A financial crisis occurs when prices of assets and liabilities decrease sharply, threatening the solvency of businesses and households. Historically, these crises have been triggered by stock market crashes, bank runs, the bursting of financial bubbles, and sovereign defaults. They can affect one country or multiple nations and sectors of the economy. Financial crises can cause recessions and depressions.
The 2008 financial crisis was sparked by the failure of the investment firm Lehman Brothers in September 2008. The crisis spread as hedge funds and banks around the world revealed substantial holdings of subprime mortgage-backed securities, which were rapidly losing value. This created a global liquidity crisis as investors withdrew funds from institutions that were unable to sell their assets. Credit markets froze and many institutions unable to borrow from other lenders were forced to close up shop. Business investment slumped and household spending declined as confidence plummeted.
Fortunately, extraordinary policy responses prevented the financial system from collapse and set the stage for economic recovery. These included the federal government’s purchase of distressed debt from private firms through TARP, the guarantee of bank debt by the FDIC, and the bank stress tests; the large fiscal stimulus package known as the American Recovery and Reinvestment Act; and several rounds of quantitative easing.
The crisis also highlighted problems with the structure of incentives at financial institutions. Compensation practices that rewarded short-term performance and did not adjust for risk contributed to excessive borrowing and investment in bad assets. The lack of oversight by regulatory agencies and the failures of management at many systemically important institutions increased the likelihood of a crisis and made it worse when it struck.
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