Financial crises are the periods of mental, emotional and psychological pain for almost all the people of the country being affected by the crisis. Such periods are usually accompanied with high levels of unemployment, abnormal levels of inflation, very low or negative levels of growth and sudden devaluations.
Most of the time, due to the interlinkedness and the systemic nature of the financial system of the world, financial crises in a country or an area affect people all over the world. Only a select few institutions with impeccable risk management practices are able to withstand a financial crisis.
In this blog, we’ll go through 3 of the world’s devastating financial crises- The Great Depression (1929-1939), The International Debt Crisis (1981-1989) and The Great Recession (2007-2009).
Great Depression (1929 to 1939)
The lead-up to October 1929 saw equity prices rise to all-time high multiples of more than 30-times earnings, and the benchmark Dow Jones Industrial Average increased 500% in just five years.
The NYSE bubble burst violently Oct. 24, 1929, a day that came to be known as Black Thursday. Ripples from the crash spread across the Atlantic Ocean to Europe triggering other financial crises such as the collapse of the Boden-Kredit Anstalt, Austria’s most important bank. In 1931, the economic calamity hit both continents in full force.
The 1929 stock market crash wiped out nominal wealth, both corporate and private, and sent the U.S. economy into a tailspin. In early 1929, the U.S. unemployment rate was 3.2%; and by 1933, it had soared to 24.9%. Despite unprecedented interventions and government spending by both the Herbert Hoover and Franklin Delano Roosevelt administrations, the unemployment rate remained above 18.9% in 1938 as stated by investopedia.
There are a vast variety of factors responsible for the build up of the great depression of 1932 and it created new lows in unemployment and GDP growth rate.
Basically, the stock market crash of 1929 brought about the emotions of fear, anxiety and depression in people all over the world and finally resulted in runs on banks and these runs resulted in the failure of a lot of the banks in the whole world.
Finally, the New Deal was introduced twice by President Franklin Roosevelt of the United States in 1933, this helped in boosting industrial production.
It introduced federal (more about federal reserve system) aid to the unemployed (unemployment welfare schemes), more regulations were imposed on the industries, legal protection was provided to the workers and various other Social Security Programs were introduced which finally led to the slow recovery from the Great Depression which lasted for 10 years.
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The International Debt Crisis (1981 to 1989)
In the 1970s, a lot of the developing countries borrowed money freely in the international credit markets at low interest rates, these credit markets facilitated by the global banking industry gave away loans to the developing countries at low interest rates because they had a lot of capital with them at the time and they believed that investing in the developing markets would give them great returns.
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The loans were used for investment purposes and to increase the overall consumption in the developing nations. The banks had grown their cash reserves in the period leading up to the 1970s crisis due to the oil trade which boomed in that period.
The international debt crisis lasted from 1981 to 1989 and majorly affected the East European countries- Poland, Romania and Hungry and the Latin American country- Chile. Finally, it was solved by the establishment of the International Monetary Fund responsible for the financial health of the whole world.
The systemic aspect of the crisis gradually became better by 1983 although the difficulties in servicing debt remained.
And the period from 1985 to 1987 had a sustained growth improving the debt conditions of the developing countries and by 1989, the developing countries saw improvements in the economic environment and finally the international debt crisis subdued.
The Great Recession (2007 to 2009)
The great recession of 2007 to 2009 began with the sub-prime crisis and the burst of the housing market in the United States leading to a financial crisis .
Once housing prices fell and the homeowners started walking away from the previously sought for mortgages, the Mortgage-Backed Securities that were held by investment banks saw a rapid decline in their value, several of these Mortgage-Backed Securities collapsed and a few were later bailed out in September 2008. This phase is referred to as the subprime mortgage crisis. As explaining about the mortgage crisis, lean types and components of mortgage.
The banks were not able to provide funds for the various purposes in the economy, homeowners got stuck in the process of getting out of debt and the ones who had refinanced faced severe losses with the devaluation of the MBS.
Overall, the whole economy started going into a deep recession that lasted for 19 months from December 2007 to june 2009.
The great recession of 2007-09 was the biggest economic turmoil after the 1930s great depression and resulted in a 4% decline in the US GDP and the world GDP growth rate declined from 5%in 2007 to 3.75% in 2008 and 2% in 2009.
The loan losses for the global financial institutions in this period for the whole world were $1.5 trillion and the banking industry faced the biggest hit with even the biggest banks in the world collapsing during this period.The first big bank to collapse was the Lehman Brothers and it collapsed in September 2008.
The credit freeze brought the global financial system to the extent that it almost collapsed during this crisis. Oil prices declined by more than 50% and even the food prices and other commodity prices fell by similar amounts, equity markets all around the world fell by 30% in the period and the situation was one of complete chaos.
To get out of this situation, the US Federal Reserve and the European Central Bank injected $2.5 trillion into the credit markets which acted as expansionary monetary policy.
(Must read: Expansionary Fiscal Policy)
A detailed economic stimulus legislation was passed by the United States and several economic stimulus packages were implemented by the European countries.
There was again a very complex challenge of increasing the growth as well as limiting inflation faced by a lot of countries around the world. Multilateral efforts were necessary to meet this global aim.
The policy actions undertaken to get out of this solution included programs that were used to purchase distressed assets, public funds that were used to recapitalize banks and provide guarantees and policy rates that were reduced to boost consumption and investments by the central banks. Multilateral efforts were initiated to get the whole world out of this recession.
By October 2009, economic growth turned positive along with the increase in commodity prices, pickup in industrial production in particular manufacturing and most importantly the consumer confidence started coming back in particular that in the housing industry.
Apart from The Great Depression (1929-1939), The International Debt Crisis (1981-1989) and The Great Recession (2007-2009), there are other financial crisis with devastating effects on the economies of several countries including the Suez Crisis (1956), The East Asian Economic Crisis (1997-2001), The Russian Economic Crisis (1992-1997) and The Latin American Debt Crisis in Mexico, Brazil and Argentina (1994-2002).
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An important point to be noted in all these financial crises is that the banking industry has always played a crucial role in all of them. This is because the banking industry of an economy forms the financial backbone of the economy.
It is therefore important for, both domestic and international bodies to regulate and supervise the banking industry with special emphasis on the various financial risks faced by the banking industry, in particular the credit risk, the operational risk, the market risk and the liquidity risk.
(Referred blog: What is investment banking?)
It can also be observed that eventually banks played a pivotal role in the recovery from the financial crisis of the past and thus, a country with a strong banking system has a better and faster chance of recovery from any financial crisis in the future.