Financial Crisis

Introduction
In recent decades, financial crises have stopped the momentum of economic development of many countries around the world. In some cases, they have destroyed almost completely different financial systems. The term financial crisis is applied broadly to a variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth but do not necessarily result in changes in the real economy. Many economists have offered theories about how financial crises develop and how they could be prevented. There is no consensus, however, and financial crises continue to occur from time to time. The purpose of this study is to analyze the causes of financial crisis, the types of financial crisis and the impact caused in the countries that have experienced them.

Explanation of financial crisis
Financial crises have come in many forms although they have many common elements. A financial crisis is often associated with one or more of the following phenomena: substantial changes in credit volume and asset prices, severe disruptions in financial intermediation and the supply of external financing to various players in the economy. As such, financial crises are typically multidimensional events and can be hard to characterize using a single indicator. Studies have clarified some of the factors driving a financial crisis, and sometimes to be driven by “irrational” factors. These include sudden runs on banks, contagion and spillovers among financial markets, limits to arbitrage during times of stress, emergence of asset busts, credit crunches, and other aspects related to financial turmoil. However it still remains a challenge to understand and identify the deeper causes.
Financial crises are often preceded by asset and credit booms that eventually turn into busts. Many theories that describe the sources of financial crises have recognized the importance of asset and credit booms. However, explaining why asset price bubbles or credit booms are allowed to continue to a point where it is no longer sustainable has been challenging. We will now take a closer look on asset and credit booms and their impacts.
Asset bubbles are sharp increases in asset prices and often lead to crashes. A bubble, an extreme form of such deviation, can be defined as “the part of a grossly upward asset price movement that is unexplainable based on fundamentals.” A speculative bubble exists in the event of large, sustained overpricing of some class of assets. One factor that frequently contributes to a bubble is the presence of buyers who purchase an asset based solely on the expectation that they can later resell it at a higher price, rather than calculating the income it will generate in the future. If there is a bubble, there is also a risk of a crash in asset prices: market participants will go on buying only as long as they expect others to buy, and when many decide to sell the price will fall. However, it is difficult to predict whether an asset's price actually equals its fundamental value, so it is hard to detect bubbles reliably. Some economists insist that bubbles never or almost never occur. Well-known examples of bubbles (or purported bubbles) and crashes in stock prices and other asset prices include the Dutch tulip mania, the Wall Street Crash of 1929, the Japanese property bubble of the 1980s, the crash of the dot-com bubble in 2000–2001, and the now-deflating United States housing bubble. The 2000s sparked a real estate bubble where housing prices were increasing significantly as an asset good
Credit booms can be triggered by a wide range of factors, including shocks and structural changes in markets. Shocks may include changes in productivity, economic policies and capital flows. Rapid movements in asset and credit markets during financial crises are quite different from those normally observed. Asset and credit boom and busts differs from the movements observed over the course of a normal business cycle. An asset or credit boom usually takes place over shorter time periods and result in faster increases in the financial variables. The slope of a typical boom is two to three times larger than a regular episode, while a bust is much longer, deeper and results in a more violent downturn. Asset price busts can affect bank lending and other financial institutions’ investment decisions and in turn the real economy through two channels. First, when borrowing/lending is collateralized and the market price of collateral falls, the ability of the firm to rely on assets as collateral to retain loans or extend new credit becomes impaired. This in turn will adversely affect investments. Second, the large price dislocations arising from fire sales and related financial turmoil distorts the decision making of financial institutions to lend or invest, prompting them to hoard cash. Through these channels, fire sales can trigger a credit crunch and cause a severe contraction in real activity. Those asset price booms supported through leveraged financing and involving financial intermediaries appear to entail larger risks for the economy. Evidence from past events suggest that whether excessive movements in asset prices lead to severe misallocations of resources depends in large part on the nature of boom and how it is financed. Booms largely involving equity market activities appear to have lower risks of adverse consequences.
Another common contributor to financial crisis is through the means of leveraging, which means borrowing to finance investments. When a financial institution (or an individual) only invests its own money, it can, in the very worst case, lose its own money. But when it borrows in order to invest more, it can potentially earn more from its investment, but it can also lose more than all it has. Therefore, leverage magnifies the potential returns from investment, but also creates a risk of bankruptcy. Since bankruptcy means that a firm fails to honor all its promised payments to other firms, it may spread financial troubles from one firm to another.
The average degree of leverage in the economy often rises prior to a financial crisis for example, borrowing to finance investment in the stock market ("margin buying") became increasingly common prior to the Wall Street Crash of 1929. In addition, some scholars have argued that financial institutions can contribute to fragility by hiding leverage, and thereby contributing to underpricing of risk.
Many analyses of financial crises also emphasize the role of uncertainty, where investment mistakes are caused by lack of knowledge or the imperfections of human reasoning. One way the government has attempted to reduce uncertainty is by regulating the financial sector. The major goal of regulation is to increase transparency, meaning making institutions’ financial information publicly known by giving regular reports through standardized accounting procedures. Some financial crises have been blamed on insufficient regulation, and have led to changes in regulation in order to avoid a repeat

