Financial Crisis

Any situation where significant financial assets – such as stocks or real estate – suddenly experience a sharp decline in value

What is a Financial Crisis?

A financial crisis is defined as any situation where one or more significant financial assets – such as stocks, real estate, or oil – suddenly (and usually unexpectedly) loses a substantial amount of their nominal value.

 

Financial Crisis

 

Thus, common examples of a financial crisis include financial market crashes – either widespread or within specific industries – housing market crashes and bank runs. A bank run happens when large numbers of bank depositors seek to withdraw, all at once, all their funds on deposit with their bank.

In the United States, over the past couple of centuries, financial crises of one sort or another occur roughly every 25-30 years. Recent examples include the Global Financial Crisis of 2008 and the dot-com speculative bubble bursting around the turn of the century.

 

Summary

  • A financial crisis is generally defined as any situation where significant financial assets – such as stocks or real estate – suddenly experience a sharp decline in value.
  • Financial crises are often preceded by periods of economic boom and overextension of credit to borrowers.
  • Economic recessions that follow a financial crisis are usually significantly more severe than recessions that are not preceded by a specific financial crisis.

 

Understanding Financial Crises

While various financial crises differ in both their nature and their severity, there appear to be many commonalities that typically accompany such crises.

One is that a financial crisis is often preceded by, accompanied by, or followed by situations where there are widespread credit problems. The 2008 Global Financial Crisis was no exception. It was largely precipitated by the massive boom in subprime mortgage lending, which created a large stack of mortgage loans that were virtually doomed from the start to eventually end up in default.

Subprime mortgage loans are loans granted to homebuyers with relatively lower credit scores – in short, large loans given to people who are likely to encounter difficulty making the loan payments.

According to several studies of financial crises, the rapid expansion of available credit – in other words, a boom in the amount of credit extended to borrowers – followed by a shorter period of sharp credit tightening, frequently provides an early warning indication of a coming financial crisis. Financial crises are nearly invariably followed by a period of severe credit tightening, where lenders seek to curb their risk exposure by only extending credit to borrowers with stellar credit ratings.

Another fact about financial crises is that although they don’t – thankfully – happen very frequently, they do seem to occur with relative regularity. Over the past century and a half or so, the United States experience, on average, some type of financial crisis about once every 25 to 30 years. However, the most recent history shows financial crises arising a bit more often. The U.S., for example, suffered a major stock market meltdown in 1987, then the dot-com bubble in the early 2000s, and then the 2008 Global Financial Crisis.

Financial crises are often difficult to foresee, and one reason is the fact that the immediate cause may be a relatively small event or series of events. For example, the dot-com bubble that happened around 2000-2002, while it was cataclysmic for many investors in the rapidly growing tech industry, initially involved a relatively small proportion of the overall stock market. And, despite the failure of numerous companies, several dot-com companies, such as Amazon and Google, enjoyed massive growth in the ensuing years.

Finally, a financial crisis commonly leads to a notably severe period of overall economic recession. An economy’s gross domestic product (GDP) typically declines by up to 50% more during a recession that follows a financial crisis, compared to a “normal” recession that is not preceded or ushered in by a particular crisis.

 

The Next Financial Crisis?

The world may be on the verge of another major, global financial crisis in the wake of the Covid-19 pandemic (if we’re not already in one). However, it’s difficult to see, as of mid-2020, what the ultimate economic consequences of the virus and the widespread quarantine lockdowns may be. It is, in part, because many lenders are currently practicing credit forbearance – that is, not pressing debtors who are falling behind in making their loan payments.

Therefore, the true level of financial distress being experienced by many companies and individuals is not readily apparent. Many market analysts warn that, thus far, we’ve only seen the tip of the iceberg in terms of both corporate and personal bankruptcies – that there are likely many more to come.

Secondly, governments are doing everything they can think of to prop up their economies. However, while most governments are pledging to do “whatever it takes,” their extraordinary efforts cannot be sustained forever. Although interest rates remain, for the moment, at record-low levels, there are already signs of lenders in the U.S. beginning to tighten up on credit. A severe credit crunch in the not-too-distant future is certainly not out of the question.

 

Related Readings

CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

  • Bank Run
  • Economic Collapse
  • Dotcom Bubble
  • The Economic Crash of 2020

Financial Analyst Training

Get world-class financial training with CFI’s online certified financial analyst training program!

Gain the confidence you need to move up the ladder in a high powered corporate finance career path.

 

Learn financial modeling and valuation in Excel the easy way, with step-by-step training.