Financial crisis

A financial crisis is a situation where financial assets suddenly lose much of their nominal value. Assets are things people or companies own that have value. When these values drop quickly, it can cause massive trouble. If this loss of value leads to a broader reduction in economic activity, it is called an economic crisis. An economic crisis affects the entire economy, not just specific investments.

One common type is a banking crisis. This often starts with a bank run. A bank run happens when many depositors try to withdraw their money at once. Banks use fractional-reserve banking, which means they lend out most of the cash they receive. Because they do not keep all the cash on hand, they cannot pay everyone back immediately. If many people demand their money at once, the bank becomes insolvent. This means it cannot meet its obligations. A widespread event of this kind is called a banking panic.

Another type involves speculative bubbles. A speculative bubble occurs when the prices of certain assets stay much higher than their actual value for a long time. This often happens because buyers purchase assets only to resell them at higher prices later. They do not focus on the actual income the asset might generate. Eventually, the prices collapse, which is known as a crash. History shows many such events. There was the Dutch tulip mania in the 17th century and the South Sea Bubble in the 18th century.

Currency crises can also occur. This is when a country's money loses value rapidly. This is sometimes called a devaluation crisis. It often happens when people realize a fixed exchange rate is about to fail. This causes speculation, which forces the currency to lose value. On an international level, a country might also experience a sovereign default. This happens when a country cannot pay back its debt. In the early 1980s, many Latin American countries defaulted on their debt. In 1998, Russia experienced a crisis where the ruble lost value and the government defaulted on bonds.

Financial crises are often linked to the concept of leverage. Leverage means borrowing money to finance investments. If you only use your own money, you can only lose what you have. However, if you borrow money to invest, you can lose much more than your original amount. This can lead to bankruptcy. Bankruptcy can then spread financial trouble to other firms. This is sometimes called contagion. Before the Wall Street crash of 1929, many people used margin buying, which is borrowing to buy stocks.

Another cause is an asset-liability mismatch. This happens when the risks of a firm's debts and assets do not align. For example, banks take short-term deposits that people can withdraw anytime. They use that money to make long-term loans to homeowners. If depositors panic and withdraw money faster than the bank can collect on its loans, a crisis occurs. Bear Stearns faced this issue in 2007–08. They could not renew the short-term debt they used to fund long-term mortgage investments.

These crises can lead to much larger economic problems. A recession is defined as negative GDP growth lasting two or more quarters. If a recession is very long or severe, it is called a depression. The Great Depression is a famous example. It followed the stock market crash of 1929 and many bank runs. Some economists believe financial crises are hard to predict because of reflexivity. This is the idea that people's expectations can change the actual outcome. If everyone expects a bank to fail, their actions might actually cause it to fail.