Types of financial crisis
While financial crises can take various shapes and forms, they can typically be distinguished between two broad types. Reinhart and Rogoff classifies the financial crisis into two types: those classified using strictly quantitative definitions (currency and sudden stop crises), and those dependent largely on qualitative and judgmental analysis (debt and banking crises).
A currency crisis is brought on by a decline in the value of a country’s currency. The decline in value will negatively affect the economy by creating some instability in the exchange rates, meaning one unit of currency will no longer have the same value as it used to in another currency. In general, a currency crisis develops through the interaction between investor expectation and what those expectations cause to happen. There are three generations of models that typically are used to explain the currency crisis. The first generation of models, largely motivated by the collapse in the price of gold, an important nominal anchor before the floating of exchange rates in the 1970s, was often applied to currency devaluations in Latin America and other developing countries. They show that a sudden speculative attack on a fixed or pegged currency can result from rational behavior by investors who correctly foresee that a government has been running excessive deficits financed with central bank credit. Investors continue to hold the currency as long as they expect the exchange rate regime remain intact, but they start dumping it when they anticipate that the peg is about to end. This run leads the central bank to quickly lose its liquid assets or hard foreign currency supporting the exchange rate. The currency then collapses. The 'second generation' of models of currency crises starts with the paper of Obstfeld (1986). In these models, doubts about whether the government is willing to maintain its exchange rate peg lead to multiple equilibria, suggesting that self-fulfilling prophecies may be possible, in which the reason investors attack the currency is that they expect other investors to attack the currency. The third generation of crisis models explores how rapid deteriorations of balance sheets associated with fluctuations in asset prices, including exchange rates, can lead to currency crises. These models are largely motivated by the Asian crises of the late 1990s.
Sudden drop crisis is a sudden reduction in net capital flows into an economy. It is characterized by swift reversals of international capital flows, decline in production and consumption, and corrections in asset prices. Sudden stops can be triggered either by foreign investors when they reduce or stop capital inflows into an economy, and/or by domestic residents when they pull their money out of the domestic economy, resulting in capital outflows. Since sudden stops are generally preceded by robust expansions that drive asset prices significantly higher, their occurrence can have a very adverse impact on the economy and lead it towards a recession. A sudden stop may also be accompanied by a currency crisis or a banking crisis or both. Sudden stops often take place in countries with relatively small tradable sectors and large foreign exchange liabilities. Sudden stops have affected countries with widely disparate per capita GDPs, levels of financial development, and exchange rate regimes, as well as countries with different levels of reserve coverages. Most events usually share two elements: a small supply of tradable goods relative to domestic absorption (a proxy for potential changes in the real exchange rate), and a domestic banking system with large foreign liabilities, raising the probability of a perverse cycle. Empirical studies find that many sudden stops have been associated with global shocks. For a number of emerging markets, e.g., those in Latin America and Asia in the 1990s and in Central and Eastern Europe in the 2000s, following a period of large capital inflows, a sharp turn of capital flows occurred, triggered by global shocks (such as increases in interest rates or changes in commodity prices). Sudden stops are more likely with large cross-border financial linkages.
Debt crisis is a general term for a proliferation of massive public debt relative to tax revenues. This is mainly in reference to Latin American countries during the 1980s, and the United States and the European Union since the mid-2000s. The European sovereign debt crisis occurred during a period of time in which several European countries faced the collapse of financial institutions, high government debt and rapidly rising bond yield spreads in government securities. The European sovereign debt crisis started in 2008, with the collapse of Iceland's banking system, and spread primarily to Greece, Ireland and Portugal during 2009. The debt crisis led to a crisis of confidence for European businesses and economies.
Banking crisis is a financial crisis that affects the activity of banks in how they manage assets, liabilities and the equity in their possession. During crises, banks are exposed in the so called “bank run”, which means that bank depositors suddenly rush to withdraw their savings and capital. The action comes due to the panic caused in the financial market because depositors believe that banks will soon go bankrupt, and as a result they may lose their capital accumulated over the years. Due to systematic banking crisis, financial and corporate sectors in a country experience financial difficulties in their payments. As a consequence, loans related problems arise, and most of the capital of the banking system weakens. This situation is accompanied by increased interest rates, slowdown or reversal of capital flows, and the depressed prices of assets including capital and real estate. A similar situation prevents banks to pay back deposits if they are required suddenly by their customers. As a general consensus, banking crises will limit the economic development of countries. While crises tend to occur in the declining economies, problems in the banking sector have also independent negative effects on the real economy. Further research conducted by Cashin and Duttagupta (2011) concluded that banking crisis are generally correlated with very high inflation, bank deposits combined with low liquidity, and banking low profitability that emphasizes that risk of foreign currency in the market, economic instability and poor financial sustainability. Although banking crises have occurred over centuries and exhibited some common patterns, their timing still remains hard to predict.
Implication
Some financial crises have little effect outside of the financial sector, like the Wall Street crash of 1987, but other crises are believed to have played a role in decreasing growth in the rest of the economy. There are many theories why a financial crisis could have a recessionary effect on the rest of the economy. Macroeconomic and financial consequences of crises typically share many commonalities across various types. Although there are obvious differences between crises, the similarities are in terms of the patterns that follow during these events. Large output losses are common to many crises and other macroeconomic variables (consumption, investment and industrial production) typically register significant declines. Financial variables such as asset prices follow similar patterns qualitatively, with variation in time and severity. We will look further into these impacts in the following section.
Financial crises have large economic costs. Crises have large effects on economic activity and can trigger recessions, which happens in most cases following a financial crisis. And financial crises often tend to make these recessions worse than a “normal” business cycle recession. The average duration of a recession associated with a financial crisis is some six quarters, two more than a normal recession. There is also typically a larger output decline in recessions associated with crises than in other recessions. And the cumulative loss of a recession associated with a crisis is also much larger than that of a recession without a crisis. The real impact of a crisis on output can be computed using various approaches. For a large cross-section of countries and long time period, Claessens, Kose and Terrones (2012) use the traditional business cycles methodology to identify recessions. Regardless of the methodology, losses do vary across countries while overall losses tend to be larger in emerging markets. The median output loss for advanced countries is now about 33 percent which exceeds that of emerging markets, 26 percent. Recent studies have documented that recoveries following crises tend to be weak and slow, with long-lasting effects. Kannan, Scott, and Terrones (2013) employed cross-country data and conclude that recoveries following financial crises have been typically slower, associated with weak domestic demand and tight credit conditions. These findings are consistent with those reported in several other studies as well. A crisis is often associated with a large downward movement in financial variables. During a crisis, credit and asset prices tend to decline or grow at a slower rate than normal. A large sample study of advanced countries suggested that credit declines by about 7 percent, house prices fall by 12 percent, and equity prices drop by more than 15 percent during a crisis. Asset prices (exchange rate, equity…) and credit tend to exhibit the same properties during a crisis but with a longer duration and larger amplitude.
Another impact or effect of a financial crisis is contagion. Contagion refers to the idea that financial crises may spread from one institution to another, as when a bank run spreads from a few banks to many others, or from one country to another, as when currency crises, sovereign defaults, or stock market crashes spread across countries. When the failure of one particular financial institution threatens the stability of many other institutions, this is called systemic risk. One widely cited example of contagion was the spread of the Thai crisis in 1997 to other countries like South Korea. However, economists often debate whether observing crises in many countries around the same time is truly caused by contagion from one market to another, or whether it is instead caused by similar underlying problems that would have affected each country individually even in the absence of international linkages.

