Group Project Report

Financial Crises

Authors – Group 6:
Egle Savickaite (40063785)
Lau Cheuk Wai (53086530)
Monika Andrijauskaitė (4006 4628)
Bao Yi Zhu (40063552)

4th of December
Hong Kong
Introduction
The 2008 financial crisis has affect the whole world. From households to companies to
industries, and even countries were not spared. Many people have lost their jobs, companies
went bankrupt, industries faced major downturn in sales and revenues and countries were,
and still are, struggling with budget deficits. The world was shocked. In order to prevent
future crises like these, one has to understand the concept of financial crises from its
foundation to its effects. This paper is structured in a way that will cover financial crises in all
its aspects by aiming to answer four questions: 1) What are financial crises?; 2) What are the
effects of financial crises on businesses?; 3) What give rise to financial crises?; and lastly 4)
What are the recommendations for the government to prevent future financial crises? By
doing so, this paper aims to provide a thorough understanding of financial crises, and to
provide possible recommendations to prevent such crises in the future.

What are financial crises?

To begin with, it is important to have knowledge on what financial crisis is. Definition in
dictionary suggests that financial crisis is a situation in which the value of financial
institutions or assets drops rapidly. Of course, that creates a significant disturbance to
financial markets. Usually, financial crisis is associated with one or more phenomena which
have negative impact not only on certain businesses but on the global economy in general.
A financial crisis often involves a situation when a panic occurs due to the fact that investors
sell off assets or withdraw money from saving accounts because they expect that keeping
them at a financial institution will lead to the drop of their value (Claessens and Kose, 2013).
In addition, financial crisis can be a result of institutions or assets being overvalued and can
be also stimulated by the behavior of investors. Additionally, according to Claessens and
Kose (2013), there are more reasons why financial crises can occur:
 large scale balance sheet problems (of firms, households, financial intermediaries and
sovereigns);
 serious disruptions in financial intermediation;
 the supply of external financing to various parties in the economy;
 large scale government support when failing business or economy gets financial
assistance to prevent collapse
However, although literature gives many possible causes of financial crisis, usually it remains
very difficult to find and emphasize the consistency and deeper reasons behind all these
factors (Claessens and Kose, 2013). Moreover, studies were conducted on various stages of
the crises including small financial disruptions that are later followed by national or even
global crises. Likewise, once the causes and reasons of the crises are discussed, the long-term
potential consequences for the economy can be given. For instance, 2007-09 Financial Crisis
had long lasting consequences including a significant loss of trust in government institutions
and in public as well as enormous increase in the underemployed and frustrated job seekers
(Luttrell, Atkinson and Rosenblum, 2013). Underemployed people are those who want a job
but can only find part-time work whereas frustrated job seekers are those who become
discouraged and give up looking for work. Other effects of the the financial crisis includes
lower supply of credits, lower consumption and investment in real economy, decreased asset
prices and many others. Therefore, financial crises threaten not only financial markets but the
whole economic environment.

Types of financial crises

As mentioned above, financial crises can be different in terms of forms and duration. There
are two main groups of crises: those classified using quantitative methods and those classified
using qualitative analysis (Claessens and Kose, 2013). Here we would like to revise four
main types of financial crises including:
 Currency crises
 Sudden stops
 Debt crises
 Banking crises
Currency crises

A definition by Burnside et al. (2007) suggests that currency crisis is a situation in which the
exchange rate depreciates substantially during a short period of time. The research by
Claessens and Kose (2013) gives a broader explanation saying that “currency crisis involves
a speculative attack on the currency resulting in a devaluation (or sharp depreciation), or
forcing the authorities to defend the currency by expending large amount of international
reserves, or sharply raising interest rates, or imposing capital controls”. Currency crises
negatively affect the economy because exchange rates are no longer stable. Therefore,
conclusion can be drawn that such crisis causes devaluation of the currency as one unit of the
currency cannot buy as much as it used to.
Sudden stops

Simple definition of a sudden stop suggests it is a sharp reduction in net capital flows into
economy (Claessens and Kose, 2013). Sudden stop can be associated with sudden reversals
of international capital flows, declines in production and consumption and corrections in
asset prices. Foreign investors here play an important role because if they reduce or stop
capital inflows into economy, it is possible that sudden stop will be induced. Another way for
this type of financial crisis to occur is when domestic residents of the country pull their
money out of the economy which then results in capital outflows. In general, sudden stops
like all other kind of financial crisis are unfavorable to the economy.
Debt crises

