Financial Crises, Types, Causes and Prevention - Term Paper Example

?Running Head: FINANCIAL CRISES Financial Crises, types, causes and prevention of the of October 17, Table of Contents Title: Financial Crises, types, causes and prevention 1 Name of the Student: 1 Name of Institution: 1 October 17, 2012 1 1. Introduction 3 2) Types of Financial Crisis 3 3) Causes of Financial Crisis 7 4) Prevent Financial Crisis 9 4) Conclusions 10 References 11 1. Introduction Financial crisis is a term used to identify events and situations where an entity such as a bank, financial institutions, and the stock market will suddenly see a devaluation of their assets. In such a situation, the entity would face liquidity problems, have cash flow problems, and see the net worth decreasing. If it happens to a market or a bank, then there would be panic selling that further brings the prices of stocks down. There would be a run on the banks with a large number of people attempting to withdraw cash. Assets would lose their valuation. Depending on the severity of the crisis, the market would recover in a few days or the ill effects would persist for a few years. A financial crisis is followed by recession and a general slowdown of the market. Financial crisis can even happen to individuals and businesses and such entities cannot pay their bills, they cannot pay their employees and their business would be repossessed. Recession is said to follow financial crisis and when the GDP becomes negative for two quarters, then the nation is said to be in recession (World Bank, 28 June 2012). This paper examines the subject of financial crisis and discuses various types, causes and method of preventing such a crisis. 2) Types of Financial Crisis Financial crisis usually results in a notional and ‘on paper’ wealth of a firm. If the firm has retained its assets and other infrastructure then after the crisis is over, it can regain its previous position in the market. Financial crises usually occur in a free and liberal market economy that is not subject to protection and where market forces are free to act on the economy. As an example, UK, USA and many other nations have a free and open economy hence financial crisis occur in these markets. However, in the former Soviet Russia, nation such as North Korea and even China where the market is regulated, market forces are not allowed to act freely. Types of financial crisis are broadly classified as international and domestic crisis (Cipriani and Guarino, 2008). These again have sub types and these are discussed as below. A) International Financial Crisis International financial crisis occur at two levels and mechanisms. One is where turmoil in the global stock markets causes a global market crash that precipitates a financial crisis. Another type is the currency crisis that can lead to sovereign default. These terms are explained as below. 1) Global Crisis Global crises can begin in one corner of the world and then if the causes and money involved is high, the crisis can spread to other stock exchanges and nations quickly. One of the reasons is due to the inter connectedness of the stock markets and financial markets across the world. Hence, if the London Stock Market Index crashes and it cannot recover, it will cause the Japan Nikkei index and the US based Dow and NYSE index also to crash. This can create a financial crisis when there is no liquidity in the market and funds, loans, cash is not available. As a result, banks cannot clear the payments, customers and depositors cannot withdraw crash and business also cannot pay their vendors and employees. When this cash shortage is long lasting and it affects all the nations, then it becomes a global crisis (Banerjee, 2008). 2) Currencies One of the worst forms of financial crisis is the currency crisis and sovereign default. When a nation that has a fixed exchange rate faces a speculative attack on its currency, then it is forced to devalue the currency. This devaluation is done when the currency appreciates excessively against the global reserve currency, the USD. A currency crisis can lead to balance of payment crisis and this means that the nation is not able to honour its sovereign debt. A nation issues bonds and other instruments to raise money for development and growth expenses. These bonds have a certain maturity value and maturity period after which they must be redeemed. A nation relies on taxes, foreign depository inflows and other means to support its activities. Due to currency crisis, the nation cannot honour its debt and it cannot pay for the bonds when they mature. This has happened with Greece, Iceland, Zimbabwe and other nations (Krugman, 2009). B) Domestic Financial Crisis Domestic crisis occur in some nations and they may be restricted to these nations only. However, financial markets across the world are interlinked and interconnected. This means that when a nation faces a sovereign debt crisis, then its trading partners made of other nations and private firms are unable to get their dues cleared. As a result, the domestic crisis can become a regional crisis or even global crises. The recent Tsunami and earthquake in Japan has forced the nation into deep recession. Its trading partners such as USA and UK are also impacted. However, Japan is a net exporter and hence other nations may not be severely affected by the crisis (Cooper and John, 2008). 1) Banking Crisis Banking crisis or bank runs occur when rumours about an impending crash of a bank begins to start. As a result, depositors and people that have savings accounts rush to withdraw their cash. Even a large bank does not have that much operating cash and it is unable to pay the customers. This in turn creates panic that is more widespread. Some examples are the bank runs of Northern Rock of USA in 2007, the Bear Stearns Bank collapse in 2008 and other such crisis. If the rumours are false, then the bank management arranges for funds to be despatched to all branches and people are allowed to withdraw their funds. Such a move usually instils confidence among the customers (Kindleberger and Aliber, 2005). 2) Mortgage Crisis The mortgage crisis and the US sub prime mortgage crisis is an example of such a crisis and it started the global economic recession of 2007. A citizen of limited means usually takes loans from banks and financial institutions to buy a house. The house is then mortgaged to the bank. Banks usually lend to people who are ‘prime’ and this means that they have the means to pay the instalments. In the case of the US sub prime case, loans were given to ‘sub prime’ people who did not have a steady job and who did not have the means to repay the loans. A few sub prime cases and defaulters could be managed. However, when thousands of such people defaulted, banks that had lent loans faced liquidity problems and they could not raise any more funds. Worse, these banks such as Lehman Brothers, Northern Rock and others had borrowed money from other UK and European banks. The cycle was repeated in other nations also and caused widespread recession and financial crisis (Williams, 2010). 