Causes and effects of financial crises and systemic risk

Financial crises can disrupt entire economies, often stemming from periods of economic growth that mask underlying issues.

Types of financial crises

Financial crises can take several forms, each with significant repercussions:

• A rapid decline in asset values, such as property or stock prices.
• A government failing to repay its debts, leading to broader economic instability.

Factors leading to financial crises

Crises frequently follow extended phases of economic stability, characterised by:

• Low borrowing costs.
• Readily available loans.
• High levels of speculative activity.
• Over-optimism among investors and institutions.

These elements can precipitate a downturn, turning prosperity into recession.

Systemic risk

A key issue is systemic risk, where a failure in one area, like a single financial institution, threatens the stability of the entire market or financial system. Such problems can escalate rapidly across borders, transforming localised issues into global threats. Economies typically take longer to rebound from recessions triggered by financial crises compared to standard economic slumps.

How speculation and banks create market bubbles

Speculation involves purchasing assets with the hope of reselling them at a profit, but it carries inherent dangers that can inflate market bubbles. Banks contribute to this by facilitating excessive borrowing, amplifying risks across the financial system.

The nature of speculation

Speculation entails acquiring assets at a low price and aiming to sell them higher, but it involves uncertainty—if values drop, losses occur.

Formation and bursting of market bubbles

Overly optimistic predictions of asset value increases can inflate bubbles:

• Investors may pay inflated prices expecting continued rises, pushing values beyond the assets' real worth.
• When faith in the market wanes, the bubble collapses, prompting mass sales to limit losses.
• This results in sharp price drops, leaving holders with heavy debts and devalued holdings.

Role of banks in bubble creation

Financial institutions exacerbate bubbles by offering loans too freely, encouraging over-investment and inflating asset prices unsustainably.

The credit crunch and the 2008 financial crisis

The 2008 financial crisis exemplifies how speculative bubbles and lending practices can lead to widespread economic distress, including a credit crunch that restricts access to finance.

Events leading to the 2008 crisis

The crisis originated in the US property sector:

• Expansion in high-risk "sub-prime" loans boosted housing demand, driving up prices.
• Escalating values attracted more investors, further inflating the market.

Bursting of the housing bubble

The bubble deflated when borrowers defaulted on unaffordable loans, causing property values to plummet. This eroded banks' capital reserves, prompting them to curtail lending—a situation known as a credit crunch.

Wider economic impacts

The credit shortage eroded trust in the economy, reducing overall spending and demand, which deepened the recession.

Negative externalities in financial markets

Financial markets generate negative externalities because issues in this sector affect the broader economy, imposing costs on society that are not borne by the responsible parties.

Causes of negative externalities

Poor risk handling by financial entities creates externalities. For instance, reckless decisions contributing to the 2008 crisis required taxpayer-funded interventions to stabilise major banks.

Examples of negative externalities from the 2008 crisis

The fallout included:

• Sharp reductions in national output (GDP).
• Widespread salary reductions.
• A surge in job losses.

The "too big to fail" problem

Certain banks grew so large that their failure posed a systemic threat:

• A collapse could spark widespread panic and bank runs, potentially destabilising the entire sector.
• Governments, like in the UK, intervened with massive bailouts to avert catastrophe, despite the enormous public cost.

Asymmetric information, adverse selection, and moral hazard

Asymmetric information arises when parties in a transaction have unequal knowledge, leading to market inefficiencies like adverse selection and moral hazard in financial dealings.

Asymmetric information

This occurs when one side, such as a borrower, possesses more details than the other, like a lender, about repayment likelihood.

Adverse selection

• Adverse selection happens when sellers attract undesirable buyers due to information gaps, causing unintended high risks.
• In insurance, providers set premiums based on expected clients.
• However, healthy individuals may find rates too high and opt out, leaving only high-risk (costly) clients.
• Raising premiums worsens the issue, attracting even riskier customers and threatening the provider's viability.

Moral hazard

• Moral hazard involves increased risk-taking when consequences fall on others.
• Banks might issue high-risk loans for greater returns, knowing government bailouts could cover failures if problems arise.