Financial crises refer to a situation in the financial market where there is a major disruption in its functioning. It includes a steep decline in the asset prices and failures of financial and non-financial institutions.
It is called a bank run or panic during which investors sell off their assets or withdraw their money from the bank in fear of it going bankrupt.
Like columbia bank Medford, many banks maintain good creditworthiness and enjoy the confidence of their customers. But some firms are not able to channelize funds efficiently from savers to borrowers in productive investment opportunities.
Therefore, due to a sudden decline in the asset prices with firms or banks not paying back, investors with the fear of losing their money start selling their assets. As a result, the economic activity contrasts sharply with a steep decline in growth.
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Factors causing Financial Crises
Increase in interest rates
Individuals or firms that are less likely to pay back are generally seen as involved in risky investment projects and willing to pay a higher interest rate. With the market being driven by an increased interest rate, good credit borrowers are less likely to borrow. This leaves the market cornered by bad credit risk.
This leads to an increase in adverse selection problems, which pushes the bank to stop lending at all. In turn, it causes a major decrease in investment and a contraction of economic activity.
Increases in uncertainty
Perhaps due to a financial institution’s failure, the uncertainty increases among individuals with a prominent financial market failure or recession to follow. This causes a decline in lending, investing, or economic activity.
The contraction in the individuals’ investing abilities leads to a fall in the cash flow in the bank’s balance sheet. If the balance sheet decline is severe, it will lead to multiple bank failures that result is known as bank panic.
So, look out for the various factors that causes financial crises and try to rectify them to have a good investment.