What causes financial crises?

Credit and liquidity risk transformation are the major drivers of financial crises.

Even every single bank manager shows due diligance, giant credit risk concentrated in the financial system could push a financial agency into default in an economic downturn.

To stop spillover effect of defaults, all types of financial guarantees and insurances should strictly be regulated. Supervisors should be able to know the derivate risks that each financial agency is exposed.

Financial system produces safe and liquid assets through collaterals and gurantees. Though, they are merely safe in good times.

The trigger of a financial crisis can be both economic and financial. 2008 was a financially motivated crisis while COVID-19 starts with a demand shock. However, once the trigger is pulled, the mechanism of the financial crisis starts to run. Understanding how it works, criminals behind a crisis can be revealed.

Credit and liquidity risk transformation are the major drivers of financial crises. A great portion of investors accepts no risk. Because governments insure deposits up to a limit, depositing large amounts into a bank is not safe. Riskless securities are the only alternative for whealthy investors who consent even negative returns with the motivation of preserving their wealth. Financial system produces safe and liquid assets through collaterals and gurantees. Though, they are merely safe in good times.

A financial asset can be safe and liquid via two instruments: collateral and guarantee. The asset is backed by another asset, which is called ‘collateral’. During a crisis, collateral prices sharlply fall. For this reason, collateral is accompanied by a guarantee. A guarantor guarantees the debt as a third party. For bank deposits, the guarantor is the government. Nonetheless, giant institutional cash polls such as mutual funds are not covered by government guarantees. The private guarantee products serve giant funds in the form of insurance, CDO etc.

Before the 2008 global financial crisis, all types of financial guarantee instruments enormously expanded. Billions of insurance or derivative transactions connected financial institutions all over the world. Thus, a subprime mortgage crisis turned into a global crisis, rapidly spilling over every cell of the financial system. Until COVID-19, complex and interdepedent relations through derivatives continued to rise in the financial sector. Financial authorities even do not know about bilateral derivate transactions, which are made over-the-counter (OTC).

At this point, we can ask the question: Who is responsible for financial crises? The answer would be guarantee and insurance tools that create interdependence amid financial system. Bearing credit risk, the financial system transforms funds into credits. The system performs well until credits collectively default in an economic downturn. When a crisis hits, weak financial agencies pull their guarantors into default.

Searching for criminals does not solve the crisis problem. Even every single bank manager shows due diligance, giant credit risk concentrated in the financial system could push a financial agency into default in an economic downturn. If defaults independently occur, the credit risk does not convert into the systemic risk, which devestates the entire financial system.

To stop the spillover effect of defaults, all types of financial guarantees and insurances should strictly be regulated. Supervisors should be able to know the derivate risks that each financial agency is exposed. Thus, the systemic risk can become managable both from financial agencies’ and supervisors’ perspective.