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Essay: Financial Crises

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  • Subject area(s): Finance essays
  • Reading time: 2 minutes
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  • Published: 9 September 2015*
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  • Words: 584 (approx)
  • Number of pages: 3 (approx)

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According to IMF, financial Crises can defined as a situation in which the value of financial institutions or assets drops rapidly, it may occur following phenomena: substantial changes in credit volume and asset prices; severe disruptions in financial intermediation and the supply of external financing in the economy; large scale balance sheet problems; and large scale government support in the form of liquidity (Claessens & Kose, 2013). There may various causes of financial crises.
Firstly, it may management mistake of financial institutions. Research from R??theli in 2010 found that risk misperception, policy mistakes, and lack of bounded rationality by financial institutions is general causes of financial crises. Better bank risk management as well as possible changes to regulation and monetary policy, it can reduce exposure of crisis. In addition, asset-liability mismatch (e.g. mismatch between the short-term liabilities of bank- its deposits and long-term assets- its loans) by financial institutions also is seen to be major factor contribute to financial crises (Cabral, 2012).
Secondly, credit ratings and securitization is another factor contributes to financial crises. It means securitizes lower credit quality of the investment. According to Hennessey, Holtz-Eakin, D, & and Thomas in 2011, failures in credit rating and securitization will transform bad mortgages become toxic of financial market, likely with subprime-mortgage crisis in 2008. Furthermore, research from Andersen, Hager, Maberg, Naess and Tungland in 2012 has mentions that credit ratings is important because wrongly rated mortgage-backed securities or derivatives some risky bond as safe investments it will make buyers failed to look behind the meaning of credit ratings and influence the stability of financial market.
Thirdly, commonly regulatory failures it will lead financial crisis occurs. Financial institutions have a responsibility to make sure a regulation function properly. However, degree of transparency for borrower becomes a main issue of regulatory. For example, if bank no have strict rule to make loan it will easily let moral hazard problem occur. So, research from Ravi, Kapoor and Schaumburg in 2012 has described that moral hazard as a root cause of the subprime mortgage crisis or global recession in 2008.
Forth, liquidity risk and leverage is considered as essential cause of the crisis. Leverage can defined as borrowing to finance investment, when financial institution or an individual borrows from public in order to invest more, it can potentially earn more from its investment, but also may lose more than what they borrow (Merrouche & Nier, 2010). Therefore, excessive leverage lead to bankruptcy risk of correlated firm or financial institution sharply increases due to serious losses. Commonly, firm or bank will unable to meet common shock from financial market and as consequences, crisis of financial sector will arise. Study from Cabral in 2012 recommends that in order to prevent financial crisis, banks should increase their financial leverage and liquidity structure vulnerability by impose capital and reserve requirements.
Last but not least, financial contagion is frequently cited as a contributor to financial crises. Financial contagion means spread of financial crises from one institution or country to another.
Financial shock and panic of investor is important element of financial contagion occur. If investor lost a confidence and trust in the financial system it may lead to financial crisis. Crisis can start anywhere in the world, and they can spread widely as long as the problems of one country arise via commerce, currencies, investments or derivatives in other countries (F??r??escu, 2012). Asian Financial crisis (spread of the Thai currency crisis in other countries like South Korea and Indonesia) in 1997 is one of the typical examples to show the terrible effect of contagion.

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