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Term Paper on Financial Crisis

Term Paper # 1. Introduction to Financial Crisis:

A financial system performs three crucial functions – resource allocation, asset pricing and providing mechanisms for settlement. A financial crisis affects all the three functions. It may arise out of events external to the economy (the US subprime mortgage crisis was an external event for Iceland, and the EU), or internal events (the US subprime mortgage crisis was an internal event for USA).

It may begin in the banking sector and spreads to the rest of the economy (a banking crisis), begin in the sovereign debt market when the government is unable to repay scheduled domestic debt obligations (sovereign debt crisis), or begin in the foreign exchange market (a currency crisis). Irrespective of the label and the triggering event or events, every financial crisis affects the value of the currency of the affected country. Thus, all crises are currency crises first and foremost. This article describes the causes and consequences of a financial crisis.

A post mortem of every crisis is conducted by policymakers, central banks, academics, national and international think tanks, and international institutions such as the IMF, each with different objectives—to trace the chain of circumstances, to explain why a certain set of circumstances and macroeconomic indicators precipitated the crisis, to identify regulatory lacunae, to compare crisis-hit economies at the same or different stages of economic development, to suggest solutions for rapid recovery, and to draw lessons that can be used by governments to anticipate and swiftly respond to future crises. The analyses offer diverse views on what went wrong, how and why.


Every crisis causes a severe economic setback followed by a prolonged recovery. It provides an opportunity for testing institutional responses, risk management practices, robustness of policies, and economic resilience, leading to regulatory overhaul where necessary. Globalization, economic interdependence (such as that between China and USA), capital account convertibility, and financial integration add layers of complexity, besides increasing the probability of contagion (the spread of a crisis to other economies).

Term Paper # 2. Causes of Financial Crisis:

The twentieth-century world experienced a financial crisis every decade. The Report on Fuller Capital Account Convertibility (2006) describes the movement of a currency crisis from country to country “Brazil was suffering from both-fiscal and Balance of Payments weaknesses and was affected in the aftermath of the East Asian crisis in early 1998 when inflows of private foreign capital suddenly dried up. After the Russian crisis in 1998, capital flows to Brazil came to a halt”.

Is there a connection between financial crises and the exchange rate regime? Economists are divided about the causation—financial crises occurred in countries that were beginning to remove capital controls, irrespective of the exchange rate regime the countries followed. The causes were macroeconomic mismanagement, unsustainable populist policies, sustained inflation, weak laws, non-enforcement of laws, and underdeveloped financial markets.

When a country’s weak and poorly regulated banking system collapses, it triggers a flight of capital. The sudden spike in demand for foreign currency, and large scale selling of local currency, depletes foreign exchange reserves, the country’s foreign exchange market collapses, and a currency crisis is in full swing.


Raising interest rates to stem capital outflows leads to inflationary pressures and a further decline in the value of the currency. A higher rate of inflation means a higher discount rate for future cash flows. Under the dividend valuation model, this translates into a decline in current share prices and equity market indices.

An increase in the cost of borrowing and decrease in credit off-take, as companies postpone expansion plans. Due to higher costs of borrowing, disposable income falls, and the demand for goods and services falls, triggering recessionary tendencies. Thus, the apparent solution (interest rate increase) to a perceived problem (capital outflows) can create more problems. There are renewed calls for stimulus packages to kick-start economic growth, as policymakers and central bankers nervously watch macroeconomic variables.

