Fundamentals of Banking Crises

Banking crises have a range of short-term and long-term repercussions, domestically and globally, that reduce economic output and growth.

Learning Objective

Key Takeaways

Key Points

• Banks play a critical role in economic growth, primarily through investment and lending.
• After a banking crisis, investment suffers. When banks lack liquidity to invest, growing business depending upon loans struggle to raise the capital required to execute upon their operations.
• The fall in liquidity and investment, in turn, drives up unemployment, drives down governmental tax revenues and reduces investor and consumer confidence.
• Imports and exports play an increasingly large role in the health of most developed economies, and as a result, the relative well-being of trade partners plays an increasingly critical role in the success of domestic economies.

Key Terms

• Economic crisis: A period of economic slowdown characterised by declining productivity and devaluing of financial institutions often due to reckless and unsustainable money lending.
• liquidity: The degree to which an asset can be easily converted into cash.

Banking crises have a dramatic negative effect on the overall economy, often resulting in an eventual financial and economic crisis in a given economic system. Banking crises have a range of short-term and long-term repercussions, domestically and globally, that underline the severe repercussions of irresponsible banking practices, poor governmental regulation, and bank runs. The most useful way to frame the consequences of bank crises is by observing the critical role banks play in economic growth, primarily through investment and lending.

Domestic Consequences

Within a given system, banking failures create a range of negative repercussions from an economic perspective. Banks coordinate and economy's savings and investment: the act of pooling money to capture higher returns for everyone while simultaneously funding business dependent upon leveraging debt and equity. With this in mind, a banking crises can have a variety of averse individual and economic consequences within the system.

First and foremost, investment suffers. When banks lack liquidity to invest, businesses that depend upon loans struggle to raise the capital required to execute upon their operations. When these businesses cannot produce the capital required to operate optimally, sales decline and prices rise. The overall economic performance of any debt-dependent industries becomes less dependable, driving down consumer and investor confidence while reduce overall economic output. Banks also perform more poorly, due to the fact that they have less capital to invest and returns to acquire.

This drives down the overall economic system, both in the short term and the long term, as companies struggle to succeed. The fall in liquidity and investment drives up unemployment, drives down governmental tax revenues and reduces investor and consumer confidence (damaging equity markets, which in turn limits businesses access to capital). There is a distinctive cyclical nature to these adverse effects, as each are interconnected in a way that creates a domino effect across the domestic economic system.