Financial Crisis with Examples

1. Financial Crisis
GROUP 11

2. What is a Financial Crisis???
 A financial crisis is a situation in which the value of financial
institutions or assets drops rapidly
 A situation in which the supply of money is outpaced by the demand
for money. This means that liquidity is quickly evaporated because
available money is withdrawn from banks, forcing banks either to sell
other investments to make up for the shortfall or to collapse
 A financial crisis is often associated with a panic or a run on the
banks, in which investors sell off assets or withdraw money
from savings accounts with the expectation that the value of those
assets will drop if they remain at a financial institution.

3. When does a Financial Crisis occur???
 A particularly large disruption to information flow occurs in
financial markets
 Financial frictions and credit spreads increase sharply
 Financial markets become incapable of channeling funds to
households and firms with productive investment
opportunities
 A sharp contraction in economic activity

4. Dynamics of Financial Crisis in
Advanced Economies
Stage 1: Initiation of Financial crisis
Deterioration in
Financial
Institutions’
Balance Sheets
Asset-Price
Decline
Increase in
Uncertainty
Adverse Selection and Moral Hazard
Problems Worsen and Lending Contracts
Economic Activity Declines

5. Stage 2:
Banking
Crisis
Banking Crisis
Adverse Selection and
Moral Hazard
Problems Worsen and
Lending Contracts
Economic Activity
Declines

6. Stage 3: Debt
Deflation
Unanticipated Decline
in Price Level
01
Adverse Selection and
Moral Hazard
Problems Worsen and
Lending Contracts
02
Economic Activity
Declines
03

7. Case 1: The
Great
Depression
Stock Market Crash
• In 1928 and 1929, prices doubled
in US Stock market
• Tightening of monetary policy to
raise interest rates by Federal
Reserve Officials
• Stock market crashed in Oct 1929

8. Case 1: The
Great
Depression
Bank Panics
• Mid 1930, stocks recovered almost half of their
losses and credit markets stabilized
• Severe droughts in Midwest led to decrease in
Agricultural production, resulting in defaults on
farm mortgages
• Banks in these regions had substantial
withdrawals causing full fledged panic in Nov
and Dec 1930
• President Franklin D Roosevelt declared a bank
holiday, a temporary closing of all banks

9. Case 1: The
Great
Depression
Continuing Decline in Stock Prices
• Stock prices kept falling and declined to 10% of their value
• Economic contraction worsened adverse selection and moral hazard
problems in financial markets
• Financial markets struggled to channel funds to borrower-spenders
with productive investment opportunities
• Lenders began charging businesses much higher interest rates to
protect themselves from credit losses

10. Case 1: The
Great
Depression
• 25% decline in the price level
• Huge decline in prices triggered debt deflation in which
net worth fell
• Unemployment rose to 25% of the labor force
Debt Deflation
• Bank panics spread to the rest of the world
• Contraction of US economy sharply decreased the
demand for foreign goods
• Worldwide depression caused great hardship,
unemployment rose, leading to rise of fascism and
World War II
International Dimensions

11. Case 2: The
Global
Financial
Crisis
Causes
• Financial Innovation in
Mortgage Markets
• Agency Problems in
Mortgage Markets
• Asymmetric Information and
Credit-Rating Services

12. Case 2: The
Global
Financial
Crisis
• Residential Housing Prices: Boom
and Bust
• Deterioration of Financial Institutions’
Balance Sheets
• Run on the Shadow Banking System
• Global Financial Markets declined
• Failure of High-Profile Firms
Effects

13. India: Lessons
from the
Financial
Crisis
 Macroeconomic stability alone is not
sufficient
 Financial stability necessitates greater
coordination with fiscal authorities
 Need to layout policy coordination
framework
 Need to insulate financial sector
 Fiscal consolidation for independent
conduct of monetary policy
 Fiscal-monetary coordination
 Strengthening the Reserve bank balance
sheet