Why do financial crises happen?

CHINA FINANCIAL - In Brief 09 Jul 2015 by Michael Pettis

Financial crises are analogous to bank runs. They occur when the liquidity needed to bridge the gaps created by mismatches between assets and liabilities suddenly becomes unavailable. Insolvency by itself is not a sufficient condition, and only leads to a financial crisis when it causes creditors to refuse to roll over liabilities that cannot be serviced out of assets. Financial crises can be triggered by a wide variety of events, some seemingly trivial, but they require the following conditions: · Significant asset and liability mismatches within the country’s balance sheet and financial system, usually exacerbated by highly pro-cyclical mismatches that reinforce exogenous shocks (because highly pro-cyclical entities outperform during periods of economic expansion, there is a natural sorting process in which the longer such periods last, the more a country’s financial system will be tilted towards pro-cyclicality). · A period in which mutually reinforcing slower-than-expected economic growth and faster-than-expected credit growth create rising uncertainty about the allocation of debt servicing costs. · A transmission mechanism from the trigger event into the financial system, for example a fall in the price of assets can cause a surge in non-performing loans, or it can cause households to cut back on consumption. When these conditions are in place, even a small shock can directly or indirectly (in the latter case by forcing agents to respond adversely to a rise in uncertainty), trigger a self-reinforcing series of events that spiral out of control.

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