What is a Financial Crisis?

Jessica Ellis

In economic terms, a financial crisis is a situation in which widespread assets suddenly lose value. This can occur due to a variety of internal and external influences and, like a massive earthquake, take years of rumblings before the big crisis occurs. Financial crises often result in recessions, which are consecutive quarters of negative growth in the gross domestic product, or GDP.

One common type of financial crisis is known as "a bubble".
One common type of financial crisis is known as "a bubble".

Despite a global financial crisis developing in the early 21st century, the term and its implications are still little understood. This type of crisis has been a part of economics for centuries with varied results. Holland's Tulip Mania of the 17th century, the Australian banking crisis of 1893, and the Wall Street Crash and Great Depression of the 1930s are all examples of this type of incident. The ability to survive and rebuild after a financial crisis has depended on many different kinds of factors, including outbreaks of war, changing market, and new economic regulations.

The Great Depression, which led to hardship for a large portion of Americans, is one of the most famous financial crises.
The Great Depression, which led to hardship for a large portion of Americans, is one of the most famous financial crises.

One common type of financial crisis is known as a bubble. This economic oxymoron occurs when stock prices are driven so high through speculation that it becomes completely unreasonable to purchase more, as they will never yield at maturity what was initially paid. When the market reaches this “unreasonable” horizon, an enormous sell-off of stocks generally follows, resulting in an astronomical decline in value.

A banking crisis occurs when investors pull money out of financial institutions too fast for the bank to keep up. Since most modern banks lend out the money they take in, this means that the bank may not be able to return the money in investors' accounts if too much is pulled out. Without banking insurance, people can lose all money in their accounts, the fear of which can propel more and more investors to pull money out. If a bank fears it may not have enough capital to cover investments, it may be reticent to lend any, which can lead to a broader financial crisis by preventing approval of loans.

The global economy is often vulnerable to currency crises, which happen when a rapid devaluation in one region's currency that makes it too unstable to set exchange rates. If the region has a fixed exchange rate, it may use monetary reserves to make up the difference in value. This practice can in turn lead to a sovereign default, where a country can no longer afford to pay back the difference it owes and any amount it has borrowed from foreign partners.

One common factor in many financial crisis situations is the idea of a growing panic or herd mentality. In a bubble economy, investors egg each other on by buying more and more stock, sending the price and the expectations shooting up. In a bank run, what begins as a few investors pulling out money can play on fears of a bank run, leading more and more people to destabilize the bank for fear of it destabilizing. In many cases, after a crash has occurred, financial experts are faced with many questions about why the crisis was unforeseen or ignored, yet it may take years of context and distance to get a clear picture of the situation.

A financial crisis occurs when widespread assets, held by entities such as banks, suddenly lose value.
A financial crisis occurs when widespread assets, held by entities such as banks, suddenly lose value.

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