Why Financial Crises Occur Flashcards
What is a financial crises
Major disruptions in financial markets characterized by a sharp decline in asset prices
When do financial crises occur
When there is an increase in asymmetric information from a disruption in the financial system that percents capital from flowing from lenders to borrowers with productive investments
What are the three stages of a financial crisis
Initiation, banking crisis and debt deflation
How may a financial crisis begin
Financial liberalization, asset price booms or busts, spines in interest rates or increased uncertainty
What is meant by financial liberalization
Eliminations of restrictions in the financial markets or the introduction of new securities
What are the pros and cons of financial liberalization
It can promote financial development in the long run but it also often leads to an unfounded credit boom as the banks are inexperienced with the changes and thus make worse deals. As they realize assets are going bad they cut back on lending which hampers investment and deprives the market of their analysis leading to an economic contraction
What is deleveraging
When banks cut back on lending
What are asset price bubbles
When the price of assets are driven way beyond their fundamental value
How do asset bubbles cause financial crises
When people loose faith in an increased price increase there is no longer an incentive to buy at all which leads to a sharp decline in the assets market value. This in turn leads to a devaluation of collateral which makes banks more hesitant to lend and prevents investment
How do interest rate spikes lead to financial crisis
More expensive for firms to get liquidity so its a contraction in itself but it will also attract those who are desperate disproportionally which puts a lot of worse borrowers in the banks and this makes it more hard for them to function
What is bank panic
When multiple banks fail at once wich triggers a bank run
What is a fire sale
When banks sell assets to cover withdrawals from depositors
What happens in the banking crisis part of a financial crises
When some events triggers a deterioration in the banks balance sheets some may collapse which triggers a bank panic that creates further uncertainty due to information asymmetry untill public or privat authorities clear up the misunderstandings and bails out or liquidates the assets of the struggling banks
What happens in the debt deflation step of a financial crises
The economic downturn from the banking crisis leads to a sharp decline in prices which means interest payments will be proportionally larger increasing the liabilities if firms and slowing down the recovery
What are asset backed securities
A security that is made of a large number of debt contracts with collateral packed into a bundle and than divided into securities
