Definition of Financial Crisis
Financial crisis – the financial crisis is an economic phenomenon that is expressed in the imbalance between various area of the economy. It can be caused by external and internal factors and always has consequences.The financial crisis has a medium level and long-term negative impact on economic activity in the country and influence the dynamics of the well-being population.
Impact on the financial sector and financial markets can sharply increase an interest, an ever-increasing share of bank problems and non-bank financial institutions, debts problem. Additionally, it enlarges important reduction in loans to the economy and households, chain bankruptcies, a transition to a loss-making model of banking and other financial activities, the prevalence of speculative over-investment financial activities, a large-scale drop in securities prices.
It delays in settlements with the growing collapse of the payment system, the emergence of massive losses in the market derivatives, the cessation of liquidity in financial markets and financial institutions with a domino effect, banking panic.
Types/classification of Financial Crisis
The international finance crisis leads to an uncontrolled fall in the national currency rate, a massive outflow of capital from the country, an uncontrollable increase in external debt and overdue payments by the state and commercial organizations, the transfer of systemic risk to the international market and financial markets of other countries.
A local financial crisis is is a deep breakdown of the state financial system, a sharp decrease in the value of any financial assets. Restrictions influence the world economy and global finance as short-term turbulence, risks and losses that do not break the main course of the movement in the world economy. Local crises permeate the life of developing economies like Russia, Kazakhstan with a frequency of 1 – 2 times in 10 – 15 years.
A sectoral crisis encompasses one of the sectors of the national economy and is caused by a change in the structure of production, disruption of normal economic ties, etc. Sectoral crises are characterized by declines in production and curtailment of activities in one of the industries (for example, in the coal, steel, textile industry).
It should be noted that this classification of crises is rather arbitrary. In reality, it is difficult to separate one type of crisis from another, to draw a clear line. One crisis can combine several types at once. And it is impossible to separate them from one another, because in the economy, everything is interconnected.
Crises in the banking sector, can be triggered by a massive withdrawal of deposits as a result of a drop in confidence in banking institutions or the national currency. This leads to closure, takeover or nationalization financial organizations. Or it could be caused by internal banking financial problems resulting in license revocation or large-scale financial support to an important financial institution. What affects the entire banking system and leads to its restructuring.
Liquidity crises is a lack of liquid cash which making it difficult to fulfillment by banks, enterprises of their obligations. The reasons for the crisis can be different: capital flight; reduction in investment; massive loan defaults, outflow of deposits from banks.
Currency crises is a sharp drop in the value of the national monetary unit as a result of loss of confidence in it and the reduction of gold and foreign exchange reserves. A sharp drop in the exchange rate is the main symptom of the crisis. A 15-25% fall in the exchange rate of the national currency against the US dollar or other significant currency is considered a crisis.
When investors become confident in the inevitability of a banking crisis, this forces them to revise their portfolios, replacing local currency assets with foreign assets. When central banks transfer liquidity to the banking system to keep troubled banks afloat, the excess money created can initiate currency speculation and put pressure on foreign exchange reserves.
FINANCIAL CRISIS MODELS
Financial crisis models have been emerging since the late 1970s. As a result of the studies carried out so far, first, second, and third-generation crisis models have been developed. All these models were developed specifically to explain the features of financial crises. As world economies experience new crises, the shortcomings of the previous models that are insufficient to explain the crisis were evaluated; and new models have been created based on their predecessors.
The first-generation financial crisis model was developed to explain the crises in Latin America in the 1970s-1980s. The main reason for the crisis was that expansionary monetary policy is not compatible with exchange rate policies, first modeled by Krugman (1979), based on Salant and Handerson (1978).
The second-generation financial crisis model was developed by Obstfeld (1994) based on the first-generation model, which was insufficient to explain the 1992 European Exchange Rate Mechanism (ERM) crisis. It has been emphasized that multiple equilibria caused concerns; the expectations of economic agents may impact the economy while governments sought to balance political and economic agendas.
