Question

What is meant by a financial crisis ? What are sources of a crisis ? What is the link between a financial crisis and an economy crisis ? What is meant by a contagion effect a financial crisis? How does it spread from one country to another in an open economy?

Answer 1

Under a financial crisis, the liquidity of the assets quickly deteriorate and the investors tend to withdraw their money and assets from the banks with the fear of losing the worth of their money. This shortfall of money forces the banks and financial institutions to sell their other investments to make up for the loss of such assets.

Sources of a financial crisis:

Leverages are hard to account for and their calculation lacks a certain level of transparency which makes it dangerous for structured securities. It is hard to limit the amount of leverages provided and hence it is important to impose harsh capital requirements in order to restrict leverages to some extent. Some financial firms in the industry are either too big or too important to fail. They are assumed to be self regulatory and it is believed that they no longer need any sort of outside restrictions beyond the basics. They just seem too important to fail. Proper taxation and governance are quite important. The taxation system should be in such a way that it promotes long-term investments over short-term speculations. It needs to be ensured that the subsidy provided to banks are completely and properly utilized. The financial system has widened its scope and now has the potential to affect whole of economies. Hence, it becomes essential for the governments to ensure proper regulations and restrictions are being carried out while giving out these financial firms any sort of power.

With the failure of banks and financial institutions, the liquidity of money gets affected which eventually results in an economic crisis. Financial contagion is the spread of market disturbances from one country to another. It essentially happens among countries who try to integrate their financial markets with the international markets. The financial contagion is the extension of economic crisis among various countries. It is witnessed at both the domestic and international level. At the domestic level, with the initiation of financial crisis within bank or financial institution, the confidence in similar institutions decreases hence, resulting in an economic crisis. This crisis tend to spread over to various countries to which such banks and institutions were directly or indirectly related.