Predicating
Predicating a financial crisis has been a challenge for centuries. And while it is easier to document vulnerabilities, such as increasing asset prices and high leverage, it has been difficult to select a single set of indicators to explain the various types of crises consistently over time. The first generation of models focused on macroeconomic imbalances. The early models, mainly aimed towards the banking and currency crises, while focusing on the macroeconomic and financial imbalances of emerging markets. The next generation still focused on the external crises, with more emphasis on balance sheet variables. And later models showed a combination of variables can help identify situations of financial stress and vulnerabilities. Global factors can play important roles in driving sovereign, currency, balance-of-payments, and sudden stops crises. A variety of global factors is often reported to trigger crises, including deterioration in the terms of trade, and shocks to world interest rates and commodity prices.
Overall though, rapid growth in credit and asset prices is found to be the most reliably related to increases in financial stress and vulnerabilities. Borio and Lowe (2002) document that out of asset prices, credit and investment data, a measure based on credit and asset prices is the most useful: almost 80 percent of crises can be predicted on the basis of a credit boom at a one-year horizon, while false positive signals are issued only about 18 percent of the time. Building on this, Cardarelli, Elekdag, and Lall (2009) found that banking crises are typically preceded by sharp increases in credit and house prices. Many others have also found the coexistence of unusually rapid increases in credit and asset prices, large booms in residential investment, as well as deteriorating current account balances, to contribute to the likelihood of credit crunch and asset price busts.
Conclusion
The term financial crisis is applied broadly to a variety of situations in which some financial assets suddenly lose a large part of their nominal value. Although some variables are strongly related to the causes of a financial crisis, there are still various types of crisis that can lead to similar impacts on the economy. Financial crises have caused much debate among difference economists. Many have attempted to explore the possibility of detecting and preventing crises before they can cause damages that will require much more time and effort to repair the situation and bring the economies back to its normal and sustainable development. In this report, we have answered three questions: the different types of financial crisis and their causes, the impacts of financial crisis, and also predicting the financial crisis.

References
Allen, R. E., 2010, Financial Crises and Recession in the Global Economy, Edward Elgar Publishing, 3rd Edition.
Claessens, Stijn, and M. Ayhan Kose. "Financial Crises: Explanations, Types, and Implications." Imf.org. 28 Jan. 2013. Web. 8 Dec. 2015. <http://www.imf.org/external/pubs/ft/wp/2013/wp1328.pdf>.

Klingebiel, D., R. Kroszner, and L. Laeven, 2007. "Banking Crises, Financial Dependence, and Growth," Journal of Financial Economics,
Kaminsky, G., S. Lizondo, and C. Reinhart, 1998, “Leading Indicators of Currency Crisis,” IMF Staff Paper