The third-generation financial crisis models were developed after the Asian crisis, which occurred in the second half of the 1990s; the previous models were insufficient to explain the dynamics of the crises. It was emphasized that the contagious feature of the crises, the money and banking crises affect each other with a vicious circle. Besides, that financial liberalization, one of the blessings of globalization, led to financial vulnerability.
First Generation Crisis Model
Salant and Handerson (1978) created a model that examines gold pricing between 1968-1974, resulting in the collapse of the Bretton Woods system. The study that inspired Krugman showed how the price stabilization programs for the gold market caused the collapse of the gold-money system with destructive speculations. In the model, it was considered that gold reserves could be depleted by accepting gold as an exhaustible resource. In the crisis environment, the price set in the gold market tends to rise with the expectation of speculators that gold prices will increase.
To avoid abnormal fluctuations, the balance of prices depends on the sale of government reserves. However, if this process is prolonged and sales interventions increase, price control will become unsustainable with the prediction of reserves depletion. In his research, Krugman (1979) contended out that foreign currency reserve is as exhaustible as gold reserves. Thus, foreign currency sales made by governments to protect national currency value will lead to depletion in foreign exchange reserves.
Besides, poor macroeconomic policy is a cause of fragility and speculation in economies. One example is the expansionary monetary policy. While the aim is to finance the budget deficits, the expansion of money will result in more national money than demand, a rise in inflation, capital outflow, and negative expectations.
The excess money in the market will be channeled to foreign currency, resulting in foreign currency reserve sales to maintain the economies with crawling peg or fixed exchange rate regimes. The decline in foreign exchange reserves will cause the perception that the fixed exchange rate cannot be maintained.
There are two limitations to the model. The first one is that it is a simple macroeconomic model; although this helps to achieve certain conclusions, the causes of the balance of payment crisis are not explained. Secondly, only the intervention with foreign exchange sales has been evaluated to balance the exchange rate value, whereas various interventions can be applied to the markets.
The pioneering work of Krugman (1979), whose model has been named as first-generation financial crisis or canonical models in the literature, has inspired many other models. One of the important works is the model of Flood and Garberin (1984). In the study, perfect foresight continuous-time, discrete-time models were developed based on Krugman’s non-linear model. It is accepted that collapse of fixed exchange rate regimes is inevitable. Thus, the period for the collapse can be estimated depending on the reserves.
In general, these models were developed to explain the external debt and balance of payments crises that began in 1973, when oil and energy prices began to rise tremendously, triggered by the 1982 Mexican moratorium, and often occur in Latin American countries. Among the causes of crises are fundamental economic factors such as exchange rate imbalance, budget deficit, and balance of payments.
The causes of the crises are fundamental economic factors, such as exchange rate imbalance, budget deficit, and balance of payments. The main thesis in these models is that the deficit financing pathways and expansionary macroeconomic policies that governments use to sort budget deficits eliminate the possibility of maintaining a fixed exchange rate policy.
The first-generation financial crisis models used to explain the currency crises in 1973-1982 Mexico and 1978-1981 Argentina are described as the deterioration in the fundamental macroeconomic indicators resulting from the wrong economic policies implemented in the fixed exchange rate system. Turkey’s 1994 financial crisis is an example of the first-generation models.
Second Generation Crisis Models
In the first-generation financial crisis models, unsustainable exchange rate policies and fundamental macroeconomic imbalances of the governments are explained mechanically. Second-generation models were developed following the first generation of financial crisis models, which were insufficient to explain the 1992 European Exchange Rate Mechanism (ERM) crisis and the 1994 Mexican crisis. Second-generation financial crisis models tried to explain the self-fulfilling expectations of economic actors.
Obsfeld (1994) emphasized that, unlike Krugman’s (1979) first-generation financial crisis model, the depletion of the reserves and the collapse of the fixed exchange rate regime did not occur in the 1992 ERM crisis. In the ERM 1992 crisis, European governments faced a challenge of, on the one hand, high interest rates and unemployment causing economic and political pain and, on the other, the political objective of a target rate.
