Question

Explain 4 causes of financial crises

Answer 1

Financial crisis in an economy is caused due to a number of factors reinforcing each other. Some of the main root causes are listed as follows:

(i) Leverage

Excess leverage is the cause of all banking crisis. It goes beyond thebalance sheet and is embedded in off-balance sheet instruments such as derivatives and structured securities.

(ii) Liquidity

Similar to leverage, liquidity mismatches is also a cause of worry. Lending long and borrowing short may mislead investors about the true liquidity position of the bank and can also lead to run on the bank in case of panic.

(iii) Taxes and subsidies

Tax policy has a significant impact on the cost and flow of capital and the current tax code. They are needed to discourage short term speculation and encourage long term investment. It should also be ensured thst subsidies provided to retail banks is recycled back into the economy rather than used for speculation.

(iv) Governance

Governance is also an integral part of the system. For instance, in the case of exchange, there is no way a democratic society would condone high frequency trading which benefits a few at the expense of reduced system resilience.