Jan 15, 2019 in Business

Financial Crises Essay

Causes Of Financial Crises And Why Some Quickly Spread Globally

Introduction

Financial crises, simply put, are situations when money supply is less than the demand. Institutions tend to depreciate in value. A financial crisis is usually characterized by severe disruptions in the value of financial institutions’ assets, their access to funding or their clients trust. There are many causes of financial crises but mainly it is the lack of necessary liquidity in the financial institutions. It usually leads to reduced business activities and in this situation most individuals usually find that their income is greatly outpaced by debt. Investor confidence hugely affects the occurrence of financial crises. If confidence in a country’s currency, financial assets or its economy is lost, international investors withdraw their investments and funds from the country leading to a major economic problem that if not properly managed can even lead to a ripple effect all around the world. Another situation is if there is a banking panic leading to a mass withdrawal of money and leading system collapse. Financial crises have become a very common occurrence in the world today especially in specific sectors of the economy. A financial crisis though should be differentiated with economic crises. An economic crisis affects a whole economy while a financial crisis can hit a sector of an economy and not necessarily affect the other sectors of the same economy.

Causes of Financial Crises

There are many situations that can result or lead to financial crises. According to Arghyrou & Kontonikas (2010), one of the most common causes of financial crises is the speculative bubble. This is when investors buy stock speculatively. If a lot of investors do this for one stock then its price shoots up and might be very high. In this case people will want to sell to make huge profits so once everyone starts selling at the same time the price falls too. If at the time of buying the stock is more than its current price plus the interest and dividends then the stock is said to be exhibiting a bubble.

Another is cause of financial crises comes about when a country defaults on its debts or speculates an attack on its debts leading to devaluation of its currency. Arghyrou & Kontonikas (2010) note that such a situation is normally volatile and may adversely affect other countries that were in business with affected country. Investors, since the currency has value has depreciated, lose value of their investments.

Leveraging of finance or borrowing to finance other investments is said to be another cause of financial crises. Institutions do this to avoid losing their own money in case they invest and the investment fails. So it borrows money and invests it , it earns it profits and pays off its debt as well , but the investment can again also fail and thus  the financial institution loses a lot more than it has. This may cause bankruptcy and clearly in such a situation the bank cannot pay off its debts and hence spreads its financial troubles to other firms. Before financial crises it has been observed that the magnitude of leveraging increases noticeably. An example is before the Wall Street crash in 1929, margin buying had become very common (Caceres & Segoviano, 2010).

Mismanagement of an institutions assets and liabilities is also another cause. The way that a bank manages the risk of bank runs occurring is often seen as wrong. They invest in long term projects using customer deposits and incase of a panic withdrawal by customers the bank is left totally exposed since it cant liquidate its money fast enough thus no way to prevent a bank run. Internationally , if a government decides to sell bonds using US dollars rather than use its own currency , it creates a problem since their liabilities are in US currency but their assets are in their own denomination thus run the risk of sovereign default the is a lot of fluctuation in exchange rates.

Some financial crises have been blamed on insufficient regulations of financial institutions by the government. Most governments tend to regulate financial sector to provide some transparency. These regulations also make sure that the financial institutions have enough assets to meet their contractual obligations. Problems also occur when there is over regulation. In such a situation some Investors tend to shy away from such countries. Banks mostly are usually the institutions targeted since they handle people’s money hence they need to be controlled a bit. One bit of control they do not really favor is the fact that they have to increase their capital when risk rises which ultimately causes them to decrease their lending rate.

Fraud is another known factor that causes financial crises. Fraud occurs when a company gains investors by misleading them and making claims they cannot fulfill or about their investment strategies. A lot of rogue traders have cost investors millions of money and created financial crises in the process. At this point the issue of government regulation is brought up again since this would help curb such problems.

