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FINANCIAL CRISIS AND SYSTEMIC RISK


Author: Chahat Kanchan, II Year of B.A.,LL.B from Kirit P Mehta School of Law, Mumbai.


ABSTRACT

A financial crisis is a disturbance to financial markets in which adverse selection and moral hazard problems worsen to the point where financial markets are unable to properly direct funds to those with the best investment possibilities.


In the present times, financial crises have become somewhat common. This is because the crisis of one country affects the countries around it. The most recent instance is of the Ukraine crisis, which is affecting the countries around it and the countries that are involved in trade with it. But no matter how common they become, they nevertheless result in loss of the economies for the country and its people and the businesses and trade of the country.



KEY WORDS

Financial crisis, Systemic risks, Economy, Great Depression of 1929.



INTRODUCTION

The world has seen numerous financial crises in the past decades. All these events were faced with shocks from people all over the world, for no one foresaw them and hence no one was ready to face them. For instance,

  • The worst financial crisis of the 20th century was the Great Depression of 1929, which almost lasted for about a decade. It resulted in what every crisis results, increased unemployment rates and massive loss of income.

  • The OPEC Oil crisis of the 1980s, where there was a sudden rise in the price of oil. It resulted in an increase in the level of uncertainty, in the midst of the outbreak of the Iran-Iraq War (1980-1988).

  • The economic downturn of the Japanese economy in the 1990s. in the 1990s, the Japanese economy suffered a prolonged recession, which finally ended in 2002.

  • The Asian Financial Crisis of 1997, which began as a currency crisis in Bangkok, and spread to neighbouring economies soon.

  • The Financial Crisis of 2007-2008, the only crisis that was worse than the Great Depression of 1929. It caused havoc in the financial markets of the world.

  • The contraction of the economy of Ukraine this year due to Russian invasion has sent the country’s economy into recession, which is affecting economies in Europe and Central Asia, such as India and United States.


All of these crises were caused because of different events and impacted different countries but all of them had one thing in common, all of them had the same impact. They resulted in falling back of the economy, increase in the unemployment rates, hike in the prices of goods and commodities.



REVIEW OF LITERATURE

D. Besar, P. Booth, KK Chan and J. Pickles, of the Institute and Faculty of Actuaries talk about financial crisis and systemic risks in their paper, Systemic Risks in Financial Services. They talk about the impact of financial crises on the economy of a country and how financial deregulation has played a role in the occurrence of the crises.


Nicole Tham Ping says that the relationship that exists between the fall of assets, the increase in the unemployment rate and a rise in the level of debts are all associated with and are impacts of global financial crises.


K G Viswanathan tells how all the global crises that have occurred in the past till date, have almost the same impact, such as fall in the employment rate, rise in the level of debts, and the economy of the country and the countries involved in trade with that country are affected.



RESEARCH OBJECTIVES

The objectives of this research paper are as follows:

  • An analysis of The Great Depression of 1929, the worst financial crisis of the 20th century.

  • To analyse systemic risks and how they impact an economy.



RESEARCH HYPOTHESIS

The research hypothesis in the paper is- the worst impact of the Great Depression was upon America.



DATA COLLECTION

For this research paper, data has been collected from secondary sources like journals and websites.



THE GREAT INDIAN DEPRESSION

FINANCIAL CRISIS

In a financial crisis, asset prices see a steep decline in value, businesses and consumers are unable to pay their debts, and financial institutions experience liquidity shortages.


A panic or a bank run is frequently connected with a financial crisis, in which investors sell assets or remove money from savings accounts because they believe the value of those assets will decline if they remain in the financial institution.


A financial crisis can also occur when a stock market crash occurs, a sovereign default occurs, or a currency crisis occurs. A financial crisis might affect only banks or it can affect an entire economy, a region's economy, or the entire world's economy.


A financial crisis can result from a variety of factors. In general, a crisis can emerge when institutions or assets are overvalued, and irrational or herd-like investment behaviour can add to the problem. When a bank failure is rumoured, for example, a rapid run of selloffs might result in reduced asset prices, pushing consumers to dump assets or make large savings withdrawals.



THE DEPRESSION OF 1929

A depression is a particularly severe sort of economic downturn. Depressions are defined by their length, abnormally high unemployment rate, decreased credit availability, shrinking production as buyers dry up and suppliers cut back on production and investment, a high number of bankruptcies, including sovereign debt defaults, significantly reduced trade and commerce (especially international trade), and highly volatile relative currency value (often due to currency devaluations). Price deflation, financial crises, and bank failures are other features of a depression that do not usually occur during a recession.


The Great Crisis was a worldwide economic depression that began in the United States in the 1930s and lasted until 1945. The Great Depression began in 1929 in most countries and lasted until the late 1930s in others. It was the twentieth century's longest, deepest, and most widespread slump in the twenty-first century.


The Great Depression began in the United States after a major drop in stock values that began around September 4, 1929, and resulted in the stock market crash of October 29, 1929, which made headlines around the world. The day is regarded so ominous that it is referred to as the Black Tuesday.


