What are the Causes of financial instability?

Since the last global economic crisis, economists, governments, and central banks in the individual economies have focused on maintaining financial stability in the respective countries, researching the causes of instability in the financial system, and defining measures that can counteract a future financial crisis. The terms "financial crisis" and "financial instability" are often equated, although these terms have to be considered differently. But how are these to be defined now?

According to the definition of some economists, financial instability occurs as soon as a large number of market players are no longer solvent, and liabilities to their own creditors can no longer be paid. In this state, the financial system is vulnerable to a financial crisis. A financial crisis is particularly prevalent when there is a rapid and significant deterioration in financial indicators. For example, this could be a sharp increase in short-term interest rates, a drop in share and bond prices, and the sudden insolvency of systemically important companies. The financial crisis is often seen as an extreme case or the culmination of financial instability. This shows that a financial crisis presupposes financial instability. But what causes can now be so serious that the stability of the financial system is endangered? Economists name a variety of indicators that point to the development of an unstable financial system. Let’s have a look at the causes of financial instability.

Incomplete monitoring and regulatory policies

Monitoring and regulatory policies are often so sketchy and incorrect that they result in unstable financial systems. The reaction is usually only given when financial crises occur, and damage can no longer be prevented. While the 2009 financial crisis was answered with new laws and regulations, this crisis could have been countered in advance through stricter and more consistent monitoring.

An example of this is the shadow banks, which have emerged in the course of increasing innovations in the financial market in recent years. A large number of new institutions developed at a rapid pace, which, in a way, do banking, but are not a bank from a legal perspective. As a result, these institutions do not fall within the scope of the relevant regulation. Shadow banks are a parallel, largely unregulated banking system, which is nevertheless not protected from being a partial trigger of a financial crisis and from having to deal with the same problems as those of the banks. The strong networking of the institutions in the shadow banking sector with traditional banks is also to be seen as critical.

Assuming that there are now sufficient regulations and that the financial system is adequately monitored, there is still the problem of the fast pace of the financial market and the complexity of the global financial system. Accordingly, globalization has enormously expanded the networks in which the financial institutions operate and has also become very confusing. In addition, the difficulties of efficient monitoring and regulation have increased insofar as new markets have also created new transmission channels for financial shocks both domestically and abroad. In the course of this development, the possibility of monitoring financial market institutions has become increasingly difficult. 

Missing or poorly implemented regulations and monitoring are a real danger to cause financial instability. Even if market regulations have often existed for a long time, the rapid development of financial innovations over the past few years has meant that this instrument has not been able to take effect as quickly as it would have been necessary.

Fluctuations in asset prices

A prerequisite for ensuring stability in the financial system is maintaining price stability. Fluctuations in asset prices upset the balance in the financial system and are, therefore, another cause of financial instability. Both stabilities - financial stability and price stability - have to be viewed over a longer period of time in order to be able to recognize fluctuations in asset prices at all and to not overlook the formation of possible asset price bubbles. If these price bubbles suddenly burst, changes in asset prices can have consequences for financial stability.

Asset price cycles often go hand in hand with periods of long, loose monetary policy. The expansive monetary policy (expansion of the money supply) leads to increased lending, which causes asset prices to rise over time. If a price bubble forms, asset prices will suddenly fall, and the likelihood of a possible financial crisis resulting from financial instability will increase exorbitantly. Asset price bubbles can lead to financial instability if, for example, they have seriously weakened the financial situation of financial institutions. However, an asset price bubble does not have to represent financial instability.

Even if fluctuations in asset prices do not always lead to instabilities in the financial system, politicians can pursue the goal of focusing on a balance of asset prices. However, it should be noted that asset price stability is not always beneficial for economic well-being, and the pursuit of it could be very costly. Costly, especially when it comes to “piercing a bubble,” using monetary policy measures that require a strong tightening of monetary policy.

Asymmetric information

Asymmetric information is available when market players have different levels of knowledge. This can also have a negative impact on the balance in the financial system. Instabilities in the financial market often result from decisions made in the past, although future developments could not have been foreseen at the time. Decisions are made based on the information available, among other things. Market participants rarely have all the information available. This is how investors act based on any assessments and expectations in the market, whereby unexpected developments concerning interest rates, prices, or exchange rates can lead to errors. Therefore, different distributions of information can help market players reveal behavior that threatens financial stability. In order not to let things get this far, it is recommended that trustworthy information channels are selected and decisions made, and actions are taken based on them.

Financial instability through expansionary monetary policy

Most analysts refer to the state failure in the last financial crisis, which was primarily triggered by the supposedly over-expansionary monetary policy of the Federal Reserve and partly also of the European Central Bank. It is criticized that these institutions with too low-interest rates between 2001 and 2004 would have induced an excessive increase in the money supply. This expansive monetary policy was designed to serve the purpose of promoting economic growth and encouraging the public to invest. Even if essential economic policy goals can be achieved through the expansion of the money supply, this policy also favors the emergence of fluctuations in asset prices and consequent instabilities in the financial system.

Growing lending linked to securitization techniques.

A key role of central banks is to set interest rate targets that banks offer each other for short-term loans. If these interest rates are higher than the central banks deem necessary, they provide the banks with additional liquidity until their interest rates have dropped sufficiently due to the increased money supply. In addition, central banks automatically increase the money supply as soon as new sectors of the economy are opened up to the credit cycle. The effect of this is that the economy is flooded with credit. Conversely, if production or real economic growth is not increased, this leads to financial instability.

In addition to expansive lending, there is the problem of securitization. The securitization technology represents a financial innovation that aims at balancing risk structures on the one hand, but on the other hand, creates false incentives to grant loans that are independent of repayment options. What matters is that the one who grants the loan no longer bears the risk, and the one who is at the end of the “securitization cascade” knows no risk. Banks can, therefore, pass on the risk as soon as the opportunity arises.

The development of securitization techniques and the associated shifting of risk entice banks to lend more and more. Loans are primarily used to invest in different markets and to boost the economy accordingly. Increased lending, however, harbors the risk of instability in the financial system due to chain reactions (e.g., the bursting of a wealth bubble). 

Conclusion:

Financial instability can be triggered by several factors, with particular emphasis on asset price fluctuations and the interplay between unregulated shadow banking financial services and the issuing of (securitized) loans. These causes are also so worrying that these developments initially appear harmless and are only classified as critical when it is often too late, and financial stability is no longer ensured. In any case, constant monitoring or monitoring of asset prices is recommended. Financial innovations are also to be examined to what extent these could influence possible instabilities and regulated if necessary.

Economists have performed remarkably in recent years and have identified a variety of causes in their work. These results are an important basis for preventing future financial crises. However, new triggers of financial instability will continue to emerge in the next few years, which is why further research will be absolutely necessary.

Author: Vicki Lezama