Financial crisis is a term used to describe a period of economic turmoil. It usually begins with a banking/credit panic or bank run, where a large number of people withdraw their savings from a bank because they fear it is about to collapse. This panic usually leads to a sharp decline in asset prices and increased borrowing restrictions on businesses and individuals. It is a type of financial disruption that can cause recession.
A number of factors contributed to the crisis, including excessive leverage (a rise in debt relative to equity) and the buildup of risk in too-big-to-fail firms. These firms are so important to the financial system that if they fail, there is a high risk that the failure would spread rapidly and have significant adverse consequences for the economy and for many other firms. Examples of too-big-to-fail financial firms include Fannie Mae and Freddie Mac, as well as investment banks such as Bear Stearns.
Another factor that contributes to financial crises is the mismatch between an institution’s short-term liabilities (its deposits from customers) and its long-term assets, which are largely in the form of loans made by banks. This mismatch can be exacerbated by a rise in interest rates.
This is because higher interest rates raise the cost of borrowing, reducing purchasing power and forcing businesses to cut back on investments and lay off employees. As the economy slows, unemployment rises, and consumers spend less, which leads to lower economic growth and eventually a recession.