3) Causes of Financial Crisis Financial failures can be caused by a number of reasons. Four reasons are analyse in this paper and these occur frequently. The reasons are leverage, regulatory failures, fraud and recessionary effects. A) Leverage The term leverage refers to the practice of borrowing finds to invest in the stock market. To make profits in the stock market, large sums must be invested since the margins per scrip can be low. When a firm or even an individual uses self-funding then it can happen that the maximum amount lost would be restricted to loss of own funds and the liability is reduced. However, when funds are borrowed from external sources often at high interest rates, any upheavals in the market can mean a wipeout of the investment. This may not seem very sever when borrowing is restricted to a few investors. However, when a large number of borrowers often in thousands borrow funds and the market crashes, huge bankruptcies result. Along with individuals, banks also collapse and since banks borrow from other banks or the central reserve bank, the failure has a domino effect (Brunnermeier, 2009). B) Regulatory Failures The government and the stock exchanges have brought in some regulations that help to prevent frauds and crises in the financial sector. These regulations are not meant to curb free trade or the free market but to prevent fraud and excessive spike in the markets. The regulations are also designed to prevent excessive risk taking, cartelisation, fixing the market through rumours, credit swaps and other such abnormal behaviour. Regulations also prevent and black list rogue traders and firms that perpetrate crises. Regulations such as the Basel II and III Accords are designed to act as checks and balances and to prevent firms from making fraudulent claims while raining IPOs. However, excessive regulations also mean that banks have to increase their cash reserve ratios, this reduces funds available in the market, and it can lead to financial crisis (Kaufman and Scott, 2003). C) Fraud Fraud is one of the reasons that can cause the collapse of some institutions though the financial failure and crisis may be limited to a few depositors, investors and a few firms. Frauds can be made by senior managers in the firm who make false accounting entries or make false representation in the market. Deposits are often lured into the market with promises of high inters rate and Ponzi schemes. Invariably, such firms collapse and the owners of the firm are arrested or they go into hiding. Some examples are Madoff Investments, Bring Banks, Fannie Mae, Freddie Mac, Lehman Brothers, Enron, WorldCom and many others (Kaufman and Scott, 2003). D) Recessionary Effects Financial crisis in many cases produce recessionary effects on the economy if the crisis is very large and if it involves a large number of banks. Recessionary effects also in turn bring in financial failures since funds are not available and liquidity is not available in the market. In such a case, the financial crisis becomes a contagion that spreads from one firm to another and even jump to other countries (Garber, 2001). 4) Prevent Financial Crisis Some methods to prevent financial crisis are suggested in this section. These are broad recommendations that can reduce instances of financial crisis and reduce its negative effects (Kaufman and Scott, 2003). A) Transparency It is argued that bringing transparency into the financial market can help to reduce financial crisis. This means that the mechanism and processes used in the transaction, market trends and indicators and the process used for valuation must become clearer. In this manner, recessionary trends can be quickly spotted (Brunnermeier, 2009). B) Financial Regulations It is better to ‘over’ regulate the market than to have less regulations and risk frauds and market crashes. The stock exchange board of the major stock exchanges already have the power to step in and halt trade when there is a quick and huge drop or increase in the price. This can indicate the formation of a bubble. Regulations can help to identify and stop such events. More than the government intervention, leading and responsible stockbrokers and their association should take up self-regulation and prevent rogue traders from starting a run on the market and for banks (Brunnermeier, 2009). C) Financial Stability Financial stability is difficult to achieve since banks make profits by taking up lending to entities with more risk. However, in their search for profits, these institutions should not take excessive risks and suffer huge losses. The banking regulatory authorities and the bank management should adopt safe methods to maintain stability rather than increase risk with short-term gains (Brunnermeier, 2009). 4) Conclusions The paper has examined the subject of financial risks and discussed various types of crisis, their cause and methods to prevent such crisis. Such crises occur not only due to fraud but also to greed and anticipation for more profits. Availability of credit with lower interest rates makes people more prone to take up higher risks. While some amount of risk is expected, reckless gambling and behaviour can cause a serious shortage of funds and impact the liquidity of banks and the market. Other types of crisis occur due to currency manipulation, global impacts of events, mortgage crisis, leverage and also due to recession. Some amount of careful behaviour and better regulations can help to reduce the risk of financial crisis. References Banerjee. A. (2008). A simple model of herd behavior. Quarterly Journal of Economics, 107(3), pp. 797-817 Brunnermeier. M. (2009). Deciphering the liquidity and credit crunch 2007-2008. Journal of Economic Perspectives, 23 (1), pp. 77-100 Cipriani. M and Guarino. A. (2008). Herd Behavior and Contagion in Financial Markets. The B.E. Journal of Theoretical Economics, 8(1), pp. 1-54 Cooper. R and John. A. (2008). Coordinating coordination failures in Keynesian models. Quarterly Journal of Economics, 107 (3), pp. 441-463 Garber. P. (2001). Famous First Bubbles: The Fundamentals of Early Manias. CA: MIT Press Kaufman. G and Scott. K. (2003). What is systemic risk, and do bank regulators retard or contribute to it?' The Independent Review, 7 (3), pp. 45-49 Kindleberger. C. P. and Aliber. R. (2005). Manias, Panics, and Crashes: A History of Financial Crises, 5th ed. Wiley Publications: London Krugman. P. (2009). A model of balance-of-payments crises. Journal of Money, Credit, and Banking, 11, pp. 311-325 Williams, M. (2010). Uncontrolled Risk: The Lessons of Lehman Brothers and How Systemic Risk Can Still Bring Down the World Financial System. McGraw-Hill: NY World Bank, (28 June, 2012). Financial Crisis: What the World Bank Is Doing. World Bank. Retrieved 17 October 2012 from http://www.worldbank.org/financialcrisis/bankinitiatives.htm Read More