When many banks—either depository banks or shadow banks—get into trouble at the same time, there are two possible explanations. First, many of them could have made similar mistakes, often due to an asset bubble. Second, there may be financial contagion, in which one institution’s problems spread and create trouble for others.
In an asset bubble, the price of an asset is pushed to an unreasonably high level due to expectations of further price gains.
Shared Mistakes In practice, banking crises usually owe their origins to many banks making the same mistake of investing in an asset bubble. In an asset bubble, the price of some kind of asset, such as housing, is pushed to an unreasonably high level by investors’ expectations of further price gains. For a while, such bubbles can feed on themselves. A good example is the savings and loan crisis of the 1980s, when there was a huge boom in the construction of commercial real estate, especially office buildings. Many banks extended large loans to real estate developers, believing that the boom would continue indefinitely. By the late 1980s, it became clear that developers had gotten carried away, building far more office space than the country needed. Unable to rent out their space or forced to slash rents, a number of developers defaulted on their loans—and the result was a wave of bank failures.
A similar phenomenon occurred between 2002 and 2006, when rapidly rising housing prices led many people to borrow heavily to buy a house in the belief that prices would keep rising. This process accelerated as more buyers rushed into the market and pushed housing prices up even faster. Eventually the market runs out of new buyers and the bubble bursts. At this point asset prices fall; in some parts of the United States, housing prices fell by half between 2006 and 2009. This, in turn, undermines confidence in financial institutions that are exposed to losses due to falling asset prices. This loss of confidence, if it’s sufficiently severe, can set in motion the kind of economy-wide vicious downward spiral that marks a financial contagion.
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A financial contagion is a vicious downward spiral among depository banks or shadow banks: each bank’s failure worsens fears and increases the likelihood that another bank will fail.
Financial Contagion In especially severe banking crises, a vicious downward spiral of financial contagion occurs among depository banks or shadow banks: each institution’s failure worsens depositors’ or lenders’ fears and increases the odds that another bank will fail.
As already noted, one underlying cause of contagion arises from the logic of bank runs. In the case of depository banks, when one bank fails, depositors are likely to become nervous about others. Similarly in the case of shadow banks, when one fails, lenders in the short-term credit market become nervous about lending to others. The shadow banking sector, because it is largely unregulated, is especially prone to fear- and rumor-driven contagion.
There is also a second channel of contagion: asset markets and the vicious cycle of deleveraging. When a financial institution is under pressure to reduce debt and raise cash, it tries to sell assets. To sell assets quickly, though, it often has to sell them at a deep discount. The contagion comes from the fact that other financial institutions own similar assets, whose prices decline as a result of the “fire sale.” This decline in asset prices hurts the other financial institutions’ financial positions, too, leading their creditors to stop lending to them. This knock-on effect forces more financial institutions to sell assets, reinforcing the downward spiral of asset prices. This kind of downward spiral was clearly evident in the months immediately following Lehman’s fall: prices of a wide variety of assets held by financial institutions, from corporate bonds to pools of student loans, plunged as everyone tried to sell assets and raise cash. Later, as the severity of the crisis abated, many of these assets saw at least a partial recovery in prices.
A financial panic is a sudden and widespread disruption of the financial markets that occurs when people suddenly lose faith in the liquidity of financial institutions and markets.
Combine an asset bubble with a huge, unregulated shadow banking system and a vicious cycle of deleveraging and it is easy to see, as the U.S. economy did in 2008, how a full-blown financial panic—a sudden and widespread disruption of financial markets that happens when people suddenly lose faith in the liquidity of financial institutions and markets—can arise. A financial panic almost always involves a banking crisis, either in the depository banking sector, or the shadow banking sector, or both.
Because banking provides much of the liquidity needed for trading financial assets like stocks and bonds, severe banking crises almost always lead to disruptions of the stock and bond markets. Disruptions of these markets, along with a headlong rush to sell assets and raise cash, lead to a vicious circle of deleveraging. As the panic unfolds, savers and investors come to believe that the safest place for their money is under their bed, and their hoarding of cash further deepens the distress.
So what can history tell us about banking crises and financial panics?