Economic Crisis

Economic or Financial Crisis is a broad term used to describe a situation in which a

financial institution loses a big part of their value. Over the years, it has been associated
with banking panics, recessions, stock market crashes, bursting of other financial
bubbles, currency crises, and sovereign defaults. Many theories have been proposed for
the cause and prevention of an economic crisis, however, it is seen regularly around the
world.

Types of Financial Crises

1. Banking Crises:

A banking crisis is seen when a bank suffers from several bank runs at the same time.In
other words, when there is a sudden rush of withdrawals by bank’s depositors.Banking
crisis may leave the bank in bankruptcy.

2. Stock Market Crash:

Stock Market crash is a social phenomenon with a sudden fall in stock prices in the stock
market.

3. Currency Crisis:
Currency Crisis is a type of financial crisis that occurs due to a quick change of value of
currency, undermining is ability as a medium of exchange.

4. Recession/Depression:

Recession is known as the reduction of country’s gross domestic product (GDP) for
several quarters.

What Causes an Economic Crisis?

Strategic Complementarities in Financial Markets For any business or an investment to

be successful, it requires important decisions to be made by the investors. It is also
observed that investors also require guessing what the other investors will do. Thus,
according to economists ‘Strategic Complementarities’ is an incentive to mimic the
strategies of others, which can influence the financial market accordingly.

Leverage

Leverage is the term used when money is borrowed to supplement existing funds for
investment in a way where the outcome, whether positive or negative, is
magnified.Leverage increases the risk of bankruptcy, hence, it is seen that the average
degree of leverage in the economy rises preceding a financial crisis.

Asset-liability Mismatch

Another factor that can contribute in creating a financial crisis is called asset- liability
mismatch. Asset-liability mismatch occurs when there is no correspondence between the
assets and liabilities.

Economic Psychology and Herd Behavior

Emphasized by analyses of financial crises, human and social, cognitive and emotional
factors play a major role in making the economic decisions. Mistakes of these economic
decisions can cause a financial crisis. A separate branch of economics, known as
Behavior Finance, studies these errors in economic and quantitative reasoning.

Regulatory Failures

In order to eliminate or diminish the financial crisis, government plays a role by

regulating the financial sector. Goal of the government in regulation is transparency of an
institution, making sure that institutions can meet their contractual obligations by
observing their reserve requirements, capital requirements, and creating limits on
leverage.

Fraud

One of the major reasons for collapse of financial institutions is fraud. It occurs when
companies attracts depositors through misleading claims about their investment
strategies, for example, the Charles Ponzi's scam in early 20th century Boston.

Contagion

The idea of a financial crisis spreading from one institution to another, or from one
country to another is known as Contagion, occurring during currency crises, sovereign
defaults, or stock market crashes spread across countries.

Recessionary Effects

Recessionary effect plays a role in decreasing growth on rest of the economy. There are
many theories to explain this phenomenon which includes 'financial accelerator', 'flight to
quality' and 'flight to liquidity', and the Kiyotaki-Moore model.

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