But when is a country vulnerable to a crisis? Reasons identified in past crises are listed below:

i. The economy is dependent on external demand and over-reliant on exports (Thailand in the 1997 Asian crisis).


ii. The export basket is composed primarily of commodities.

iii. Companies are highly leveraged (South Korea, 1997), or corporate revenues and purchases are in different currencies— currency mismatch (Asian crisis, 1997).

iv. Bank assets are denominated in a currency different from that of bank liabilities (Thailand, 1997).

v. The gross non-performing assets (NPAs) of financial institutions are high, and NPA provisioning is inadequate (Philippines, 1997).


vi. A lax regulatory environment (US financial sector crisis, 2008). Financial regulators and capital market regulators do not ensure that sectoral lending caps, asset-liability management guidelines, and capital adequacy norms are being strictly followed (Thailand, 1997).

vii. Excessive loan exposure to a particular sector such as real estate (Hong Kong, 1997).

viii. Excessive short-term borrowing overseas by the financial sector and high levels of maturity mismatch and currency mismatch (Thailand, 1997).

ix. Financial institutions, companies and market participants issue and trade in financial instruments such as securitized OTC derivatives, whose risk-return characteristics are poorly understood by all parties including central banks and market regulators.


x. There is mispricing of risk by the financial sector (subprime crisis, 2007).

xi. High levels of external debt, and high level of government debt (Argentina, 2002)

xii. The government’s inability to repay external debt (Greece in the EU crisis of 2010, Argentina in 2003, Mexico in 1994), and inability to redeem domestic short-term debt (Russia, 1998).

xiii. BoP deficits (Ireland, 2010), and the imposition of fiscal austerity measures (Chile)


xiv. The re-imposition of capital controls (Malaysia, 1998)

xv. Investor panic sweeping across countries in the region causing contagion (Asian crisis 1997) and reversal of short-term capital flows (Mexico 1994, Argentina 1995)

xvi. Speculative attacks on the domestic currency (Brazil, 1997)

xvii. High levels of inflation (Turkey, 2000)


xviii. An overvalued domestic currency (Mexico, 1994)

xix. Stable exchange rates with little volatility (Indonesia, Korea, Malaysia, Philippines, Thailand)

As can be seen, there are usually multiple causes, and isolating the impact of any one cause is problematic. Paradoxically, a currency crisis can also hit a country that has been enjoying high growth rates, low inflation and low fiscal deficits, as the Thai currency crisis (1997) demonstrated. This makes the identification of causation even more difficult. But invariably every crisis results in a loss of confidence in the country and its institutions, and exposes financial market vulnerabilities.

Central banks play a critical role in a currency crisis, bailing out the financial sector, financial markets and even the government. The European Central Bank helps individual EU countries that face a crisis. Greece’s huge budget deficit rendered it unable to repay government debt that matured in May 2010. The European Central Bank announced the creation of a € 440 billion special-purpose vehicle to guarantee loans to governments. In December 2010, Ireland became another EU country in crisis, while Portugal and Spain (the other two countries in the ‘PIGS’ quartet) teetered on the brink of a crisis throughout 2010.

Effects of Financial Openness:

i. An increase in ‘hot money’ inflow and outflow.


ii. Greater volatility in the stock market and foreign exchange market.

iii. Increase in speculative trading and noise trading.

iv. Increase in the number and variety of financial entities.

v. Increase in the volatility of foreign exchange reserves.

vi. Restructuring of the financial sector.

vii. Decreased state ownership of financial sector firms.


viii. instantaneous reflection of global events in asset prices.

A country’s financial sector and real sector are buffeted by the vagaries of the international financial system. As liquidity increases in the international financial system and profitable investment opportunities dwindle in advances countries, there is a rush to invest in emerging market economies, and among them, newly industrialized countries. The sudden influx of capital flows leads to a massive increase in foreign exchange reserves, domestic currency appreciation, and increase in money supply. The economy booms as banks use the easy monetary policy to extend loans.

Corporate credit off-take rises, along with per capita consumption. Investor confidence and creditor confidence is high. As the economy overheats, there can be a sudden crisis of confidence among foreign investors. The sudden capital flight causes deflation and recessionary trends. The domestic currency depreciates. The central bank expends foreign exchange reserves to prevent the currency depreciation. Desperate to attract capital back into the economy, the government dismantles remaining capital controls. The boom-bust economic cycle is repeated time and again.

