FINANCIAL CRISES

I. Introduction ...............................................................................................................

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II. Explaining Financial Crises ...............................................................................................

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A. Asset Price Booms and Busts....................................................................................

B. Credit Booms and Busts ............................................................................................

C. Impact of Asset Price and Credit Busts ...................................................................

III. Types of Financial Crises.................................................................................................

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A. Currency Crises .......................................................................................................

B. Sudden Stops ...........................................................................................................

C. Foreign and Domestic Debt Crises ..........................................................................

D. Banking Crises ........................................................................................................

IV. Identification, Dating and Frequency of Crises .................................................................

A. Identification and Dating ........................................................................................

B. Frequency and Distribution .....................................................................................

V. Real and Financial Implications of Crises ..........................................................................

A. Real Effects of Crises ..............................................................................................

B. Financial Effects of Crises ......................................................................................

VI. Predicting Financial Crises ...............................................................................................

VII. Conclusions ..............................................................................................................

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References ....................................................................................................................

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INTRODUCTION

A Financial crises is a major disruption in the financial system that impedes the economy’s ability to the intermediate between those who want to save and those who want to borrow and invest not surprisingly, given the financial system central role, financial crises  have a broad macroeconomics impact. Throughout history, many of the deepest recessions have followed problems in the financial system. This downturn include the great depression of the 1930s and the great recession of 2008-2009

The 2007-09 global financial crises have been a painful reminder of the multifaceted nature of crises. They hit small and large countries as well as poor and rich ones. As fittingly described by Reinhart and Rogoff (2009a), “financial crises are an equal opportunity menace they can have domestic or external origins, and stem from private or public sectors. They come indifferent shapes and sizes, evolve over time into different forms, and can rapidly spread across borders. They often require immediate and comprehensive policy responses, call for major changes in financial sector and fiscal policies, and can necessitate global coordination of policies

 The widespread impact of the latest global financial crisis underlines the importance of having a solid understanding of crises. As the latest episode has vividly showed, the implications of financial turmoil can be substantial and greatly affect the conduct of economic and financial policies. A thorough analysis of the consequences of and best responses to crises has become an integral part of current policy debates as the lingering effects of the latest crisis are still being felt around the world.

This paper provides a selected survey of the literature on financial crises. Crises are, at a certain level, extreme manifestations of the interactions between the financial sector and the real economy. as such, understanding financial crises requires an understanding of macro financial linkages, a truly complex challenge in itself. The objective of this paper is more modest: it presents a focused survey considering three specific questions. First, what are the main factors explaining financial crises? Second, what are the major types of financial crises? Third, what are the real and financial sector implications of crises? The paper also briefly reviews the literature on the prediction of crises and the evolution of early warning models.

Section II reviews the main factors explaining financial crises. A financial crisis is often an amalgam of events, including substantial changes in credit volume and asset prices, severe disruptions in financial intermediation, notably the supply of external financing, large scale

Balance sheet problems and the need for large scale government support. While these events can be driven by a variety of factors, financial crises often are preceded by asset and credit booms that then turn into busts. As such, many theories focusing on the sources of financial crises have recognized the importance of sharp movements in asset and credit markets. In light of this, this section briefly reviews theoretical and empirical studies analyzing the developments in credit and asset markets around financial crises.

Section III classifies the types of financial crises identified in many studies. It is useful to classify crises in four groups: currency crises; sudden stop (or capital account or balance ofPayments) crises; debt crises; and banking crises. The section summarizes the findings of theliterature on analytical cause and empirical determinants of each type of crisis. The identification of crises is discussed in Section IV. Theories that are designed to explain Crises are used to guide the literature on the identification of crises. However, it has been difficult to transform the predictions of the theories into practice. While it is easy to design quantitative methods to identify currency (and inflation) crises and sudden stops, the Identification of debt and banking crises is typically based on qualitative and judgmental analyses. Irrespective of the classification one uses, different types of crises are likely to Overlap. Many banking crises, for example, are also associated with sudden stop episodes and Currency crises. The coincidence of multiple types of crises leads to further challenges of Identification. The literature therefore employs wide range of methods to identify and classify crises. The section considers various identification approaches and reviews the Frequency of crises over time and across different groups of countries

Section V analyzes the implications of financial crises. The macroeconomic and financial implications of crises are typically severe and share many commonalities across various types. Large output losses are common to many crises, and other macroeconomic variables typically register significant declines. Financial variables, such as asset prices and credit, usually follow qualitatively similar patterns across crises, albeit with variations in terms of duration and severity of declines. The section examines the short- and medium-run effects of crises and presents a set of stylized facts with respect to their macroeconomic and financial implications

