Financial Crisis – Meaning, Impact, Causes and Types


Meaning of Financial Crisis

A financial crisis is simply the collapse of the entire financial system making it inefficient to perform its functions. It refers to a situation where financial instruments or institutions face a steep fall in their prices. The financial crisis disrupt the financial market which leads to liquidity shortage and improper allocation of capital.
It results in the excessive withdrawal of money by investors who expect a rapid fall in assets, bank panics, sovereign default, and crash of stock markets. This financial turmoil causes insolvency among people due to which they are not able to pay off their debts. Financial crisis may be either limited to a particular region or the economy or it may also spread at a world level.

Types of Financial Crisis

Banking crisis

It occurs when customers loses confidence in banks and suddenly withdraws the deposited amount in large numbers. Banks generally carry on their business by lending loans out of the amount received by them as deposits. They maintain only small amount of cash as reserve with them. Frequent withdrawal by people at a large scale makes banking organizations insolvent due to which they are unable to pay rapidly all deposits of customers.   

Balance of payment crisis

This type of crisis is also termed as external debt crisis. Government sometimes fails to fulfill its obligation of external debts due to inability to produce adequate funds. As there is liquidity shortage in market, they are unable to attract capital for paying off debts.

Currency crisis

Currency crisis means a steep fall in the value of currency in comparison to other currencies in foreign exchange market. This situation brings ill effects over the economy where currency losses its credibility to be used as a reliable means of exchange. Currency crisis brings instability in exchange rate which can be stabilized by central bank and government either by intervening in forex market or selling off their foreign currency reserves. 

Speculative bubbles and crashes

It occurs when assets are purchased at much higher price than their real intrinsic value with the future expectations of price appreciation or better future growth. This sudden spike in price of assets occurs due to excessive buying by people. However it follows a steep decline in assets price back to normalized level where investors begin to sell out their holdings. 

Causes of Financial Crisis

Financial market failures

Failure of financial market serves as a great cause for bringing financial crisis. Many times investors consider irrational terms instead of fundamental terms for trading in these markets. This brings steep rise and decline in asset prices which cause instability in whole market. In addition to it, due to financial innovation complexity has risen and trading on rational terms becomes difficult.

Structural Changes in global economy

Global imbalances lead to unsustainable pattern which contributes to financial crisis. Some countries like US and UK run on large deficit every year whereas others like Germany, china and japan run on large surpluses. These imbalances among economies create financial disruptions.

Rating agencies failures

These agencies failed to perform their work as per the standards and have given AAA ratings to subprime-mortgaged –backed securities. Rating agencies become incompetent to their duties because of ineffective regulation, poor economic model and conflicts of interest.

Market-to-market accounting

Companies in early 1990s were asked to report their assets at current market value by FASB standards. This forces banks to recognize losses on ‘fire sale’ prices that prevails in distressed markets and are lower than long-term fundamental values. These losses undermine market confidence and push every bank into insolvency. 

No systematic risk regulator

Absence of any risk regulator having jurisdiction over all systematically important financial institutions is another major cause. FED which serve as the role of systematic regulator lack the authority to oversee hedge funds, non-bank derivatives dealers, investment banks etc. 

Failure of risk management system

Many firms do a separate analysis for market risk and credit risk. However this system fails in case of complex structure products, where risk is indistinguishable.  

History of Financial Crisis

Financial crisis brings many hardships for nations as it adversely affect their economy. It may bring complete devastation for countries and halt their progress. The world has till date witnessed various financial crises in period of 100 years.

Here are few of the major financial crises witnessed around the world:-

The Great Depression 1932

Great Depression is one of the severe financial crises of 20th century that spreads widely across the world. It originated in United States around 1930. This crisis begins with fall in stock prices on 4 September, 1929. On 29 October, 1929 U.S. stock market crashes thereby making it a worldwide news. This crisis continues from 1929 to 1939 and was worst economic downturn. It has led to the collapse of American economy and also left negative effects around the world. Around 20,000 American companies were bankrupt, 15 million peoples lost their jobs and most of American banks failed.

International Debt crisis

International debt crisis begins on 20 August, 1982. The reason for occurrence of this crisis was failure of Latin American Countries to repay their foreign debt. These countries borrowed huge amounts in 1960s and 1970s from international creditors for their development activities. Mexico failed to repay its debt due to collapse of oil prices as it borrowed funds against future oil revenues. After Mexico, other Latin American countries like Brazil, chile, Peru, Argentina and Uruguay also faces debt-servicing issues. It continues from 1981 to 1989 and covered around 20 countries.

The OPEC Oil Price Shock of 1973

Oil crisis of 1973 occurred in October 1973 when OPEC (Organization of petroleum exporting countries) member countries began an oil embargo. These countries halted oil exports to US and its allies. In March 1974, by end of embargo there was a huge shortage of oil which led to major spike in oil prices from around US $3 per barrel to $12. It causes economic crises in US and several other developed countries.

Asian crisis of 1997-1998

This crisis began in July 1997 in Thailand and spreads in many Asian economies. It occurs due to devaluation of Baht currency of Thailand. Government of Thailand due to lack of foreign currency, decided to abandon its fixed exchange rate against the U.S. dollar. This decline in currency quickly widespread across the East Asian markets which causes stock market crash, government upheaval and decline in import revenue.

Credit crisis of 1772

Crisis of 1772 begin in London and then quickly spreads to other parts of Europe. On 8 June 1772, Alexander Fordyce, partner in British banking house James, Neale, Down and Fordyce lost huge sum thereby shorting stock of East India Company. Fordyce, on 8 June 1772 fled to France for avoiding repayment of debt. This news quickly spread and resulted in banking panic in England. More than 20 banks become bankrupt and stopped payments to creditors and depositors. The crisis soon spread to Netherland, Scotland, British American colonies and parts of Europe. 

Financial crisis of 2007-2008

It is also termed as Global financial crisis and was the worst economic crisis around the globe. This financial crisis was most serious crisis after 1930 Depression which collapses the financial market. It initiated in 2007 due to collapse of subprime mortgage market in U.S. and then expanded into international banking crisis with failure of Lehman Brothers investment bank in September 2008. Huge bailouts of financial institutions and other measures were employed to limit the spread of crisis. The crisis led to the global economic downturn causing global recession and it almost took decades for things become normal.

Impact of Financial Crisis

Deregulation of financial sector

Financial crisis adversely affect functioning of financial institutions of nation. Banks during time of crisis goes bankrupt and are not able to do payment to depositors and creditors.

Loss of employment opportunities

Industry and trade are hit badly due to emergence of financial crisis in an economy. The crisis brings a complete halt to business operations. There is shortage of funds due to which business are not able to carry on their activities. As a result of this, huge number of peoples lost their job during the time of crisis. 

Decline in demand of imports

The nation facing financial crisis sees a great decline in value of its imports. People are short of funds due to which they tend to limit their demand. Business also imports fewer commodities as they are short of funds which tend to bring down the demand of import for nation. 

Balance of payment imbalance

Financial crisis brings balance of payment of a country to an unfavorable position. It shows imbalance in accounts as countries are not able to pay off their debts. Government revenue falls steeply at this point of time as a result of which it is not able to meet its expenditure and pay off its debts.

Reduce investments

Level of investment falls sharply as financial crisis emerges in an economy. Investor’s losses confidence in market and tries to liquidate their holdings in panic. Due to frequent withdrawal of amount at the same time by investors, various financial institutions and stock market of a country collapse.