How Financial Institutions Are Affected by Financial Crises

In light of the current economic conditions caused by the global pandemic, many pundits are concerned about financial institutions affected by the financial crisis and what financial institution failures could mean for personal finances. Financial crises are not uncommon. In fact, they’re a normal part of the economic cycle. Fortunately, the government and the financial industry have now implemented safeguards against crashes like the one that occurred in 2008. 

 

Learn more about what those safeguards are, what causes bank crises, how recessions impact financial institutions, and what financial institutions do about them below.

 

How Do Financial Institutions Affect the Economy?

 

A financial crisis can really make a financial institution suffer. Recessions cause credit losses, lost revenue, and decreased investment value. As a financial institution’s ability to offer credit recedes, the effects of the recession are amplified. Economists refer to this phenomenon as the “financial accelerator.” Crises like these lead to poor performance. There is significantly less capital to use for investments and returns, which in turn drives unemployment up in the long term and reduces tax revenue. 

 

Who Benefits From a Recession?

 

Not all the impacts of a financial crisis are bad for the economy. Some industries thrive in times of economic downturn, including second-hand stores, supermarkets, payday loan companies, liquor stores, and any that company offering essentials, cheap entertainment, or discounted goods. First-time homebuyers also benefit from lower interest rates on mortgage loans in recessions.

The Causes and Effects of Financial Institution Failures

 

There is no single reason that financial institutions fail. It can happen for many reasons, including the following, that have happened in the past:

 

• Contagion: The United States is highly interconnected with other world economies. When one economy fails, ours can get caught in the domino effect, which economists refer to as “contagion,” and it can result in any of the causes that follow in this list. When there is a low demand for imported goods, it spurs a global recession that tanks consumer confidence in the economy and lowers share prices worldwide. 

 

• A decrease in borrowing: During financial crises, people become more fiscally conservative. They stop spending their money superfluously, avoid new debts, and start saving instead, which means that financial institutions lose money on the interest made on loans. When this happens, financial institutions dramatically reduce their interest rates to encourage borrowing and investing in order to help stimulate the economy.

 

• Mass withdrawals: As we saw in the Great Depression, the stock market crash led to a skepticism towards financial institutions, which caused many people to withdraw their money from the institution all at once. Most financial institutions’ capital was already invested and they lacked enough free funds to cash out all accounts at once, sending the public into an even greater state of hysteria. 

 

• Government oversight: Many failures can simply be put down to government oversights. The 2008 financial crisis was partially caused by government regulations that put pressure on the financial sector to make it easier to buy homes. Many consumers who had purchased homes eventually had to default on their mortgage loans, and financial institutions in the US and abroad lost money. In turn, financial institutions could no longer lend to each other or offer as much credit to customers. 

 

• Feedback loops in the stock market: Another cause of the 2008 crisis was the positive feedback loop effect that took place in the stock markets, in which investors picked stocks that were most appealing to other investors. This investing behavior causes major stock market rises and crashes that result in losses for financial institutions that don’t have high leverage.

How financial institutions Prevent Future Crises

 

In 2010, following the 2008 financial collapse, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed, which created new regulations in the United States and abroad to protect financial institutions and their clients or members. The act held financial institutions to high liquidity standards and forced them to keep more assets readily available so as to reduce the risk of future events like those mentioned above.

 

While the financial industry has learned lessons from disasters of the past, subsequent laws put in place have not entirely kept financial institutions from assuming excessive risk. Irresponsible banking behaviors, poor-quality corporate debt accumulation, and loose monetary policy are the factors that economists say are likely to spur the next financial crisis. As such, another crash could be on the horizon. 

 

How You Can Safeguard Your Bank Against Collapse

 

As a financial institution, you have immense technology at your disposal that can help you assess and measure risk without human error. Companies like BMA Banking Systems offer solutions like risk management to help you minimize your losses in tough economic times. Contact us today to find out how our solutions could work for your institution.