Factors That Trigger a Financial Crisis - Essay Example

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Sewanee University of the South
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A financial crisis refers to a condition that leads to the rapid loss of value of assets of financial institutions. During this period banks may collapse resulting in a fall of financial flows and financial development which impact on the overall economic growth of countries. Financial crisis, however, happen over time as a result of a range of problems such as loose regulation of banks and exuberance in the market for houses. The financial crisis requires urgent actions to bail out economic sectors, protect individuals from the declining incomes and respond to the general collapse of the economy. These measures are expensive since they require undertaking at times when there is little or no foreign or domestic borrowing implying government has low revenue. This paper evaluates the various factors that trigger a financial crisis and how they impact on the economy.

Firstly financial markets enable households, businesses, and governments to meet their needs and want through lending while in turn, they earn profits. Businesses require funds for expansion; states partly respond to their budgetary needs through borrowing while individuals need resources for consumption. Banks make money from accepting deposits from people and government which they later lend out thus earning interest income. Banks must balance the lending and deposits balances otherwise they may have liquidity problems. Continued liquidity may cause solvency problems for the banks. Liquidity issues limit borrowing which may lead to an eventual collapse of the economy.

Another factor that triggers financial crisis is instability in the economic system which emanates from the mass decision to re- allocate economic resources. Should savings activity from people increase more than consumption or vice versa, there will be a re-allocation of resources since there is no balance. Also, investors may move money from present time to a later date through investments they make which also lead to re-allocation of resources since there will be a shortage of money at the moment. In such a case people act on expectations without consideration of risk; therefore, they act independently.

Irrational investing also trigger a financial crisis. Bubble bursting arises due to overvalued assets. One may ask what an overvalued asset is or why are assets over-valued? An overvalued asset is one whose current price may not be justified by the expected earnings. Over valuations arises basically due to expectations that prices will increase hence an improvement in values which might be wrong or correct. Individuals base their economic behavior on their expectations. In the housing and stock markets, people buy in the hope of price increase due to demand from others. However, in such a case one assumes that all individuals have the same mind-set. Economists rely on rational behavior however if the outcome of economic behavior is based on what other people do then it is not rational. Due to high prices that are as a result of demand, increased entry of more speculators leads to a stagnation of demand while supply is still high hence the result is a sharp decline in prices. Such contraction of markets leads to financial crisis.

The greater fool and herding theories give an explanation of how people make investments irrationally. The buying activity is not guided by finance or economic factors but basically because other people are buying and there is someone else who will buy if one sells. However, due to limited resources, a time comes when no one is willing to make the purchase.

The lending action by bank officers without adequately appraising the customers on their ability to repay the loans may also trigger a financial crisis. Bank officers may only consider their commissions on loans sales without assessing capability to repay these loans which may end up us nonperforming cases. An increase in non-performing loans disturbs the balance between deposits and loans which may lead to bank liquidity. Also, conspicuous consumption may trigger a financial crisis. Conspicuous consumptions refer to buying of goods because others have bought them not because one benefits from the purchase. In such a case individuals borrow beyond their capacity of income to repay loans thus contributing to bad loans. Non-performing loans affects the liquidity of banks as they lead to insolvency of banks due to liquidity problems,

Securitization of large loans was another trigger of the financial crisis. Financial institutions made financial assets from loans by repackaging them and selling the financial instruments to individuals. There was a repackaging of the mortgage-backed securities into derivatives which were a combination of low, medium and high risk. The derivatives had both elements of good and bad risk mostly speculative risk making them attractive. The derivatives were sold to new buyers, and there was a continuous change of hands from an investment firm to another and from the firm to a country spreading all over. Some financial institutions were overleveraged as a result while asset prices were falling. As a result, there was an exposure to the financial institutions since they had less capital also the asset prices were declining.

Lastly, the concept of market fundamentalism triggers financial crisis through the firm belief that markets can solve many of the economic problems through forces of demand and supply. The perception is wrong since it is the authorities' that intervene preventing the financial markets from going down

In conclusion, factors that trigger the financial crisis include misallocation of resources, light regulation of financial institutions, misjudging of the market and irrational investing. These factors, however, may not trigger crises in unison but through a series of interconnections. If financial systems collapse, there will be less borrowing and less economic activity. If the credit system dries up, then the economic system will collapse, and government intervention consequently is required to prevent a collapse of the financial systems which are the channel between the savers and investors.

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