Lecture 1
Financial Crises and their Causes
Professor Roman Matousek
Kent Business School
Kent University
Anhui University of Finance &Economics
Bengbu
12-14 May 2014
1
Learning Objectives
• To compare and contrast different types of
financial crises.
• To critically evaluate potential causes of
financial crises.
• To apply this knowledge into the current
economic environment.
2
Introduction: Financial crises &
Terminology
Definition
• A full-scale financial crisis is triggered by a sharp fall in
the prices of a large set of assets that banks and other
financial institutions own, or that make up their
borrowers' financial reserves.
• In the 19th and early 20th centuries, many financial crises
were associated with banking panics, and many
recessions coincided with these panics.
• Other situations that are often called financial crises
include stock market crashes and the bursting of other
financial bubbles, currency crises, and sovereign defaults
3
Con’t
• Financial Crises can have domestic or external origins, and
stem from private or public sectors.
• They come in different shapes and sizes, evolve over time into
different forms, and can rapidly spread across borders.
• They often require immediate and comprehensive policy
responses.
• They call for major changes in financial sector and fiscal
policies, and can necessitate global coordination of policies.
(like in the case of current Global Financial Crisis – GFC)
44
Mishkin’s (2001)definition of a financial crisis:
• A financial crisis is a disruption to financial markets in which
adverse selection and moral hazard problems become much
worse, so that financial markets are unable to efficiently
channel funds to those who have the most productive
investment opportunities.
55
Types of Financial Crises
•
•
•
•
Currency crises.
Sudden stops (in capital flows).
Debt crises.
Banking crises.
You can have different classifications
• Currency Crises
• Banking Crises
• International crises
66
Average number of financial crises
over decades
77
88
How to Explain Financial Crises and
their Forms
Financial crises have common elements, they do come in many forms.
• A financial crisis is often associated with one or more of the
following phenomena:
i) substantial changes in credit volume and asset prices;
ii) severe disruptions in financial intermediation and the supply of
external financing to various actors in the economy;
iii) large scale balance sheet problems (of firms, households,
financial intermediaries and sovereigns);
iv) large scale government support (in the form of liquidity support
and recapitalization).
• Thus, financial crises are typically multidimensional events and
can be hard to characterize using a single indicator.
99
Con’t
Factors driving crises:
i) Fundamental factors—macroeconomic imbalances &
internal or external shocks—are well defined and
observed.
But no rigorous answers as exact causes of crises.
ii) “Irrational” factors – like runs on banks, contagion and
spillovers among financial markets, limits to arbitrage
during times of stress, emergence of asset busts, credit
crunches, and firesales, and other aspects related to
financial turmoil.
The idea of “animal spirits” an attempt to explain crises.
10 10
What happens around financial crises
• Asset Price Booms and Busts
• Credit Booms and Busts
• And what’s the impact of Asset Price and Credit Busts?
11 11
Asset Price Booms and Busts
• Sharp increases in asset prices, sometimes called bubbles,
and often followed by crashes have been around for
centuries.
• Asset prices sometimes seem to deviate from what
fundamentals would suggest and exhibit patterns different
than predictions of standard models with perfect financial
markets.
• A bubble, an extreme form of such deviation, can be
defined as “the part of a grossly upward asset price
movement that is unexplainable based on fundamentals” .
• Patterns of exuberant increases in asset prices, often
followed by crashes.
12 12
Con’t
• Some asset price bubbles and crashes are well known.
Such historical cases include:
• The Dutch Tulip Mania from 1634 to 1637, the French
Mississippi Bubble in 1719-20, and the South Sea Bubble in
the United Kingdom in 1720.
• During some of these periods, certain asset prices increased
very rapidly in a short period of time, followed by sharp
corrections. These cases are extreme, but not unique.
• In the recent financial crisis, for example, house prices in a
number of countries have followed this inverse U-shape
pattern.
13 13
14 14
15 15
16
17
18 18
19 19
How to Explain Asset Price Bubbles?
• Individual rational behaviour can lead to collective
mispricing, which in turn can result in bubbles.
These explanations consider asset price bubbles as
agents’ “justified” expectations about future returns.
Under rational expectations, the asset price does not
need to equal its fundamental value, leading to
“rational” bubbles.
Thus, observed prices, while exhibiting extremely large
fluctuations, are not necessarily excessive or
irrational. For example, to explain the internet
“bubble” of the late 1990s.
20 20
Con’t
• Micro distortions and macro factors can lead to
bubbles as well.
Fund managers who are rewarded on the upside more
than on the downside bias their portfolios towards
risky assets, which may trigger a bubble.
Other microeconomic factors (e.g., interest rate
deductibility for household mortgages and corporate
debt) can add to this, possibly leading to bubbles.
21 21
Con’t
• Investors’ behaviour can also drive asset prices away
from fundamentals, at least temporarily.
Mechanisms, such as herding among financial market
players, informational cascades, and market
sentiment, can affect asset prices.
The phenomenon of contagion – spillovers beyond
what “fundamentals” suggest – may have similar
roots. Empirical work confirms some of these
channels.
22 22
Con’t
• Busts following bubbles can be triggered by small shocks.
Asset prices may experience small declines, whether due to
changes in fundamental values or sentiment.
• Changes in international financial and economic conditions,
for example, may drive prices down.
• A drop in prices can trigger a fire sale, as financial institutions
experiencing a decline in asset values struggle to attract shortterm financing. Such “sudden stops” can lead to a cascade of
forced sales and liquidations of assets, and further declines in
prices, with consequences for the real economy.
• Relationships among financial intermediaries are multiple
and complex. Information asymmetries are prevalent among
intermediaries and in financial markets. These problems can
23
easily lead to financial turmoil.
23
Credit Booms and Busts
• A rapid increase in credit is another common thread
running through the narratives of events prior to
financial crises.
• Leverage buildups and greater risk-taking through rapid
credit expansion, in concert with increases in asset
prices, often precede
• Both distant past and more recent crises episodes
typically witnessed a period of significant growth in
credit (and external financing), followed by busts in credit
markets along with sharp corrections in asset prices.
24 24
25 25
Con’t
• The patterns before the East Asian financial crisis in
the late-1990s resembled those of the earlier ones in
Nordic countries
• Banking systems collapsed following periods of rapid
credit growth related to investment in real estate.
• The experience of the United States in the late 1920s
and early 1930s exhibits some features similar to the
run-up to the recent global financial crisis with,
beside rapid growth in asset prices and land
speculation, a sharp increase in (household)
leverage.
26 26
27 27
28 28
Conclusion
• Asset Price and Credit Boom and Busts are quite complex.
• There is still not convincing theory that would help to explain
these movements.
• In fact to predict Financial crises is hard and economists are
unable to do it.
• During a briefing by academics at the London School of
Economics on the turmoil on the international markets the
Queen asked: "Why did nobody notice it?“
29 29