Financial crises and systemic risk

Financial crises can disrupt entire economies, often following periods of strong growth and leading to prolonged downturns. These events highlight the interconnected nature of financial systems, where issues in one area can spread widely.

Types of financial crises

• Asset price collapses - Sudden drops in asset values, such as shares or property prices
• Sovereign debt crises - Governments failing to repay loans

Financial crises frequently occur after times of economic boom, driven by factors like low borrowing costs, easy access to loans, over-optimism, and high-risk investments. Recovery from recessions linked to financial crises tends to be slower than from typical economic slumps.

The nature of systemic risk

Systemic risk refers to the danger that a problem in one part of the financial system, such as a single institution, could trigger a collapse across the entire sector or even the global economy. For instance, difficulties in one nation's banks can rapidly affect others internationally, turning a local issue into a widespread crisis.

How banks contribute to market bubbles

Speculation involves purchasing assets at low prices with the aim of selling them later at higher values to generate profits, though it carries risks if prices decline. Banks can fuel these activities by providing loans too readily, which may inflate asset values beyond their real worth.

The formation and bursting of market bubbles

How bubbles form and burst:

• Over-optimistic predictions of rising asset prices lead investors to pay inflated amounts, creating a bubble where market values far exceed true asset worth.
• When confidence fades, investors sell off assets quickly to limit losses, causing prices to crash.
• This leaves speculators with significant debts if they borrowed funds, and assets that have lost much of their value.

Banks exacerbate bubbles by extending credit to speculators, enabling larger purchases and further price inflation.

The credit crunch and the 2008 financial crisis

How the 2008 crisis developed:

• A bubble formed in the US property market due to growth in high-risk mortgages for those with weak credit histories, boosting demand and driving up house prices.
• As more investors entered the market, prices rose even higher.
• The bubble collapsed when borrowers defaulted on unaffordable loans, leading to falling property values.
• Banks' capital reserves declined, prompting them to cut back on lending, which created a credit crunch.
• This erosion of trust reduced overall economic activity, lowered total demand, and sparked a severe recession.

Externalities in financial markets

Financial markets produce negative externalities, where actions in the sector impose costs on the wider economy. These arise partly from the critical role of banks and the risks they manage.

Causes of negative externalities

Poor risk handling by financial institutions creates costs that are borne by others outside the sector. For example, during the 2008 crisis, taxpayer funds were used to rescue failing banks, preventing broader collapse.

Impacts of the 2008 financial crisis

• Sharp reductions in national output (GDP)
• Declines in workers' earnings
• Sharp increases in joblessness

The 'too big to fail' problem

Some banks grow so large that their failure poses a systemic threat. If such a bank collapsed, it could spark widespread panic, leading to rushes on deposits at other banks and potentially the downfall of the entire sector. Governments may intervene with rescues, using public money, as seen in the UK where billions were spent to stabilise key institutions.

Asymmetric information leading to adverse selection and moral hazard

Asymmetric information happens when one side in a transaction, such as a lender, has less knowledge than the other, like a borrower, about key details. This imbalance can create inefficiencies and risks in financial dealings.

Adverse selection in financial markets

Adverse selection arises when sellers attract the riskiest buyers without realising it, leading to unintended high-risk exposure.

Example in insurance markets:

• Insurance companies set premiums based on expected customer profiles.
• Healthy individuals may find premiums too costly and opt out, leaving only those with higher health risks, who are more expensive to cover.
• This skews the customer base towards unprofitable groups, potentially causing financial losses or business failure.
• Raising premiums worsens the issue, as only the highest-risk individuals remain willing to pay.

Moral hazard in financial markets

Moral hazard occurs when parties take greater risks knowing others will bear the costs if things fail.

Examples of moral hazard:

• Banks might issue high-risk loans for bigger profits, expecting government bailouts if defaults mount.
• This encourages reckless behaviour, as the full consequences are shifted to taxpayers or the economy.

Market rigging and its effects

Market rigging involves collusion among financial traders or workers to manipulate markets for personal or firm gains, distorting normal operations and causing failure.

How market rigging occurs

Traders might artificially boost apparent demand for investments, inflating prices unnaturally. This prevents markets from functioning based on true supply and demand.

Consequences and regulation of market rigging

Laws prohibit market rigging, with penalties aimed at deterrence. However, weak enforcement or mild punishments can fail to prevent it. In recent cases, banks have faced fines worth billions for rigging currency markets, where they coordinated to influence exchange rates unfairly.