1. IRL 6230: INTERNATIONAL FINANCIAL
MECHANISMS
Financial Crises:
Causes and Consequences

2. Session Objectives
By the end of this session, students should be able to:
Define financial crisis and differentiate between systemic and nonsystemic crises.
Describe a generic asset bubble.
Define leverage and explain its role in asset bubble formation.
Explain why bubbles burst, causing financial panics.
Define and explain the importance of lender of last resort.
Define and explain the importance of bailouts.
Narrate the causes and consequences of the financial crisis that began in 2007.

3. What is a financial crisis?
A financial crisis occurs when one or more financial markets or
intermediaries cease functioning or function only erratically and
inefficiently.
Financial crisis is a situations in which some financial institutions or
assets suddenly lose a large part of their nominal value or simply it’s
value drops rapidly .
A disturbance to financial markets, associated typically with falling
asset prices and insolvency amongst debtors and intermediaries, which
ramifies through the financial system, disrupting the market’s capacity
to allocate capital

4. What is a financial crisis? Cont.
A nonsystemic crisis involves only one or a few markets or sectors, like the
Savings and Loan Crisis. A systemic crisis involves all, or almost all, of the
financial system to some extent, as during the Great Depression and the crisis
of 2008.
Financial crises are neither new nor unusual. Thousands of crises, including
the infamous Tulip Mania and South Sea Company episodes, have rocked
financial systems throughout the world in the past five hundred years.
Two such crises, in 1764–1768 and 1773, helped lead to the American
Revolution.Tim Arango, “The Housing-Bubble and the American
Revolution,” New York Times (29 November 2008),
WK5. www.nytimes.com/2008/11/30/weekinreview/30arango
.html?_r=2&pagewanted=1&ref=weekinreview

5. Financial Crises in Developed / Emerging Countries
In recent years heavily disruptive financial crises have dominated the
scene of global finance and put into question the benefits from
financial globalization.
Financial crises have become more frequent and severe in both
developed markets (DM) and emerging markets (EM)
Recent developed markets crises
 US housing and sub-prime crisis in 2006-2008
 Global Financial Crisis (GFC) of 2008-2009

6. Financial Crises in Developed / Emerging Countries
Sovereign debt crises and economic crisis in the Eurozone (2010- 2013):
 Greece, Ireland, Portugal, Spain, Italy, Cyprus, Slovenia. + continuing Grexit
Risk.
(Brexit: regarded by most as a shock rather than a crisis)
Recent emerging market crises:
 Mexico (1994), East Asia (1997-98), Russia (1998), Turkey and Argentina
(2001)
 China’s 2015-16 financial market turmoil
 Turkey 2017-17

8. What are the key causes of financial crises?
Financial market failures
1.Irrational exuberance among agents (Shiller)
2.Increased complexity arising from financial
innovation
3.Minsky hypothesis – stability breeds instability

9. What are the key causes of financial crises? Cont.
Policy failures
1. Unintended consequences of financial deregulation
2. Banks too big to fail? Risky behaviour due to moral hazard?
3. Interest rates too low for too long (e.g. USA, EZ 2002-2007)
4. Large models of the economy which assume agents (businesses and consumers) always
behave rationally 5. Failures of ratings agencies in pricing risk accurately
Structural changes in the global economy
1. Economic imbalances including global savings glut and low /zero real interest rates
2. 2. Media and modern communications – immediate feedback

10. Or The End of Economic Theory?
Economists cannot agree on
what caused the crisis
What are the short, medium and long term effects
Who is to blame
How long it will last
Solutions
When the next crisis will happen
2007–2012 financial crisis

11. The 2007–2012 financial crisis, also known as the Global Financial
Crisis and 2008 financial crisis.
It resulted in the threat of total collapse from large financial institutions,
the bailout of banks by national governments, and downturns in stock
markets around the world.
In many areas, the housing market also suffered, resulting
in evictions, foreclosures and prolonged unemployment.
The crisis played a significant role in the failure of key businesses,
declines in consumer wealth estimated in trillions of US dollars, and a
downturn in economic activity leading to the 2008–2012 global
recession and thus contributing to the European sovereign-debt crisis.
Global Financial Crisis cont.

