T7 Causes of Financial Crises

Question 1

A financial crises occurs when

Answer 1

there is a large disruption to information flow in FM with the result financial fractions increase sharply & financial markets stop functioning

Question 2

Stage 1 of a financial crises

Answer 2

initiation of financial crisis - usually begins in the following ways:
Credit Boom & Bust - mismanagement of financial innovation leads to asset price boom & bust
Asset price boom & bust - busts often cause a decline in value of financial institutions assets
Increase in uncertainty - caused by failure of institutions: just after a recession or following a stock market crash. Reduced information during such periods

Question 3

Stage 2 of a financial crises

Answer 3

Banking crisis - deteriorating balance sheet & tougher business conditions lead to insolvency as net worth becomes negative
Contagion from asymmetric information. Fear for deposit safety, not knowing the quality of banks loan portfolios. Panic withdrawals to the point of bank failure
Uncertainty can lead to bank runs. Massive asset sell off to raise funds causing price declines to point of insolvency
Fewer banks operating = limited info about creditworthiness of borrowers - spenders. Increasingly severe adverse selection & moral hazard problems deepen the crisis.

Question 4

Stage 3 of a financial crisis

Answer 4

Debt inflation - Substantial unanticipated decline in the price level leads to a further deterioration in firms’ net worth because of the increased burden of indebtedness. Many debt contracts have fixed IR and long maturity. This means unanticipated decline in price level raises the value of borrowing firms liabilities in real terms without raising real value of borrowing firms assets. Increased pressure on borrowers ability to repay loans.