What Is a Financial Crisis?
In afinancial 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 runduring which investors sell off assets or withdraw money from savings accountsbecause they fear that the value of those assets will drop if they remain ina 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.
Key Takeaways
- Banking panics were at the genesis of several financial crises of the 19th, 20th, and 21st centuries, many of which led to recessions or depressions.
- Stock market crashes, credit crunches, the bursting of financial bubbles, sovereign defaults, and currency crises are all examples of financial crises.
- A financial crisis may be limited to a single country or one segment of financial services, but is more likely to spread regionally or globally.
What Causes a Financial Crisis?
A financial crisis may have multiple causes. Generally, a crisis can occur if institutions or assets areovervalued 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 aneconomy 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:
- Tulip Mania (1637). Though some historians argue that this mania did not have so much impact on the Dutch economy, and therefore shouldn't be considered a financial crisis, it did coincide with an outbreak of bubonic plague which had a significant impact on the country. With this in mind, it is difficult to tell if the crisis was precipitated by over-speculation or by the pandemic.
- Credit Crisis of 1772. After a period of rapidly expanding credit, this crisis started in March/April in London. Alexander Fordyce, a partner in a large bank, lost a huge sum shorting shares of the East India Company and fled to France to avoid repayment. Panic led to a run on English banks that left more than 20 large banking houses either bankrupt or stopping payments to depositors and creditors. The crisis quickly spread to much of Europe. Historians draw a line from this crisis to the cause of the Boston Tea Party—unpopular tax legislation in the 13 colonies—and the resulting unrest that gave birth to the American Revolution.
- Stock Crash of 1929. This crash, starting on Oct. 24, 1929, saw share prices collapse after a period of wild speculation and borrowing to buy shares. It led to the Great Depression, which was felt worldwide for over a dozen years. Its social impact lasted far longer. One trigger of the crash was a drastic oversupply of commodity crops, which led to a steep decline in prices. A wide range of regulations and market-managing tools were introduced as a result of the crash.
- 1973 OPEC Oil Crisis. OPEC members started an oil embargo in October 1973 targeting countries that backed Israel in the Yom Kippur War. By 1978, a barrel of oil stood at about $14, up from $3 in 1973. Given that modern economies depend on oil, the higher prices and uncertainty led to the stock market crash of 1973–74, when a bear market persisted from January 1973 to December 1974 and the Dow Jones Industrial Average lost about 49% of its value.
- Asian Crisis of 1997–1998. This crisis started in July 1997 with the collapse of the Thai baht. Lacking foreign currency, the Thai government was forced to abandon its U.S. dollar peg and let the baht float. The result was a huge devaluation that spread to much of East Asia, also hitting Japan, as well as a huge rise in debt-to-GDP ratios. In its wake, the crisis led to better financial regulation and supervision.
- The 2007-2008 Global Financial Crisis. This financial crisis was the worst economic disaster since the Stock Market Crash of 1929. It started with a subprime mortgage lending crisis in 2007 and expanded into a global banking crisis with the failure of investment bank Lehman Brothers in September 2008. Huge bailouts and other measures meant to limit the spread of the damage failed and the global economy fell into recession.
- COVID19 Pandemic. A global stock market crash began in February 2020. From February 20 until March 23, 2020 the S&P 500 lost over 30% of its value. This was a result of the COVID-19 pandemic, which caused widespread panic and uncertainty about the future of the global economy. Despite being severe and with global reach, markets and national economies rebounded quickly and by early April 2020, the S&P 500 had began a decisive rise, surpassing its pre-pandemic high in August 2020.
The 2008 Global Financial Crisis
The 2008 Global Financial Crisis remains one of the deepest economic downturns in modern history and deserves special attention, as its causes, effects, response, and lessons are still relevant to the current financial landscape.
Loosened Lending Standards
The crisis wasthe result of a sequence of events, each with its own trigger and culminating in thenear-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.
The amount of subprime mortgage debt, which was guaranteed by Freddie Mac and Fannie Mae, continued to expand into the early 2000s whenthe Federal Reserve Board began to cut interest rates drastically to avoida recession. The combination of loose credit requirements and cheap money spurred a housing boom, which drove speculation,pushing up housing prices and creating a real estate bubble.
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 themarket for CDOsbegan to heatup, 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 wereworthless due to the toxic debt they represented, they attemptedto unload the obligations. However, there was no market for the CDOs. The subsequent cascade of subprime lender failurescreated 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. By March 2013, the S&P bounced back from the crisis and continued on its 10-year bull run from 2009 to 2019 to climb to about 200%. 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:
- More comprehensive regulation of financial markets, including more oversight of derivatives, which were brought into exchanges.
- Regulatory agencies, which had been numerous and sometimes redundant, were consolidated.
- A new body, the Financial Stability Oversight Council, was devised to monitor systemic risk.
- Greater investor protections were introduced, including a new consumer protection agency (the Consumer Financial Protection Bureau) and standards for "plain-vanilla" products.
- The introduction of processes and tools (such as cash infusions) is meant to help with the winding down of failed financial institutions.
- Measures meant to improve standards, accounting, and regulation of credit rating agencies.
The 2020 Financial Crisis
In February of 2020, the COVID19 virus was discovered in China. The disease soon made its way around the world, killing millions and stoking fear. This, in turn, caused markets to fall and credit to the financial system to grind to a halt.
The pandemic resulted in strict lockdowns and travel restrictions, which had a significant impact on global supply chains, consumer demand, and financial markets. Investors became increasingly concerned about the economic consequences of the pandemic, leading to a rapid sell-off in stock markets around the world. The crash was particularly severe in March 2020, when the Dow Jones Industrial Average (DJIA) experienced its worst day since 1987, falling over 2,000 points in a single day. Other major stock indexes, such as the S&P 500 and the FTSE 100, also experienced significant losses. From February 12 through March 23, 2020, the DJIA lost 37% of its value.
Central banks and governments around the world responded with various measures to stabilize the financial system and support the economy, including monetary stimulus and fiscal policies such as government spending and tax breaks.
Despite the severity of the initial crash, the markets rebounded somewhat in the following months, and many investors saw significant gains toward the end of 2020 and into 2021, where markets hit new all-time highs. However, the long-term economic consequences of the pandemic are still unclear, and many industries and countries are still struggling to recover fully.
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. Some believe that financial crises are an inherent feature in how modern capitalist economies function, where the business cycle fuels speculative growth during economic booms, only to be met by contractions and recession. During these contractions, borrowers default on their loans and creditors tighten their lending criteria.
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.
The Bottom Line
A financial crisis occurs when asset prices drop steeply, businesses and consumers cannot pay their debts, and financial institutions experience liquidity shortages. Various factors contribute to a financial crisis, including systemic failures, unanticipated or uncontrollable human behavior, incentives to take excessive risks, regulatory absence or failures, or natural disasters such as pandemic viruses. Some of the historical examples of financial crises include Tulip Mania, the Credit Crisis of 1772, the Stock Crash of 1929, the 1973 OPEC Oil Crisis, the Asian Crisis of 1997-1998, and the 2008 Global Financial Crisis.