There are two main types of debt crises: a foreign debt crisis and a domestic public debt
crisis. A foreign debt crisis occurs when a country is not able or not willing to pay back its
foreign debt (Claessens and Kose, 2013). It is known that countries borrow money from
international financial institutions or other sources in order to increase budget on developing
infrastructure, enhancing public services or for many other reasons. However, if a country
cannot meet its financial obligations and is unable to pay the debts due to various
circumstances, a foreign debt crisis might occur.
The second type of debt crises is a domestic public debt crisis. This crisis takes place when “a
country does not honor its domestic fiscal obligations in real terms” (Claessens and Kose,
2013). According to the researchers, domestic public debt crises can be triggered in several
ways. It can be done by defaulting, inflating its currency or by using financial repression.
Banking crises

Banking crisis can be defined as a financial crisis that “affects the activity of banks in how
they manage assets, liabilities and the equity in their possession (Merovci et al., n.d.). This
type of crisis involves large scale bank runs and failures. The concept ‘bank run’ when people
rush to withdraw their savings is caused by the panic and assumptions that the bank will go
bankrupt.

Effects of financial crises

Throughout centuries, the world has been experiencing different kinds of financial crisis.
Each crisis no doubt had an immense effect on the society and economy. In 2008, the
financial crisis, which is also known as the subprime mortgage crisis, demonstrated most of
the phenomena of a financial crisis including a large scale of bank runs, a sharp decline of
assets value and large scale of government bail-out. This crisis is also considered to be the
worst financial crisis since the Great Depression in the 1930s. As such, since this financial
crisis possess a high degree of severity, in the following, the effects of this financial crisis on
different types of businesses will be discussed in depth.
Since the 2000s, with the decrease of the FED fund rate from 6% to 1% and the rising
expectation of real estate appreciation, mortgage borrowings rose. Banks seized this
opportunity and packaged the mortgage loans into CDO (Collateral Debt Obligations) and
sold them to investors, which mainly consisted of investment banks who received mortgage
payments from home owners. Overtime, as the banks wanted to chase after high return and
expand their market, they started lending to some lower quality borrowers which were also
known as the subprime mortgage. Since the financial intermediates were highly leveraged to
buy risk CDOs from subprime borrowers, many were unable to pay the loans thus boosted the
current account deficit and as a result, the credit bubble burst and many investors went
bankrupt and the subprime mortgage crisis broke out.

Effects on the banking business sector

With this financial crisis, one of the major businesses being affected, the banking industry,
was traumatized. Over 400 banks went bankrupt or were acquired. One of the stark examples
is the sudden collapse of Lehman Brothers, a major investment bank. According to the
Economist, an economic newspaper company, its closure took huge taxpayer-financed bail-
outs to shore up the industry and its filling remains the largest bankruptcy filling in U.S
history, with Lehman holding over USD $600 billion in asset. (Mumudi, 2008) As such, we
can see how the banking business sector, particularly Lehman Brothers were affected and
faced bankruptcy because of its leveraging investment in the housing assets.
Not only did many banks face bankruptcy, the banking business as a whole also faced
hardship brought by the financial crisis. According to the Federal Reserve’s Senior Loan
officers Opinion Survey (SLOOS), the financial crisis has severely weakened the U.S
banking industry. The number of bank failures has skyrocketed and it continues to climb.
Bank stocks plummeted and banks tightened their lending terms and standards to
unprecedented levels. (Kwan, 2010) Here, we can see how business owners and managers
had to make management decisions in order to cut costs since the outbreak of the financial
crisis but at the same time to maintain operational productivity. It is also revealed that the
coefficient on the interaction of the change in the capital-to- asset ratio with the initial
capital-to-asset ratio will be negative, so that a change in the capital-to-asset ratio leads to a
larger reduction in loan growth rate or deposit growth rates. (Barajas, Chami, Cosimano,
Hakura, 2010)

Effects on real-estate business

Apart from the banking sector, another business affected by financial crisis is the real estate
business. Since the real estate business is one of the participants or is linked in the CDO,
when the credit bubble burst in which the housing price fell, not only did the business
experience a decline of real estate value, it also made the business much more difficult to
obtain credit as they have taken large losses on their portfolios of mortgage backed securities,
these losses have affected their capital reserves and limited their ability to make loans. (Kim,
Viau, 2014) As a result, the demand for real estate has slowed and prices have fallen. As
such, we can see the 2008 financial crisis made the real estate business more difficult to
operate because of its lowered creditability and the fall of its asset value.
While the banking and real estate business had faced hardship brought by the financial crisis,
general business and small business also experienced downturn and obstacles.