The rapid and sudden collapse of US stock market prices on October 29, 1929 is commonly seen as the start of the Great Depression. Some, however, disagree with this perspective, regarding the stock market crash as a consequence rather than a cause of the Great Depression.


The event that led to the great depression started with the rise in the level of the stock market in the early 1930s. Businesses started spending more and more on production of goods, i.e., mass production, in the initial half of the year. But there were many who had faced losses in the previous year, and thus, to make up for those, started cutting back on their expenditure. And upon this, America was facing a severe drought at that time. So eventually, in that year, the interest rates had dropped very low. The automobiles sales had declined. The cars that were so in demand one were not being purchased by the people. In general, there were many people who were unemployed and those who had jobs, their wages and incomes had been reduced. At first, the fall in the US economy was the cause that dragged down most other countries, and subsequently each country's internal shortcomings or strengths made things worse or better.


The United States' economy was damaged by the Great Depression of 1929. Half of all banks went bankrupt. Unemployment had climbed to 25%, and homelessness has increased. Housing prices dropped 30%, international trade fell 60%, and prices fell 10% per year. The stock market took 25 years to recover. In the first five years of the Great Depression, the GDP shrunk by half. This continued until 1939, when the preparations for World War II led to a growth of 8% in 1939 and 8.8% in 1940.

Year192019301940195019601970Unemployment Rate5.2%8.7%14.6% 5.3%5.5%4.9%


Thus, The Great Depression had the following effects: industrial production fell by 50%, international trade fell by 30%, and investment dropped by 98%. Thus, it is safe to say that the Depression affected America more than any other country, because although other countries were affected, none of them were as badly affected as America. Thus the hypothesis stands correct.



SYSTEMIC RISKS

WHAT ARE SYSTEMIC RISKS?

A large-scale disruption affecting all financial institutions is not the same as systemic risk. Many financial entities, whether banks or non-banks, can be affected by big shared shocks. For example, there could be a significant drop in overall spending (all too common in smaller economies subject to terms of trade or export shocks). A negative outcome could result in increased loan losses and lower earnings for many institutions.


When an initial disturbance is transmitted via the networks of links that connect enterprises, families, and financial institutions with one another, a systemic risk arises, leading to the breakdown or degradation of these networks. It is the possibility that an event at a very small scale, let’s say at the level of an individual bank, could trigger instability for an entire economy. It is sometimes known as a Domino Effect.


The concept of systemic risks came to be known after the Global Financial Crisis of 2008. To understand this in a very simple way, let us take the example of the Millennium Bridge in London. The bridge was opened in June, 2000, on the River Thames. Now what happened was that as soon as the bridge opened and people started to walk on it, it started swaying. And the reason behind this swaying was a mystery, even to the engineers who had constructed the bridge. Eventually, it earned the nickname of the Wobbly Bridge.


Finally, people understood the reason behind the swaying of the bridge. It was a reason that no one foresaw. It was a systemic risk. It is a well-known fact that when soldiers have to cross a bridge, they are asked to walk out of lock step, or else they would create a risk of wobbling of the bridge. But while the construction of the bridge, the engineers did not think about this because they thought that the people would be walking their different ways, i.e., not in lock step, so there would be no chance of the bridge wobbling.


So, when a gust of wind hit the bridge, the people were leaning against the movement, and to balance themselves started moving back and forth. And thus, unknowingly, the people on the bridge, without knowing each other and without talking to each other started moving in lock step, like an army of soldiers. Thus, causing the bridge to sway. The systemic event here was a little sway from the wind which caused the whole bridge to sway, with the people on it.



THE FLASH CRASH OF 2010

On 6th May, 2010, there was crash in the stock market, also known as the Flash Crash, in the United States market. It lasted for approximately 36 minutes. Due to a computer-based algorithm, the prices of shares fell very quickly and were very steep. But they were back up very quickly. It happened because a Kansas based man had an algorithm, that sold off more shares if there was much going on in the market. It decided to sell-off more shares as it saw action in the market. What happened because of this was that these shares that were sold off by this investor, were quickly purchased by traders. This cycle continued where these shares were being sold at lower prices and it continued. The algorithm noticed this and started selling more shares due to the action in the market. And so the prices started falling even more. This continued to such an extent that the prices went very low causing the crash of the market. The prices went so low that the investors of the market noticed this and finally brought the share prices back up.


It was concluded that the algorithm, individually, did the right thing, but when all the factors act together, can cause huge risks in the market. Thus, this was an instance of Systemic Risk in play. Systemic risks is caused by the interaction of people in financial market where they come together at the worst possible time and do the exact same thing, like sell off their assets at the same time and thereby causing the market to crash. Just like what the people did on the Millennium Bridge.



CONCLUSION

The impact that the global crises have on the countries cannot be avoided, no matter how prepared the country’s financial system is. And although the countries are strengthening their financial systems and economies, to recover from the impact COVID-19 had, damage recovery takes time. This is so because the reason behind the crisis comes to be known only after the crisis occurs, thus it cannot be prevented in any way.


The only way to mitigate these crises is to be financially aware so as to avoid doing mistakes that lead to systemic risks, but then the question that arises is that what to do and what not to do to avoid risks. And that is a question that no one has an answer to yet.


REFERENCES