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What is a Financial Crisis?

February 25, 2021 · 8 minute read

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What is a Financial Crisis?

The COVID-19 pandemic and efforts to contain it shut down large portions of the economy and brought on a financial crisis. What this crisis will look like in the future remains unknown, but financial crises are not new phenomena. Here’s a look at what a financial crisis entails and what we can learn from crises of the past.

Financial Crisis Definition

During a financial crisis, asset prices drop rapidly, usually over the course of days or a few weeks. This drop is often accompanied by a stock market crash as investors panic and pull money from the market. It may also be associated with bank runs in which consumers withdraw assets for fear they will lose value if they remain in the bank. This type of downturn may be the beginning of a recession.

Recessions are a general period of economic decline during which unemployment may rise, income and consumer spending may fall, and business failures may be up. (To stay up-to-date on the current financial crisis and possible recession visit SoFi’s Recession Help Center.)

Common Causes of Financial Crises

There are a number of situations that can cause a financial crisis, including the bursting of financial bubbles, defaults on debt, and currency crises.

Stock market bubbles occur when stock prices rise precipitously, often driven by speculation and investors overvaluing stocks. As more people jump on the bandwagon and buy stocks, prices are driven higher, a cycle that is not based on the stock’s fundamental value. Eventually this situation becomes unsustainable and the bubble bursts. Investors sell and prices drop quickly.

A failure to meet debt obligations can also lead to a financial crisis. For example, a country may be unable to pay off its debts. This may happen as a country starts to face higher interest rates from lenders worried that the country may not be able to pay back their bonds. As lenders require higher bond yields to offset the risk of taking on a country’s debt, it becomes more and more expensive for that country to refinance. Eventually the country will default on its debt, which can cause the value of its currency to drop.

A currency crisis occurs when a country’s currency experiences sudden volatility as a result of factors such as central bank policies or speculation among investors. For example, a currency crisis may occur when a country’s central bank pegs its currency to another country’s floating currency (one whose value depends on supply and demand) and fails to maintain that peg.

Examples of Financial Crises

The modern financial crises date back hundreds of years, perhaps to the South Sea Bubble of 1720. Here’s a look at a handful of other well-known financial crises that happened in the United States and abroad:

America’s First Financial Crisis

The stage for the United States’ first financial crisis was set in 1790. At that time, the U.S. had few banks, and Alexander Hamilton wanted to bring the financial system to par with the systems that existed in Britain and Holland. To do so he started the first central bank, known as The First Bank of the United States (BUS). To get the bank off its feet, the public could buy shares in the bank with a mixture of cash and government bonds.

Two problems swiftly arose. The demand for government bonds to buy shares lead some investors—led by one William Duer—to try and corner the bond market by borrowing widely to buy bonds. Also, the BUS quickly dwarfed other banks, becoming the nation’s largest lender. Investor flush with credit began to use their newfound cash to speculate in futures and short sales markets.

In spring of 1792, the BUS ran low on hard currency and cut lending. Duer and his cohort were forced to take on new debt to pay off old debt, and tightening credit, led U.S. markets on a downward spiral.

Knowing the financial system he’d worked hard to build was on the verge of collapse, Hamilton was forced to use public funds to buy back U.S. bonds and prop up the price of those bonds. Additionally he had to direct money to failing lenders, and allowed banks with collateral to borrow as much as they wanted with a penalty rate of 7%. Not only was this America’s first financial crisis, it was also the first instance of a government bailout, setting a precedent for future financial crises.

Stock Crash of 1929

Perhaps the granddaddy of financial crises, the 1929 stocks crash came at a time when stock speculation led to booming markets. New technologies, such as radio, were particularly popular investments. At the same time, however, consumer prices were falling and established businesses flagging, creating tension within the economy.

The Federal Reserve raised interest rates, in an effort to slow the overheated markets. Unfortunately, the hike wasn’t big enough to slow the economy. It ended up further hurting already weakening businesses, and industrial production continued to fall.

The market crashed October 28 and October 29, 1929. The 29th came to be known as Black Tuesday. By mid-November the market was down 45%. By the next year, banks began to fail. Customers began withdrawing cash as fast as they could, causing bank runs.

The crisis devastated the economy, forcing businesses to close and causing many people to lose their life savings. The crisis sparked the Great Depression, and the Dow wouldn’t climb to its previous heights for 25 years.

The crash led to a number of financial reforms. The Glass-Steagall legislation separated regular banking, such as lending, from stock market operations. It also gave the government power to regulate banks at which customers used credit to invest.

The government also set up the Federal Deposit Insurance Commission (FDIC) to help prevent bank runs by protecting customer deposits. The creation of the FDIC helped stabilize the financial system, because individuals no longer felt they needed to withdraw their money from the bank at the slightest sign of economic trouble.

1973 OPEC Oil Crisis

In October 1973, the 12 countries that make up the Organization of Petroleum Exporting Countries (OPEC) agreed to stop exporting oil to the United States in retaliation for the U.S. decision to offer military aid to Israel. As a result of the embargo, the U.S. experienced gas shortages, and oil prices in the U.S. quadrupled.