Effects on general business companies

One of the major problems faced by general business, that is, organizations which supplies
goods or services to a variety of buyers, is the lack of cash flow. In light of recession brought
by the crisis, customers are cutting their spending thus makes the inflow of cash into the
business slow down. Since the lack of cash flow, many businesses would turn to lenders to
obtain small business loans. As leaders have implemented stricter guidelines, it is more
difficult for businesses to obtain loans (Lorette, 2010). In this way, businesses would need to
get through the stage of slow cash flow times.
Due to the budget cuts, some business would also need to cut back on their employers.
According to Moira and Herbst, 2009, the average hours per work per week in the U.S
declined to 33, the lowest level since the government began collecting the data in 1964. Not
only did general business companies had a hard time on their finance, their GDP value also
decreased. From the BEA press releases, it is recorded that the output of goods and services
produced by labor and property decreased at an annual rate of approximately 6% in the fourth
quarter of 2008 and the first quarter of 2009. As such, we can see that business companies are
affected by the financial crisis in different ways.

Effects on small business

Not only were general business companies were affected, small business particularly is also
one of the victims of the financial crisis. Small business provides economic opportunities to
diverse groups of people. They are vital to the U.S economy. According to the U.S small
business administration, small businesses account for half of the U.S private-sector
employment and produced 64% of net job growth in the U.S between 1993 and 2008.
However, since the outbreak of financial crisis, small banks which largely rely on banks for
credit faced hardship. From the Senior Loan Officer Opinion Survey of Banking Lending
Practices of the Federal Reserve System, It is found that the lending standards for small-
business loans tightened during the year of 2008 and 2009 as lenders’ tolerances for risk
decreased. The decline in bank lending for small business is much larger than that of larger
firms, with bank lending to small firms declined from $659 billion in June 2008 to $543
billion in June 2011 while the lending of larger firms declined from $2.14 trillion in June
2008 to $1.96 trillion in June 2011. (Cole, 2012) From these figures, we could see that this
decline of bank lending have a direct effect on small business thus in turn would affect the
job market and economic growth as whole.

Summary and Conclusion

Financial crisis, particularly the subprime mortgage crisis in 2008, posed different kinds of
severe adverse effect on different business sectors. From the banking business faced
bankruptcy, had to tighten their lending terms and standards and experienced a reduction on
loan and deposit growth rate, real estate business’s housing price and demand fell and its
increasing difficulty to obtain credit, business companies had to go through a period of lack
of cash flow to small businesses had to bear the burden of the declining bank lending, the
financial crisis brought a chain effect on different businesses as each business sector are more
or less related to each other. As such, we can see that business from different sectors are
closely related and are adversely affected by financial crisis in different ways.
What give rise to financial crises?

This part of the paper will elaborate on theories that explain financial crises. There are three
theories explaining financial crises: 1) banking crises and panics; 2) credit frictions and
market freezes; and 3) currency crises.
A banking crisis and banking panics occur when many banks experience runs at the same
time. A run on the bank can be defined as: a number of customers withdrawing their deposits
from a financial institution at the same time, because they have lost trust in the financial
institution. It is interesting that these runs on the bank never occur simultaneously at different
locations, however, at each location the runs do occur suddenly. A single bank, or a group of
banks at a single location could perhaps honour these withdrawals, if at the same time other
banks were not faced with these withdrawals. But when the banking system cannot honour
these demands for redemption then a suspension occurs. There are several theories on why a
banking panic occurs. The first theory is the random withdrawal theory. In the Diamond and
Dybvig model a banking panic occurs because of self-fulfilling prophecy. If agents think that
other agents think there will be many withdrawals, then agents at the end of the sequential-
service line will suffer losses. Thus, all agents, seeking to avoid losses associated with being
at the end of the line, may suddenly decide to redeem their claims, causing the very event
they imagined. Diamond and Dybvig argued that agents would develop such believes due to
random events like “a random earnings report, a commonly observed run at some other bank,
a negative government forecast, or even sunspots”. The second theory is the asymmetric
information theory. This theory argues that there is asymmetric information between the
banks and the depositors. Bank depositors may receive information leading them to revise
their risk assessment of the banks. However, due to asymmetric information they do not
know which individual banks are most likely to be affected. Since depositors are unable to
distinguish indi- vidual bank risks, they may withdraw a large volume of deposits from all
banks in response to a signal. Banks then suspend convertibility, and a period follows in
which the banks themselves sort out which banks among them are insolvent.