12. Possible causes
1. Loose monetary policy – low interest rates
2. Financial deregulation
3. New, complex, innovative financial products
4. US housing boom, sub-prime mortgages
5. Globalisation and the new US-Asia economic model
6. Ratings Agencies

13. Sub Prime Lending :
 Intense competition between mortgage lenders for revenue and
market shares, and the limited supply of creditworthy borrowers,
caused mortgage lenders (i.e. pvt. securitizers) to relax underwriting
standards and proliferate risky mortgages to less creditworthy
borrowers.
 Subprime mortgages remained below 10% of all mortgage
originations until 2004, when they spiked to nearly 20% and remained
there through the 2005–2006 peak of the United States housing
bubble.
Background

14. The immediate cause or trigger of the crisis was the bursting of the United States
housing bubble which peaked in approximately 2005–2006.
The key causes leading to crisis can be listed as :
Housing price increase during 2000-2005, followed by a levelling off and price
decline
The bailout of banks by national government
Increase in the default and foreclosure rates beginning in the second half of 2006
Collapse of major investment banks by 2008
Avoided investigations of GSEs
2008 collapse of stock prices
Causes of Financial Crises

15. The US Federal Reserve – to get
economy out of recession (IT
bubble burst-2000) -- cut
interest rates,
Large Increase in money supply
& Liquidity with banks ----
(cheap credit availability )
Increased housing & real estate
prices (low interest rates, excess
liquidity -- lending for houses
quite attractive)
Banks provided Sub-prime &
Ninja loans…..!!!!.
…….housing prices rising &
rising…………
During Housing & credit
booms… oversupply is there–
- [no. of CDO (MBS) investors
throughout the world greatly
increased…..]
As housing prices declined,
sub-prime households started
defaulting in making their
installments
Banks as well as CDO investors
suffered heavy losses.. ..
Leading to ‘Liquidity Crunch’…
Financial investment
institutions went bankrupt &
lacked liquidity…. Leading to
‘Credit Crunch’
Consumption demand and
investment adversely
affected……..
Hence, The Slowdown in ECONOMIC
GROWTH….!!!!
Why the Economic Crisis.?

16. • Source: US Census Bureau, Harvard University, State of Nation’s Housing Report ,2008
•

17. Growth of Housing Bubble
Between 1997 and 2006, the price of the typical American house
increased by 124%.
During the two decades ending in 2001, the national median home price
ranged from 2.9 to 3.1 times median household income.
This ratio rose to 4.0 in 2004, and 4.6 in 2006.
This housing bubble resulted in many homeowners refinancing their
homes at lower interest rates, or financing consumer spending by taking
out second mortgages secured by the price appreciation.

19. Easy Credit Conditions
Lower interest rates encouraged borrowing. From 2000 to 2003,
the Federal Reserve lowered the federal funds rate target from 6.5% to
1.0%.
This was done to soften the effects of the collapse of the dot-com
bubble and the September 2001 terrorist attacks, as well as to combat a
perceived risk of deflation.
Additional downward pressure on interest rates was created by
the high and rising U.S. current account deficit, which peaked along
with the housing bubble in 2006.

20. Other Background Reasons
Weak and fraudulent underwriting practices
Predatory lending
Increased debt burden or over-leveraging
 Financial innovation and complexity
 Incorrect pricing of risk
 Boom and collapse of the shadow banking system

21. Financial institutions:
 The first notable event signaling a possible financial crisis, occurred in
the United Kingdom on August 7, 2007 when BNP Paribas, citing "a
complete evaporation of liquidity", blocked withdrawals from three
hedge funds.
 The significance of this event was not immediately recognized but
soon led to a panic as investors and savers attempted to liquidate
assets deposited in highly-leveraged financial institutions.
 The financial institution crisis hit its peak in September and October
2008.
Impact on Financial Market

22. Impact on Financial Market
Several major institutions either
failed, were acquired under
duress, or were subject to
government takeover. These
included Lehman Brothers , Merrill
Lynch , Fannie Mae , Freddie Mac
, Washington Mutual, Wachovia
,Citigroup and American
International Group (AIG).

23. Demise of Top ‘5’ of Wall Street
Mounting subprime
losses; panicked financial
markets and sucked out
liquidity from the market
led to the demise of the
top five investment banks
/ financial intermediaries
of “The Wall Street” .

