The Core Characteristics of Financial Crises

The basic features of financial intermediation - asymmetric information and liquidity transformation - have not changed along history. In an intermediated financial system, the asymmetric information between investors and intermediaries can cause withdrawals of capital even in the presence of good investments. It is the combination of asymmetric information and illiquidity that gives rise to the possibility of a banking crisis, a situation whereby all depositors want their cash back. A securities-based financial system has the same attributes as the classic banking business model. Providing liquidity in securities markets by buying relatively illiquid securities and selling more liquid securities is the same risky activity as banking. Therefore, a security crisis is associated with an increase in demand for liquidity, or more liquid securities. This puts strain on the balance sheets of those intermediaries who provide liquidity in securities markets: their assets fall in value, including sovereign bonds of troubled countries, and their liabilities increase in value. To restore their own financial equilibrium, those intermediaries sell their assets in a situation where buyers are relatively fewer. Securities prices fall further, and this causes the “panic”, the “flight to quality”, the “run”, or whatever one chooses to call it. Short term credit dries up, including the normally straightforward repurchase agreement (“the run on repo”), interbank lending, and commercial paper markets. This panic is usually followed by a very sharp recession. The chapter also deals with the argument if financial crises are predictable by the usual economic models, or they are rare unpredictable phenomena (black swans), and finally the extension of the global crisis to the European sovereign debt and banking sector is shortly analyzed.