The second theory that gives rise to financial crises is credit frictions and market freezes. In
contrast to the above-mentioned banking panics, this theory emphasizes on the other side of
the balance sheet. Namely: the borrowers. In the credit market firms, entrepreneurs, and
investors borrow from financial institutions in order to finance their investments. When
lending the money, the bank needs to make sure that the agents have a large enough incentive
to preserve the quality of the investment and repay the loan. This means that the agents have
to have a large enough stake in the investment or it has to be able to secure the loan with a
collateral. In other words, the more capital a potential borrower has, the easier it will be to get
a loan. Holstrom and Tirole (1998) argue that a negative shock in the economy can cause
potential lenders to have less capital on average. Hence, restricting the possibilities of them to
get a loan. Leading to an accelerator effect that amplifies the negative shock. There is another
accelerator effect at the side of the financial intermediaries: a decrease of capital of the
financial intermediaries will also result in credit frictions. However, a key feature that is
missing in this model is the role of financial intermediaries. Eggertson and Krugman (2011)
have provided a different angle on the role of credit frictions in the macroeconomy. One of
the causes is asymmetric information. If investors have private information about the quality
of their investments, banks will be reluctant to lend the money, because they are not sure of
the quality of the investment. In extreme situations, when the only motivation for a financial
transaction to happen is based on information, this leads to a market freeze: no transactions
will happen in equilibrium. If there are other gains to transaction between lenders and
borrowers, credit provision may still occur, but then the increase in the magnitude of
asymmetric information, that is, increasing the share of informed or the degree of underlying
uncertainty might reduce the amount of credit provided. Another cause of credit friction and
market freezes is bubbles. A bubble arises when speculators care more about the believes of
other speculators of the fundamental asset than about the asset themselves, resulting in large
deviations of prices from the fundamentals. Abreu and Brunnermeier (2003) stated that
speculators know that a bubble exist, but not when it bursts, hence they will have incentive to
ride on the bubble before it bursts, thus adding more fuel to it. When the bubble bursts, a
sudden drop in price of the assets occurs, leading to major losses for the speculators. When
these assets are used as collateral for the loans, banks will be more reluctant to provide credit.
Resulting in credit frictions and market freezes.
The third theory that addresses financial crises is currency crises. A currency crisis occurs
when there is serious doubt whether a country can maintain its currency at the country’s fixed
exchange rate. This doubt happens when it is not sure whether the country’s central bank has
enough foreign reserve. There are three-generation models of this theory. The first and
second-generation model focus on the government alone. The first-generation model states
that due to the need to monetize government budget deficit, the government will constantly
lose foreign reserves. Hence, the country will not be able to maintain its fixed exchange rate.
This leads to devaluation of the currency and investors will then flee the currency. The
second-generation model is one about self-fulfilling prophecy. Where the expectation of a
collapse of the exchange rate regime leads to the government to abandon this regime. Hence,
investors expect the currency to devaluate; they attack the currency, leading to devaluation of
the currency ultimately.
The third-generation models connect currency crises to models of banking crises and credit
frictions. These models argue that currency crisis can lead to banking crisis when domestic
banks have debts denominated in foreign currency. Another possibility is credit friction of
foreign investments. Decreased foreign investment in the domestic market, leads to less
demand for domestic goods relative to foreign goods, resulting in depreciation of the
currency.
The theories that are mentioned above are all possible causes of financial crises. The theories
are depicted separately, but historical events have shown that one often leads to the other.

Recommendations for government

As argued above, financial crises can be and in most of the cases are very harmful to both the
global economy in general and businesses all other the world no matter how big they are.
Hence, analyst in the economics field are working on research not only how to deal with
financial crises but also what actions should be taken by the government in order to prevent
them in the future. There are many various steps and we are going to describe some of them
in this section.

To begin with, as in most of the cases financial crisis are caused by some kind of failure from
financial intuitions’ side, the government should start their actions by increased supervision
of banks, especially the ones that have the biggest power. The regulators should pay attention
not only to the quality of a bank’s balance sheets (accounting standards and disclosure
requirements) but also on the employed risk-management and its transparency. It should
make sure that banks are employing adequate risk-management and that its monitoring is at a
best quality (Mishkin, F.S., 2000).

Moreover, the government should drop the too-big-to-fail policy. A too-big-to-fail company
is usually a big conglomerate which is operating under special regulations from the
government side and is strongly protected from failure. The shareholders of such kind of
firms are protected by a promised amount of money in case of bankruptcy (Kaufman, G.G.,
2013). According to Mr. Mishkin (2000) the too-big-to-fail rule causes a moral hazard
problem – a case where investor are taking a higher position on a stock just because they
know that they are insured. Limiting or even eliminating the rule would result in increased
awareness from investors’ side which would increase banks’ transparency of the operations in
order to ensure the trust from investors.

