The 1930s and 2008 crises
The Great Depression: in 1929 share prices in the USA crashed after years of speculation, many banks failed and savers lost deposits. Firms cut production, about a quarter of US workers lost their jobs, and trade between countries shrank. Governments later introduced deposit insurance and bank rules.
The 2008 global financial crisis began with risky housing loans in the USA that were packaged and sold as securities all over the world. When house prices fell, borrowers defaulted, the securities lost value, and banks were afraid to lend to each other. Large banks failed or were rescued with public money. World output and trade fell and unemployment rose in many countries. Both crises show the same pattern: boom, bubble, burst, panic, recession.
Speculative bubbles
The fundamental value of an asset is what it really earns (rent from a house, profits from a company). A speculative bubble exists when the market price is much higher than this value only because buyers expect to sell later at an even higher price.
What feeds a bubble: easy credit (cheap loans), herd behaviour (everyone is buying), stories like "this time is different", and the fear of missing out. A bubble stops when buyers run out or lenders get nervous; prices then fall sharply, which is a crash. Those who borrowed to buy still owe the full loan even though the asset is worth much less.
Bank panics and chain failures
A bank keeps only a small part of deposits as cash; the rest is lent out. So if many savers ask for cash at once, the bank cannot pay. This is a bank run. Even a healthy bank can fail if people only believe it is in trouble: the fear becomes true (a self-fulfilling panic).
Banks also lend to each other and hold each other’s assets. When one bank cannot repay, the banks that lent to it lose too, and then their lenders worry. This is contagion or a chain of failures, also called systemic risk. A bank so connected that its failure would shake the whole system is "too big to fail".
Channels to the real economy
The real economy is production, jobs and incomes. A financial crisis reaches it through several channels:
- Credit crunch: banks stop lending, so firms cannot pay suppliers or invest, and families cannot buy homes or cars.
- Wealth effect: falling prices of shares and houses make people poorer, so they spend less.
- Confidence: firms and households fear the future and postpone spending.
- Trade: lower demand in one country cuts exports of others.
Less spending means less output, so firms cut jobs, and incomes fall further. This downward circle is a recession; governments and central banks answer with lower interest rates, public spending and rescue funds.
Bank supervision and solvency ratio
Bank supervision means a public authority (for example the central bank) checks banks, makes rules and can stop risky behaviour. International Basel rules guide most countries.
A bank is solvent if its assets are worth more than its debts. Its own money (equity, capital) is the cushion that absorbs losses. The solvency ratio = capital ÷ risk-weighted assets × 100. Regulators demand a minimum, for example total capital at least 8% of risk-weighted assets, plus extra buffers for big banks. Other tools: liquidity rules (hold enough cash), stress tests, deposit insurance (savers are repaid up to a limit, so they do not run), and rules on how banks can bundle and sell loans.
Key formulas and definitions
- Solvency ratio (%) = capital ÷ risk-weighted assets × 100
- Bank survives a loss if loss ≤ capital
- Price bubble gap = market price − fundamental value
- Change in price (%) = (new − old) ÷ old × 100
Worked examples
1. A bank has capital 12 and risk-weighted assets 150. Find its solvency ratio. Is it above 8%?
12 ÷ 150 × 100 = 8%. It is exactly at the minimum of 8%.
2. A house price rose from 40 to 100 in 5 years, but the rent it earns still suits a price of 50. Find the bubble gap and the percent rise.
Rise = (100 − 40) ÷ 40 × 100 = 150%. Bubble gap = 100 − 50 = 50.
3. A bank has 100 in assets and 8 in capital. A 5% loss hits the assets. Does it survive? What if the loss is 10%?
5% of 100 = 5 loss, which is less than capital 8, so it survives with 3 left. A 10% loss is 10, which is more than 8, so it fails (insolvent).
4. After a crash prices fall from 100 to 60. Find the percent fall and the rise needed to recover.
Fall = 40 ÷ 100 × 100 = 40%. To go from 60 back to 100 needs 40 ÷ 60 × 100 = 66.7%.
Common mistakes
- Thinking a bubble means the asset is worthless. It means the price is above real value, not zero value.
- Believing only bad banks face runs. Even healthy banks fail if panic is large.
- Mixing up capital and cash. Capital is the owners’ money (a cushion); cash is what the bank holds to pay depositors.
- Thinking financial crises stay in finance. They cut loans, spending, output and jobs.