Costs of Financial Crises (Financial Economics)

This short revision note looks at some of the main costs of a financial crisis and financial instability affecting one or more countries.

Economic and Social Risks from Financial Instability

1. Taxpayers (Bailout costs)
2. Depositors (Risk of lost savings)
3. Creditors (Unpaid debts)
4. Shareholders (Lost equity)
5. Employees (Lost jobs)
6. Government (increased deficit)

Financial Crisis and Contagion Effects

Contagion occurs when a localised crisis spreads to have a much wider impact. This was certainly the case with the global financial crisis in 2007 which essentially started in the sub-prime segment of the US housing market but whose contagion effects were far reaching.

• Sub prime mortgages
• Mortgage companies
• Lenders & Home builders
• Financial markets
• US economy
• Global economy

How a Financial Crisis Hits Business Investment

Financial crises eventually feed through into the real economy and usually cause a fall in business investment

1. Higher cost of credit – commercial banks become more risk averse and may raise interest rates on higher risk loans
2. Falling asset prices weaken bank balance sheets and mean they have less money to lend out. Banks restrict credit to rebuild capital
3. A desire to maintain higher lending of bank liquidity causes a fall in lending to new and small businesses which can hamper entrepreneurial activity
4. The fall in asset prices causes a fall in consumer spending / aggregate demand and economic confidence – businesses less likely to invest when spare capacity is growing
5. Fall in share prices hits the ability of listed companies to raise extra capital to fund their investment plans

Impact on Share Prices of Previous Financial Crises

Multiple financial crises often happen simultaneously. For example, the Global Financial Crisis in 2008 was initially focused on the housing market (an asset price bubble) but then spread into the wider banking system and onto government debt problems.