The last section concludes with a summary and suggestions for future research. It then considers the most relevant issues for research in light of these lessons. One is that future research should be geared to eliminate the “this-time-is-different “syndrome. However, this Isa very broad task requiring addressing two major questions: How to prevent financial crises? And, how to mitigate their costs when they take place? In addition, there have to be more intensive efforts to collect necessary data and to develop new methodologies in order to guide both empirical and theoretical studies

THE ANATOMY OF CRISES

Financial crises are not all alike, but they shares some common features .in a nutshell, here the six elements that are the center of the most financial crises.

• Assets-price booms and busts
• Insolvencies at financial institutions
• Falling confidence
• Credit crunch
• Recession
• A vicious circle 

The Anatomy of a financial crisis: this figure is a schematic illustration of the six elements of a financial crisis.

Policy responses to a crisis

Conventional monetary and fiscal policy

Lender of last resort

Policies to prevent crises

Focusing on shadow banks restricting size

Reducing excessive risk taking

Making regulation work Better

Financial crises have been a major source of economic fluctuations and a main driver of economic policy. In 1873 Walter Bagehot published a celebrated book called Lombard Street about how the bank of England should manage a financial crisis. His recommendations that it should act as a lender of last resort has over time become the conventional wisdom. In 1913.in aftermath of the banking has over time become the conventional wisdom. In 1913, in the aftermath of the banking panic of 1907, congress passed the act establishing the Federal Reserve. Congress wanted the new central bank to oversee the banking system in order to ensure greater financial and macroeconomics stability.

The fed has not always been successful in accomplishing this goal. To this day, many economist believe that the great depression was so serve because the fed failed to failed to follow Bagehot’s advice and act as lender of last resort .if it had acted more aggressively, the crises of confidence in the banks and the resulting collapse in the money supply and aggregate demand  might have been averted. Mindful of this history, the fed played a much more active role in trying to mitigate the impact of the financial crises of 2008-2009

The anatomy of a crisis

Financial crises are not all alike, but they share some common features, in a nut shell here are the six elements that are the centre of the most financial crises. The financial crises of 2008-2009 provides a good example of each element

Assets –price booms and busts: 

Often, a period of optimisms, leading to a large increase in assets prices, precedes financial crises. Sometimes peoples bid up  the price of assets  above its fundamental value(that is, the true value  based on an objective analysis of the  cash flows the assets will generate)in this case ,the market for the assets is said to be in the grip of a speculative bubble. Later, when sentiment shifts and optimisms turn to pessimism, the bubble bursts and prices begin to fall. The decline in assets prices is the catalyst for the financial crises.

In 2008 and 2009, the crucial asset was residential real estate. The average price of houses in united state had experienced a boom earlier in the decade. This boom was driven in part by lax lending standards; many subprime borrowers those with particular risky credit profiles were lent money to buy house while offering only a very small down payment. In essence the financial system failed to do its job of dealing with asymmetric information by making loans to many borrowers who, it turned out, would later have trouble making their mortgage payments .the housing boom was also encouraged by government policies that promoted home ownership and was fed by excessive   optimism on the part of home-buyers who thought prices would rise forever. The housing boom, however, proved unsustainable. Over time the number of homeowners falling behind on their mortgage payments rose,, and sentiment among home-buyers shifted . Housing prices fell by about 30 percent from 2006 to 2009. The nation had not experienced such a large decline in housing prices since the 1930s.

Insolvencies at Financial Institutions;

A large decline in assets prices may cause problems at banks and other financial institutions. To ensure that borrowers reply their loans, banks often require them to post collateral. That is, a borrower has to pledge assets that a bank can seize if the borrower defaults. Yet when assets decline in price, the collateral falls in value, perhaps below the amount of the loan in this case, if the borrower defaults on the loan, the bank may be unable to recover its money.

Banks rely heavily on leverage, the use of borrowed funds for the purpose of investment, leverage amplifies the positive and negative effect of assets returns on banks financial position. A key number is the leverage ratio: the ratio of bank assets to bank capital. A leverage ratio of 20 for example, means that for every $1 in capital. Put into the bank by its owners the bank has borrowed $19, which then allows the bank to hold $20 in assets. In this case, if defaults cause the value of the bank’s assets to fall by 2 percent, then the bank’s capital will fall by 40 percent. If the value of bank assets falls more than 5 percent, then its assets will fall below its liabilities, and the bank will be insolvent. In this case, the bank will not have the resources to pay off all its depositors and other creditors. Widespread insolvency within the financial system is the second element of financial crises.

