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Diagnosing a financial crisis
The defining feature of a financial crisis is that financial assets such as stocks suddenly lose a large amount of their value. In essence, people pull their money out of anything that they perceive as remotely risky and put it somewhere where they think it’ll be safe – which is why gold and central London property do so well during crises.
As part of this ‘flight from risk’, financial institutions become very reluctant to lend money to people (or even each other) – sometimes called a credit crunch. This reluctance causes problems for lots of good, well-run businesses, which are profitable but need some short-term cash for liquidity reasons. Without funding, many such businesses go under.
Your local butcher or baker going bankrupt is one thing – it’s certainly sad for them and their employees, but any wider fallout is unlikely (except perhaps for your stomach). But a large financial institution going under is another thing altogether – it has the potential to create widespread panic and chaos, because such a business is in the middle of a complex web of transactions with other financial institutions.
The failure of just one large bank can easily reverberate throughout the economy and lead to multiple bank failures and even the collapse of the financial system as a whole – this process is called financial contagion.
To avoid financial contagion, governments often feel obliged to bail out the financial sector during times of crisis. This response tends to be unpopular with the public, because previously private liabilities become the responsibility of the taxpayer. You may have heard the phrase ‘heads I win, tails you lose’, which refers to the idea that financial institutions and their employees do very well for themselves during the good times, but that during the bad times taxpayers are left with the bill.
Fighting financial crises: Lender of last resort
One of the main problems financial institutions (and indeed other businesses) face during a financial crisis is that they have extreme difficulty borrowing money.
Many of these institutions have lots of assets – in theory more than enough to cover their liabilities. But a lot of these assets are illiquid – that is, turning them into cash quickly is difficult. For example, a bank may own your mortgage, which is a valuable asset because it gives the bank the right to a stream of payments from you over a number of years. But what good is something that pays out in 10 or 20 years when the bank needs the cash now?
Furthermore, trying to sell these assets isn’t going to help: the financial crisis means that no one wants to buy assets – and if they do, they’ll pay only a fraction of their value during ‘normal times’ (called a fire sale). In ‘normal
times’ a financial institution wouldn’t even need to sell its assets to borrow money – it would use them as collateral to get a loan on the understanding that if it fails to repay, the lender seizes the collateral as compensation.
But during a financial crisis, asset prices have fallen so much that lenders are reticent to lend money even if collateral is offered to secure the loan. Here’s where policy makers (typically the central bank) can step in and act as a lender of last resort. In practice, this term means being willing to lend to financial institutions that can’t easily borrow elsewhere, and furthermore, accepting collateral from them based on the market value of that collateral in ‘normal times’ rather than the current (very low) market value.
The role of the lender of last resort isn’t to stop insolvent businesses from going under – that is, businesses whose assets (even in normal times) are insufficient to cover their liabilities. No, the lender of last resort’s job is to help businesses that – due to the crisis – are suffering from short-term liquidity (cash flow) problems. They have enough assets to cover their liabilities; the crisis is just making borrowing hard for them.
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