Some economists believe that to have a developed financial system is to face the risk of financial crises. Understanding the causes and consequences of financial crises is a key to understanding how they can be prevented.

A financial crisis is a sudden and widespread disruption of financial markets. Such a crisis can occur when people suddenly lose faith in the ability of financial institutions to provide liquidity by bringing together those with cash to offer and those who need it. Since the banking system provides liquidity for buyers and sellers of everything from homes and cars to stocks and bonds, banking crises can easily turn into more widespread financial crises, as happened in 2008. In addition, an increase in the number and size of shadow banks in the economy can increase the scope and severity of financial crises, because shadow banks are not subject to the same regulations as depository institutions.

Financial crises have a significant negative effect on the economy and are closely associated with recessions. Historically, the origins of the worst economic downturns, such as the Great Depression, were tied to severe financial crises that led to decreased output and high unemployment (especially long-term unemployment). Recessions caused by financial crises tend to inflict sustained economic damage, and recovery from them can be very slow. Figure A.2 on the next page shows the unemployment and duration associated with selected banking crises around the world.

When the financial system fails, there can be an economy-wide credit crunch, meaning that borrowers lose access to credit—either they cannot get credit at all, or they must pay high interest rates on loans. The lack of available or affordable credit in turn causes consumers and businesses to cut back on spending and investing, which leads to a recession. In addition, a financial crisis can lead to a recession because of a decrease in the price of assets. Decreases in housing prices are especially significant because real estate is often an individual’s largest asset. Consumers who become poorer as a result of the decrease in the price of housing respond by reducing their spending to pay off debt and rebuild their assets, deepening the recession.

Finally, financial crises can also lead to a decrease in the effectiveness of expansionary monetary policy intended to combat a recession. Typically, the Fed decreases the target interest rate to provide an incentive to increase spending during a recession. However, with a financial crisis, depositors, depository institutions, and borrowers all lose confidence in the system. As a result, even very low interest rates may not stimulate lending or borrowing in the economy.

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Before the Great Depression, the government pursued a laissez-faire approach to banking. That is, the government let market forces determine the success or failure of banks, just as they did in other markets. However, since the Great Depression, considerable government regulation of financial markets has been implemented to prevent the severe economic downturns that can result from financial crises. Governments take three major actions to diminish the effects of banking crises: they act as a lender of last resort, guarantee deposits, and provide private credit market financing.

When governments act as a lender of last resort (usually through a central bank, such as the Federal Reserve), they provide funds to banks that are unable to borrow through private credit markets. Access to credit can help solvent banks—banks that have assets in excess of their liabilities—withstand bank runs without requiring them to sell off assets. In the case of financially unsound banks that are truly insolvent and will eventually go bankrupt, the government creates confidence in the banking system by guaranteeing the banks’ liabilities. Deposit guarantees assure depositors that they will receive their deposits, preventing possible bank runs that would result from fear that deposits could be lost. Finally, governments have the ability to provide credit to shadow banks and to purchase private debt to keep the economy afloat when a banking crisis causes private credit markets to dry up.

In 2008, the combination of a burst housing market bubble, a loss of faith in the liquidity of financial institutions, and an unregulated shadow banking system led to a widespread disruption of financial markets.

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The collapse of Lehman Brothers—a large shadow bank—set off the 2008 financial crisis, first in the United States and eventually across the globe. Although a number of factors led to the bank’s collapse and the subsequent worldwide economic downturn, economists have identified four major causes of the 2008 financial crisis:

The economy experienced a long period of low inflation, stable growth, and low global interest rates prior to the 2008 financial crisis. These macroeconomic conditions encouraged risk taking by shadow banks because they made it easy and cheap to borrow money. The banks searched for new ways to invest the funds they borrowed from short-term credit markets to earn higher returns in financial markets. One way to invest was through securitization, assembling a group of loans into a pool and selling shares of that pool to investors. Before the 2008 crisis, Lehman Brothers had been borrowing heavily in short-term credit markets and investing in subprime mortgages. Subprime lending had been a part of the banking industry for a long time, but subprime borrowing increased in the period leading up to the crisis. Subprime mortgages started to be packaged into so-called low-risk securities by pooling them together as collateralized debt obligations. These debt obligations are a type of financial derivative, a financial contract that has value based on the performance of another asset, index, or interest rate. Unfortunately, the shadow banks invested in these derivatives without accurately assessing their risk. When the real estate bubble burst, people began to default on their subprime mortgages and the value of the collateralized debt obligations fell. Because real estate markets represent a large part of the economy and shadow banks had invested heavily in subprime mortgages, the defaults quickly exposed the fragility of the financial system.

In 2008, when rumors of Lehman’s exposure in the housing market spread, the shadow bank was no longer able to borrow in short-term credit markets to finance its long-term obligations. Without access to credit, Lehman Brothers went bankrupt.

Chains of debt linked Lehman to other financial institutions. Credit default swaps had been created to spread the risk of default on loans, but in fact they concentrated that risk. AIG was a large insurance company that provided those swaps. When the housing bubble burst, the large number of defaults caused AIG to collapse soon after Lehman Brothers.

The 2008 crisis was like a traditional bank run—except that it was in the shadow banking system. The fall of Lehman Brothers led to a credit freeze, withdrawals of mutual funds, and a fall in derivative prices.

Finally, relaxed regulation of investment banks in the shadow banking sector failed to prevent the start and spread of the financial crisis. Prior to 2008, risk taking by shadow banks increased for several reasons. To begin with, given the vital importance of the financial system to the economy as a whole, many people thought the government would step in to prevent severe problems. That is, large financial institutions were considered “too big to fail.” This led to the problem of moral hazard, which exists when a party takes excessive risks because it believes it will not bear all of the costs that could result. At the same time, the large profits earned by shadow banks further encouraged increased risk taking. Initially, the high-risk shadow banking activities were not a problem, because economic conditions were good. When the housing bubble burst, however, everything changed. It became clear that derivatives, which were thought to mitigate or eliminate default risk, only hid it. Because much of the existing government regulation did not apply to shadow banks, it could not prevent their activities from continuing to crisis.

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The 2008 financial crisis caused significant, prolonged damage to economies across the globe, with consequences that continued years later. For example, by the end of 2009, the United States’ economy had lost over 7 million jobs, causing the unemployment rate to increase dramatically and remain high for years after, as shown in Figure A.3. In particular, the crisis led to an increase in long-term unemployment, which rose to almost half of the total unemployment in the economy.

The recession in the U.S. economy sent ripples throughout the world, and the years since the recession have seen only a weak recovery. For example, Figure A.4 shows that it took more than five years for the United States to get back to the precrisis level of real GDP. In addition, in 2011–2012, fear of a second crisis related to public debt in Southern Europe and Ireland further hampered economic recovery from the crisis.

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The intervention of the U.S. government and the Federal Reserve at the start of the financial crisis helped to calm financial markets. The federal government bailed out some failing financial institutions and instituted the Troubled Asset Relief Program (TARP), which involved the purchase of assets and equity from financial institutions to help strengthen the markets.

The Federal Reserve pursued an expansionary monetary policy, decreasing the federal funds rate to zero. The Fed also implemented programs to foster improved conditions in financial markets, significantly changing its own balance sheet. For example, the Fed acted as a lender of last resort by providing liquidity to financial institutions, it provided credit to borrowers and investors in key credit markets, and it put downward pressure on long-term interest rates by purchasing longer-term securities.