Bubbles & crises – painful patterns

Last weekend was a bit scary for the financial sector, even with the market firming up in recent days. After all, takeovers and bailouts are a sign both that decision makers are concerned and that they see compelling reasons to be concerned. So the rescues feed the fear.

A long-term perspective: Banking crises have occurred regularly for 400 years or more,  two distinguished financial economists note in a 2007 book called Understanding Financial Crises. The cycles that cause banks and I-banks to start imploding follow familiar patterns, for example the credit-and-asset-bubble pattern:

The typical sequence of events in such crises is as follows. There is initially a financial liberalization of some sort and this leads to a large expansion in credit. Bank lending increases by a significant amount. Some of this lending finances new investment but much of it is used to buy assets in fixed supply such as real estate and stocks. Since the supply of these assets is fixed the prices rise above their ‘fundamentals.’ …

The process continues until there is some real event that means returns on the assets will be low in the future. Another possibility is that the central bank is forced to restrict credit because of fears of ‘overheating’ and inflation. The result of one or both of these events is that the prices of real estate and stocks collapse. A banking crisis results because assets valued at ‘bubble’ prices were used as collateral.

– Franklin Allen & Douglas Gale
Understanding Financial Crises
(New York: Oxford University Press, 2007)

The authors document, with empirical and theoretical insights, that what looks like collapse invariably evolves into recovery and renewal. Excesses are corrected as people learn their lessons, for a time. Allen and Gale warn that the costs to society of trying to regulate or legislate crises (or bubbles) out of existence can be greater than the short-term pain caused by those same market gyrations.

What do these patterns, or our place in the cycle, mean for investor communications? I’d love to hear your comments, and I plan to post some ideas soon on practicing IR in a negative market environment.

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