BUS614 Study Guide

Unit 6: Financial Crises

6a. Compare a financial crisis to an economic recession

  • What is the relationship between a financial crisis and an economic crisis?

A financial crisis is when one or more financial assets suddenly decrease in value, leading organizations to encounter significant losses and difficulties meeting their obligations. An economic crisis generally follows such a crisis.

Financial crises generally start with a sudden fall in a financial asset value after having experienced a period of growth that was facilitated by increased access to borrowing. With that, the decline in the value of collateral will cause households to reduce their debt and borrowing so that there is a feedback effect on the asset price.

On the other hand, an economic crisis comes from a financial crisis. It is characterized by a lack of liquidity, lower production levels and increased unemployment, high inflation levels or low precision levels, and lower GDP. These can result from asset mismatch, mismanagement, and sudden asset value decline.

One of the notable forms of recession is what is referred to as a double-dip recession, which is a recession followed by a short-lived recovery, followed by another recession similar to what the EU is currently experiencing due to the COVID-19 Pandemic.

To review, see Global Recession, The Global Financial Crisis, and The Effects of Coronavirus on the Economy.

 

6b. Identify trends that might lead to a financial crisis, such as systematic and regulatory failures 

  • What are the causes of a financial crisis?

Generally, a financial crisis could be an inflation crisis, a currency crisis, a banking crisis, or a sovereign debt crisis. Generally, a banking crisis occurs as a result of a mass withdrawal of deposits from banks at the same time. This is what is referred to as a bank run.

A bank run is one of the forms of a banking crisis and, along with regulatory failures, indicates a lack of trust in the banks, reducing the number of future deposits.

At times, regulators may opt for a soft approach while regulating the financial sector, leading to a lack of proper regulations and, thus, the lack of government oversight. This is particularly dangerous as the lack of proper regulation and government oversight would lead banks to leverage themselves to capture gains even in extremely high-risk instances.

A currency crisis happens when there is a severe depreciation in the value of a particular currency. This would lead to a loss of trust in the currency, where investors would disregard the use of this currency. In many instances, a currency crisis comes from unsustainable fiscal policies where most governments cannot maintain the exchange rate peg. As a result of the government's ability to maintain the peg, the government would likely allow the currency to float, leading to rapidly increasing inflation rates.

To review, see Financial Crises, Fundamentals of Banking Crises, and Regulating Financial Markets after the Meltdown.

 

6c. Analyze the notions of "too big to fail" and "moral hazard"

  • How is "too big to fail" connected to moral hazard?

A moral hazard happens when institutions (or individuals) take risks they normally wouldn't, knowing they are protected from the consequences of such risk. It happens due to a contractual relationship between two parties where one party assumes more risk that would negatively affect the other party. Therefore, Moral Hazard is post-contractual asymmetric information.

On the other hand, Too Big To Fail (TBTF) is a notion by which the government saves big institutions through bailouts. This means that some institutions (financial or otherwise) are large enough that their failure may cause distress to the economic system nationwide, making the expensive option of saving these institutions through government bailouts a necessary expense.

Due to their size relative to the economy, some financial institutions take on more risk than they normally would, knowing they have government support should they need it.

To review, see Are Banks Too Big to Fail or Too Big to Save?, Moral Hazard, and Regulating Financial Markets after the Meltdown.

 

Unit 6 Vocabulary

This vocabulary list includes the terms that you will need to know to successfully complete the final exam.

  • Financial Crisis
    • A financial crisis is when one or more financial assets suddenly decrease in value, leading organizations to encounter significant losses and difficulties meeting their obligations.
  • Economic Crisis
    • An economic crisis is one characterized by a lack of liquidity, lower production levels and increased unemployment, high inflation levels or low recession levels, and lower GDP
  • Bank Run
    • A bank run is the sudden withdrawal of deposits from banks simultaneously.
  • Systematic Risk
    • Systematic risk is considered an inherent risk of a particular sector.
  • Regulatory Failure
    • Regulatory failure is the lack of proper government oversight and the lack of proper regulation.
  • Currency Peg
    • A currency peg is an exchange rate policy by which governments fix the exchange rate of their national currency to another foreign-denominated currency.
  • Moral Hazard
    • A moral hazard is post-contractual asymmetric information
  • Too Big To Fail
    • TBTF is the notion by which big institutions are saved through government bailouts