Triggers of a Financial Crisis

Last year, the world was hit with the outbreak of a new virus. The effects would end up being catastrophic not just to people’s health, but also to the economy’s stability. Recovery was gradual and even now we are still feeling the effects. It didn’t take long for this pandemic to trigger a financial crisis at a magnitude not seen since the Great Depression and Recession.

For this recent crisis, it is easy to pin the blame on COVID-19. However, how can one describe the causes of past financial crises? Who is to blame? What was the straw that broke the camel’s back? Providing an easy answer is difficult because, in actuality, there are an array of triggers.

Defining this dilemma

Financial crises are times when asset prices experience a sharp decline in value. Businesses and consumers cannot repay their debts and financial institutions start seeing liquidity shortages. A financial crisis usually correlates with a panic or a bank run. During this period, investors make haste to sell their assets or withdraw money from savings accounts. This is mostly out of fear that those assets’ value will drop if they stay in a financial institution.

Other situations that could be seen as a financial crisis include the following:

  • Hypothetical financial bubble bursts
  • Stock market crashes
  • Sovereign defaults
  • Currency crises

Generally speaking, a financial crisis may be limited to banks. Alternatively, they spread across a single economy, a region’s economy, or economies around the world.

The 2008 Recession

Probably one of the best – and most recent – examples of a financial crisis is the 2007-2009 global recession. Otherwise known as the ‘the Great Recession’, this was the steep drop in economic activity during the late 2000s. It is considered by many to be the most noteworthy economic downturn since the Great Depression. While the effects were global, they were not necessarily equal. The more developed economies like Europe, North America, and South America would fall into a severe recession.

The “Great Recession” refers to both the U.S. recession (December 2007 – June 2009) and the global recession in 2009. The economic slump would start with the U.S. housing market going from a boom to a flop. An abundance of mortgage-backed securities (MBS’s) and derivatives would lose a considerable amount of value. Products like Ninja Loans emerged as temporary solutions.

What causes them?

A financial crisis will often result from various causes. Generally speaking, a crisis can happen if assets or institutions are overvalued. As such, irrational or herd-like investor behaviour can intensify the effects. For instance, a breakneck series of sell-offs can lead to lower asset prices. This in turn will urge people to discard assets or conduct huge savings withdrawals when they suspect a bank failure.

Some major factors that can spark a financial crisis include the following:

  • Systemic failures
  • Human behaviour that is unpredictable and/or uncontrollable
  • Regulatory absence or missteps
  • Encouragement to take too much risk
  • Contagions that create a slew of problems that extend from one institution or country to another

Leaving a financial crisis unchecked can provoke an economic recession or depression. Even when steps are taken to avoid them, they can still occur. Not only that but they could also accelerate or expand.

This is a rather simple way of explaining what the causes of a financial crisis are. However, this is a broad subject consisting of various answers and there is more ground to cover.

1 – Too Big to Fail

The phrase “Too big to fail” refers to a business or business sector deep within a financial system or economy. In fact, their deep involvement means that the business’ failure could result in a humongous economic disaster.

Rational thinking informs us that the industry is full of big and complex firms. Moreover, they are too “systemically important” to manage or tolerate failure. As such, there is a demand for system architecture with serious modifications. Academic studies that evaluate economies of scale and scope have flaws and are essentially a distraction from the main issue. Even if one acknowledges that efficiencies improve continually, what matters is that no sustainable system will optimize efficiency. 

All systems must find a way to properly balance efficiency with resiliency. The latter seeks improvements through decentralization, diversity, and maintaining excess buffers. Regular aggregation of scale and risk-benefit management first by receiving a promotion from shareholders. Shareholders will benefit second by prospering thanks to a growing government subsidy providing a competitive advantage. All of this is at the expense of a society enduring disastrous externalized costs of a total system collapse.

2 – A rise in uncertainties

Playing it safe is often the most popular route to take. Particularly for companies unable to plan for the future and investors feeling like they cannot predict future corporate earnings. The same thing applies to interest, inflation, and default rates. They retain cash rather than invest in new equipment or even a new factory. Evidently, this will reduce aggregate economic activity.

3 – Problems in banking, as well as panicking

Suppose that something severely damages the balance sheets of banks, like higher default rates on loans). In such a situation, banks will cut down on their lending. Doing so will help them avoid potentially filing for bankruptcy and/or triggering the fury of regulators.

Banks are the utmost important external finance source in a majority of countries. Therefore, opting to downsize will negatively affect the economy. It will decrease the overall flow of funds between entrepreneurs and investors. If bank balance sheets suffer, some are likely to fail. This could potentially trigger the failure of even more banks for two reasons:

  1. Banks normally owe each other a considerable amount of sums. If a big bank owing too many smaller banks fails, then it could jeopardize the solvency of creditor banks. 
  2. A few banks failing could potentially induce those who hold banks’ monetary liabilities to run on the bank. It could pull their funds out altogether because they can’t tell if they are using a good bank or not.

What’s tragic is that all banks engage in fractional reserve banking. That is to say, no bank retains enough cash on hand to properly meet its monetary liabilities. Where is the tragedy in this? Well, runs wind up becoming self-fulfilling prophecies, so to speak. This effectively destroys even the most financially stable institutions in a few days. Or even a few hours.

Banking panics and the dead banks that remain create a strong sense of uncertainty. Similarly, they cause higher interest rates and balance sheet deterioration. All of these outcomes have the capacity to hurt cumulative economic activity.

4 – Complications with leverage and liquidity

A common trigger for many financial crises is excess leverage. Going by its definition, leverage is something that goes beyond balance sheets. It is typically embedded in off-balance sheet instruments, such as derivatives. Moreover, dangerous hidden leverage resides in securities with more structure. Much like leverage, liquidity mismatches (i.e. borrowing short and lending long) must also be subject to a cutback.

5 – Fiscal issues regarding the government

Governments spending much more than they take in through taxes and other revenues have no choice but to borrow. The more they borrow, the harder it will be for them to service their loans. This will increase fears of a potential default, thus diminishing their bonds’ overall market price. Evidently, this will harm the balance sheets of firms investing in government bonds. What’s more, it could result in a crisis of exchange rates. This is mostly because investors sell assets denominated in their local currency out of a need to seek safety.

Abrupt value declines of local currency create gigantic difficulties for firms that are borrowing in foreign currencies. Such currencies include dollars, yen, euro, and sterling. This is due to them paying more units of local currency than they anticipated for each unit of foreign currency. A majority of them are unable to do so, which leads to them defaulting. In doing so, they increase asymmetric information, as well as a sense of uncertainty.

Conclusion

These five triggers are just some of the factors that contribute to a financial crisis. The truth of the matter is there are a wide variety of causes, both common and uncommon. There is no one root trigger. On top of that, they are not necessarily tied to corrupt decisions by bankers, regulators, or bad guys. At the end of the day, the blame can be put on basic human failings. They are inevitable, which is why precautions should be taken to mitigate any potential damage.

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