Financial crisis Term Paper Example | Topics and Well Written Essays - 2000 words

Financial crisis - Term Paper Example In such a situation, the entity would face liquidity problems, have cash flow problems, and see the net worth decreasing. If it happens to a market or a bank, then there would be panic selling that further brings the prices of stocks down. There would be a run on the banks with a large number of people attempting to withdraw cash. Assets would lose their valuation. Depending on the severity of the crisis, the market would recover in a few days or the ill effects would persist for a few years. A financial crisis is followed by recession and a general slowdown of the market. Financial crisis can even happen to individuals and businesses and such entities cannot pay their bills, they cannot pay their employees and their business would be repossessed. Recession is said to follow financial crisis and when the GDP becomes negative for two quarters, then the nation is said to be in recession (World Bank, 28 June 2012). This paper examines the subject of financial crisis and discuses various types, causes and method of preventing such a crisis. 2) Types of Financial Crisis Financial crisis usually results in a notional and ‘on paper’ wealth of a firm. If the firm has retained its assets and other infrastructure then after the crisis is over, it can regain its previous position in the market. Financial crises usually occur in a free and liberal market economy that is not subject to protection and where market forces are free to act on the economy. As an example, UK, USA and many other nations have a free and open economy hence financial crisis occur in these markets. However, in the former Soviet Russia, nation such as North Korea and even China where the market is regulated, market forces are not allowed to act freely. Types of financial crisis are broadly classified as international and domestic crisis (Cipriani and Guarino, 2008). These again have sub types and these are discussed as below. A) International Financial Crisis International financial crisis occur at two levels and mechanisms. One is where turmoil in the global stock markets causes a global market crash that precipitates a financial crisis. Another type is the currency crisis that can lead to sovereign default. These terms are explained as below. 1) Global Crisis Global crises can begin in one corner of the world and then if the causes and money involved is high, the crisis can spread to other stock exchanges and nations quickly. One of the reasons is due to the inter connectedness of the stock markets and financial markets across the world. Hence, if the London Stock Market Index crashes and it cannot recover, it will cause the Japan Nikkei index and the US based Dow and NYSE index also to crash. This can create a financial crisis when there is no liquidity in the market and funds, loans, cash is not available. As a result, banks cannot clear the payments, customers and depositors cannot withdraw crash and business also cannot pay their vendors and employees. When thi s cash shortage is long lasting and it affects all the nations, then it becomes a global crisis (Banerjee, 2008). 2) Currencies One of the worst forms of financial crisis is the currency crisis and sovereign default. When a nation that has a fixed exchange rate faces a speculative attack on its currency, then it is forced to devalue the currency. This devaluation is done when the currency appreciates excessively against the global reserve currency, the USD.