Term Paper # 3. Global Financial Crisis:

The crisis rewrote the rules of the game, when it came to dealing with the concerted economic fallout and worldwide recession that it triggered. The crisis began in the US housing market, and spread via securitized instruments issued by US banks and housing finance companies, to the banking sector (in the USA, UK, EU, Switzerland, Australia and Iceland), and to hedge funds that held OTC securitized financial instruments. The term ‘toxic assets’ entered the lexicon of financial crisis literature.

Central banks in USA, UK, and the EU spent more than $ 150 billion as they fought to infuse liquidity in the money market and keep their financial systems running. The entire financial sector in USA shed jobs, went through consolidation, and struggled to stay afloat, as more than two hundred banks failed. The US government abandoned its adherence to a free market ideology that is best captured by the Darwinian analogy ‘only the fittest survive’.

It offered assistance through loans and equity purchase to financial firms that were deemed ‘too big to fail’ (TBTF). In 2008, the share price of insurance giant AIG fell by more than 94 %, to an all-time low of $3. With operations in over a hundred countries, it was forced to take $85 billion in assistance from the US government in return for equity. Dutch bank ING, took a € 10 billion bailout package from the Dutch government, Swiss bank UBS received over $5 billion in aid from the Swiss government.


The government of UK spent more than $60 billion to recapitalize its banks, France and Netherlands spent € 360 and € 200 billion respectively to shore up their banks. Investment bank Goldman Sachs converted itself into a bank holding company so as to be able to access cheap funds and government assistance. The global financial crisis made governments and regulators realize that market discipline is inadequate and must be backed by rigorous regulatory oversight.

Financial Sector Reforms in the USA:

The US regulatory framework that had been structured in the 1930s was inadequate to deal with sweeping changes in the financial system including new financial instruments and their attendant risks. The Obama administration introduced the Dodd Frank Act (2010). It was passed with the aim of dealing with TBTF financial institutions, and to limit the risk in the financial system.

Its salient features are:

i. The constitution of the Financial Stability Oversight Council, to assess systemic risk.

ii. Thorough regulatory oversight of financial derivatives.


iii. Increase in capital adequacy norms for the banking sector.

iv. The prevention of banks from undertaking proprietary trades. This was known as the Volcker rule.

v. Permission to the US government to force closure of a financial firm that could cause potential harm to the whole financial system

vi. Limits on executive compensation by giving shareholders a right to veto high pay packages.

The Asian Crisis (1997):

Financial openness in East Asian countries lead to large capital inflows in the 1980s and 1990s. Their bank based financial systems were relatively unused to competition, and operated in an environment of directed credit, interest rate ceilings, and restriction on entry of foreign banks. As their economies embraced financial openness, interest rate ceilings were removed, banks were permitted to borrow overseas, and lend in the domestic market.


There was an explosive growth of non-banking finance companies and FII inflows. Thailand set up a mechanism (Bangkok International Banking Facility) to attract more short term capital inflows. Some of the countries that were on a fixed exchange rate (Thailand) rapidly accumulated foreign exchange reserves. There was rapid credit expansion by banking systems in Korea, Malaysia and Thailand. The risk assessment and asset-liability management expertise of financial institutions though adequate in closed economies, did not keep pace with the challenges that financial liberalization threw up.

Banks lent money to the real estate sector (Hong Kong, Malaysia, Singapore, Thailand), to companies with high levels of pre-existing debt (South Korea), and to companies whose export revenues formed a disproportionate share of total revenues (Thailand).

Companies borrowed overseas (often short term as it was cheaper than long term finance) to fund domestic expansion plans creating a maturity mismatch and a currency mismatch (Thailand). Because companies and banks were used to a stable value of the domestic currency, they did not hedge the currency risk in overseas borrowings, and in foreign currency-denominated export revenues.

