Drivers of Financial crisis

Financial behemoths like Merrill Lynch, Citigroup, and a bank Northern Rock had to make announcements of many billions in loan losses even leading to the sacking of CEOs. The news from global credit markets has been discouraging for months.

Given the above context we have made a study of one crisis to offer a summary of seven drivers. It helps to understand what drives financial crises which we have out lined below:

Growth: New inventions stimulate expansions and eventually over expansion. Sooner or later the markets will correct the mistakes that occurred during the expansions. These periods, post invention, are “hot markets incubators” for financial crises. When markets are hot, there is a sharp increase in trading activity talk of a paradigm shift entry by inexperienced players, rising prices, aggressive financing, and so on. During hot markets decision makers are prone to make bigger mistakes.

Complexity: This may be related to growth. But the macro economy evolves with more complexity that makes it hard for depositors and investors to know what is going on. Complexity is reflected in factors such as the expanding size and scope of the economy, technological change, and growing demographic diversity. The problem with complexity is asymmetric information, the imbalances within and among investors about what is known.

Inflexibility: Inflexibility refers to the absence of sufficient safety or cushion against shocks. A system engineer would call this, “tight linkage” parts of a system. Such linkage is “tight” where there are few safety buffers. Trouble can spread rapidly .In financial system inflexibility could refer to the insufficiency of reserves of cash to meet the withdrawal demands of depositors or of capital to absorb loan losses.

Cognitive biases: Behavioral economists such as the Nobel prize-winner, Daniel Kahneman, have documented cognitive biases in markets, such as over optimism, over pessimism, deal frenzy, failure to ignore sunk costs, and so on. Cognitive biases prevent rational action and prevent leaders from being mentally prepared for trouble.

Adverse leadership: Leaders do things advertently or inadvertently in the advance of crises that elevate risk – they may say or do things to promote speculation increase the uncertainty or investors and/or amplify cognitive biases.

Economic shock: The Sixth driver of crises is some kind of real economic shock that spooks depositors and investors. Each crisis has a trigger of some sort. Trouble breaks out and spreads rapidly – the trouble could be a natural disaster (such as a massive earthquake, 1906), a sovereign default (such as Russia, 1998) or the onset of a major war (1914). A ‘shock’ must be real (not cosmetic), costly, unambiguous and surprising.

Collective action: Seventh, the depth and duration of every crisis is affected by the quality of leadership in organizing collective action People can behave in ways that promote individual welfare, but worsen societal welfare. The prime example would be the rush to with draw funds from a bank during a panic – such behavior while individually sound, may produce a self-fulfilling prophecy of bank failure.

Inadequate collective action leads to inappropriate responses, for example: delay, over action creating other problems, unethical behavior such as acting in one’s self interest rather than in the interest of the community and in fighting due to old operating rivalries, cultural difference, or misunderstandings.
These seven factors constitute a system of failure. Rapid growth, complexity; tight linkage, cognitive biases, and adverse leadership create a medium of confusion and propagation. A shock occurs followed by poor response, poor results more confusion, propagation of the problems, and so on.

The current financial crisis illustrates these factors:

1. Growth: Indeed the global economy has been growing rapidly for years.
2. Growing complexity: Globalization creates more complexity especially with the increase in sheer scale and scope of markets and players. And we have seen increasing complexity in financial markets institutions and instruments.
3. Tight linkage: The relatively high consumer indebtedness in the US, and the aggressive use of leverage by hedge funds private equity firms, and specialized investment vehicles be speak a reduction in the ability to absorb financial shocks.
4. Cognitive bias: Some analysts point to astonishing price increases in the US and elsewhere in real estate .Some analysts suggest that the equity indexes in India and China reveal a “bubble” of optimism.
5. Leaders elevate risk: The sackings of CEOs at UBS, Merrill Lynch, and Citigroup were associated with adventures into the risky sub-prime loan market.
6. Real shock: The obvious candidate is the surprising rate of default on home mortgage loans in the US that emerged starting in late 2006.
7. Collective action: Central banks have shifted sharply from restrictive to expansionary monetary actions. One group of major banks is trying to organize a private market source of liquidity in sub-prime loans.

It seems likely that this crisis has longer to run. Any crisis will ricochet through the global financial system. Eventually it will come to rest, but until then will perturb other players and perhaps knock some into the pockets. Watch for, active intervention by central banks, failures of institutions –those that are most highly levered, are poorly diversified and/or poorly managed are the most vulnerable, efforts at collective action by the central banks or private groups.

Financial crises tend to run their course within12 to 18months. Therefore as long as one is invested in sound assets and can afford to be patient, the best advice is to wait out the crisis and whatever happens in the capital markets don’t panic.