Contemporary Finance

15Financial Instability and Financial Crises

15.1 Defining Financial Crises

Financial crises are major disturbances involving interruption of credit intermediation, widespread intermediary failures, and significant macroeconomic impact. Funding liquidity is a typical crisis trigger as short-term lenders decline to continue extending credit and assets must be quickly sold at a loss. Market liquidity and market functioning are disordered, with the potential or reality of impairment of payments systems. Asset prices typically display extreme volatility, and many risk asset prices plummet. Economic activity falls rapidly; recession or a depression ensues that is generally unusually long and severe. There is more often than not an international dimension: the crisis affects a number of countries with abrupt changes in exchange rates or capital flows, transmitted via trade and financial channels.

Financial crises are a very old phenomenon, dating back at least to the late medieval era and the origins of deposit banking. Major crises before the Great Depression include:

• 1343: Collapse of several Florentine banks on the failure of England to repay war-financing debts.
• 1763: Widespread failures of Dutch and German banks follow the end of the Seven Years’ War and war boom.
• 1825: Bank of England suffers a gold drain, widespread bank failures, and stock and bond price declines following the post-Napoleonic war credit expansion.
• 1837: Widespread suspension of specie payments by and failures ...