In simple words financial crises is monetary hardship, economic disaster; economic distress.
A financial crisis is a situation when money demand quickly rises relative to money supply. The world history has seen many financial crises including the great depression and the very recent US financial crises.
CAUSES OF FINANCIAL CRISES
- 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 For example, commercial banks offer deposit accounts which can be withdrawn at any time and they use the proceeds to make long-term loans to businesses and homeowners.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
- 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. Behavioral finance studies errors in economic and quantitative reasoning.
- 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. George Soros has called this need to guess the intentions of others 'reflexivity'.
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
- Regulatory failures
Governments have attempted to eliminate or mitigate financial crises by regulating the financial sector. One major goal of regulation is transparency: making institutions' financial situations publicly known by requiring regular reporting under standardized accounting procedures. Another goal of regulation is making sure institutions have sufficient assets to meet their contractual obligations, through reserve requirements, capital requirements, and other limits on leverage.
Fraud has played a role in the collapse of some financial institutions, when companies have attracted depositors with misleading claims about their investment strategies, or have embezzled the resulting income.
Contagion refers to the idea that financial crises may spread from one institution to another, as when a bank run spreads from a few banks to many others, or from one country to another, as when currency crises, sovereign defaults, or stock market crashes spread across countries. When the failure of one particular financial institution threatens the stability of many other institutions, this is called systemic risk.
TYPES OF FINANCIAL CRISES
Types of financial crisis prevailing are as follows
- Banking crises
When a bank suffers sudden withdrawals by its depositors, this situation is called a bank run. Since banks lend out most of the cash they receive in deposits, it is difficult for them to quickly pay back all deposits if these are suddenly demanded, so a run may result in bankruptcy, causing many depositors to lose their savings unless they are covered by deposit insurance. A situation in which bank runs are widespread is called a systemic banking crisis or just a banking panic. Bank panic may result from bad market reports or many other factors. Many financial crises have been attributed to such banking panics.
- Speculative bubbles and crashes
Bubbles are hard to identify as they are a result of an asset price not matching its value. If most market participants buy the asset primarily in hopes of selling it later at a higher price, instead of buying it for the income it will generate, this could be evidence that a bubble is present. 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.
- International financial crises
When a country that maintains a fixed exchange rate is suddenly forced to devalue its currency because of a speculative attack, 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.
- Wider economic crises
Negative GDP growth lasting two or more quarters is called a recession. An especially prolonged recession may be called a depression, while a long period of slow but not necessarily negative growth is sometimes called economic stagnation.
US FINANCIAL CRISES
US financial crises were amongst the most anticipated financial crisis ever. It all started in mid 2007 when the housing bubble of the US market was collapsed by the subprime mortgage market. A subprime mortgage is a type of loan granted to individuals with poor credit histories who, as a result of their deficient credit ratings, would not be able to qualify for conventional mortgages. Because subprime borrowers present a higher risk for lenders, subprime mortgages charge interest rates above the prime lending rate. Once interest rates began to rise and housing prices started to drop moderately in 2006-2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated.
CASUSES OF FINANCIAL CRISIS
- Falling stock prices
Falling stock prices have caused companies to reduce their hiring and capital spending while governments are forced to raise taxes or reduce services, as revenue from capital gains taxes declines. And the combination of reduced wealth and higher interest rates will finally cause consumers to pull back on their debt-financed consumption.
- War in Iraq and Afghanistan
The wars in Iraq and Afghanistan have already costed about $900 billion. U.S. banks made loans to people that could not afford to pay back the loans. A few of those banks almost went bankrupt and had to be rescued by American taxpayers. So much debt has been created. All that debt causes the U.S. dollar to be weak. It takes more dollars to buy the same stuff you could have bought with less money ten or fifteen years again.
- Limited amount of oil in America
The fact that there is a limited amount of oil in America affects the economy too. That causes the price of oil to increase. The price oil affects the price of everything you buy in the stores because it takes gas or diesel to ship those products to the consumer.
EFFECTS OF THE CRISES
- Impacts on financial institutions
The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. The IMF estimated that U.S. banks were about 60 percent through their losses, but British and euro zone banks only 40 percent.
- Credit markets and the shadow banking system
During September 2008, the crisis hit its most critical stage. There was the equivalent of a bank run on the money market mutual funds, which frequently invest in commercial paper issued by corporations to fund their operations and payrolls. Withdrawal from money markets was $144.5 billion during one week, versus $7.1 billion the week prior. This interrupted the ability of corporations to rollover their short-term debt.
- Wealth effects
There is a direct relationship between declines in wealth, and declines in consumption and business investment, which along with government spending represent the economic engine. Between June 2007 and November 2008, Americans lost an estimated average of more than a quarter of their collective net worth. Housing prices had dropped 20% from their 2006 peak, with futures markets signaling a 30-35% potential drop. Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in late 2008. Total retirement assets, Americans' second-largest household asset, dropped by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total a staggering $8.3 trillion.
