Question

How does a deterioration in balance sheets of financial institutions and the simultaneous failures of these institutions cause a decline in economic activity?

Answer 1

The 2 main important functions of banks is Accepting deposits and Granting loans.

If the banks or other financial institutions face a deterioration (decline/ process becoming progressively worse) in the balance seets, it will lead to substantial decline in their capital. When there is reduction in capital, the company has 2 choices:
a) The institutions can raise a fresh capital
b) The institutions can cut back on their lending.

But unfortunately, these financial institutions find very difficult to raise fresh capital since they are facing balancesheet deterioration. Therefore these institutions have very fewer resources to lend and ultimately leads to reduction in lending. Contraction in lending leads to reduction in investment spending and gradually when these deterioration becomes severe, it will leads to simultaneous failure of these institutions and finally slows down the economic activity.