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Why Some Financial Crises Quickly Spread Globally

According to Koo (2011) one of the main reasons for spread of financial crises is the heavy dependency on the developed countries. Third world countries have very limited sources making it necessary to trade with other countries that have what they need. Resources, such as oil are not found in most countries and being that most machines work on a daily basis dependent on oil, hence in such situations there is only one option and that is to trade , making the country dependent on another.

China, USA, Russia, Germany and Britain are the world’s super power and posses resources that they use to trade with the other countries and get what they want from the particular nation. In a way this affects a country’s sovereignty since the super power usually tries to get a deal out of their resources since they know that the country is desperate. 

All that though was brought about by the emergence of free trade, as countries opted to quit the concept of specialization. Before free trade, countries used to create their own resources just enough for them as trading amongst each other had not picked up yet. After the emergence of free trade it got easier since it meant that a country could now stop trying to do everything for itself and focus on what it could offer as trade to other countries (Koo, 2011). Example Mexico now deal with plantations, China deals more with the manufacture of things, Russia concentrated more on oil and USA’S biggest export is machinery. Free trade had its benefits and but also had its perks since the issue of dependency slowly started to arise. 

If for example Mexico sells its plantations to USA then once USA stop buying from them, it means that Mexico get no money hence they cannot buy from other countries what exactly they need hence there is a financial crises. This chain of events becomes global since, Mexico itself has to buy another product from a different country but without money from their exports, they cannot (Caceres, Guzzo & Segoviano, 2010). This thus means that they cannot pay their debts and hence default. Therefore, their financial problems spread to other countries in that manner. Another way is that maybe the country Mexico is buying resources from is heavily dependent on that money , so once Mexico do not buy from them , it means they also do not have money hence cannot pay their debts and also cannot buy resources as well. So in that case the effect of financial crises in one country leads to a ripple effect all over the world hence it becomes a global problem.

Another reason why it spreads so quickly is the fact that some countries have control over some of the world’s most important resources but refuse to share so ask to raise it demand hence as expected is such cases the price of the particular resource becomes really high. The resource is sold at very steep prices and other countries have to raise their prices of the particular goods they export to raise money to buy the good. This creates a hostile market and most countries result to taking loans to pay for the resource hence there is a financial crisis globally. The country not sharing its resources might actually not be doing it purposely; it might be due to shortage of the same resource in the country for its own people to use, so they unintentionally create a situation in the market where the demand is higher than the supply leading to financial crises. A country can also do this to have better bargaining power over another country. Having a vital resource like oil always puts that particular country on the upper hand when they are looking to buy a resource or gain it from another country. The oil could be used as a bargaining chip in such situations meaning the country in need either complies with the oil rich country or risk getting the oil at hefty prices or not get the oil at all. 

Another reason why it spreads so quickly is similar monetary policies. Example countries using the Euro zone will tend to experience the same effect if the currency suffers in the market. Being that most of these countries are developed countries, it means if there is financial crises, using the same logic of dependency, then it means that other countries will suffer the same effect. 

The US dollar is the most relied on currency in the world when performing deals. Most countries tend to sell their bonds in American dollars rather than use their own. This may later own lead to a problem since, their liabilities are in US currency but their assets are in their own denomination thus run the risk of sovereign default, as there is a lot of fluctuation in exchange rates. 

Conclusion

Financial crises is a global problem especially if ripples out of the region experiencing it. However, this does not to mean that there are no solutions to it. The best solution that seems to be able to at least curb this menace is government intervention. Regulation of financial institutions needs to be utilized since it has proven to have the best results so far. Though a good method it should not be too tough so to ensure that the regulations do not stop investors or scare them away by being too strict. If a plan could be developed to help countries stop being too reliant on the super powers ,it would also help stop financial crises since the ripple effect from one country’s financial crises would not affect the other dependent countries too much. There is no way that financial crises can be avoided completely but they can be reduced a lot to a state that they cannot be felt that much. Nevertheless, it will take an initiative by the whole world combined to achieve this.

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