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Last Updated: Monday, 3 September 2007, 05:17 GMT 06:17 UK
Financial crises: Lessons from history
Analysis
By Steve Schifferes
Economics reporter, BBC News

Wall St Crash headline

The current market jitters are centred on disturbances in the world's credit markets. Worries about the viability of sub-prime mortgage lending have spread around the financial system, and the central banks have been forced to pump in billions of dollars to oil the wheels of lending.

But what happened in previous financial crises, and what are the lessons for today?

There have been a growing number of financial crises in the world, according to the International Monetary Fund (IMF).

Among the key lessons of previous major financial crises are:

  • Globalisation has increased the frequency and spread of financial crises, but not necessarily their severity
  • Early intervention by central banks is more effective in limiting their spread than later moves
  • It is difficult to tell at the time whether a financial crisis will have broader economic consequences
  • Regulators often cannot keep up with the pace of financial innovation that may trigger a crisis.

THE DOT.COM CRASH, 2000

During the late 1990s, stock markets became beguiled by the rise of internet companies such as Amazon and AOL, which seemed to be ushering in a new era for the economy.

Steve Case, head of AOL, as merger with Time Warner is announced
When AOL's Steve Case took over Time Warner, the dot.com boom peaked

Their shares soared when they listed on the Nasdaq stock market, despite that fact that few of the firms actually made a profit.

The boom peaked when internet service provider AOL bought traditional media company Time Warner for nearly $200bn in January 2000.

But in March 2000, the bubble burst, and the technology-weighted Nasdaq index fell by 78% by October 2002.

The crash had wider repercussions, with business investment falling and the US economy slowing in the following year, a process exacerbated by the 9/11 attacks, which led to the temporary closure of the financial markets.

But the Federal Reserve, the US central bank, cut interest rates throughout 2001, gradually lowering rates from 6.25% to 1% to stimulate economic growth.

LONG-TERM CAPITAL MANAGEMENT, 1998

The collapse of hedge fund Long-Term Capital Market (LTCM) occurred during the final stage of the world financial crisis that began in Asia in 1997 and spread to Russia and Brazil in 1998.

LTCM was a hedge fund set up by Nobel Prize winners Myron Scholes and Robert Merton to trade bonds. The professors believed that in the long run, the interest rates on different government bonds would converge, and the hedge fund traded on the small differences in the rates.

John Merryweather, head of LTCM
John Meriwether, a Wall Street trader, headed LTCM
But when Russia defaulted on its government bonds in August 1998, investors fled from other government paper to the safe haven of US Treasury bonds, and interest rate differences between bonds increased sharply.

LTCM, which had borrowed a lot of money from other companies, stood to lose billions of dollars - and in order to liquidate its positions it would have to sell Treasury bonds, plunging the US credit markets into turmoil and forcing up interest rates.

So the Fed decided that a rescue was needed. It called together the leading US banks, many of whom had invested in LTCM, and persuaded them to put in $3.65bn to save the firm from imminent collapse.

The Fed itself made an emergency rate cut in October 1998 and markets soon returned to stability. LTCM itself was liquidated in 2000.

THE CRASH OF 1987

US stock markets suffered their largest peacetime one-day fall yet on 19 October 1987, when the Dow Jones Industrial Average index of shares in leading US companies dropped 22% and European and Japanese markets followed suit.

New York Stock Exchange
Program trading on the New York stock market worsened the crisis
The losses were triggered by the widespread belief that insider trading and company takeovers on borrowed money were dominating the markets, while the US economy was entering into an economic slowdown.

There were also worries about the value of the US dollar, which had been declining on international markets.

These fears grew when Germany raised a key interest rate, boosting the value of its currency.

Newly-introduced computerised trading systems exacerbated the stock market declines, as sell orders were executed automatically.

Concerns that major banks might go bust led the Fed and other major central banks to lower interest rates sharply.

"Circuit-breakers" were also introduced to limit program trading and allow the authorities to suspend all trades for short periods.