Though the embargo ended in March of 1974, its destabilizing effects are largely blamed for the economic recession of 1973–1975. High gas prices meant American consumers had less money in their pockets to spend on other things, lowering demand and consumer confidence.

Other factors beyond the embargo, including wage-price controls and the Federal Reserve’s monetary policy, exacerbated the financial crisis. Wage-price controls forced business to keep wages high, keeping them from hiring new employees. In a series of monetary moves, the Federal Reserve quickly raised and lowered interest rates. Businesses unable to keep up with the changes protected themselves by keeping prices high, which contributed to inflation.

The period’s high unemployment, stagnant economic growth, and inflation came to be known under the portemanteau “stagflation.”

Asian Crisis of 1997–1998

The Asian financial crisis began in Thailand in July 1997. It spilled over to other East Asian nations and eventually had ripple effects in Latin American and Eastern Europe.

Before the crisis began, Thailand had pegged its currency to the U.S. dollar. After months of speculative pressure that depleted the country’s foreign exchange reserves, Thailand devalued its currency, allowing it to float on the open market. Malaysian, Indonesian and Singapore currencies were devalued as well, causing high inflation that spread to East Asian countries, including South Korea and Japan.

Growth fell sharply across Asia, investment rates fell, and some countries entered into recession.

The International Monetary Fund (IMF) stepped in, providing billions of dollars of loans to help stabilize weak Asian economies in Thailand, Indonesia, and South Korea.

In exchange for its loans, the IMF required new rules that led to better financial regulation and oversight.
Countries that received the loans had to raise taxes, reduce public spending, and raise interest rates.

Global Financial Crisis of 2007–2008

The origins of the Global Financial Crisis are complicated. They started with government deregulation that allowed banks to use derivatives in hedge fund trading. To fuel this trading the banks needed mortgages and began lending to subprime borrowers who had questionable credit. When interest rates on these mortgages reset higher, borrowers could no longer afford their payments.

At the same time, housing prices dropped as demand for homes fell and borrowers who could no longer afford their payments were now unable to sell their homes to cover what they owed on their mortgage. The value of the derivatives collapsed and banks stopped lending to each other, resulting in a financial crisis and eventually the Great Recession.

As a result of the financial crisis, the government took over mortgage giants Fannie Mae and Freddie Mac and bailed out investment banks on the verge of collapse. Additionally, Congress passed the Dodd-Frank Wall Street Reform Bill to prevent banks from taking on too much risk again in the future.

European Sovereign Debt Crisis

The European Sovereign Debt Crisis followed swiftly on the heels of the Global Financial Crisis. The crisis largely began in Greece in 2009 as investors and governments around the globe realized that Greece might default on its national debt.

At that point the nation’s debt had reached 113% of its GDP. Debt levels within the European Union were supposed to be capped at 60%, and if the Greek economy slowed down it might have trouble paying off its debt. By 2010, the E.U. discovered irregularities in the Greek accounting system which meant that its budget deficits were higher than previously suspected. Bond rating agencies subsequently downgraded the country’s debt.

Investors were concerned that similar events might spread to other members of the E.U., including Ireland, Spain, Portugal and Italy who all had similar levels of debt. In response to these concerns investors in sovereign bonds from these countries demanded higher yields to make up for the increased risk they were taking on. That meant the cost of borrowing rose in these countries. And because rising yields lowers the price of existing bonds, eurozone banks that held these bonds began to lose money.

Eurozone leaders agreed on a 750 billion euro rescue package that eventually reached 1 trillion euros by 2012.

Investing During a Financial Crisis

Investing during a recession or financial crisis may not sound like a whole lot of fun. Watching stock prices plummet can give even the most seasoned investor heart palpitations. But keeping an investment plan on track during a crisis is critical to future success. In the face of a financial crisis, there are a few considerations to make.

First, watching a market spiraling out of control may inspire panic, tempting investors to pull their money out of stock. However, that may be exactly the wrong instinct. Bear markets are almost always followed by a recovery, and selling assets may mean that investors lock in losses and miss out on subsequent gains.

Second, investors may want to consider buying more stock when markets are down. Purchasing stock when prices are low during a bear market may provide the opportunity for increased profits as the market turns around.

Down markets can be a good opportunity for investors to stress test their risk tolerance. If falling prices lead to panic, an investor may realize their portfolio carries too much risk for their tastes and may decide to rebalance a portion of their portfolio into more conservative investments. Beware of rebalancing during a financial crisis, however. It can be hard to predict how investments will fair once the market turns around. So it can be better to wait until markets stabilize before making any big moves.

In the end, it’s important to remember that investing is a long-term proposition. Diversified investment portfolios that take an investor’s goals, time horizon, and risk tolerance into account are typically designed to weather short-term financial storms.

If you have questions about building a portfolio, allocating your wealth or how market conditions will affect your financial situations, it can help to talk to a financial planner.

As a SoFi member, you can make a complimentary appointment with a SoFi Financial advisor, who can answer questions you may have regarding your portfolio and the market. Downloading the SoFi app can also help you stay up-to-date on market developments.

Learn more about SoFi Invest® today.

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