Financial crisis and its effect on banks

Introduction
Financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and any recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth; they do not directly result in changes in the real economy unless a recession or depression follows. Many economists have offered theories about how financial crises develop and how they could be prevented. There is little consensus, however, and financial crises are still a regular occurrence around the world.

Types of financial crisis: Banking crisis International financial crisis Wider economic crisis

Causes and consequences of financial crisis:

Asset liability mismatch Regulatory failures Recessionary effects Leverages Strategic complementarities in financial crisis

How the global financial crisis affects India:

The key question confronting the economy now is the backwash effect of the global financial crisis. Central banks in several countries, including India, have moved quickly to improve liquidity and warning that there could be some impact on credit availability. That implies more expensive credit (even public sector banks are said to be raising money at 11.5 per cent, so that lending rates have to head for 16 per cent and higher -- which, when one thinks about it, is not unreasonable when inflation is running at 12 per cent). For those looking to raise capital, the alternative of funding through fresh equity is not cheap either, since stock valuations have suffered in the wake of the FII pull-out. In short, capital has

suddenly become more expensive than a few months ago and, in many cases, it may not be available at all. The big risk is a possible repeat of what happened in 1996: Projects that are halfway to completion, or companies that are stuck with cash flow issues on businesses that are yet to reach breakeven, will run out of cash. If the big casualty then was steel projects (recall Mesco, Usha and all the others), one of the casualties this time could be real estate, where building projects are half-done all over the country and some developers who touted their 'land banks' find now that these may not be bankable. The only way out of the mess is for builders to drop prices, which had reached unrealistic levels and assumed the characteristics of a property bubble, so as to bring buyers back into the market, but there is not enough evidence of that happening. The question meanwhile is: Who else is frozen in the sudden glare of the headlights? The answer could be consumers, many of whom are already quite leveraged. More expensive money means that floating rate loans begin to bite even more; even those not caught in such a pincer will decide that purchases of durables and cars are not desperately urgent. And it is not just the impact of those caught on the margin that must be considered. The drop in real estate and stock prices robs a much larger body of consumers of the wealth effect, which could affect spending on a broader front. In short, the second round effects of the financial crisis will be felt straightaway in the credit-driven activities and sectors, but will spread beyond that in a perhaps slow wave that could take a year or more to die down. One danger meanwhile is of a dip in the employment market. There is already anecdotal evidence of this in the IT and financial sectors, and reports of quiet downsizing in many other fields as companies cut costs. More than the downsizing itself, which may not involve large numbers, what this implies is a significant drop in new hiring -- and that will change the complexion of the job market. At the heart of the problem lie questions of liquidity and confidence. What the RBI needs to do, as events unfold, is to neutralize the outflow of FII money by unwinding the market stabilization securities that it had used to sterilize the inflows when they happened. This will mean drawing down the dollar reserves, but that is the logical thing to do at such a time. If done sensibly, it would prevent a sudden tightening of liquidity, and also not allow the credit market to overshoot by taking interest rates up too high. Meanwhile, there is an upside to be considered as well. The falling rupee (against the dollar, more than against other currencies) will mean that exporters who felt squeezed by the earlier rise of the currency can breathe easy again, though buyers overseas may now become more scarce. Overheated markets in general (stocks, real estate, employment-among others) will all have an

element of sanity restored. And for importers, the oil price fall (and the general fall in commodity prices) will neutralize the impact of the dollar's decline against the rupee.

What is banking crisis? When a bank suffers a sudden rush of withdrawals by depositors, this is called a bank run. Since banks lend out most of the cash they receive in deposits, it is difficult for them to quickly pay back all deposits if these are suddenly demanded, so a run may leave the bank in bankruptcy, causing many depositors to lose their savings unless they are covered by deposit insurance. A situation in which bank runs are widespread is called a systemic banking crisis or just a banking panic. A situation without widespread bank runs, but in which banks are reluctant to lend, because they worry that they have insufficient funds available, is often called a credit crunch. In this way, the banks become an accelerator of a financial crisis. Examples of bank runs include the run on the Bank of the United States in 1931 and the run on Northern Rock in 2007. The collapse of Bear Stearns in 2008 has also sometimes been called a bank run, even though Bear Stearns was an investment bank rather than a commercial bank. Banking crises generally occur after periods of risky lending and heightened loan defaults. The U.S. savings and loan crisis of the 1980s led to a credit crunch which is seen as a major factor in the U.S. recession of 199091.

How financial crisis effect banking system in india? Though Indian banks exposure to the troubled eurozone is negligible, funding pressure could impact india. "The recent regulatory prescriptions for European banks have raised fears of deleveraging. Indian banks are not expected to bear any direct impact on account of their negligible exposure to the troubled zone. "However, they could be indirectly affected on account of funding pressures. The scope for countercyclical financial policy could be explored in financial regulations in order to minimize negative impact of accumulated financial risks. This will go a long way in providing needed stability to the financial system. The sovereign risk concerns, particularly in the euro area, affected financial markets for the greater part of the year, with the contagion of Greece's sovereign debt problem spreading to India and other economies by way of higher-than-normal levels of volatility. Despite the demanding operational environment, it said, the Indian banking sector demonstrated continued revival from the peripheral spillover effects of the recent global financial turmoil. Highlighting the importance of financial inclusion in the financial sector, the Survey said it is seen as an important determinant of economic growth.

Banks need to take into account various behavioral and motivational attributes of potential consumers for a financial inclusion strategy to succeed. Besides, access to financial products is constrained by lack of awareness, unaffordable products, high transaction costs, and products which are not customized and are of low quality. A major challenge in the times ahead would be to meet financing requirements, particularly of the unorganized sector and the self-employed in the micro and small business sector.

Conclusion: