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What causes financial crises?

  • Writer: Macroprudential Policy
    Macroprudential Policy
  • May 15, 2020
  • 6 min read

Updated: Aug 16


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Credit and liquidity risks are the major drivers of financial crises.


Financial crises are complex and destructive events that occur when vulnerabilities in the financial system are exposed—often by an economic or financial shock.

Banks are not the primary instigators of financial crises; they are victims of contagion from unregulated nonbanks


Triggers: Economic vs. Financial Origins


Financial crises can originate from two types of shocks:


  1. Financial Triggers – originate within the financial sector, such as excessive leverage, credit bubbles, or asset mispricing.

    • Example: The 2008 Global Financial Crisis began in the U.S. housing market, where subprime lending practices led to a cascade of defaults.


  2. Economic Triggers – arise from real economy shocks, such as pandemics, wars, or natural disasters.

    • Example: The COVID-19 crisis was triggered by a global demand and supply shock, which then spread into financial markets via liquidity withdrawals and credit downgrades.


Despite different triggers, both types of crises can destabilize the financial system once the core vulnerabilities are activated.


Risk Transformation and the Illusion of Safety


The core function of modern finance is to transform risky and illiquid assets into instruments perceived as safe and liquid. This transformation depends on two key tools:


1. Collateral


A financial instrument is backed by another asset. If the borrower defaults, the collateral is seized.

  • Problem: In times of crisis, collateral values—especially those tied to real estate or volatile markets—plummet, rendering even high-quality loans unsafe.

📉 Example: U.S. house prices fell over 20% nationally between 2006 and 2012 (S&P/Case-Shiller Index), undermining trillions of dollars in mortgage-backed securities (MBS).


2. Guarantees and Insurance


Financial products often come with guarantees, either from:

  • Public guarantors (e.g., government deposit insurance), or

  • Private entities (e.g., credit default swaps, monoline insurers, or structured financial products like CDOs).


These guarantees work in good times, but in a crisis, they fail collectively—as the entities providing the guarantees themselves become illiquid or insolvent.

🔍 Case in Point:AIG, one of the world’s largest insurers, collapsed in 2008 due to its exposure to credit default swaps—necessitating a $180 billion government bailout.


Systemic Risk and Interconnectedness


The financial system’s interconnectedness means that nonbank distress quickly becomes a banking problem (BIS, 2022). When shadow banks face runs or hedge funds implode, banks suffer losses on loans and derivatives exposures (Claessens et al., 2012). Moreover, nonbanks rely on banks for funding, creating a dangerous feedback loop. The collapse of Long-Term Capital Management (LTCM) in 1998 nearly brought down Wall Street’s biggest banks due to counterparty risks—a clear example of how unregulated nonbanks can destabilize the entire system (Lowenstein, 2000).


The expansion of over-the-counter (OTC) derivatives and bilateral contracts has created a dense web of interdependent obligations across the financial system. The collapse of a seemingly minor actor can have outsized consequences.


Lehman Brothers (2008):


  • Was not considered too big to fail, but its failure triggered a global liquidity freeze.

  • According to Ben Bernanke, 12 out of 13 major U.S. financial institutions were at risk of failure days after Lehman's collapse (Carney, 2011).


Data Point:


  • The notional amount of OTC derivatives exceeded $600 trillion in 2008 (BIS), making it impossible for regulators to track risk exposure in real-time.

The financial system became a house of cards—safe until it wasn’t.


Who Is to Blame?


Financial crises have devastating consequences for economies, wiping out savings, destabilizing markets, and triggering recessions (Reinhart & Rogoff, 2009). While banks are often blamed for these crises, the reality is that they operate under strict regulatory frameworks designed to limit excessive risk-taking.


Banks are subject to stringent capital requirements, liquidity rules, and stress tests imposed by regulators such as the Federal Reserve, the European Central Bank, and the Basel Committee (BCBS, 2022). These measures ensure that banks maintain sufficient buffers against losses and avoid excessive leverage. If banks fail, it is typically because risks have concentrated elsewhere in the financial system, overwhelming even prudent institutions (Adrian & Shin, 2010).


In contrast, nonbanks operate with far fewer constraints. The largest nonbanks—such as BlackRock, Fidelity, and hedge funds like Bridgewater—manage trillions in assets, often exceeding the size of the biggest banks (IMF, 2023). For instance, BlackRock’s $10 trillion in assets under management dwarfs JPMorgan Chase’s $3.7 trillion balance sheet (BlackRock, 2023; JPMorgan Chase, 2023). Yet, unlike banks, these institutions are not required to hold capital reserves against potential losses, nor are they subject to the same liquidity mandates (Pozsar, 2014). This regulatory asymmetry allows nonbanks to engage in risky activities—such as leveraged trading, derivatives speculation, and illiquid investments—without adequate safeguards.


Historical Cases: Financial Crises Begin in Nonbanks and Spread to Banks


1. The 2008 Global Financial Crisis (GFC)


While subprime mortgage lending by banks played a role, the crisis was primarily fueled by nonbanks. Investment banks like Lehman Brothers (which operated more like a hedge fund than a traditional bank) and shadow banking entities packaged toxic mortgages into complex securities (Gorton & Metrick, 2012). Money market funds, such as the Reserve Primary Fund, faced runs when Lehman collapsed, freezing short-term funding markets (McCabe, 2010). These nonbank failures then spilled over into the banking sector, forcing government bailouts to prevent a total meltdown (Bernanke, 2015).


2. The 2019-2020 Repo Market Crisis


A liquidity shortfall in the repurchase agreement (repo) market—dominated by nonbanks—triggered a near-seizure of short-term funding (Duffie, 2020). Hedge funds and money market funds, heavily reliant on leverage, faced margin calls, forcing the Federal Reserve to intervene with emergency liquidity (Afonso et al., 2021). Once again, nonbank instability threatened the broader banking system.


3. China’s Evergrande Collapse (2021-Present)


China’s property crisis was ignited by the downfall of Evergrande and other highly leveraged real estate developers—nonbank financial entities that borrowed excessively from shadow lenders (Huang, 2022). Their defaults strained China’s banking sector, demonstrating how nonbank failures can endanger regulated institutions (PBoC, 2023).


Conclusion: Regulate Nonbanks Before the Next Crisis


Banks are not the primary instigators of financial crises; they are victims of contagion from unregulated nonbanks (Tucker, 2018). The solution lies in extending prudential oversight to shadow banks, hedge funds, and other systemic nonbank entities (FSB, 2023). Without stricter regulation, the next crisis will inevitably begin outside the banking sector—and once again, the entire financial system will pay the price. Policymakers must act before it’s too late.


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