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INSTITUTE OF ACCOUNTANCY ARUSHA

BEF II & BFB II (2023/2024)

FINANCIAL MARKETS AND INSTITUTIONS (FMI)

TOPIC: FINANCIAL MARKET FAILURE OR FINANCIAL CRISIS

An overview of financial crisis

A financial crisis is a situation in which the financial system of a country or region experiences
a sudden and severe disruption, leading to a significant economic downturn. The root cause of
a financial crisis can vary, but they are typically characterized by a sudden loss of confidence in
the financial system, which can cause a run-on banks and other financial institutions.

During a financial crisis, financial institutions may become insolvent, meaning they do not have
enough assets to cover their liabilities, leading to a wave of bankruptcies and a contraction of
credit. This can cause a ripple effect throughout the economy, as businesses struggle to access the
capital they need to grow and expand, leading to job losses and a slowdown in economic growth.

There have been many financial crises throughout history, and they have varied in scope and
severity. Some of the most significant financial crises in recent memory include the Great
Depression of the 1930s, the Asian Financial Crisis of 1997, the Global Financial Crisis of
2008-2009, and the Eurozone Crisis of 2010-2012.

Governments and central banks often respond to financial crises by implementing various policy
measures aimed at stabilizing the financial system and mitigating the economic damage. These
measures can include bailouts of failing financial institutions, injection of liquidity into the system,
and regulatory reforms to prevent similar crises from happening in the future.
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Dynamics of financial crises

Financial crises in advanced economies have progressed in two stages.

Stage one: Initial phase

Financial crises can begin in several ways: credit and asset-price booms and busts or a general
increase in uncertainty caused by failures of major financial institutions.

a) Credit boom and bust

A credit boom and bust is a cyclical economic phenomenon in which the availability of credit
(the ability to borrow money) increases rapidly, leading to a surge in economic activity and
asset prices. This surge in economic activity leads to an increase in demand for goods and services,
which, in turn, can lead to inflation. At some point, however, the credit bubble bursts, and the
market experiences a sudden contraction, often leading to a financial crisis.

During a credit boom, lenders become more willing to lend, and borrowers become more willing
to take on debt. This leads to an increase in borrowing and lending, which, in turn, leads to an
increase in spending and investment. This cycle can lead to the expansion of credit and the
creation of new financial products.

As the credit boom progresses, asset prices, such as stocks, real estate, and commodities, can
experience a rapid increase in value. This increase in asset prices can create a self-reinforcing cycle
of borrowing, lending, and investment, as borrowers use the value of their assets to borrow more
money and invest in new ventures.

However, this cycle of expansion can become unsustainable, and eventually, the market
experiences a sudden contraction. This contraction can be triggered by a variety of factors, such
as a rise in interest rates or a decline in asset prices. As lenders become less willing to lend,
borrowers may struggle to repay their debts, leading to a wave of defaults and bankruptcies.

This sudden contraction can lead to a financial crisis, as investors and creditors scramble to protect
their investments. In extreme cases, governments may intervene to prevent a systemic collapse of
the financial system. Overall, while credit booms can be beneficial for the economy in the short
term, they can also create significant risks in the long term. Understanding the causes and effects
of credit booms and busts is essential for policymakers, investors, and the general public alike.
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b) Asset-Price Boom and Bust

An asset-price boom and bust refers to a phenomenon where the prices of certain assets, such
as stocks, bonds, or real estate, rise rapidly in value, only to suddenly collapse. This cycle can
lead to significant economic and financial instability.

During an asset-price boom, investors become increasingly optimistic about the future, leading
them to bid up the prices of certain assets. As the value of these assets increases, other investors
may begin to follow suit, leading to a self-reinforcing cycle of price increases. This cycle can be
driven by a variety of factors, such as strong economic growth, low-interest rates, or innovations
in the financial sector.

However, as the asset prices continue to rise, they can become detached from underlying economic
fundamentals, such as earnings or rental income. This detachment can create a bubble in asset
prices, where prices are driven up by speculation rather than underlying value.

At some point, the bubble will burst, often triggered by a sudden shock to the economy or a shift
in investor sentiment. As investors begin to sell their assets, prices can quickly decline, leading
to a sharp contraction in the market. This contraction can cause significant economic and
financial damage, including job losses, bankruptcies, and a decline in consumer and business
confidence.

