What happens in financial crises

Question 1

Asset-price bubbles

Answer 1

the prices of a bank’s assets (such as houses) usually keep going up every year

this leads to people buying the assets just so that they can sell them again for a higher price

this is an asset-price bubble

eventually people start to worry about the bubble bursting and try to get rid of their assets by selling them, which causes their price to go down and leads to the bubble actually bursting

financial crises begin when the bubble bursts

Question 2

what do falling asset prices mean for banks?

Answer 2

a bank’s capital (or owner’s equity) is its assets minus liabilities

when the value of a bank’s assets go down dramatically, it can have its capital wiped out and therefore become insolvent

Question 3

what happens when some banks become insolvent?

Answer 3

confidence in other banks falls too

because many banks are interdependent and have similar lending practices

this leads people to withdraw their deposits from banks

Question 4

fire sales

Answer 4

insolvent banks become liquidated and so have to sell their assets

solvent banks also have to sell their assets due to shrinking reserves

many banks selling assets at the same time leads to fire sales, which cause dramatic price declines

Question 5

what happens after fire sales?

Answer 5

A credit crunch

this is when it becomes increasingly difficult for people to get a loan

because the banks that are still solvent are reluctant to loan, preferring to keep reserves in cash

this leads to a reduction in AD and therefore a recession

the recession reduces asset values further, along with incomes and profits

which in turn cause more bankruptcies and defaults

this becomes a vicious circle