Types of Financial Crisis (Financial Economics)

This study note looks at different types of financial crisis

Types of financial crisis

• Currency crisis when a fixed exchange rate regime collapses or a currency goes into a free fall
• Balance of Payments (BoP) or external debt crisis
• Sovereign debt crisis
• Banking crisis
• Corporate debt crisis
• Household debt crisis
• Broad financial crisis that combines many elements of the above crises (Argentina 2001 for example)

What is a financial crisis?

“A disturbance to financial markets, associated typically with falling asset prices and insolvency amongst debtors and intermediaries, which ramifies through the financial system, disrupting the market’s capacity to allocate capital.”– (Eichengreen and Portes 1987)

“Bank runs, sharp increases in default rates accompanied by large losses of capital that result in public intervention, bankruptcy or forced merger of financial institutions.” (Schularick and Taylor, 2012)

Distinction between Solvency and Liquidity Crises

Insolvency crisis:

• An agent (such as business, individual or a bank) is insolvent when its debt relative to its income is so high that it will not be able to pay back its debt and the interest on it (i.e. there is an unsustainable debt)
• May require some form(s) of debt restructuring / debt relief to lower default risk

Illiquidity crisis:

An agent is solvent but illiquid when its debt is not unsustainable but it has large amounts of this debt coming to maturity (i.e. short term debt) and it is not able to roll it over (this creates liquidity crisis, rollover/run crisis)

• Illiquidity can lead to insolvency as illiquidity can trigger default
• In a liquidity crisis, international institutions may step in to provide emergency funds as a “lender of last resort”

Are Financial Crises Becoming More Frequent?

Recent developed markets crises

• US housing and sub-prime crisis in 2006-2008
• Global Financial Crisis (GFC) of 2008-2009
• Sovereign debt crises and economic crisis in the Eurozone (2010-2013): Greece, Ireland, Portugal, Spain, Italy, Cyprus, Slovenia. Grexit Risk.

Recent emerging market crises:

• Mexico (1994), East Asia (1997-98), Russia (1998), Brazil (1999), Turkey and Argentina (2001)
• EM mini-crisis in 2013-15 and China’s 2015 turmoil