What is a financial crisis?

When there is a steep decline in the value of financial assets, a sudden jump in the number of loan defaults, and a serious liquidity problem, there is a Financial Crisis.

In this context, the term “financial assets” refers to items of value owned by individuals or corporations that can be converted to cash, such as stocks and real estate. The plural of the word “crisis” is “crises.”

A dramatic drop in the value of financial assets can lead to severe disruptions in the economy. This can result in banks and other financial institutions struggling to survive, businesses going bankrupt, and people losing their jobs and savings.

Financial crises have a profound impact on the economy of a country, region, and sometimes even the whole world.

The Corporate Finance Institute says the following about the term “financial crisis”:

“A financial crisis is generally defined as any situation where significant financial assets – such as stocks or real estate – suddenly experience a sharp decline in value. They are often preceded by periods of economic boom and overextension of credit to borrowers.”

“Economic recessions that follow a financial crisis are usually significantly more severe than recessions that are not preceded by a specific financial crisis.”

Investors lose confidence

Fundamentally, a financial crisis is triggered when investors suddenly lose confidence. This may be due to an economic downturn, a major bank or financial institution facing difficulties, unexpected geopolitical events, a rapid increase in interest rates, or a sudden change in economic policy.

When confidence is lost, there is a serious risk of a domino effect occurring. Investors sell off their assets, values crash, liquidity dries up, credit markets tighten, consumer confidence falters, and central banks scramble to stabilize the economy, making it hard for companies to operate and for consumers to spend.

Two images depicting the concept of a Financial Crisis
Image created by Market Business News.

Three main types of financial crises

  • Banking crisis

This is one of the most common types. Banks play a key role in the economy by lending money and facilitating payments.

When account holders, that is, people like you and me, fear that banks might become insolvent, they rush to withdraw their money. This kind of panic situation is called a bank run.

If a bank does not have enough liquidity to cover these withdrawals, it can collapse, leading to a banking crisis.

During the Panic of 1907, also known as the Knickerbocker Crisis, a number of bank runs in the United States over a three-week period caused the New York Stock Exchange to suddenly fall almost 50%. Panic spread across the country, resulting in a serious financial crisis.

  • Stock Market Crash

A sharp fall in the stock market index, known as a stock market crash, may lead to a loss of wealth and confidence. If it is severe enough, the consequences can be devastating.

The most severe crash in American history was The Wall Street Crash, which occurred in late October 1929. It is also known as The Great Crash, the Crash of 29, or Black Tuesday.

In a previous article, I wrote the following about this event:

“Some financial experts had warned that the American economy was losing steam. In September 1929, investors began selling shares in large numbers. Other investors became nervous and soon there was a panic. More and more people rushed to sell their shares.”

From one week to the next, thousands of investors lost their money. The domino effect was severe – banks closed down across the country and millions of ordinary Americans lost their savings. The Wall Street Crash preceded The Great Depression, America’s and the world’s most severe and longest-lasting economic downturn in history.

  • Global Financial Crisis

Some financial crises affect multiple countries simultaneously. Countries’ economies are much more interconnected today than they used to be. Therefore, a crisis in one country tends to quickly spread to others.

If you mention the term “Global Financial Crisis” to people today, most of them will think of the last one, which occurred in 2008. The 2008 crisis was the worst global crisis since the Wall Street Crash and the subsequent Great Depression.

The 2008 global crisis was followed by the Great Recession, which lasted until 2012.

Other types of financial crises

Below you can see brief details about six other types of financial crises.

  • Currency Crisis: A sharp decline in the value of a country’s currency.
  • Sovereign Debt Crisis: A nation’s inability to repay its debts.
  • Corporate Debt Crisis: Companies struggle to pay back their loans.
  • Systemic Financial Crisis: Widespread collapse of financial institutions and markets.
  • Commodity Crisis: Major fall in commodity prices affecting economies.
  • Inflation Crisis: Money loses value rapidly, eroding purchasing power.

A devastating impact

A financial crisis can have a devastating effect on a country’s economy. Unemployment rates tend to soar, businesses go bankrupt, and consumers and companies find it much harder to borrow money from banks.

Governments usually step in to bail out major banks and companies. However, this can lead to increased national debt and tax increases.

Millions of people across the world lose their homes, savings, jobs, and face financial uncertainty.

Preventing financial crises

Total prevention is not possible due to the complex and varied causes of financial crises.

However, measures such as stricter regulations of financial markets and financial institutions, more comprehensive risk management by banks, and better-informed investment decisions can help minimize the risk.

Banks in various countries are required to undergo periodic stress tests, which are assessments conducted to determine their resilience in hypothetical adverse economic scenarios, including financial crises.

Conclusion

A financial crisis is a significant economic event that negatively affects not only the financial system but also the broader economy. Such crises have been recurring features throughout modern history, each leaving a unique imprint on the economic landscape.