FINANCIAL CRISES
AND ITS IMPACT ON
THE FINANCIAL SYSTEM
Lecturer – Oleg Deev
oleg@mail.muni.cz
Contents
• Definition of financial crisis
• Historical overview of financial crises
• Theories of financial crises
• Policy issues
• Global financial crisis of 2007-2010
• Impact of the global financial crisis on the financial system
The following lecture will give you only a brief overview of financial
crises theory. However, the presented information will provide you with
the structure of existing ideas and issues, what I believe will be a guide
for you through the vast amount of current information on crisis and its
solutions
Definition
• Crisis – is a situation of a complex system, when big
changes, usually bad, appear possible
• Economic crisis – a situation in the economy, which
indicates a sharp transition to a recession
• Financial crisis – a situation in which some financial
institutions or assets suddenly lose a large part of their
value
• Banking crisis
• Currency crisis
• Stock market crash
• Sovereign default
Historical overview
• Financial crises prior to 17th century are connected to
sovereign defaults
• 1637 – tulip mania in the Netherlands
• 1866 – the Overend & Gurney crisis in England
• Going back to the first half of 20th century and before there
many examples of financial crisis, which were significantly
frequent
• One of the significant outcome of crises was the establishment of
central bank’s control and supervision over the financial system
• 1929 – stock market crash
• early 1930s – banking crisis in the US
• The Great Depression
• 1945-1971 – no banking crises anywhere in the world (apart
from one in Brazil in 1962)
Some solutions of the Great Depression
• Herbert Hoover’s programs (1930-1932):
• Smoot-Hawley Tariff Act – raised tariffs on imported items
• Federal Home Loan Bank Act – promoted new home constructions
and reduced foreclosures
• Emergency Relief and Construction Act – included funds for public
works programs
• Franklin Delano Roosevelt’s programs (1933-1934):
• Securities Act of 1933 – regulated the securities industry
• Securities Exchange Act of 1934 – created Securities and
Exchange Commission (SEC)
• Glass-Steagall Act (The Banking Act of 1933 - “repealed” in 1999) –
federal insurance of bank deposits; separation of bank types
according to their businesses (commercial and investment banking)
1945-1971 – period without financial crises
• Bretton-Woods financial system
• Extensive regulation of the financial system
• Governments controlled the allocation of funds to
different industries through state-owned banks or
heavily regulated banks
• Financial system was ceased to perform its basic
functions of allocating investments
• Financial market inefficiencies
• Calls for deregulation
Theories of crises - categories
1. Financial panic (multiple equilibrium)
2. Business cycle (essential crises)
3. Inconsistent government macroeconomic
policies
4. Bubbles creation and collapse
5. Amplification (contagion and fragility)
6. Flawed government microeconomic
policies
Financial panic
• Bank run – a situation, when a bank suffers a sudden rush
of withdrawals by depositors
• Credit crunch – a situation, in which banks are reluctant to
lend, because they worry that they have insufficient funds
available
• Causes of financial panic are different in every situation
• Example: Northern Rock – In the beginning of the global
financial crisis bank sought and received a liquidity support
from the Bank of England to replace funds it was unable to
raise from the money market. This led to panic among
individual depositors fearing that their savings might not be
available (first bank run in UK in 150 years)
Business cycle
• Economy functions with fluctuations, which occur around
a long-term growth trend, and typically involve shifts over
time between periods of relatively rapid economic growth
and periods of relative stagnation or decline
• The returns on bank assets will be low when the economy
goes into a recession or depression
• Given banks’ fixed liabilities in the form of deposits or
bonds they may unable to remain solvent
Inconsistent macroeconomic policies
• Mostly connected with the currency crises and
inflow/outflow of speculative investments
• Crises arise as a result of government strategies that are
inconsistent with a fixed or pegged exchange rate or
inadequate monetary policy
• Growth of state debt is an indicator of possible financial
crisis
Government debt as % of GDP (2010)
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
0
20
40
60
80
100
120
140
State Federal
Federal and State US Government Debt
as % of GDP
1974 1979 1984 1989 1994 1999 2004 2009
0
100
200
300
400
Percent (%) of GDP
0
10
20
30
40
50
60
Trillions of US Dollars
Total Debt to GDP Total Debt
Total US Debt Outstanding (Household,
Business & Government)
Bubbles in asset prices
• Bubble in a financial asset – a situation, when the
price of asset exceeds the present value of the
future income
• It is difficult to tell in practice whether an asset's
price actually equals its fundamental value
• Financial crises occur after a bubble in asset
prices collapses
• Examples: Wall Street Crash of 1929, Japanese
property bubble of 1980s, dot-com bubble in
2000-2001
Financial contagion and fragility
• Financial contagion – a situation, in which small shock,
which initially affect only a part of financial system, spread
to the rest of the system
• Causes of contagion: trade and real links, interbank markets,
financial markets co-movement (co-integration), payment systems
interdependence
• Example: Asian financial crisis of the late 1990s
• Financial fragility – a situation, when a small shock has a
large effect on the financial system.
