What exactly is a financial crisis?
During a financial crisis, asset prices plummet, loans are unpaid, and financial institutions face liquidity problems. During a financial crisis, investors may panic and sell assets or remove money from savings accounts for fear of a decrease in value.
Financial crises may also involve speculative bubbles, stock market crashes, sovereign defaults, or currency crises. A financial crisis may affect banks, the whole economy, a region, or the planet.
What causes a financial crisis?
Multiple factors can produce a financial crisis. A crisis can arise when institutions or assets are overvalued and aggravated by irrational investor activity. When a bank failure is suspected, a quick succession of selloffs can depress asset prices, leading people to dump assets or withdraw enormous amounts of funds.
Systemic failures, unexpected human behavior, incentives to take excessive risks, regulatory flaws, or contagions that spread problems from one institution or nation to another can cause financial crises. An unaddressed crisis might lead to a recession or depression in the economy. Financial crises can occur, accelerate, or intensify despite preventative actions.
Financial Crisis Examples
It has occurred since the currency was invented. Notable financial crises include:
Tulip Mania (1637)
Some historians think that this frenzy didn’t touch the Dutch economy enough to be termed a financial crisis, but it coincided with a bubonic plague epidemic that did. Given this, it’s hard to know if over-speculation or the epidemic caused the catastrophe.
Credit Crisis of 1772
This crisis began in London in March or April after fast credit growth. Alexander Fordyce, a bank partner, escaped to France after losing a lot of money shorting East India Company shares. A panicked run on English banks bankrupted over 20 significant banks or stopped payments to depositors and creditors. The problem swiftly extended across Europe. According to historians, the Boston Tea Party, unpopular tax legislation throughout the 13 colonies, and the American Revolution stem from this dilemma.
1929 Stock Crash
After excessive speculation and borrowing to acquire shares, share values plummeted on October 24, 1929. It caused the Great Depression, affecting the world for nearly a decade. It had a more extended societal influence. An abundance of commodities caused the crisis by lowering prices. After the crisis, many restrictions and market-management instruments were established.
1973 OPEC oil crisis
OPEC initiated an oil embargo in October 1973 against Yom Kippur War supporters. A barrel of oil cost $12 after the embargo, up from $3. The 1973–74 stock market meltdown occurred when the Dow Jones Industrial Average lost 45% of its value due to increasing oil costs and uncertainty. Modern economies depend on oil.
Asian Crisis 1997–1998
The crisis began in July 1997 with the Thai baht crash. The Thai government let the baht float because it ran out of foreign money. A massive devaluation that rocked Japan and most of East Asia caused debt-to-GDP ratios to increase. Financial regulation and oversight improved after the crisis.
2007–2008 global financial crisis
The 2007–2008 global financial crisis was the most significant economic calamity since the 1929 Stock Market Crash. The 2007 subprime mortgage lending crisis became a worldwide banking catastrophe in September 2008 when Lehman Brothers failed. Massive bailouts and other steps to mitigate damage failed, and the world economy entered a recession.
COVID-19
A global stock market crisis began in February 2020. The S&P 500 dropped 30% from February 20 to March 23, 2020. The COVID-19 outbreak prompted panic and worry about the world economy. Though severe and worldwide, markets and national economies returned swiftly, and by early April 2020, the S&P 500 had risen decisively, exceeding its pre-pandemic high in August 2020.
The 2008 global financial crisis
As one of the worst economic downturns in history, the 2008 Global Financial Crisis merits special attention for its causes, impacts, reactions, and lessons.
Relaxed Lending Standards
The banking system nearly collapsed due to several events, each with its own origin. Some claim that the crisis began in the 1970s with the Community Development Act, which loosened credit rules for low-income clients, leading to subprime mortgages.
When the Federal Reserve Board cut interest rates to prevent a recession in the early 2000s, subprime mortgage debt, which Freddie Mac and Fannie Mae insure, increased. The combination of low credit criteria and cheap money led to a housing boom, causing speculation and a real estate bubble.
Financial crises, such as a banking/credit panic or stock market catastrophe, differ from recessions.
Complex Financial Instruments
After the dot-com crash and the 2001 recession, investment banks developed collateralized debt obligations (CDOs) from mortgages acquired on the secondary market to generate quick gains. Investors couldn’t grasp subprime mortgage risks since they were packaged with prime mortgages. As the CDO market heated up, the housing bubble burst after years of development. As house values collapsed, subprime borrowers defaulted on debts worth more than their homes, compounding the fall.
