Economics of money, banking and financialmarketsfinancial crisis

I.WHAT ARE THE DIFFERENCES BETWEEN FINANCIAL CRISIS AND ECONOMIC CRISISComponentsFinancial crisisEconomic crisisany of a broad variety of situations in which some financial assets sudden

VIETNAM NATIONAL UNIVERSITY HO CHI MINH CITY

UNIVERSITY OF ECONOMICS AND LAW

1 Huỳnh Công Tiến K214043333 2 Phan Nguyễn Minh Phương K214040331 3 Nguyễn Phương Anh K214040319 4 Trần Minh Khôi K214041647 5 Nguyễn Thị Mai Hương K214041646

I.WHAT ARE THE DIFFERENCES BETWEEN FINANCIAL CRISIS

AND ECONOMIC CRISIS 3

II.CAUSES OF FINANCIAL CRISIS 4

1 Stock Market Crash: 4

2 Bank Panics: 4

3 Continuing Decline in Stock Prices: 4

4 Debt Deflation: 4

5 International Dimensions: 5

III.EXAMPLE OF FINANCIAL CRISIS 5

IV.TYPES OF FINANCIAL CRISIS 6

1 Main reasons leading to financial crisis in 2008 10

2 The impact of the 2008 financial crisis 15

References: 19

I.WHAT ARE THE DIFFERENCES BETWEEN FINANCIAL CRISIS AND ECONOMIC CRISIS

ComponentsFinancial crisisEconomic crisis

any of a broad variety of situations in which some financial assets suddenly lose a large part of their

Significant changes in asset price, changes in the volume of national credit, severe

balance sheet problems, disturbances in the intermediary financial activities, and large-scale support of the government

values of securities and stock, and frauds like

A financial crisis is basically a market failure in the financial sector; if there are not any actions taken it can result, it can lead to an

economic crisis.

An economic crisis is a dangerous state of an

economy at a given point in time Which also has a negative impact on the general

Effects The financial crisis has directly affected the financial sectors and

Economic crises affect the economic entities in

the entire economy.

II.CAUSES OF FINANCIAL CRISIS

When financial frictions rise, financial markets are less able to efficiently direct funds from savers to families and businesses with profitable investment possibilities, which has the effect of decreasing economic activity A financial crisis happens when there is a significant disturbance in the flow of information in the financial markets, which causes financial frictions to rise significantly and the financial markets to collapse

1 Stock Market Crash:

Prices doubled on the American stock market in 1928 and 1929 According to Federal Reserve officials, excessive speculation was to blame for the stock market boom They sought a tightening of monetary policy to raise interest rates in an effort to restrain the increase in stock values in order to stop it By the time the stock market plummeted in October 1929 and fell by 40% by the end of the year, the Fed had received more than it had anticipated.

2 Bank Panics:

Farmers were unable to repay their bank loans by the middle of 1930 as a result of droughts in the Midwest that caused a severe fall in agricultural production

3 Continuing Decline in Stock Prices:

Prices for stocks kept dropping Stocks had lost 10% of their value from their peak in 1929 by the middle of 1932 Financial markets had a difficult time directing money to borrowers, spenders, and prospects for profitable investments.

4 Debt Deflation:

The level of prices dropped by 25% as a result of the continued deflation brought on by waning economic activity Because of the increased burden of the

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debt held by businesses and households as a result of the sharp decrease in prices, debt deflation was sparked.

5 International Dimensions:

Despite having its roots in the United States, the Great Depression was a global phenomenon With millions upon millions of people out of work as a result of bank panics in the United States that also spread to other countries, World War II and the rise of fascism were sparked by the ensuing unrest.

III.EXAMPLE OF FINANCIAL CRISIS

Financial crises are not uncommon; they have happened for as long as the world has had currency Some well-known financial crises include

Asian Crisis of 1997–1998 This crisis started in July 1997 with the collapse of the Thai baht Lacking foreign currency, the Thai government was forced to abandon its U.S dollar peg and let the baht float The result was a huge devaluation that spread to much of East Asia, also hitting Japan, as well as a huge rise in debt-to-GDP ratios In its wake, the crisis led to better financial regulation and supervision.

The 2007-2008 Global Financial Crisis This financial crisis was the worst economic disaster since the Stock Market Crash of 1929 It started with a subprime mortgage lending crisis in 2007 and expanded into a global banking crisis with the failure of the investment bank Lehman Brothers in September 2008 Huge bailouts and other measures meant to limit the spread of the damage failed and the global economy fell into recession.