• One of the mechanisms – shock spreads geographically
• Example: Russian default in August 1998. Amount of debt defaulted
on was very small relative to assets in the world, however around
three quarters of the world’s stock markets fell in the day after the
announcement
Flawed microeconomic policies
• Crises are due to:
• guarantees of the banking sector by the government
(for example, deposit insurance) – leads to a moral
hazard where banks knowingly take excessive risks
• or the prospect of bail outs by the government or
international organizations – the notion of “too big to
fail”
• Another possible problem is the lack of adequate
bankruptcy procedures (inadequate domestic
bankruptcy laws, lack of established procedure
for the bankruptcy of sovereign countries)
Theories of crises - discussion
• Which theory explains the nature of crises better?
• Crises are complex phenomenon in practice
• There is no one theory of crises that explain all
aspects of the phenomenon
• Any theories of crises are not mutually exclusive
• Actual crisis may contain elements of some
combination of previously discussed theories
• In your opinion which theory explains the global
financial crisis of 2007-2010?
Policy issues
• Financial crises pose many policy issues
• Since the Great Depression it has been taken as axiomatic by
many policymakers that crises must be avoided at all costs
• Much of the banking and financial regulation that exists is
designed to prevent crises
• One of the cornerstones of finance is the idea that projects with
high risk have high returns on average. This suggests that if an
economy is to have high expected returns to allow it to grow
quickly it must also have a high degree of risk associated with
its capital stock. High growth may therefore be correlated with
frequent crises. Eliminating crises by forcing banks and hence
firms to take less risks may slow the growth of the economy
Policy issues
• To what extent are crises desirable or undesirable?
• Should there be a central bank to provide liquidity to
the financial system?
• Should there be an international lender of last resort?
• Should central banks intervene to prevent bubbles in
asset prices?
• Do individual institutions pose a systemic risk to the
financial system and if so what can be done about it?
• Are government guarantees of the banking system
desirable?
Global financial crisis of 2007-2010
• The collapse of the US housing bubble
• Downturn in stock market all over the world (50%
fall of the Dow Jones Index)
• Collapse of large financial institutions (Lehman
Brothers, AIG)
• The bailout of banks by national governments
(Northern Rock, Fannie Mae, Freddie Mac)
• Global economic recession in 2008
• European sovereign debt crisis
The mechanism of credit crisis
The short film “The Crisis of Credit Visualized” (available on
YouTube) illustrates the mechanism of the subprime mortgage
crisis in the US
After watching this film you should be able to answer
the following questions:
1. What are the direct and indirect causes of the
global financial crisis of 2007-2010?
2. What is leverage?
3. What is the role of rating agencies in the financial
crisis?
4. In your opinion what measures should be taken to
overcome the credit crisis?
What happened?
Low interest rates, high leverage and overconfidence led to
the creation of bubbles which then burst
• US housing market went bust and real estate prices started
falling
• Prices of complex financial securities that were created to
underwrite the housing market collapsed
• Institutions that issued these assets along with the investors that
bought them suffered huge losses in many cases exceeding the
capital of these firms
• Losses along with collapse in confidence in these products
triggered a financial meltdown starting from Wall Street and
rapidly spreading to London, Continental Europe, Asia and the
Rest of the World
• With the global financial system on the verge of total meltdown,
governments stepped in to avert mass panic and an economic
collapse that would result in a global depression worse than that
of the 1930s
What did governments do?
Intervened in order to prevent a systemic collapse and an
economic depression
• Governments responded swiftly and decisively to save the
system from collapse by applying Keynesian economics (based
on the hard lessons that were learned in the 1930s)
• Central banks stepped in and provided liquidity to the banking
system (allowing it to keep functioning)
• Slashed interest rates
• Expanded the money supply
• Governments provided bailouts for major financial institutions
to avert their collapse or took them over outright
• Governments also cut taxes and raised spending to prevent the
economy from falling into a deep recession or even depression
Recovery remains too dependent on
government support
• Although economies are rebounding around the
world, the recovery is not even
• The emerging economies of China, India, Brazil
are faring better and leading the rebound
• The economies of the USA, Europe and Russia
are lagging behind
• Recovery is still overly dependent on government
spending, bailout money and low interest rates
• Intervention came at a high price:
• unprecedented expansion in the supply of money and
• unprecedented peacetime expansion in government
deficits
Causes of the global financial crisis
• The inability of home owners to make mortgage payments
• Poor sense of judgment by borrowers and landers
• Speculation and overbidding during borrowing period
• Risky mortgage products
• High personal and corporate debt
• Complex financial innovation that concealed default risk
(for example, over-the-counter default swaps derivatives)
• Lack of proper government regulation
• Global macro imbalances (for example, between U.S
(deficit) and some emerging economies, incl. China
(surplus)
• Weak financial institutions
• Exchange rate problem adjusted by system
Impact on the global financial system
• Falling of capital markets
• Nationalization of large financial institutions
• Increase of sovereign debts in many countries
• Fall in governments revenue
• Fall of exchange rates
• Deficit balance of payments
• Rising levels of unemployment and inflation
• Possible implementation of new regulation
procedures to avoid future crises
Real GDP growth rates, in %
Adjusted Monetary Base in the US
Effective US Federal Funds Rate, %
US Total Reserves (excluding Gold)
General Government Net Liabilities
as % of GDP