Financial Crisis

What Is a Financial Crisis?

In a financial crisis, asset prices see a steep decline in value, businesses and consumers are unable to pay their debts, and financial institutions experience liquidity shortages. A financial crisis is often associated with a panic or a bank run during which investors sell off assets or withdraw money from savings accounts because they fear that the value of those assets will drop if they remain in a financial institution.

Other situations that may be labeled a financial crisis include the bursting of a speculative financial bubble, a stock market crash, a sovereign default, or a currency crisis. A financial crisis may be limited to banks or spread throughout a single economy, the economy of a region, or economies worldwide.

What Causes a Financial Crisis?

A financial crisis may have multiple causes. Generally, a crisis can occur if institutions or assets are overvalued, and can be exacerbated by irrational or herd-like investor behavior. For example, a rapid string of selloffs can result in lower asset prices, prompting individuals to dump assets or make huge savings withdrawals when a bank failure is rumored.

Contributing factors to a financial crisis include systemic failures, unanticipated or uncontrollable human behavior, incentives to take too much risk, regulatory absence or failures, or contagions that amount to a virus-like spread of problems from one institution or country to the next. If left unchecked, a crisis can cause an economy to go into a recession or depression. Even when measures are taken to avert a financial crisis, they can still happen, accelerate, or deepen.

Financial Crisis Examples

Financial crises are not uncommon; they have happened for as long as the world has had currency. Some well-known financial crises include:

The Global Financial Crisis

As the most recent and most damaging financial crisis event, the Global Financial Crisis, deserves special attention, as its causes, effects, response, and lessons are most applicable to the current financial system.

Loosened Lending Standards

The crisis was the result of a sequence of events, each with its own trigger and culminating in the near-collapse of the banking system. It has been argued that the seeds of the crisis were sown as far back as the 1970s with the Community Development Act, which required banks to loosen their credit requirements for lower-income consumers, creating a market for subprime mortgages.

A financial crisis can take many forms, including a banking/credit panic or a stock market crash, but differs from a recession, which is often the result of such a crisis.

Complex Financial Instruments

In the meantime, the investment banks, looking for easy profits in the wake of the dot-com bust and 2001 recession, created collateralized debt obligations (CDOs) from the mortgages purchased on the secondary market. Because subprime mortgages were bundled with prime mortgages, there was no way for investors to understand the risks associated with the product. When the market for CDOs began to heat up, the housing bubble that had been building for several years had finally burst. As housing prices fell, subprime borrowers began to default on loans that were worth more than their homes, accelerating the decline in prices.

Failures Begin, Contagion Spreads

When investors realized the CDOs were worthless due to the toxic debt they represented, they attempted to unload the obligations. However, there was no market for the CDOs. The subsequent cascade of subprime lender failures created liquidity contagion that reached the upper tiers of the banking system. Two major investment banks, Lehman Brothers and Bear Stearns, collapsed under the weight of their exposure to subprime debt, and more than 450 banks failed over the next five years. Several of the major banks were on the brink of failure and were rescued by a taxpayer-funded bailout.

Response

The U.S. Government responded to the Financial Crisis by lowering interest rates to nearly zero, buying back mortgage and government debt, and bailing out some struggling financial institutions. With rates so low, bond yields became far less attractive to investors when compared to stocks. The government response ignited the stock market, which went on a 10-year bull run with the S&P 500 returning 250% over that time. The U.S. housing market recovered in most major cities, and the unemployment rate fell as businesses began to hire and make more investments.

New Regulations

One big upshot of the crisis was the adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act, a massive piece of financial reform legislation passed by the Obama administration in 2010. Dodd-Frank brought wholesale changes to every aspect of the U.S. financial regulatory environment, which touched every regulatory body and every financial services business. Notably, Dodd-Frank had the following effects:

Financial Crisis FAQs

What Is a Financial Crisis?

A financial crisis is when financial instruments and assets decrease significantly in value. As a result, businesses have trouble meeting their financial obligations, and financial institutions lack sufficient cash or convertible assets to fund projects and meet immediate needs. Investors lose confidence in the value of their assets and consumers' incomes and assets are compromised, making it difficult for them to pay their debts.

What Causes a Financial Crisis?

A financial crisis can be caused by many factors, maybe too many to name. However, often a financial crisis is caused by overvalued assets, systemic and regulatory failures, and resulting consumer panic, such as a large number of customers withdrawing funds from a bank after learning of the institution's financial troubles.

What Are the Stages of a Financial Crisis?

The financial crisis can be segmented into three stages, beginning with the launch of the crisis. Financial systems fail, generally caused by system and regulatory failures, institutional mismanagement of finances, and more. The next stage involves the breakdown of the financial system, with financial institutions, businesses, and consumers unable to meet obligations. Finally, assets decrease in value, and the overall level of debt increases.

What Was the Cause of the 2008 Financial Crisis?

Although the crisis was attributed to many breakdowns, it was largely due to the bountiful issuance of sub-prime mortgages, which were frequently sold to investors on the secondary market. Bad debt increased as sub-prime mortgagors defaulted on their loans, leaving secondary market investors scrambling. Investment firms, insurance companies, and financial institutions slaughtered by their involvement with these mortgages required government bailouts as they neared insolvency. The bailouts adversely affected the market, sending stocks plummeting. Other markets responded in tow, creating global panic and an unstable market.

What Was the Worst Financial Crisis Ever?

Arguably, the worst financial crisis in the last 90 years was the 2008 Global Financial Crisis, which sent stock markets crashing, financial institutions into ruin, and consumers scrambling.