- Global contagion
The crisis rapidly developed and spread into a global economic shock, resulting in a number of European bank failures, declines in various stock indexes, and large reductions in the market value of equities and commodities.
EFFECTS ON THE GLOBAL ECONOMY
- Global effects
A number of commentators have suggested that if the liquidity crisis continues, there could be an extended recession or worse. The continuing development of the crisis prompted fears of a global economic collapse. The financial crisis is likely to yield the biggest banking shakeout since the savings-and-loan meltdown.
- U.S. economic effects
Real gross domestic product, the output of goods and services produced by labor and property located in the United States, decreased at an annual rate of approximately 6 percent in the fourth quarter of 2008 and first quarter of 2009, versus activity in the year-ago periods. The U.S. unemployment rate increased to 10.2% by October 2009, the highest rate since 1983 and roughly twice the pre-crisis rate. The average hours per work week declined to 33, the lowest level since the government began collecting the data in 1964.
SOLUTION TO THE CRISES
Following steps were proposed to solve the crises
- Housing and Economic Recovery Act of 2008
- The Housing and Economic Recovery Act of 2008 in the United States included six separate major acts designed to restore confidence in the domestic mortgage industry. The Act included providing insurance for $300 billion in mortgages estimated to assist 400,000 homeowners.
- Establishing a new regulator, the Federal Housing Finance Agency via the merger of two existing authorities, The Office of Federal Housing Enterprise Oversight (OFHEO), and the Federal Housing Finance Board (FHFB), endowed with expanded powers and authority greater than the sum of its predecessors, to supervise operation of the 14 housing government sponsored enterprises (GSEs): Raises the dollar limit of the mortgages the GSE's can purchase.
- Provides loans for the refinancing of mortgages to owner-occupants at risk of foreclosure. The original lender or investor reduces the amount of the original mortgage (typically taking a significant loss) and the homeowner shares any future appreciation with the Federal Housing Administration. The new loans must be 30-year fixed loans.
- Enhancements to mortgage disclosures.
- Community assistance to help local governments buy and renovate foreclosed properties.
- An increase in the national debt ceiling by US$ 800 billion, to give the Treasury the flexibility to support the secondary housing markets and the 14 GSEs, if necessary.
- Federal Reserve powers
A sweeping proposal was presented 31 March 2008 regarding the regulatory powers of the U.S. Federal Reserve, expanding its jurisdiction over other types of financial institutions and authority to intervene in market crises.
- Expansion of government agency authority
The U.S House passed a bill in early April, 2008 that would offer government insurance on $300 billion in new mortgages to refinance loans for an estimated 500,000 borrowers facing foreclosure and an additional 15 billion to affected states to buy and fix foreclosed homes.
- Lending practices
In response to a concern that lending was not properly regulated, the House and Senate are both considering bills to regulate lending practices.
- U.S. Congressional ethics reform
In the wake of a subprime mortgage crisis and questions about Countrywide's VIP program, ethics experts and key senators recommend that members of congress should be required to disclose information about their mortgages.
- Capital reserve requirements
Non-depository banks (e.g., investment banks and mortgage companies) are not subject to the same capital reserve requirements as depository banks. Many of the investment banks had limited capital reserves to address declines in mortgage-backed securities or support their side of credit default derivative insurance contracts. Short-selling restrictions, UK regulators announced a temporary ban on short-selling of financial stocks on September 18, 2008. Short-selling is a method of profiting when a stock declines in value. When large, speculative short-sale bets accumulate against a stock or other financial asset, the price can be driven down. Short sales were among the causes blamed for rapid price declines in Lehman Brother's stock price prior to its bankruptcy.
- Emergency and short-term responses
The U.S. Federal Reserve and central banks around the world have taken steps to expand money supplies to avoid the risk of a deflationary spiral, in which lower wages and higher unemployment lead to a self-reinforcing decline in global consumption. In addition, governments have enacted large fiscal stimulus packages, by borrowing and spending to offset the reduction in private sector demand caused by the crisis. The U.S. executed two stimulus packages, totaling nearly $1 trillion during 2008 and 2009. This credit freeze brought the global financial system to the brink of collapse. The response of the USA Federal Reserve, the European Central Bank, and other central banks was immediate and dramatic. During the last quarter of 2008, these central banks purchased US$2.5 trillion of government debt and troubled private assets from banks. This was the largest liquidity injection into the credit market, and the largest monetary policy action, in world history. The governments of European nations and the USA also raised the capital of their national banking systems by $1.5 trillion, by purchasing newly issued preferred stock in their major banks.
Governments have also bailed-out a variety of firms, incurring large financial obligations. To date, various U.S. government agencies have committed or spent trillions of dollars in loans, asset purchases, guarantees, and direct spending.