Equity shares and real estate were accepted as collateral—both susceptible to decline in value when the stock market falls (in the case of equity) and excess capacity (real estate sector). Adverse selection, crony capitalism and corruption were prevalent (Philippines, Indonesia, South Korea, Thailand). Some South Korean companies divested borrowings taken for capacity expansion, into real estate. Corporate governance was conspicuous by its absence. Even as capital inflows increased, the regulatory framework of the financial sector remained by and large unchanged.

As long as the East Asian export lead growth story remained intact, these disturbing features were ignored. To maintain the fixed exchange rate, the central bank of Thailand purchased foreign currency inflows. This lead to an increase in the supply of domestic currency, and created inflationary pressures. The subsequent rise in prices made domestic goods more expensive in the price sensitive international market.

Export revenues fell, highly leveraged companies could not repay their short term overseas debt, banks recalled loans that were invested by borrowers in real estate, in the capital market, and in long-gestation projects. Banks were under pressure to repay their own overseas borrowings. Cracks emerged in the financial sector, as regulators realized that the net NPAs of the financial sector were large enough to force many banks and NBFCs into liquidation.

As the true extent of the problem emerged in 1997, panic swept through financial markets in the region. The real estate market slumped. FIIs began selling their holdings and exited East Asian capital markets. Stock markets fell, reducing the value of shares put up as collateral by borrowers.

In countries on the floating exchange rate regime, the steep depreciation the domestic currency, created a rush to convert domestic currency into foreign currency. The Thai Baht came under speculative attack, and was allowed to float in mid-1997. In a bid to stem the hemorrhage of capital outflows, interest rates were raised. Companies already under pressure to repay loans were in no mood to borrow.

East Asian currencies – the won, the baht, the ringgit, and the rupiah- fell by more than a fifth of their pre-crisis values. There was a liquidity overhang in banking systems across East Asia as economies slid into recession in quick succession. Korea, Indonesia and Thailand were the worst affected. Subsequent analysis of the crisis hit economies, and the unfolding of the crisis, found the main culprits to be weak and fragile financial systems, ineffective regulatory oversight, over reliance on export lead growth, and sudden reversal in capital flows.

The Russian Crisis (1998):

Russia began the process of ‘glasnost’ in the early 1990s. It was a heady era that produced billionaire oligarchs such as Mikhail Khodorovsky, erstwhile head of the Russian oil giant, Yukos. Capital inflows from the west shot up, as much to assist the former communist country to emerge into capitalism, as to generate abnormal returns from capital markets of what was perceived as a fast growing economy, with huge oil reserves. Hedge funds and other institutional investors increased their holdings of Russian bonds and equities.

State-owned companies were privatized. Russian state-owned banks accustomed to rigid oversight and little operational freedom, were suddenly free to take decisions on both sides of their balance sheets. They, along with private sector companies, borrowed heavily from overseas. The Russian government issued bonds to fund fiscal deficits. It applied for and secured an IMF loan. The Russian economy was in disarray as old institutions, processes and ways of working were discarded and replaced with untried ones. It is safe to say that the financial system was not geared to meet the new challenges thrust upon it.

In August 2008, the government could not redeem its maturing bond obligations. The bond market fell. Russian banks who held large portfolios of Russian government debt, found that the portfolio values plummeted. Banks were pressurized by overseas lenders to repay short term loans, but were unable to do so. A banking crisis began to unfold. Overseas investors, who held Russian government bonds, began selling their rouble denominated financial assets, as their government bond portfolios lost value. The Russian stock market fell.

Long Term Capital Market (LTCM), a hedge fund, was one of the most celebrated cases of the Russian crisis. LTCM borrowed heavily to invest in Russian securities. The collapse of its portfolio value, pushed the highly leveraged LTCM onto the verge of bankruptcy, but it was bailed out by the US Federal Reserve. There was a flight of capital from Russia.

As the rouble’s value plummeted, the government did not allow Russian banks to repay overseas loans, but could not stem the outflows. The Russian crisis once again brought home the dangers of a weak financial system, absence of asset-liability management in the banking sector, poor regulatory oversight, and huge capital inflows.