.

Tulip mania. It is a period of turbulence in the history of the Netherlands, when the demand for tulip bulbs began to exceed the supply, and the product became overpriced (1634-1637). Tulip mania is a classic example of a stock market bubble and the collapse with all the ensuing consequences. Historians claim that the economy of the Netherlands wasn’t affected much by this period and it cannot be considered a crisis. They support the idea that the plague outbreak did more damage.

Stock crash. The stock market crash of 1929 is characterized by a significant drop in stock prices in the U.S. that began on Black Thursday, October 24, 1929 and resulted in a substantial decline in value of the assets on October 25, 28 and 29. The decline in the Dow Jones Industrial Average was caused by the hype around investments – citizens wanted to profit in bull markets, more and more ordinary people bought overvalued stocks, which led to the emergence of a speculative bubble. The situation was aggravated by the fact that many market participants bought shares using credit. This stock market crash, also known as the "Wall Street crash," marked the beginning of the Great Depression.

The 2007-2008 global financial crisis. This recession could be compared to the Great depression. The housing bubble burst, which in 2008 resulted in a serious mortgage crisis in the U.S., heralded a global banking crisis. The mortgage crisis caused a liquidity crisis of banks in September 2008, meaning banks stopped issuing loans.. During the global financial crisis, there was also a negative GDP growth, a collapse of world trade, and an increase in oil and gold prices.

Global Financial Crisis

The Global Financial Crisis is considered the most-severe financial crisis event that could be observed recently.

Eased loan standards. The triggers of the crisis were different events that had severe consequences for the banking system. Historians and economists come to the conclusion that the crisis is rooted in the 1970s when the Community Development Act entered into force. It contributed to easing of credit standards on loans for individuals with low income. It resulted in an increase in the share of subprime loans.

In the 2000s, the low interest rate policy of the Fed made Americans actively refinance mortgages. In addition, after the dot-com bubble burst, money from the stock market began to flow into the real estate segment. As a result, a new housing bubble has formed. Banks actively provided citizens with poor quality mortgages. Loans became unsecured and had a floating interest rate.

Сollateralized debt obligations (CDOs). After that, secured debt obligations have become available on the stock market. It is a type of derivative securities based on the debts of individuals, companies or states. Investment banks of that time bought debts or other obligations (mortgages) and collected these obligations into a pool. "Good" mortgages were mixed with "bad" ones in CDOs. In 2008, the pyramid of CDOs made up of mortgage loans collapsed. Some of the U.S. investment banks that specialized in the securities of the American mortgage industry and CDOs went bankrupt.

Government measures. At the peak of the Global Financial Crisis, the U.S. government tried to rescue the largest American banks. The measures implemented by the government included reducing interest rates, buying back loan debts, helping the troubled banks, etc. It negatively influenced the liquidity and profitability of bonds. As a result, the housing market cooled off and employment started to increase.

The financial crisis resulted in the creation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, one of the most important legislative acts of the U.S., adopted on July 21, 2010. It was intended to reduce the risks of the American financial system. The law significantly changed the activities of federal authorities regulating financial services and came up with an additional financial regulatory body.