The critical issue for governments here is to compare the cost of maintaining a fixed exchange rate with the macroeconomic advantages of staying in the union. Even though the reserves of industrialized European countries were sufficient, self-fulfilling expectations and multiple equilibria notions have been suggested in explaining the crisis. Accordingly, it was stated that economic agents, who made a move with the motive of a pessimistic scenario, took positions considering the future, not the present.
In the ERM crisis, the macroeconomic indicators (increasing interest rates, unemployment) worsened daily, creating multiple equilibria. Speculators looking at the increasing cost of maintaining the fixed exchange rate took positions to expect the exchange rate to be devalued. Obstfeld (1984) conducted that predicting the peak point in the context of macroeconomic deterioration and self-fulfilling expectations as a crisis cannot be calculated, unlike in the previous models. So, the exact crisis date is uncertain (Obsfeld,1994).
In these models, which are also called self-fulfilling crisis models, the policies developed for the solution to macroeconomic problems such as decreases in production levels, high unemployment rates, public debt stock, and the crises that emerge due to the high interest rate caused by the increase in financial vulnerability, caused problems in the banking sector.
The speculators observed the change in macroeconomic conditions and policies implemented by the government, which influenced expectations. As the speculative attacks increase, the cost of maintaining the fixed exchange rate system will increase. Therefore, economic individuals perceive that such attacking costs mean that the fixed exchange rate system will be abandoned.
If this situation is believed to lead to devaluation, speculative attacks will have become self-fulfilling attacks. Second-generation financial crisis models are referred to together with third-generation financial Crisis models because they address the countries in which macroeconomic balances are disturbed and the spreading effects that lead to the emergence of the currency crisis even though no crisis is observed in the economic indicators.
The formation of multiple equilibria can be explained by the fact that the exchange rate has more than one value, each of which is in balance, depending on the expectations of the speculators. In other words, there are several possible exchange rate balances, and which one will depend on expectations. Obstfeld (1994), Cole and Kehoe (1996 and 1998),
Chang and Velasco (1998) argue that the formation of multiple equilibria depends on macroeconomic data. If macroeconomic results are good (for example, there is no unemployment problem, foreign trade deficit, and liquidity problem in the banking system), the cost of defending the fixed exchange rate system will be very low. Therefore, there is no feedback process between expectations and costs.
If macroeconomic indicators are poor, devaluation is inevitable, as in first-generation models. When macroeconomic data have moderate values, multiple equilibria may occur depending on expectations. In other words, while a balance occurs due to negative expectations, leading to a high exchange rate, positive expectations may result in a low exchange rate.
The question was when it would collapse, whereas there was a range of methods to prevent a crisis that the government would consider in the new model. If this is the case, Krugman claims that the crisis as an outcome is not predictable but consequent on speculations that realized expectations instead of an utterly self-fulfilling mechanism.
Krugman concluded that it is correct that the government does have a greater range of concerns beyond mechanically pursuing credit creation until reserves run out. However, there is insufficient evidence to support the idea of multiple equilibria and self-fulfilling crises. There were apparent reasons for speculative attacks, and that the governments had been warned ahead of these risks.
First-generation financial crisis models consider weak economic data (budget deficit, overvalued domestic currency) as necessary in explaining the causes of a speculative attack on the exchange rate. However, the second-generation financial crisis models point to a speculative attack on the exchange rate and monetary policy authority that has lost the reliability of the financial system.
In other words, the central bank’s contractionary monetary policy to prevent the speculative attack on the exchange rate will decrease the total supply, increase the unemployment rates, and damage the reliability of the monetary policy. Therefore, monetary policy management needs to correctly analyze the benefits and costs of defending the exchange rate regime.
Third Generation Crisis Models
The first- and second-generation financial crisis models’ inability to explain the Asian crisis in 1997 led to developing a new model based on previous ones. Compared to the economies in previous models, Asian economies had better macroeconomic conditions. The crisis started in Thailand and spread to other East Asian countries. There was no underlying economic reason for a crisis; the fundamentals were sound; however, fear and panic resulted in a crisis.
One explanation is moral hazard, which is a decisive argument in third-generation financial crisis models. Besides, the contagion was a feature of third-generation financial crisis models. The banking and currency crises trigger each other in a vicious circle; the impact of the crisis was felt in all sectors and regions.
