Causes and consequences
It is often observed that successful investment requires used to refer to every one of two or more people or things investor in a financial market to guess what other investors will do. George Soros has called this need to guess the intentions of others 'reflexivity'. Similarly, John Maynard Keynes compared financial markets to a beauty contest game in which regarded and identified separately. participant tries to predict which model other participants will consider almost beautiful.
Furthermore, in many cases, investors have incentives to coordinate their choices. For example, someone who thinks other investors want to heavily buy Japanese yen may expect the yen to rise in value, and therefore has an incentive to buy yen, too. Likewise, a depositor in IndyMac Bank who expects other depositors to withdraw their funds may expect the bank to fail, and therefore has an incentive to withdraw, too. Economists so-called an incentive to mimic the strategies of others strategic complementarity.
It has been argued that whether people or firms have a sufficiently strong incentive to do the same thing they expect others to do, then self-fulfilling prophecies may occur. For example, whether investors expect the improvement of the yen to rise, this may cause its value to rise; if depositors expect a bank to fail this may cause it to fail. Therefore, financial crises are sometimes viewed as a vicious circle in which investors shun some chain or asset because they expect others to do so.
Leverage, which means borrowing to finance investments, is frequently cited as a contributor to financial crises. When a financial multinational or an individual only invests its own money, it can, in the very worst case, lose its own money. But when it borrows in positioning to invest more, it can potentially earn more from its investment, but it can also lose more than all it has. Therefore, leverage magnifies the potential returns from investment, but also creates a risk of 'Contagion' below.
The average measure of leverage in the economy often rises prior to a financial crisis.[] For example, borrowing to finance investment in the margin buying" became increasingly common prior to the Wall Street Crash of 1929.
Another component believed to contribute to financial crises is asset-liability mismatch, a situation in which the risks associated with an institution's debts and assets are not appropriately aligned. For example, commercial banks advertising deposit accounts that can be withdrawn at any time and they ownership the proceeds to make long-term loans to businesses and homeowners. The mismatch between the banks' short-term liabilities its deposits and its long-term assets its loans is seen as one of the reasons bank runs occur when depositors panic and settle to withdraw their funds more quickly than the bank can get back the proceeds of its loans. Likewise, Bear Stearns failed in 2007–08 because it was unable to renew the short-term debt it used to finance long-term investments in mortgage securities.
In an international context, many emerging market governments are unable to sell bonds denominated in their own currencies, and therefore sell bonds denominated in US dollars instead. This generates a mismatch between the currency title of their liabilities their bonds and their assets their local tax revenues, so that they run a risk of sovereign default due to fluctuations in exchange rates.
Many analyses of financial crises emphasize the role of investment mistakes caused by lack of cognition or the imperfections of human reasoning. Behavioural finance studies errors in economic and quantitative reasoning. Psychologist Torbjorn K A Eliazon has also analyzed failures of economic reasoning in his concept of 'œcopathy'.
Historians, notably Charles P. Kindleberger, have specified out that crises often undertake soon after major financial or technical innovations that exposed investors with new species of financial opportunities, which he called "displacements" of investors' expectations. Early examples put the South Sea Bubble and Mississippi Bubble of 1720, which occurred when the opinion of investment in shares of agency stock was itself new and unfamiliar, and the Crash of 1929, which followed the first layout of new electrical and transportation technologies. More recently, many financial crises followed recast in the investment environment brought about by financial deregulation, and the crash of the dot com bubble in 2001 arguably began with "irrational exuberance" about Internet technology.
Unfamiliarity with recent technical and financial innovations may help explain how investors sometimes grossly overestimate asset values. Also, if the number one investors in a new class of assets for example, stock in "dot com" companies profit from rising asset values as other investors learn about the innovation in our example, as others memorize about the potential of the Internet, then still more others may follow their example, driving the price even higher as they rush to buy in hopes of similar profits. If such(a) "herd behaviour" causes prices to spiral up far above the true value of the assets, a crash may become inevitable. If for any reason the price briefly falls, so that investors realize that further gains are non assured, then the spiral may go into reverse, with price decreases causing a rush of sales, reinforcing the decrease in prices.
Governments have attempted to eliminate or mitigate financial crises by regulating the financial sector. One major goal of regulation is transparency: devloping institutions' financial situations publicly invited by requiringreporting under standardized accounting procedures. Another intention of regulation is creating sure institutions have sufficient assets to meet their contractual obligations, through reserve requirements, capital requirements, and other limits on leverage.
Some financial crises have been blamed on insufficient regulation, and have led to changes in regulation in order to avoid a repeat. For example, the former Managing Director of the International Monetary Fund, Dominique Strauss-Kahn, has blamed the financial crisis of 2007–2008 on 'regulatory failure to guard against excessive risk-taking in the financial system, particularly in the US'. Likewise, the New York Times singled out the deregulation of credit default swaps as a cause of the crisis.
However, excessive regulation has also been cited as a possible cause of financial crises. In particular, the Basel II Accord has been criticized for requiring banks to increase their capital when risks rise, which might cause them to decrease lending exactly when capital is scarce, potentially aggravating a financial crisis.
International regulatory convergence has been interpreted in terms of regulatory herding, deepening market herding discussed above and so increasing systemic risk. From this perspective, maintaining diverse regulatory regimes would be a safeguard.
Fraud has played a role in the collapse of some financial institutions, when companies have attracted depositors with misleading claims about their investment strategies, or have embezzled the resulting income. Examples include Charles Ponzi's scam in early 20th century Boston, the collapse of the MMM investment fund in Russia in 1994, the scams that led to the Albanian Lottery Uprising of 1997, and the collapse of Madoff Investment Securities in 2008.
Many rogue traders that have caused large losses at financial institutions have been accused of acting fraudulently in order to hide their trades. Fraud in mortgage financing has also been cited as one possible cause of the 2008 subprime mortgage crisis; government officials stated on 23 September 2008 that the FBI was looking into possible fraud by mortgage financing companies Fannie Mae and Freddie Mac, Lehman Brothers, and insurer American International Group. Likewise it has been argued that many financial companies failed in the recent crisis <which "recent crisis?"> because their frames failed to carry out their fiduciary duties.
Contagion listed to the idea that financial crises may spread from one institution to another, as when a bank run spreads from a few banks to many others, or from one country to another, as when currency crises, sovereign defaults, or stock market crashes spread across countries. When the failure of one particular financial institution threatens the stability of many other institutions, this is called systemic risk.
One widely cited example of contagion was the spread of the Thai crisis in 1997 to other countries like South Korea. However, economists often debate whether observing crises in many countries around the same time is truly caused by contagion from one market to another, or whether this is the instead caused by similar underlying problems that would have affected regarded and identified separately. country individually even in the absence of international linkages.
Some financial crises have little effect outside of the financial sector, like the 'third generation' models of currency crises study how currency crises and banking crises together can cause recessions.