Financial crises can begin due to credit and asset price booms and busts or increases in uncertainty. This can lead to banking crises as balance sheets deteriorate and panics ensue as depositors withdraw funds. Debt deflation can then occur as the value of assets falls relative to liabilities. The 2007-2009 crisis was caused by financial innovation enabling subprime lending, agency problems in mortgage markets, and asymmetric information exacerbated by credit rating agencies. The effects included a collapse in the US housing market, deterioration of financial institution balance sheets, a run on the shadow banking system, turmoil in global financial markets, and the failure of major financial firms.

1. Project:
Financial Institutions and Markets
Topic : Financial Crises , Causes and Consequences
 SUBMITTED BY:
 SADIA AMEER (#8134)
 SANA NAZEER (#8120)
 ROHA ABBAS (#8140)
 RABIA KHAN (#8111)
 MUQADDAS JAMIL (#8139)
 BATCH: MBA 38
 SUBMITTED TO: Dr. Hameeda Akhtar

2. why do financial crises occur and why are they so damaging to the
economy?
What is financial crises?
A financial crisis occurs when information flows in financial markets experience a particularly large
disruption, with the result that financial frictions and credit spreads increase sharply and financial
markets stop functioning. Then economic activity will collapse.

3. Stage One: Initiation of Financial Crisis
Financial crises can begin in several ways: credit and asset-price boom and busts or a general increase in
uncertainty caused by failures of major financial institutions.
Financial crises can begin in several ways:
 credit boom and busts
 Asset-Price Boom and bust
 increase in uncertainty

4. Stage Two: Banking Crises
• Deteriorating balance sheets lead financial institutions into insolvency. If severe enough, these
factors can lead to a bank panic.
•Panics occur when depositors are unsure which banks are insolvent, causing all depositors to
withdraw all funds immediately
•As cash balances fall, FIs must sell assets quickly, further deteriorating their balance sheet
•Adverse selection and moral hazard become severe – it takes years for a full recovery
Stage Three: Debt Deflation:
• if a firm in 2015 has assets of $100 million (in 2015 dollars) and $90 million of long-term liabilities,
so that it has $10 million in net worth
• If the price level falls by 10% in 2016, the real value of the liabilities would rise to $99 million in 2015
dollars.
• while the real value of the assets would remain unchanged at $100 million.
• The result would be that real net worth in 2015 dollars would fall from $10 million to $1 million ($100
million minus $99 million).

5. Causes: The 2007–2009
Financial Crisis
We begin our look at the 2007–2009 financial crisis by examining three central factors:
•financial innovation in mortgage markets
•agency problems in mortgage markets
•Asymmetric Information and Credit-Rating Services

6. Financial Innovation in the Mortgage Markets:
Financial innovation in mortgage markets developed along a few lines:
•Less-than-credit worthy borrowers found the ability to purchase homes through subprime lending, a
practice almost nonexistent until the 2000s
•Financial engineering developed new financial products to further enhance and distribute risk from
mortgage lending—aggravates AI
Agency Problems in the Mortgage Markets:
Agency problems in mortgage markets also reached new levels:
• Originate to distribute.
• Principle (investor) agent ( mortgage broker) problem.
• Commercial and investment banks/ratings agencies.
(Weak incentives to asses quality of securities.
Asymmetric Information and Credit-Rating Services:
Finally, the rating agencies made asym. info worse!
•The 2007-2008 subprime mortgage crises the effect of asymmetric information. The product behind
the crises were mortgage- backed securities.
•Bank had extended the mortgage to consumer and than sold them to third parties.They were profiting
from asymmetric information.

7. Effects/Consequences of the 2007–2009 Financial Crisis
Many suffered as a result of the 2007–2009 financial crisis. We will look at five areas:
•U.S. residential housing
•FIs balance sheets
•The “shadow” banking system
•Global financial markets
•The failure of major financial firms

8. U.S. Residential Housing
• In 2007 the U.S subprime mortgage industry collapsed due to higher than expected home
foreclosure rates.
• The housing boom was lauded by economics & politicians.
Was the Fed to Blame for the Housing Price Bubble?
 Some argue that low interest rates from 2003 to 2006 fueled the housing bubble.
 In early 2009, Mr. Bernanke rebutted this argument. He argued rates were appropriate.
 He also pointed to new mortgage products, relaxed lending standards, and capital inflows as more
likely causes.
Deterioration of Financial Institutions’ Balance Sheets:
Lending standards also allowed for near 100% financing, so owners had little to lose by defaulting
when the housing bubble burst.

9. Run on the Shadow Banking System:
• The shadow banking system also experienced a run. These are the hedge funds, investment
banks, and other liquidity providers in our financial system. When the short-term debt markets
seized, so did the availability of credit to this system. This lead to further “fire” sales of assets to
meet higher credit standards.
• Both consumption and real investment fell, causing a sharp contraction in the economy.
Global Financial Markets:
• Europe was actually first to raise the alarm in the crisis. With the downgrade of $10 billion in
mortgage related products, short term money markets froze, and in August 2007, a French
investment house suspended redemption of some of its money market funds.
• Banks and firms began to horde cash.
Failure of High-Profile Firms:
• The end of credit lead to several bank failure.
• Northern Rock was one of the first, relying on short-term credits markets for funding. Others soon
followed.
• By most standards, Europe experienced a more severe downturn that the U.S.