Failures become contagious
When investors recognized CDOs were worthless owing to toxic debt, they tried to sell them. No market existed for CDOs. The bankruptcy of subprime lenders caused a liquidity contagion that spread to the top of the financial sector. Lehman Brothers and Bear Stearns imploded under subprime debt, and over 450 banks failed during the next five years. A taxpayer-funded bailout saved many large banks from collapse.
Response
The U.S. government lowered interest rates to virtually zero, bought back mortgages and government debt, and bailed out some financial institutions during the Financial Crisis. Low rates made bond yields less appealing to investors than equities. Government action sparked the stock market. By March 2013, the S&P had recovered from the crisis and extended its 10-year bull run from 2009 to 2019 to 250%. Most major U.S. cities’ housing markets rebounded, and unemployment declined as firms hired and invested.
New Rules
After the crisis, the Obama administration approved the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, a significant financial reform law. Dodd-Frank overhauled the U.S. economic regulatory landscape, affecting every regulatory agency and financial services industry. Notable Dodd-Frank effects:
- Financial market regulation, including derivatives exchanges, was expanded.
- Multiple unnecessary regulatory agencies were combined.
- The Financial Stability Oversight Council was created to monitor systemic risk.
- Investor safeguards increased with the creation of the Consumer Financial Protection Bureau and rules for “plain-vanilla” products.
- Adopting systems and tools like cash injections helps wind down failing financial organizations.
- Improvements to credit rating agency standards, accounting, and regulation.
The 2020 Financial Crisis
COVID-19 was found in China in February 2020. The epidemic spread worldwide, killing millions and causing dread. This lowered markets and halted financial system lending.
Lockdowns and travel restrictions caused by the epidemic affected worldwide supply chains, consumer demand, and financial markets. Stock markets worldwide plummeted as investors worried about the pandemic’s economic effects. In March 2020, the Dow Jones Industrial Average (DJIA) had its worst day since 1987, plummeting almost 2,000 points. S&P 500 and FTSE 100 also lost substantial ground. The DJIA fell 37% from February 12 to March 23, 2020.
Central banks and governments worldwide used monetary stimulus and fiscal policies like government spending and tax breaks to stabilize the financial system and boost the economy.
Despite the initial meltdown, markets rebounded in the following months, and many investors saw significant returns in 2020 and 2021 when prices reached new highs. Many businesses and nations are still recovering from the epidemic, and its long-term economic effects are unknown.
What is a financial crisis?
The value of financial instruments and assets drops considerably during a financial crisis. Businesses struggle to satisfy financial obligations, and financial institutions lack cash or convertible assets to fund projects and meet immediate requirements. Investors lose faith in their investments, and customers’ earnings and assets are damaged, making loan repayment impossible.
What Causes a Financial Crisis?
Financial crises have many causes, sometimes too many. Overvalued assets, systemic and regulatory failures, and consumer panic, such as many consumers withdrawing cash from a bank after learning of its financial issues, often produce financial crises. Financial crises may be inherent in modern capitalist economies, as the business cycle promotes speculative expansion during economic booms, contractions, reactions, and recessions. Creditors tighten lending standards, and borrowers default during contractions.
What Are Financial Crisis Stages?
The financial crisis has three stages, starting with its onset: system and regulatory weaknesses, institutional mismanagement, and more, which cause financial system breakdowns. Next, the financial system collapses, leaving banks, businesses, and consumers unable to pay. Finally, assets depreciate, and debt rises.
What caused the 2008 financial crisis?
Despite numerous flaws, the crisis was primarily due to the plentiful supply of subprime mortgages sold to investors. Subprime mortgage defaults boosted bad debt, scaring secondary market investors. These mortgages killed investment corporations, insurance companies, and financial institutions, forcing them to seek government bailouts. Market stocks plummeted after bailouts. Other markets followed, causing worldwide fear and market instability.
The Worst Financial Crisis Ever?
Possibly the most significant financial catastrophe in 90 years, the 2008 Global Financial Crisis destroyed stock markets, financial institutions, and consumers.
Bottom Line
Financial crises occur when asset prices plummet, firms and individuals cannot pay their debts, and financial institutions lack liquidity. Systemic failures, irrational or unpredictable human behavior, rewards for taking excessive risks, regulatory flaws, or natural disasters like pandemic viruses can all contribute to financial problems. Tulip Mania, the Credit Crisis of 1772, the Stock Crash of 1929, the 1973 OPEC Oil Crisis, the 1997–1998 Asian Crisis, and the 2008 Global Financial Crisis are instances of financial crises.
Conclusion
- Banking panics caused various 19th, 20th, and 21st-century financial crises that led to recessions or depressions.
- Financial crises include stock market crashes, credit crunches, financial bubble bursts, sovereign defaults, and currency crises.
- A financial crisis may affect one country or financial services sector but usually spreads regionally or worldwide.