24. US Stock Market
The US stock market peaked in October 2007, when the Dow
Jones Industrial Average index exceeded 14,000 points.
It then entered a pronounced decline, which accelerated
markedly in October 2008.
By March 2009, the Dow Jones average had reached a trough
of around 6,600. It has since recovered much of the decline,
exceeding 12,000 during most of 2011, and occasionally
reaching 13,000 in 2012.

25. Stock Market Returns
 As of mid-December of 2008, stock
returns were down by 37 percent
since the beginning of the year.
 This is nearly twice the magnitude
of any year since 1950.
 This collapse eroded the wealth
and endangered the retirement
savings of many Americans.
Source: www.standardpoors.com
The Economic Crisis of 2008: Cause and Aftermath S and P 500 Total Return
1
9
5
0
1
9
5
3
1
9
5
6
1
9
5
9
1
9
6
2
1
9
6
5
1
9
6
8
1
9
7
1
1
9
7
4
1
9
7
7
1
9
8
0
1
9
8
3
1
9
8
6
1
9
8
9
1
9
9
2
1
9
9
5
1
9
9
8
2
0
0
1
2
0
0
4
2
0
0
7
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%

26. The Shadow Banking System
 Economist Paul Krugman and U.S. Treasury Secretary Timothy
Geithner explain the credit crisis via the implosion of the shadow banking
system
“ Without the ability to obtain investor funds in exchange for most
types of mortgage-backed securities or asset-backed commercial
paper, investment banks and other entities in the shadow banking
system could not provide funds to mortgage firms and other
corporations.”
 This meant that nearly one-third of the U.S. lending mechanism was frozen
and continued to be frozen into June 2009.

27. Wealth effects
Between June 2007 and November 2008, Americans lost an
estimated average of more than a quarter of their collective
net worth.
By early November 2008, a broad U.S. stock index the S&P
500, was down 45% from its 2007 high.
Housing prices had dropped 20% from their 2006 peak, with
futures markets signaling a 30–35% potential drop.

28. Wealth effects
Total retirement assets, Americans' second-largest household
asset, dropped by 22%, from $10.3 trillion in 2006 to $8 trillion in
mid-2008.
During the same period, savings and investment assets (apart
from retirement savings) lost $1.2 trillion and pension assets lost
$1.3 trillion.
Taken together, these losses total a staggering $8.3 trillion

29. EFFECTS
• Unemployment reaches 10% in USA, 15% in UK, 21% in Spain,
30% Greece
• Iceland collapses. Ireland collapses.
• Greece, Portugal, Spain? Break-up of EURO?
• Bank runs lead to US bailout costing over $ 2 trillion, UK bailout
2 trillion pounds (UK debt now equals 120% GDP)
• World trade falls by 40% in 2008 – so far no real recovery

30. Who was to blame?
The financial crisis was
caused by a culmination of
bad decisions made by
individuals, organisations,
institutions and
governments.
Participant What could they have done differently?
Money Lenders
(High Street Banks)
 Tougher lending criteria (Higher deposits required)
 Been more constrained with lending
Investment Banks  Been more responsible with their attitude towards risk
Regulators  Tougher regulations required.
Bank of England  Campaigned for more action when the housing bubble
began to expand.
 Been quicker to act when the crisis began – pumped
money into the economy sooner.
Government  Given encouragement for greater regulation.
 US Government should have avoided encouraging sub-
prime mortgage lending
Borrowers
(The public)
 Ensured they live within their means – do not spend
what you do not have.
US Lenders and
Investment Banks
 Been more selective about who money was leant to.
Investors  Been more aware of the risks they were taking.
 Been more selective about how they invested their
money.

31. Avoid these policies:
• Monetary contraction
• Trade restrictions
• Tax increases
• Constant changes in policy; this merely creates uncertainty and delays private
sector recovery.
Lessons from great depression 1929-1933 to
avoid any other great depression......!!!

32.  The keys to sound policy are :
• well-defined property rights,
• monetary and price stability,
• open markets,
• low taxes,
• control of government spending,
• neutral treatment of both people and enterprises.
 It should be announced and followed that:
i. The mistakes of the 1930s will not be repeated, including the uncertainty generated by the
frequent policy changes that characterized the New Deal.
ii. In the future, government spending will be controlled and the deficit be reduced.
What Needs to be Done?

33. THANK YOU