Causes of Financial Crisis

Causes of Financial Crisis

Ireland developed high growth rates based on rapid expansion of credit and a buildup of personal debt fueled by rising property prices (Ireland's economic crisis: how did it happen and what is being done about it?). This lead to risky bank lending practices. Banks also engaged in short-term borrowing from wholesale money markets causing increased risk appetite. Supervisors and regulators failed to identify and act on the emerging risks. Where construction was a large part of the employment and economy, it caused high unemployment rates and major bank losses in a bubble burst when household income could not afford to pay mortgage debt. Property value decreased making it harder to recover the mortgage value for banks. In turn, it created difficulty for the banks to pay back the short-term borrowing to the wholesale money markets. Where risks were not identified, no plans were put in place for mitigation.

Cyprus' banking system had grown to five times its GDP (Long). Cyprus banks were lending heavily abroad, so in a global financial crisis, banks sustained major losses from bonds and exposure to other countries' banks, primarily Greece. In rescue efforts, Cyprus was required to place levies on all bank deposits. When the public presented overwhelming backlash, this caused a confiscation of a share of the depositor's money. This, in turn, caused failure in rescue efforts. This shows how one country's crisis effects other countries in a global financial crisis. Greece's financial crisis lead to Cyprus' financial crisis when Greek bonds devalued and Greek banks began to fail causing Cyprus banks to sustain losses. It also shows inefficiencies in risk management plans. Gaps in risk management plans fail to identify risks and prepare plans to mitigate for emerging risks. This in turn, caused strained in Cyprus' economy with reduced lending.

"Years of unrestrained spending, cheap lending, and failure to implement financial reforms left Greece badly exposed when the global economic downturn struck" (Q&A: Greece's financial crisis explained). Unrestrained spending caused a national debt bigger than the economy as well as debt levels and deficits exceeding the Eurozone limits. Cheap lending is a sign of financial management failure and large risk appetite. Financial reforms were needed to control spending and implement risk management plans. Where the country was spending 12.7% more than revenue received (Q&A: Greece's financial crisis explained), reform was needed to tighten spending to allow for debt reduction strategies. Risk management strategy also needed to be included in the reforms to mitigate for current and emerging risks. Lending practices were also out of alignment with the economic conditions. Interest rates needed major adjustment and control measures that would align with the economic conditions that could have afforded better practices.