What to Expect in a Financial Crisis

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Financial crises are major upheavals in the financial system, characterized by a decline in assets and the bankruptcy of many companies. They can affect economic activity in one or more countries.

The term financial crisis is used to describe a wide set of economic events which include currency crises, banking crises and stock market crises. But the term is also applied to designate debt crises or crises affecting the futures market.

A financial crisis may impact only a few countries or initiated in one country and spread by contagion to become international leading to a global economy slow down.

If a financial crisis occurs in the financial markets, the widening will lead to adverse effects on the rest of the economy, causing an economic crisis or recession. These effects are usually in the form of a credit crunch and therefore results in the decline in investment, as well as a crisis of consumer confidence.

In the event that a country which upholds a fixed exchange rate is abruptly faced with a situation whereby it has to devalue its currency due to a speculative attack, such a situation is known as a currency crisis or balance of payments crisis. And whenever a country defaults on its sovereign debt obligations, the country is said to have slipped into sovereign default.

These instances involving devaluation or default could lead to a decline in investor confidence or an abrupt increase in capital flight. Financial crises have origins in the occurrence of a category of risks managed by the market participants.

And these include market risk related to changes in rates or asset prices (interest rate risk, currency risk). Credit risk related to the reliability of a counterparty or an entire country, risks within the market and whether or not to sell an asset (liquidity risk).

These risks are not in themselves exceptional, but rather the foundation of a financial market. But when the manifestation of one of them leads to a systemic effect, various phenomena of financial crisis might occur (many of which may be concurrent).

And the events can involve a tightening of credit (credit crunch), a flight to quality, a race to liquidity, a currency crisis and a liquidity crisis (otherwise known as liquidity squeeze).

On another level, a bank run takes place whenever a financial institution experiences an abrupt rush of withdrawals by depositors. This has ramifications on the operations of the bank in that most of its cash from deposits is loaned out.

It is hard for an institution to rapidly pay back all deposits, in response to the mad rush of withdrawals.

If such crises (bank runs) take place in a widespread fashion, it becomes a systemic banking crisis or banking panic. While a state of affairs involving the reluctancy of financial institutions to lend out money, due to concerns over insufficient funds is often addressed also as a credit crunch.
 

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