In 2008 and 2009 many banks and other financial firms had in effect placed bets on real estate prices by holding mortgages backed by the real estate. They assumed that housing prices would keep rising or at least hold steady, so the collateral backing these loans would ensure their repayment. When housing prices fell however large number of homeowners found they underwater, the value of their homes was less than the amount they owned on their mortgages.  When many homeowners stopped paying their mortgages, the banks could foreclose on the house, but they could recover only a fraction of what they were owned. These defaults pushed several financial institutions towards bankruptcy. These institution include major investment banks,, government-sponsored  enterprises involved in the mortgage markets  and a large insurance company.

Falling confidence

The third element of financial crises is decline in confidence in financial institution. While some deposits in banks are insured by government policies, not all are, as insolvencies mount every financial institution becomes a possible candidate for the next bankruptcy. Individuals with uninsured deposits in those institutions pull out their money. Facing a rash of withdrawals, banks cut back on new lending and start selling of assets to increase their cash reserves.

As banks sell off some of their assets, they depress the market prices of these assets. Because buyers of risky assets are hard to find in the midst of a crises, the assets prices can sometime falls precipitously. Such a phenomenon is called a fire sale, similar to the reduced prices that a store might charge to get rid of merchandise quickly after a fire. These fire-sale prices, however,, causes  problems at other banks. Accountants and regulators may require these banks to revise their balance sheets and reduced the reported value of their own holding of these assets. In this way, problems in one bank can spread to others.

In 2008 and 2009, the financial system was seized by great uncertainty about where the insolvencies would stop.  The collapse of the giants bear Stearns and Lehman brothers made people wonder whether other large financial firms such as Morgan Stanley, Goldman Sachs, and citigroup, would meet a similar fate. The problem was exacerbated by the firm’s interdependence. Because they had many contracts with one another, the demise of any one of these institution would undermine all the others. Moreover, because of the complexity of the arrangements, depositors could not be sure how vulnerable these firms were. The lack of transparency fed the crises of confidence.

Credit crunch

The fourth element of financial crises is a credit crunch. With many financial institution facing difficulties would-be borrowers have trouble getting loans, even if they have profitable investment projects. In essence, the financial system has trouble performing its normal function of directing the resources of savers into the hands of borrowers with the best investment opportunities.

The tightening of credit was clear, during the 2008-2009 financial crises. Not surprisingly, as banks realized that housing prices were falling and that previous lending standard had been too lax, they started raising standards for those applying for mortgages. They required larger down payments and scrutinized borrow affect home-buyers. Small business found it harder to borrow to finance business expansions or to buy inventories. Consumers found it harder to qualify for a credit card or car loan. Thus banks responded to their own financial problems by becoming more cautious in all kinds of lending.

Recession:

The fifth element of financial crises is an economic downturn. With people unable to obtain consumer credit and firms unable to obtain financing for new investment projects, the overall demand for goods and services declines. Within the context of the is-lm model this event can be interpreted  as a contractionary  shift in the consumption and investment function, which in turn leads to similar shifts in the is curve  and the aggregate demand curve. As a result national income falls and unemployment rises.

Indeed the recession following the financial crises of 2008 to 2009 was a deep one. Unemployment rose above 10 percent. Worse yet, it lingered at a high level for a long time. Even after the recovery began, growth in GDP was to meager that unemployment declined only slightly.

A vicious circle 

The sixth and final element of a financial crisis is a vicious circle. The economic downturn reduces the profitability of many companies and the value of many assets. The stock market declines.  Some firms go bankrupt and default on their business loans. Many workers become unemployed and default on their personal loans. Thus, we return to steps 1(assets price busts) and 2 (financial institution insolvencies). The problems in the financial system and the economic downturn reinforce each other.

In 2008 and 2009, the vicious was apparent. Some feared that the combination of a weakening economy would cause the economy to spiral out of control, pushing the country into another great depression. Fortunately, that did not occur, in part because policymakers were intent on preventing it

II. TYPES OF FINANCIAL CRISES

While financial crises can take various shapes and forms, in terms of classification, broadlyTwo types can be distinguished.Reinhart and Rogoff (2009a) distinguish two types of crises:Those classified using strictly quantitative definitions; and those dependent largely on qualitative and judgmental analysis. The first group mainly includes currency and sudden.