Abacus: The Dynamics of Financial Crises
To many, conversations about the US financial system evoke a mixture of emotions: uncertainty, curiosity, and even dread. The structure itself is so large and elaborate that attempting to gain even a foundational knowledge is a herculean task.
Despite this, the US financial system is by nature very influential in all of our lives. Serving as the crux of 2008 crisis that hurt so many, while also helping many invest to retire, the relationship between the American people and markets is a varied one. Further, the events of the past several months have helped to illustrate the importance of the relationship between markets’ functionality and the broader economy.
An old sentiment among financial analysts is that markets thrive off normality; consider the stock market. To buyers and sellers of company shares, steady profits are often tied to a steadily growing and progressing society. When an unordinary event delivers a shock to the financial system, projections of the future may suddenly change, leading to necessary adjustments in the forecasts for business activity. Perhaps no single event is a better example of a shock than COVID-19's emergence last winter.
Following a period of relative calm for financial markets, the rise in cases of a deadly disease brought about a sense of urgency among investors. In particular, analysts became wary of the potential impact the disease could have on normal economic activity. While a typical financial crisis did not result from the ensuing pandemic, the sequence of events that commonly defines such a crisis did occur.
Two main components contributed to the early financial reaction to the pandemic: uncertainty, and its resulting decline in asset prices. A paper written by professors Stephen Nelson and Peter Katzenstein took careful note of the impact that “unpredictable and highly destabilizing events” have on financial markets, and how they translate into unpredictability in the stock market. In particular, Nelson and Katsenstein remarked on specific events and their immediate impact on trading activity. For example, a single ten-day stretch that comprised 50% of the US dollar’s decline against the Japanese Yen between the mid-1980’s and 2003.
Similarly, the authors discerned that a few select outlier stretches featured massive stock price declines, most notably when the Dow Jones fell 20% in a single trading session on October 19, 1987. Such deviations in trading are comparable to what occurred between February and March, when the S&P 500 plummeted nearly 34% based on fears surrounding COVID-19. One five-day period in the month-long stretch featured the worst week for markets since the 2008 crisis. Following this tense period of uncertainty, the second stage of traditional crises came from within the banking sector.
While the pandemic did not have as nearly as strong an effect on the US banking system as other historical events, such as the Great Depression in the 1930’s or the mortgage crisis of the 2000’s, bank conditions became glaringly worse as the virus took its toll. The consulting firm McKinsey & Company found that, under certain economic circumstances, banks across the United States, Europe, and England could lose some $400 billion in common stock.
Any significant decline in bank capital can have a drastic effect on the broader economy, as the loss can drastically reduce the number of loans a bank can afford. In cases where capital losses are especially severe, a bank can go into insolvency. Fortunately, McKinsey & Company determined that most big banks in the industrialized world would have the necessary capital to withstand income losses, but that smaller individual banks would likely face more dire consequences.
One of the reasons why big banks are generally more prepared for this crisis is the lessons learned from the 2008 collapse. Specifically, the implementation of the Dodd-Frank Act, which curbed the number of risky securities. Implemented in the wake of the mortgage-based assets that had been developed in the 2000’s, assets that inevitably declined in value after homeowners defaulted on their mortgages.
Finally, we see that the pandemic has provided insights into the mechanics of a decline in the aggregate price level. As an economy enters recession and households lose income, people spend less money on goods. Simple. The result is a decline in nationwide demand, which in turn leads to a decline in prices, otherwise known as deflation.
One index that tracks the prices of certain goods is the Consumer Price Index for All Urban Consumers (CPI-U). The index primarily consists of commonly purchased items among people living in urban regions: foods, oil, apparel, medical care services, and housing costs. After steady increases in the value of the index in the latter half of 2019, the CPI-U fell sharply in March and April, with monthly declines of 0.4% and 0.8% respectively.
Although the price level eventually stabilized, the sharp decline offered a view on how banks can be affected by the change in the price level. Banks who hold debt contracts with individuals and businesses suffer from price decreases, as any given payment of money at a lower price level is worth less than when the debt contract was created. Despite the relatively short period of deflation, the decrease in prices did no good for the banking industry, which sustained a loss of about 70% of its net income from the year prior.
Though it is difficult to characterize precisely what has happened to the financial industry in 2020, it is undoubtedly true that many of the traits that specify a crisis have become apparent for the first time in over a decade. With the worst of the pandemic lasting only a rather short time, and a banking industry strengthened compared to crises of the past, the financial system was largely able to endure the worst the virus had to offer.
The several-month long period offered a time for economists and banking experts to compare and contrast the mechanics of the current financial downturn to previous ones. As devastating as the impact was on many families around the world, had the financial system been ill-equipped the global economy would have likely suffered a much worse fate.
Andriy Onufriyenko