In the extreme cases, the government should even consider closing banks that are operating
under critical conditions at the right time. Otherwise, it could be too late and the only thing
that the government can do will be only to bail-out a dying bank. In that case the consumers
and their assets would be saved while the government budget would be harmed a lot and if
there is a time of crisis it could cause various problems such as increasing government debt,
etc. However in order to do that the government is required to hold a sufficient amount of
money – estimated at what level should it be.

To increase functionality of the financial institutions, judicial system and law enforcement
should be improved. Effective actions in this field would possibly decrease adverse selection
and even moral hazard problem. Nowadays, especially in developing countries and transition
economies, judicial systems are developed enough but due to corruption and bureaucracy law
enforcement is very weak (Slavova, S., n.d.). Hence, there is a place for improvement to
prevent future crises and improve law enforcement in general.

Another thing that the government could consider is overly regulated entry of foreign banks.
Instead of perceiving them as a threat, it could see it as an opportunity. First, foreign banks
(most likely coming from more developed countries and thus more developed systems) would
increase competition in the banking sector. This would of course be harmful to domestic
banks, however, increased competition would also improve the transparency of the operations
since banks will have to fight other their customers and investors. Moreover, if a country’s
banking system consists only of domestics banks, it can be very exposed in case of domestic
shocks. Having foreign banks on the other hand would help to maintain the stability in the
industry (Mishkin, F.S., 2000).
Some economists argue that one of the causes of financial crisis might be capital
inflow/outflow (Kaminsky et al, 1997). Of course, if a country is absolutely isolated from
other countries it will not be affected by a crisis in any way – just as North Korea has its own
economy which to them is equal to the global economy and all they have to worry about is a
possible domestic shock (which they are entirely in control of). However, nowadays it is
quite impossible and not at all beneficial for a country to be isolated, hence the government
should take a particular actions to regulate capital movement so it would not result in huge
capital inflows before crisis and outflows after it.

It might come as a surprise but monetary policy is also related to causes and prevention of
financial crisis. Even though the central bank not the government is in charge of that, they
can still cooperate to keep the inflation rate stable in order to prevent huge capital movement
caused by an interest rate mismatch.

One more thing that can be done to prevent price instability and thus financial crises is to
engage in fixed exchange rate regime. Even though there are some drawbacks of this system
(for example, a need for constant central bank intervention and huge foreign reserves),
linking currency to one that is used in developed and stable economy helps to maintain the
stability in the price level (Mishkin, F.S., 2000).

Most importantly, in order for the regulations to work, the supervisors have to be independent
and qualified enough to prevent cheating as happened with credit ratings in 2008 before the
financial crisis. Investment banks were bribing the credit rating agencies which led to a huge
decline in the economy. Hence, first of all the government should make sure that there is a
group of people with a specific education to be able to understand the importance of the
regulations and their enforcement. Also, the supervisors need to be as independent and
possible. One suggestion would be to keep them in secret. Of course, it is impossible to keep
the whole agency in secret, but it would be possible not to disclose the identities of the
supervisors to make it impossible to try reaching out for them in personal (as nowadays one
can achieve almost anything through knowing the right people)

To conclude, it is easy for the economists and analyst to say what actions are needed.
However, in reality everything is more difficult. Take the US as an example – markets are
one of the most regulated ones in the world, however we still experienced the financial crisis
in 2008. Hence, it is hard to find an equilibrium in the regulations. Some of them for example
cannot be applied together, so it is not a one day job to implement new rules in the markets.
On the other hand some of the regulations are essential for the banking sector to operate in
the most efficient way.

Conclusion
Financial crises is a very complicated concept. It is hard to recognize and understand
financial crises, because there is not just one form of financial crises. The concept of financial
crises has many different faces, and in some way the causes of financial crises are linked to
each other. Hence, a banking crises coud lead to credit and currency crices, and vice versa.
Also, a crises can only be seen in hindsight or when it is already happening, this makes it
even harder to take measures timely and accordingly. When a crisis as such happens, the
effects are felt throughout whole domestic economies, and with current state of globalization,
one crisis in a country, could spark a crisis in another country. The effects on the economy
acts like a chain reaction as well. Downturn in revenues and sales of one industrie, sparks the
same effects in other industries. Loss of consumer trust and banks reluctant to lend out money
act as amplifiers that worsen the situation even more. However, government regulations and
measures could be taken to prevent financial crises and minimize the effects when it happens.
Although it seems easy on paper to take such measures, it is hard to implement these to the
real world.
Appendix
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