COVID-19 Pandemic A global stock market crash began in February

2020 From February 20 until March 23, 2020, the S&P 500 lost over 30% of its value This was a result of the COVID-19 pandemic, which caused widespread panic and uncertainty about the future of the global economy Despite being severe and with global reach, markets, and national economies rebounded quickly and by early April 2020, the S&P

500 had begun a decisive rise, surpassing its pre-pandemic high in August 2020.

IV.TYPES OF FINANCIAL CRISIS

In their influential work, Reinhart and Rogoff (2009a), distinguish between two types of financial crises: are identified solely quantitative measures that rely on qualitative and subjective analysis The former category primarily includes sudden currency crises, while the latter encompasses debt and financial crises, which require a more nuanced understanding of the underlying economic factors There are several distinct types of financial crises, including foreign debt crises, local public debt crises, and currency crises Each of these crises has a specific definition and set of characteristics that differentiate it from the others However, it is essential to note that these categories are not mutually exclusive, and crises often overlap in terms of their causes and effects The identification and analysis of financial crises are influenced by a variety of analytical and empirical factors For instance, the use of quantitative measures to identify currency crises and sudden stops is based on specific economic indicators, such as exchange rate fluctuations and capital flows In contrast, debt and financial crises require a more subjective analysis of economic conditions, such as the sustainability of debt levels and the stability of financial institutions In the next section, we will explore how financial crises are identified, timed, and occur Understanding these factors is crucial for policymakers and investors alike, as it can help them anticipate and mitigate the impact of financial crises on the economy.

1 Banking Crises

Banking crises are a common occurrence, but they are difficult to understand Banks are fragile and vulnerable to runs by depositors, and public safety nets can limit the risk associated with such runs However, institutional weaknesses can increase the risk of a crisis, as banks rely on information, legal, and judicial environments to make prudent investment decisions and collect loans Despite banking crises being a recurring phenomenon throughout history, their timing remains hard This is due to the complex and dynamic nature of the financial system, which makes it difficult to anticipate when and where a crisis will occur The interconnectedness of financial institutions, the global economy, and the regulatory environment also contribute to the difficulty in predicting

banking crises In recent years, there have been efforts to strengthen financial regulation and supervision to prevent and mitigate the impact of banking crises However, there is still much work to be done in this area, as evidenced by the global financial crisis of 2008 which resulted in banking and a is clear that understanding and addressing banking crises is an ongoing challenge for policymakers and regulators.

Bank Runs and Banking Crises

Financial institutions are indeed fragile entities that are vulnerable to

coordination problems due to their essential role in maturity transformation and liquidity creation Coordination problems can arise when investors and institutions take action due to the fear of others taking similar actions, leading to a crisis where large amounts of liquidity or capital are withdrawn due to a self-fulfilling belief An example of a coordination problem is a bank run, where a large number of customers withdraw their deposits because they believe the bank is insolvent This can destabilize the bank to the point of bankruptcy as it cannot liquidate assets fast enough to cover its short-term liabilities.

Fragilities in the banking system have long been recognized, and several mechanisms have been developed by markets, institutions, and policymakers to reduce them Market discipline encourages institutions to limit vulnerabilities, micro-prudential regulation is designed to reduce risky behavior, deposit insurance can help reduce coordination problems, and policy interventions such as public guarantees, capital support, and purchases of non-performing assets can mitigate systemic risk.

However, regulations and safety net measures can increase the likelihood of a banking crisis when poorly designed or implemented Moral hazards due to a state guarantee can lead banks to assume too much leverage, creating systemic vulnerabilities Policies at both micro and macro levels can arise because of these fragilities.

Overall, the fragility of financial institutions and the potential for coordination problems remain significant challenges for policymakers and regulators It is essential to strike a balance between stability and avoiding hazards that could lead to a banking crisis This requires a thorough understanding of the risks inherent in financial institutions and the development of effective policies and regulations to mitigate them.

2 The collapse of the Speculative bubble

Economists use the term "bubble" to describe a financial asset, such as a stock, whose price exceeds the present value of future earnings received by its owner until maturity This means that market participants are buying the asset with the expectation of selling it at a higher price in the future, rather than enjoying the income it generates This behavior is evidence of a bubble, as market participants are not valuing the asset based on its actual worth.

