Causes of Financial Crises
Financial crises occur when the value of financial assets declines significantly, leading companies to struggle with meeting their financial obligations. Additionally, institutions may lack sufficient liquidity or liquid assets that can be converted into cash. The following are some key factors contributing to the occurrence of financial crises:
High Debt Levels
One of the primary causes of financial crises is the excessive leverage of financial assets, particularly in financial institutions. The debt levels in these entities are often disproportionately large compared to their financial assets, a situation commonly referred to as financial leverage. This imbalance can precipitate a financial crisis, affecting companies, institutions, and even governments.
Overexposure to Investment Risks in Favorable Economic Conditions
This was notably seen in the years leading up to the global financial crisis. During this period, economic conditions, especially in the United States, were highly favorable, characterized by robust and stable economic growth along with relatively low inflation, unemployment, and interest rates. As a result, housing prices surged, and many individuals resorted to excessive borrowing to invest in real estate without adequate justification or planning. Ultimately, housing prices plummeted, leaving these borrowers unable to service their debts.
Lack of Regulation and Oversight in Financial Institutions
With the expansion of financial assets, institutions issuing and trading these assets often lack sufficient regulatory oversight. The high level of trust in most financial entities made them attractive to the public. It is noteworthy that these institutions do not face the same level of scrutiny and auditing by regulatory authorities, such as central banks and commercial banks, which can lead to substantial risks in the financial system.
Corruption and Nepotism in the Banking Sector
Corruption and nepotism are both social and economic phenomena that adversely impact the financial and banking sectors, as well as the broader economy. The prevalence of nepotism leads to poor economic decision-making, while corruption results in unfair distribution and exacerbates poverty levels, pushing society closer to economic instability.
Regulatory and Administrative Errors in the Banking Sector
The global financial crisis highlighted significant lapses in lending practices, stemming from inadequate regulation of financial institutions. In many cases, these institutions extended excessively large loans to borrowers whose repayment capabilities were dubious. Centrally, banks and governments failed to fully grasp the severity of the lack of regulation in lending practices and how these shortcomings contributed to losses in the mortgage sector within the financial system.