In some cases, asset-price booms and busts can also be amplified by financial leverage, where
investors borrow money to invest in assets. As asset prices decline, investors may be forced to sell
their assets to meet their debt obligations, further depressing prices.

Overall, asset-price booms and busts can create significant risks for the economy and financial
system. Understanding the causes and effects of these cycles is essential for policymakers,
investors, and the general public alike.
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Stage two: Banking crisis

A banking crisis refers to a situation where a significant number of banks or financial

institutions are unable to meet their obligations, leading to widespread panic and instability
in the financial system. A banking crisis can have severe economic consequences, including a
contraction in lending, a decline in economic growth, and a sharp increase in unemployment.

Banking crises can have many causes, including poor lending practices, excessive risk-taking,
and inadequate regulation. For example, during a credit boom, banks may become overly
optimistic about borrowers' ability to repay their loans, leading to a surge in lending. If borrowers
are unable to repay their debts, banks may be forced to write off significant losses, leading to a
decline in their financial health.

A banking crisis can also be triggered by a sudden loss of confidence in the banking system.
This loss of confidence can be caused by a variety of factors, such as a decline in asset prices or a
sudden increase in interest rates. As customers withdraw their deposits and investors sell their
shares, banks can become insolvent, leading to a wave of bank failures.

In extreme cases, a banking crisis can lead to a systemic collapse of the financial system. To
prevent this outcome, governments and central banks may intervene, providing liquidity to
banks, guaranteeing deposits, or recapitalizing banks with public funds.

Overall, banking crises can have significant economic and social consequences, including a
decline in trust in financial institutions, a contraction in economic activity, and a rise in income
inequality. As such, preventing and managing banking crises is an essential part of macroeconomic
policymaking.
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Financial crises can occur for a variety of reasons, including:

Excessive risk-taking and leverage: Financial institutions may take on too much risk and
leverage, leading to a fragile financial system.

Asset-price bubbles: Rapid increases in the prices of certain assets, such as stocks, real estate, or
commodities, can create a self-reinforcing cycle of borrowing, lending, and investment. When the
bubble bursts, it can lead to a sudden contraction in the market.

Poor regulation: Inadequate or ineffective regulation can create a permissive environment for
excessive risk-taking and fraud.

Global imbalances: large trade imbalances, such as those between the United States and China,
can create financial imbalances and volatility.

Macroeconomic shocks: Sudden shocks to the economy, such as a recession, geopolitical crisis,
or natural disaster, can lead to a decline in asset prices and economic activity.

The effects of financial crises on an economy can be severe, including:

Decline in economic growth: Financial crises can lead to a contraction in lending, investment,
and economic activity, leading to a decline in economic growth.

Increase in unemployment: As businesses struggle to access credit and customers reduce

spending, unemployment can rise, leading to social and economic hardships.

Increase in income inequality: Financial crises can disproportionately affect lower-income

households, leading to an increase in income inequality.

Loss of confidence in financial institutions: Financial crises can lead to a decline in trust in
financial institutions, which can have long-lasting effects on the financial system.

Fiscal and monetary policy responses: Governments and central banks may intervene during a
financial crisis, using fiscal and monetary policies to stabilize the economy. These interventions
can lead to long-term consequences, such as inflation, debt accumulation, and moral hazard.

Generally, financial crises can have significant and long-lasting effects on the economy and
society, making them a critical area of concern for policymakers and the general public alike.
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CASES

You can read about the global financial crisis of 2007–2009 on your own to familiarize with the
crisis. Literature about the crisis is vastly available in the internet and in any recent Finance
textbooks

Class activity

1. How does the concept of asymmetric information help to define a financial crisis?

2. Describe the situation where banks were reluctant to lend to the public, which caused the

economy to deteriorate.

3. Discuss if True, false, or uncertain: Deposit insurance always and everywhere prevents

financial crises.

4. Define “financial frictions” in your own terms and explain why an increase in financial

frictions is a key element in financial crises.

5. “Bank bailouts built the momentum of the global financial crisis.” Discuss.