Asset bubbles are risky because they can lead to a collapse in asset prices when multiple people decide to sell, causing the price to plummet However, identifying asset bubbles can be difficult in practice, as it is challenging to determine when an asset's price has exceeded its fundamental value This can make it challenging to identify bubbles unless they are obvious to many investors.

Some argue that asset bubbles never or seldom occur However, there have been several famous examples of asset bubbles throughout history, such as the Tulip Rush in the Netherlands in 1637, the Wall Street crash of 1929, the Japanese asset bubble in the 1980s, the collapse of the dot-com bubble of 2000 – 2001, and the US housing bubble in 2007 These bubbles are a reminder of the risks associated with excessive speculation and the importance of fundamental valuation when investing in assets.

3 Currency Crisis

Theories about currency crises have undergone significant changes over the past few decades Initially, the focus was on fundamental causes such as the balance of payments and fiscal deficits However, subsequent models emphasized the role of multiple equilibria and self-fulfilling prophecies.

The first generation of models, developed in the aftermath of the collapse of the gold standard, was used to explain currency devaluations in developing countries The second generation of models highlighted the importance of expectations and the possibility of multiple equilibria Under this framework, policies before the attack and changes in policies in response to a possible attack can trigger a crisis.

The third generation of models examines how fluctuations in asset prices, including exchange rates, can lead to the rapid deterioration of balance sheets and trigger currency crises This generation also considers the role of banks and the self-fulfilling nature of crises resulting from over-borrowing due to government subsidies and volatile exchange rates.

Empirical research has attempted to differentiate between these models, but it has been challenging While some early work focused on the KFG model, which showed crisis probabilities building up to peaks just before devaluations, later research has used different methods such as censored dependent variable models, Logit models, and signaling models to estimate crisis probabilities Although certain indicators are associated with crises, it has been difficult to predict the timing of crises accurately.

Overall, our understanding of currency crises has evolved significantly over the past few decades, but predicting and preventing them remains a complex challenge.

4 Great Recession

A recession is defined as negative GDP growth that persists for two or three quarters, while a prolonged recession may be called a depression A long period of slow but not necessarily negative growth is often referred to as stagnation The US Bureau of Economic Research defines a recession as a significant decline in economic activity that spans the entire economy and persists for at least a few months, typically observable through production, employment, real income, and other indicators.

Many economists believe that financial crises can lead to recessions For instance, the Great Recession of 1929-1933 was spread through bank runs and stock market crashes, while the subprime credit crisis in the US led to the economic recession of the US and many other countries from 2008 to 2010 Some economists argue that a financial crisis is often the first shock that creates a recession, while other factors may be more important in prolonging the recession.

Milton Friedman and Anna Schwartz argued that the initial economic downturn associated with the crash of 1929 and the banking panic of the early 1930s would not have led to a prolonged economic crisis had it not been accelerated

by some of the Federal Reserve's monetary policy mistakes Thus, the role of policymakers during a recession cannot be overlooked, and their actions can be critical in mitigating the negative effects of a recession or preventing one from becoming depressed.

V CASE STUDY

The 2008 crisis was the biggest shock to the world's financial system in almost a century, and it brought the banking system to the brink of failure This case study seeks to examine the 2008 financial crisis' causes, effects, and lessons gained not only in the USA but also in the world generally

1 Main reasons leading to financial crisis in 2008

According to Mishkin (2011), the underlying driving factors behind the U.S financial crisis of 2007–2008 were the mismanagement of financial innovation in the subprime residential mortgage market and the burst of a housing price bubble After the bubble burst, the banks were left holding worthless investments in subprime mortgages worth billions of dollars Numerous individuals lost their homes, savings, and jobs as a result of the Great Recession.

It can be said that a number of the financial crises are largely influenced by six groups of factors: the impact of the asset market on balance sheets, the state of financial organizations' balance sheets, the banking crisis, rising uncertainty, rising interest rates, and government budgetary imbalances Nevertheless, this report offers some important insights into four key reasons why the 2008 financial crisis occurred.

1.1 Lax Mortgage Lending

Lending standards were loosened to the point where many people were able to purchase homes which they couldn't afford due to an abundance of credit, cheap interest rates, and rising housing prices There was a significant shock to the financial system when prices started to decline and loans started defaulting Basically, investors bought an investment called mortgage backed – securities The term mortgage backed – securities (MBS) are created when large financial institutions securitize mortgages Besides that, investors were told