Understanding International Financial Crises and Contagion

International financial crises and contagion are essential indicators of global interconnectedness. A shock in one market can have ripple effects throughout other markets or even affect an entire country.

Formally testing our market NECOF and network density in response to major events like Covid Pandemic, GFC, Sovereign Debt Crisis and Chinese Market Crisis was carried out and its results can be seen in Appendix C.

What is a financial crisis?

Financial crises place immense strain on the global economy. A financial crisis typically begins when one bank or investor fails, sparking a chain reaction of failure that devastates global credit markets. Governments then intervene with relief measures, saving institutions which were too big to fail by injecting liquidity and saving institutions deemed “too big to fail”.

Leading up to this crisis, banks and investors increased borrowing on financial markets by purchasing mortgage-backed securities (MBS). Leverage allowed for greater potential profits but also left them more exposed to losses.

As the crisis deepened, governments reduced policy interest rates to near zero and directly lent money to struggling banks and financial firms to indirectly support risky investments. Unfortunately, such an intervention entrenches state involvement by encouraging private markets to rely on state subsidies as a support mechanism – leading to a vicious cycle that could last decades before being broken by major efforts at weaning parts of finance off public subsidies and decreasing vulnerability of others.

What causes a financial crisis?

Financial crises are periods of extreme distress in global markets and banking systems, often caused by downturns in specific markets – for instance, the US housing market collapse of 2007 led to numerous investment banks, mortgage lenders, insurance companies, savings and loan associations, and other organizations financing households and businesses going bankrupt.

Crisis may also result from an erosion in investor trust, evidenced by sudden stops in capital flows into an open capital account economy, leading to balance of payments problems, currency devaluation, and possible sovereign default.

Financial crises often result from leverage, which allows an institution to increase the potential returns by borrowing and investing more than its assets can support. Mismatch between short-term liabilities (deposits) and long-term assets increases the risk that debt obligations cannot be met on time.

How do financial crises spread?

Due to globalisation, financial problems are easily spread around the globe through contagion. Contagion can be dangerous as a single issue can quickly spread throughout multiple institutions causing fear and distrust among stakeholders.

As this can result in bank runs requiring government bailouts, crisis communications should assure the public that authorities are taking measures to address root causes of panic and enhance financial oversight – possibly including macroeconomic policies as well as specific measures targeting failing banks.

The Great Financial Crisis of 2008 demonstrated how rapidly one problem can spread throughout multiple parts of the global economy. As it worsened, governments responded by injecting capital into their banking systems and buying ownership stakes in major financial firms; these measures helped stabilize markets and prevent depression but took longer than prior recessions that did not involve such dramatic events.

What are the consequences of a financial crisis?

Financial crises occur when asset prices collapse, businesses and individuals fail to repay debts they owe, and banks run out of money, wreaking havoc across one economy or, like during the global financial crisis (GFC) of 2007-2009, globally.

Governments respond to financial crises by increasing spending and offering guarantees or ownership stakes in banks in order to restore confidence. This helps prevent an overall banking system collapse that would worsen the crisis by depriving households and firms access to credit.

At the onset of the GFC, for example, the UK government intervened heavily to save Royal Bank of Scotland and Lloyds-TSB by purchasing large stakes in each institution and nationalizing Bradford & Bingley as well as Lehman Brothers assets. Rescuing banking systems cost nearly one quarter of GDP and resulted in one of the sharpest recessions since Great Depression; subsequent recoveries were more gradual compared with similar recessions that didn’t involve financial crises.