It seems that this year 2022 is on its way to being captured in the history books of the contemporary world due to all the events that have surrounded this frenetic year. Without a doubt, it has been a year full of lessons for our investment training. Precisely one of the words that has been around the most during this last year has been the word “crisis”. A word not at all well received by people, much less by investors. Well, it won't be that bad... Let's see in this investment training what the financial crises, its catalysts and which have had the most impact on history.
What is a financial crisis?
Well, let's start the investment training by first defining what exactly a financial crisis is. A financial crisis is defined as a period where the prices of financial assets suffer a sharp depreciation and consumers and companies cannot pay their debts. These events cause liquidity shortages for financial institutions. That is, a financial crisis is defined as panic situations in which investors sell their assets and withdraw all their cash from financial institutions due to fear of further depreciation of their capital. There are other events that can also be classified as a financial crisis, such as the bursting of a speculation bubble, a debt default, a stock market or currency crash. So, a financial crisis can occur in a single institution, in a single economy, in a region or at a global level.
What factors start a financial crisis?
At first glance the question sounds easy; money since it is a crisis related to finances. But there can be multiple factors that can trigger these crises. They usually occur when an asset or an institution is overvalued, which is strongly exposed to investor movements. That is, if, for example, there is a series of consecutive sales of an overvalued stock, it can cause a large depreciation in the stock. This development may lead retail investors to massively dispose of their assets. It can also occur with enormous amounts of capital withdrawals due to rumors of alleged bankruptcies of banking entities. Let's continue the investment training on financial crises by listing the factors that trigger a financial crisis, such as:
The unexpected behavior of the human being
We know that human beings and the randomness of their actions are closely linked to the history of humanity. Our unexpected behaviors have led humanity to financial crises on several occasions since records began.
Systemic problems
We can define these systemic problems as failures, situations or errors that are integrated into a culture or a system. It is due to conditions specific to a system, which require changes in the management of the policy or in its structure. For example, the recent protests in Iran occurred over a systemic problem related to the governance of the region.
Taking many risks in exchange for great benefits
Another of the great risks that can cause a financial crisis is poor risk management by financial institutions. As we have seen recently in the cryptocurrency ecosystem, the risks related to the LUNA protocol led it to bankruptcy, dragging down different entities in the sector with them.
Absence or lack of regulation
In coalition with the previous paragraph, the absence or lack of regulation in certain areas can in turn cause financial crises. We have a clear example with the great crisis of 2008, which was created by the lack of regulation in the real estate sector at the time.
Extension of problems to other institutions/countries
The clear example of spreading problems to others (what we know as passing the hot potato) is another of the triggers for financial crises. The mismanagement of the coronavirus was the trigger for the great financial crisis experienced during 2020, which little by little spread from China to the entire world.
What are the most important financial crises in history?
Financial crises are not uncommon; have occurred since the world has had control over economies. Let's continue the investment training on financial crises by listing those that have generated the most impact:
The tulip crisis 1637
The tulip crisis is one of the first known crises in contemporary history. Many historians say that it did not have that much impact in the Dutch region, but its coincidence with a bubonic plague was what made it have such an impact. This crisis has been the clear example to define speculative bubbles.
Representation of a tulip bubble graph. Source: Twitter.
Credit crisis of 1772
This crisis arose from the rapid expansion of the use of credit at the end of the 18th century. This financial crisis was born in London when Alexander Fordyce, a partner in a large bank, lost a large amount of money selling shares in the East India Company. He then fled to France to avoid repaying the amount of the loss, which caused a great avalanche of bankruptcies in English banks. The crisis spread at the speed of light, affecting a large part of European regions.
Representation of the collapse caused by the credit crisis of 1772. Source: Doug McCune.
Stock market crash of 1929.
The crash of '29 is one of the most notable financial crises in history. It began on October 24, 1929 at the culmination of a period of speculation and wild debts that led to the stock price plummeting massively. This event led the American economy into the Great Depression, a long period of more than 12 years that spread throughout the world. One of the catalysts for this crisis was an excess supply of basic products that led to a sharp drop in their prices. With this financial crisis, a wide series of tools and regulations were implemented in the financial markets.
