Table of Contents
Financial crisis occurs when financial markets crash caused by adverse selection and moral hazard become acute in financial markets, rendering these markets incapable of capital mobility. efficiency from savers to potential investors. The result was an economic downturn. (According to Commercial Banking Textbook, Statistical Publishing House)
Causes of the financial crisis
Interest rates soar
Individuals and companies with high-risk ventures are the ones willing to pay high interest rates. If market-sensitive interest rates increase with increased credit demand or due to a decrease in the money supply, those with good credit risk will no longer be eager to borrow, while those with credit risk bad still want to borrow.
Due to increased adverse selection, the bank is no longer willing to lend. The sharp decline in credit led to a sharp decline in investment and macroeconomic activity.
Sudden instability in financial markets (perhaps due to the collapse of a major financial or non-financial institution), signs of an economic downturn or a stock market crash, making it more difficult for banks to screen borrowers.
As a result, banks are no longer able to deal with the problem of adverse selection, leading to limited lending, a decline in credit, investment, and macroeconomic activity.
Effect of stock market on balance sheet
The state of a company’s balance sheet reflects the current state of asymmetric information in the financial system. A severe drop in the stock market is a factor that causes a business’ balance sheet to deteriorate.
Conversely, a deterioration of the balance sheet can increase the problem of adverse selection and moral hazard, triggering a financial crisis. A decline in the stock market decreases the equity of companies.
The equity of companies decreases, making banks less willing to lend, because equity capital is a cushion, acting as collateral for loans. When the value of the security decreases, making the bank no longer well protected, leading to the possibility of credit loss is present.
Problems in the banking sector
Banks play an important role in financial markets, because they are efficient in the production and processing of information, which underlies efficient investment in the economy.
The state of a bank’s balance sheet has an important impact on lending. If a bank’s balance sheet deteriorates (equity declines significantly), the source of loanable funds becomes constricted, leading to a credit crunch. As a result, investment fell and the economy stagnated.
Government budget deficit
In emerging countries, if the government budget deficit is severe, it will give rise to fear about the possibility of government default. As a result, the government had difficulty issuing bonds to the public, the government turned to forcing banks to buy.
If the price of government bonds falls, it will worsen the bank balance sheet, leading to a decrease in bank lending. The fear of government default can also be a trigger for a foreign exchange crisis, when the value of the local currency drops dramatically as foreign investors withdraw capital from the country.
The value of the local currency declines, worsening the balance sheet of a company with large foreign currency liabilities. A bad balance sheet increases the problem of adverse selection and moral hazard, which in turn reduces credit, reduces investment, and causes the economy to stagnate. (According to Commercial Banking Textbook, Statistical Publishing House)