A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. A broader reduction of economic activity affecting the whole economy is known as an economic crisis. 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.Charles P. Kindleberger and Robert Aliber (2005), Manias, Panics, and Crashes: A History of Financial Crises, 5th ed. Wiley, .Luc Laeven and Fabian Valencia (2008), 'Systemic banking crises: a new database'. International Monetary Fund Working Paper 08/224. Financial crises directly result in a loss of paper wealth but do not necessarily result in significant changes in the real economy (for example, the crisis resulting from the famous tulip mania bubble in the 17th century).
Many economists have offered theories about how financial crises develop and how they could be prevented. There is little consensus and financial crises continue to occur from time to time. It is apparent however that a consistent feature of both economic (and other applied finance disciplines) is the obvious inability to predict and avert financial crises. This realization raises the question as to what is known and also capable of being known (i.e. the epistemology) within economics and applied finance. It has been argued that the assumptions of unique, well-defined causal chains being present in economic thinking, models and data, could, in part, explain why financial crises are often inherent and unavoidable.
Types
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.
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.
Currency crisis
A currency crisis, also called a devaluation crisis, is normally considered as part of a financial crisis. Kaminsky et al. (1998), for instance, define currency crises as occurring when a weighted average of monthly percentage depreciations in the exchange rate and monthly percentage declines in exchange reserves exceeds its mean by more than three standard deviations. Frankel and Rose (1996) define a currency crisis as a nominal depreciation of a currency of at least 25% but it is also defined as at least a 10% increase in the rate of depreciation. In general, a currency crisis can be defined as a situation when the participants in an exchange market come to recognize that a pegged exchange rate is about to fail, causing speculation against the peg that hastens the failure and forces a devaluation.
Speculative bubbles and crashes
A speculative bubble (also called a financial bubble or an economic bubble) exists in the event of large, sustained overpricing of some class of assets.Markus Brunnermeier (2008), 'Bubbles', in The New Palgrave Dictionary of Economics, 2nd ed. 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.Peter Garber (2001), Famous First Bubbles: The Fundamentals of Early Manias. MIT Press, .
Well-known examples of bubbles (or purported bubbles) and crashes in stock prices and other asset prices include the 17th century Dutch tulip mania, the 18th century South Sea Bubble, the Wall Street crash of 1929, the Japanese property bubble of the 1980s, and the crash of the United States housing bubble during 2006–2008. The 2000s sparked a real estate bubble where housing prices were increasing significantly as an asset good.
International financial crisis
When a country that maintains a fixed exchange rate is suddenly forced to devalue its currency due to accruing an unsustainable current account deficit, 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.
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.
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,Milton Friedman and Anna Schwartz (1971), A Monetary History of the United States, 1867–1960. Princeton University Press, . a position supported by Ben Bernanke.'1929 and all that', The Economist, 2 October 2008.
Causes and consequences
Strategic complementarities in financial markets
It is often observed that successful investment requires each investor in a financial market to guess what other investors will do. Reflexivity refers to the circular relationships often evident in social systems between cause and effect – and relates to the property of self-referencing in financial markets. George Soros has been a proponent of the reflexivity paradigm surrounding financial crises.'The Theory of Reflexivity', speech by George Soros, April 1994 at MIT. 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.J. M. Keynes (1936), The General Theory of Employment, Interest and Money, Chapter 12. (New York: Harcourt Brace and Co.).
Furthermore, in many cases, investors have incentives to coordinate their choices. For example, someone who thinks other investors want to heavily buy 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.
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 crises are sometimes viewed as a vicious circle in which investors shun some institution or asset because they expect others to do so. Reflexivity poses a challenge to the epistemic norms typically assumed within financial economics and all of empirical finance. The possibility of financial crises being beyond the predictive reach of causality is discussed further within Epistemology of finance.
Leverage
Leverage, which means borrowing to finance investments, is frequently cited as a contributor to financial crises. 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).
For example, borrowing to finance investment in the stock market ("margin buying") became increasingly common prior to the Wall Street crash of 1929.
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 that 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). 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.Eichengreen and Hausmann (2005), Other People's Money: Debt Denomination and Financial Instability in Emerging Market Economies.
Uncertainty 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. Behavioural finance studies errors in economic and quantitative reasoning. Psychologist Torbjorn K A Eliazon has also analyzed failures of economic reasoning in his concept of 'œcopathy'.Torbjörn K A Eliazon (2006) –