Graphic showing the beginning of the crash of '29. Source: Business Insider.
OPEC oil crisis in 1973.️
The crisis caused the first default in history and the end of the gold standard in the dollar. This crisis occurred in 1973 when OPEC members initiated an oil embargo on countries that supported Israel in the Yom Kippur War. This war drove the price of oil from $3 to multiply its value by four to $12. This event caused the stock market crash of 1973, which led the Dow Jones index to lose about 45%.
Graph of oil price development with the gold standard in the 1970s. Source: LessWrong.
Asian crisis of 1997-1998.
As you see, crises do not understand regions. The Asian crisis began in July 1997 with the collapse of the Thai baht (THB). A lack of currency liquidity led Thailand's government to abandon peg to the US dollar. This event caused a great devaluation of the currency that quickly spread throughout the eastern part of the Asian continent, even reaching the island of Japan. This crisis ended up causing a great growth in the debt of Asian countries.
Graph of the depreciation of several Asian currencies during the 1997 financial crisis. Source: ResearchGate.
The dotcom crisis 1997-2001.
The dotcom bubble or crisis arose from the evolution that the financial markets had undergone. This evolution developed around new technologies that led humanity to the globalization of markets, starting to have live market monitoring. When we entered the year 2000 with the technology sector having matured quite a bit in a short period, there was a growth in interest rates. This event caused a massive depreciation of investments in the technology sector since financing became significantly more expensive.
Chart of the Nasdaq price from 1994 to 2005. Source: Wikipedia.
The global financial crisis of 2007-2008.️
This financial crisis was the worst economic catastrophe since the stock market crash of 1929. It began with a subprime mortgage lending crisis in 2007 and became a global banking crisis with the bankruptcy of investment bank Lehman Brothers in September 2008. Huge bailouts and other measures aimed at limiting the spread of damage failed and the global economy fell into recession.
Chart of the bankruptcies of Lehman Brothers and Bear Stearns in 2008. Source: FactSet.
The coronavirus crisis 2019-2021.裂
One of the events called “black swan” led us to one of the toughest crises in recent times. During the crisis caused by the spread of the coronavirus, we experienced the first lockdowns in history caused by a virological pandemic. These events paralyzed the activity of multiple sectors and global economies, to the point that the lack of economic production was transferred to all classes of investable assets. One of the biggest losers was oil, which saw its price in the futures market slide into negative figures, an event that has never occurred in the history of finance.
Historic moment in which oil futures descend to negative values. Source: Bloomberg.
Ukraine war 2022.
Added to the crisis that we had been experiencing due to failures in the supply chains of materials and products, we came from a time led by low interest rates and quantitative easing programs to stimulate the economy after the event in the previous paragraph. And we couldn't start the year in a better way than with a war between two nations vital for global economic growth. The conflict between Ukraine and Russia goes back a long way, the most recent occurring in 2014 in the Crimea area. Finally, at the end of February, the escalation of the conflict in Ukraine began, which has led us to a major financial crisis.
Chart with the countries with the highest inflation rates in the world. Source: Trading Economy.
This conflict has unleashed inflation in multiple sectors overnight. Fears of a possible nuclear war have paralyzed investor sentiment, leading different asset classes to depreciate more than 60% from highs. On the other hand, certain types of raw materials have benefited from these events, such as the prices of soft raw materials, oil and natural gas, the trigger of the European energy crisis.
Conclusions from this training in investment in financial crises.
As we have seen in this investment training, the advance of financial crises can cause an economy to enter a recession or depression. Even when measures are taken to avoid a financial crisis (such as those we see today) it can occur, accelerate or deepen. Therefore, it is very important for governments and financial institutions to act with transparency and security in order to allow healthy trade that allows organic growth in the economy.
Unfortunately, as we mentioned at the beginning of this investment training, the factors that can lead us to a financial crisis cannot always be predicted, because we have the randomness of human beings. Even so, correct regulation must be provided by the bodies in charge, so much so that it benefits companies, economies, retail investors themselves and, ultimately, protects all of these in equity.