Explain the different stages of a financial crisis and compare the financial crisis 2007-2010 with that of the Great Depression 1929.
* What is a financial crisis?
There is no precise definition of a financial crisis. It can be explained as a situation where disruption in financial markets leads to adverse selection and moral hazard problems to worsen, thus preventing financial markets to efficiently direct funds. A financial crisis thus results to a sharp contraction in the economy and may leads to collapse of large financial institutions, bank runs and downturn in stock market. In order to better understand how financial crisis arises, Misklin and other economists in the US developed a framework where they have identified three main stages that could lead to a financial crisis.
* Stages of a financial crisis
The first stage is initiation of financial crises .Financial crisis as we have seen from past crises, can arise due to mismanagement of financial liberalization or innovation, asset-price bubble, increase in interest rates, and an increase in uncertainty. With the removal of certain regulations and new advances in technology, financial institutions have usually taken unnecessary risk. They introduce new lines of business that is new types of loans and other financial products which automatically lead to more people taking credit where proper monitoring of the risk involved in lending were lacking. In addition to this, government safety net further worsens the problem of lack of risk management leading to increase in potential moral hazard. Depositors, unaware of their bank risk taking activities, do not feel that they should check how their money is being handled. With time, such activities lead to loan losses and defaults causing a decrease in the value of bank assets which have direct impact on bank net worth. Financial institutions, dealing with these problems, stop lending money. Moreover financial crisis can also be triggered by an asset price bubble. With the credit boom, people buy more assets causing price to rise and exceeding their fundamental prices. This often result in prices to be realigned to their true market value thus leading to a decline in net worth, a possible deterioration of financial institutions balance sheets, and a resulting increase in asymmetric information. An increase in interest rate can also initiate a financial crisis. It is usually individuals and firms engaged in high risk projects who seek credit from financial institutions even if they have to pay high interest rates. An increased demand for credit or a decline in the money supply can lead to market interest rates to rise. This will result in good credit risks borrowers to stop taking money from financial institutions whilst bad credit risks will still borrow. The increase in adverse selection will cause lenders to be more cautious in giving loans possibly leading to a decline in lending. There will be a decrease in investment which will have a direct impact on economic activity of the country thus again worsening asymmetric information problems.
Furthermore, while all the above factors may contribute in an increase in uncertainty, failure of prominent financial and non financial institution, a recession or a stock market crash, makes it more difficult for lenders to screen out good from bad credit risks. There is thus a decline in lending and investment. The uncertainty also results in banking conditions to worsen due to deterioration in their balance sheets. For some financial institutions this situation may be severe enough to lead them to insolvency. Depositors seeing the potential threat that their banks may face begin to remove their funds even if banks are healthy. This bank panic triggers the second stage, known as the banking crisis. Seeing their cash balances fall, financial institutions start selling their assets quickly which deteriorates much further their balance sheets.
The final stage is the...
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