The Asian crisis is not like those caused by financial deficits like the first generation financial crisis models nor the second generation financial crisis models in terms of its macroeconomic structure. However, it can be explained by financial excess and financial collapse. The Asian story signifies the subsequent collapse of asset values followed by a bubble and the currency crisis.
The problem started with the excessive amount of lending, particularly debts unregulated or perceived as guaranteed by the state, which encouraged risky investments, a moral hazard. Excessive risky lending caused inflation, which caused the overpricing of assets. As a result, the bubble burst. Falling asset prices created insolvency, and financial intermediaries had to stop their operations.
Krugman (1999) notes the apparent vulnerability of the Asian economies to the self-fulfilling crisis which resulted in such an extreme crisis for the region and how the contagion spread from the initial crisis to other countries, even those which seemed to have few economic links with the original country.
After financial liberalization, poor auditing and regulation in the banking sector led to the deterioration of risk management and a low capital adequacy ratio. In such an environment, dense foreign capital inflows may lead to excessive lending of banks to domestic markets, drastic increases in consumption expenditures, and soaring prices in the stock exchange and real estate market. After, the recession of the economy due to any internal and/or external shock makes the banking sector even more fragile.
Another highlight of such models is the expectation that the banks’ credit expansions by crony capitalism will turn into hidden state debt during a possible severe crisis. At the end of the morally corrupted financial management, there is a heavy burden for the public to pay. If the maturity of bank liabilities is shorter than the maturity of assets, this will cause negativity in banks’ reserve system. In such cases, a bank run begins. Banks’ funding sources and usage areas of these funds can be different from each other.
Different funding sources and different usage areas will cause currency and maturity crises simultaneously. These crises will trigger each other and create a liquidity problem for banks. The macroeconomic variables that form the basis of the country’s economy (such as money supply, high inflation rate, budget deficits, disruption in the balance of payments, employment, and unemployment) will deteriorate for the crisis’s occurrence even if they are not negative. The 1997 Asian crisis was also caused by liquidity problems, not the countries’ failure to pay their debts due to negativities in macroeconomic indicators.
The most important feature of the third-generation financial crisis models is the effect of contagion. Contagion is seen in both the 1997-98 South East Asia crisis and the 1998 Russia crisis; together, they inspired the third-generation crisis models. As a matter of fact, the crisis wave started with the fluctuation of the Thai Baht on July 2, 1997, and spread to South Korea, the Philippines, Indonesia, and Malaysia, in a short time. Similarly, upon the announcement of Russia on 18 August 1998 that it could not fulfil its obligations for the government bonds, the crisis extended to other countries such as Mexico and Brazil, putting them into crisis. The third-generation crisis models can explain this contagion effect.
If the cause of the financial crisis in one country is a financial crisis or speculative attack in another country, the crisis is transmitted from one country to another. However, the reason for the crisis in the second country is not only a crisis in the first country. After the first country crisis, the macroeconomic indicators have to deteriorate and/or the private sector expectations should change in the second country. In other words, the first crisis alone does not initiate a crisis in the second country.
Masson (1998) categorized the contagious effects of financial crises in three elements: a monsoonal effect, spillover, and pure contagion. If financial decisions and policy changes in one country negatively affect the second country’s economy, this is considered a monsoonal effect. The negative impact in developing countries due to the decisions taken in developed countries can be evaluated within this scope.
Financial crises can transmit from one country to another, directly or indirectly, through spillover or pure contagion. If the financial crisis in one country disrupts the macroeconomic balances in another country and causes a financial crisis, it is a spillover. Devaluation in one of two countries with a commercial connection may lead to loss of competition, which can cause a foreign trade deficit and loss of reserve in another country. In this case, spillover occurred.
The financial crisis in a country may not cause any changes in the second country’s macroeconomic indicators. However, the first country crisis may change investors’ opinions or risk tolerances regarding the second country’s macroeconomic indicators. As a result, private-sector expectations may change, resulting in a financial crisis of self-fulfilling expectations. In this case, the crisis has spread from the first country to the second country through pure contagion.