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Dynamics of Financial Crises in Advanced Economies

Financial crises in the Advanced Economies have progressed in two and


sometimes
three stages :

Stage One
Financial crises can begin in several ways: mismanagement of financial
liberalization
or innovation, asset price booms and busts, or a general increase in
uncertainty
caused by failures of major financial institutions.
A. Mismanagement of financial liberalization or innovation
Liberalization promotes financial development and encourages a wellrun

financial system that allocates capital efficiently. However, financial


liberalization
has a dark side. In the short run, it can cause credit boom. Credit boom
happened when the lender may not have expertise, or the incentives,
to manage risk appropriately in these new lines of business. Event with
proper management, its very hard for institution and government to
control and monitor credit risks.
Government safety nets such as deposit insurance weaken market
discipline and
increase the moral hazard incentive for banks to take on greater risk
than they
otherwise would. The depositors know that government insurance
protect from losses. The depositors will supply undisciplined banks with
funds. This makes undisciplined bank make wrong decision that make
losses. Bank losses make depositors and lenders, pulling out their
money. Bank become have less money, they cant loans money to
company. The company cant able to invest.
B. Asset Price Boom and Bust
The rise of asset prices above their fundamental economic values is an
asset-price bubble. This happened when a lot of credit used to
purchase an assets. This make the value of assets become so high ,
but when asset prices realign with fundamental economic values,
stock prices tumble and companies see their net worth drop. Lenders
look askance at firms with little to lose (skin in the game) because
those firms are more likely to make risky investments, a problem of
moral hazard. Lending contracts as borrowers become less
creditworthy from the fall in net worth.
C. Spikes in Interest Rate
increasing in interest rate causing the decline in economy activity.
Increasing in adverse selection, lenders will no longer to make loans.
Interest rate also effecting cash flow. With less cash flow, company
have less internal founds. So the company must found it from external
such a bank. But increasing in interest rate make increasing in advert
selection and moral hazard, the bank may not found the company. In
the end the company cant invest or run their project.
D. Increasing in Uncertainly
Financial Crises usually begun in period of high uncertainly. High

uncertainly cause high adverse selection , high moral hazard , reducing


lending , and economy activity.