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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 This means that liquidity is quickly evaporated becauseavailable money is withdrawn from banks (called a run), forcing bankseither to sell other investments to make up for the shortfall or tocollapse. BusinessDictionary.com

Is applied broadly to a variety of situations in which some financialinstitutions or assets suddenly lose a large part of their value. In the19th 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 stockmarket crashes and the bursting of other financial bubbles, currencycrises, and sovereign defaults.Financial crises directly result in a loss of

paper wealth; they do not directly result in changes in the realeconomy, may indirectly do so, notably if a recession or depressionfollows. Wikipedia

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

world.

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Factors of a Financial CrisesAsset Market Effects on Balance Sheets

Deterioration of Financial Institutions Balance Sheets

Banking Crises Increases in Uncertainty

Increasing Interest rates

Government Fiscal Imbalances

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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 lendinglesseconomic activity

Firms net worth can be reduced by an error on a balancesheet (stock prices going down)

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

http://www.slidefinder.net/F/Financial_Crises/5965800

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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 suffersubstantial contractions in their capital.

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

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

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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 banksfail simultaneously.

In a panic, depositors fearing for the safety of theirmoney and without insuracnce or knowing a particular

bank's loan portfolio will withdraw as quickly aspossible. When this happens in a large amount, thereis a loss of information production in financialmarkets and a bank;s financial intermediation.

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Banking Crises and Increase in

Uncertainty ContinuedWith a bank lending decrease, supplies of funds

available to borrowers decrease as well. Which thenleads into higher interest rates.

With an increase in adverse selection, bank panicscause the inability of lenders to solve this selectionprocess in credit markets.

With the inability to solve the adverse selection makesbanks' less likely to lend, and then a decline inlending, investment, and aggregate activity occurs.

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

worse banks were failing at alarming rates. During the1920s an average of 70 banks failed each yearnationally. After the crash during the first 10 months of1933, 744 banks failed.

In all, a total of 9000 banks failed during the 1930s. By,

then depositors nation wide had lost $140 billionthrough bank failures...

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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 anexternal source.

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

Resulting in a drop in cash flow, and again adverseselection and moral hazard problems become more severe.Impacting lending, investment, and overall economicactivity.

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Government Fiscal Imbalances Government imbalances may create fears of default on

government debt.

These fears can spark a foreign exchange crisis inwhich the value of the domestic currency falls sharplybecause 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. Thesebalance sheets once again lead to an increase inadverse selection and moral hazard problems.

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Dynamics of a Financial Crises The Three stages

Stage One: Initiation

Stage Two: Bank Panics Stage Three: Debt Deflation

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Stage One: Initiation Mismanagement of Financial Liberation/Innovation

Asset Price booms and busts

Spikes in interest rates, General increase in Uncertainty when banks fail

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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 financialdevelopment

Bad when management begins taking on too muchrisk

Result: Credit boom where banks lend too much andthey cant keep enough information or they have noexperience

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Mismanagement of Financial

Liberalization/Innovation Contd 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 andbanks net-worth (capital) falls

Leads to a cutback on lending or deleveraging

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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 assets

The bubble bursts and prices fall to correct levels

causing everyone to lose Banks again will deleverage

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Spikes in interest rates 1800s 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 100percentage points in a day

Leads to a decline in cash f lows and lending, leads toadverse selection and moral hazard

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Increase in UncertaintyAlways 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 adverseselection and moral hazard

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Stage Two: Banking Crisis

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What Happens Because of worsening conditions in business and

uncertainty, depositors begin to withdraw funds frombanks

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 ofthe balance sheet

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Deterioration of Financial

Institutions balance sheetsWith financial Institutions balance sheets

deteriorating, lending declines

Which leads to a decline in investment spending

Which slows economic activity

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Banking CrisisWith Institutions, even healthy ones, starting to fail

A Bank Panicoccurs when multiple banks failsimultaneously.

Depositors, because of fear and uncertainty, start toremove their deposits until the point that the bank fails

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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 selectionproblem make them less willing to lend

This declines lending

Investment

Aggregate economic activity

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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 andincrease in inflation due to gold. Banks began to lend tomuch money

Panic of 1873; Depression followed and lasted until 1879

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

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Continue. Panic of 1893; caused by railroad overbuilding and

shaky railroad financing which set off a series of bankfailures

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

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Usual Explanations High consumer debt

Ill-regulated markets that permitted overoptimisticloans by banks and investors

Lack of high growth new industries

Growing wealth inequality

This all reduced spending, lowered production andlowered confidence

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Stage Three: Debt Deflation Unanticipated Decline in Price Level

Adverse selection and moral hazard becomes moresevere

Economic activity declines

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The Great Depression Sharp Asset price increase due to a credit boom

Increased interest rates

Increased uncertainty leads to bank crises Debt Deflation