The crash seemed to have little direct economic effect and stock markets soon recovered. But the lower interest rates, especially in the UK, may have contributed to the housing market bubble of 1988-89 and to the pressures on the pound sterling which led to the devaluation of 1992.

The crash also showed that global stock markets were now closely linked, and changes in economic policy in one country could affect markets around the world. Laws on insider trading were also tightened up in the US and UK.

US SAVINGS AND LOAN SCANDAL, 1985

US Savings and Loans institutions were local banks which made home loans and took deposits from retail investors, similar to building societies in the UK.

Under financial deregulation in the 1980s, they were allowed to engage in more complex, and often unwise, financial transactions, competing with the big commercial banks.

By 1985, many of these institutions were all but bankrupt, and a run began on S&L institutions in Ohio and Maryland.

The US government insured many of the individual deposits in the S&Ls, and therefore had a big financial liability when they collapsed.

It set up the Resolution Trust Company to take over and sell any S&L assets that it could, including repossessed homes, taking over the bankrupt institutions.

The cost of the bail-out eventually totalled about $150bn.

However, the crisis probably strengthened the bigger banks by weeding out their weaker rivals, and laid the groundwork for the wave of mergers and consolidations in the retail banking sector in the 1990s.

THE CRASH OF 1929

The Wall Street crash of 1929, "Black Thursday," was an event that sent the US and indeed the global economy into a tailspin, contributing to the Great Depression of the 1930s.

President Franklin Roosevelt led the US during the Great Depression
Franklin Roosevelt became US President after the crash
After a huge speculative rise in the late 1920s, based partly on the rise of new industries such as radio broadcasting and carmaking, shares fell by 13% on Thursday, 24 October.

Despite efforts by the stock market authorities to stabilise the market, stocks fell by another 11% the following Tuesday, 29 October.

By the time the market had reached bottom in 1932, 90% had been wiped off the value of shares. It took 25 years before the Dow Jones industrial average recovered to its 1929 level.

The effect on the real economy was severe, as widespread share ownership meant that the losses were felt by many middle-class consumers.

They cut their purchases of big consumer goods such as cars and homes, while businesses postponed investment and closed factories.

By 1932, the US economy had declined by half, and one-third of the workforce was unemployed.

The whole US financial system also went into meltdown, with a shutdown of the entire banking system in March 1933 by the time the new President, Franklin Roosevelt took office and launched the New Deal.

Many economists on both left and right have criticised the response of the authorities as inadequate.

The US central bank actually raised interest rates to protect the value of the dollar and preserve the gold standard, while the US government raised tariffs and ran a budget surplus.

New Deal measures alleviated some of the worst problems of the Depression, but the US economy did not fully recover until World War II, when massive military spending eliminated unemployment and boosted growth.

The New Deal also introduced extensive regulation of financial markets and the banking system through the creation of the Securities and Exchange Commission (SEC) and the Federal Deposit Insurance Corporation (FDIC), and the separation of commercial and retail banking through the Glass-Steagall Act.

OVEREND & GURNEY, 1866; BARINGS, 1890

The failure of a key London bank in 1866 led to a key change in the role of central banks in managing financial crises.

The Bank of England was at the centre of the world financial system
The Bank of England was at the centre of the world financial system

Overend and Gurney was a discount bank which provided money for commercial and retail banks in London, the world's financial centre. When it declared bankruptcy in May 1866, many smaller banks were unable to get funds and went under, even though they were otherwise solvent.

As a result, reformers like Walter Bagehot advocated a new role for the Bank of England as the "lender of last resort" to provide liquidity (cash) to the financial system during crises, in order to prevent a failure of one bank spilling over and affect all the others ("systemic failure").

The new doctrine was implemented in the Barings Crisis in 1890, when losses by a leading UK bank, Barings, made on its investments in Argentina, were covered by the Bank of England to prevent a systemic collapse of UK banking.

Secret negotiations by the Bank and London financiers led to the creation of an £18m rescue fund in November 1890, before the extent of Barings' losses became publicly known.

The bankers also organised a committee to renegotiate the outstanding debts owed by Argentina, but a banking crisis engulfed the country and foreign lending to Argentina dried up for a decade.





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