This blog post examines why financial crises are difficult to explain with a single cause. It analyzes how self-fulfilling expectations, risk-seeking behavior, bank runs, and excessive overheating become intricately intertwined to trigger crises.
Despite extensive research on past financial crises, consensus on their causes often remains elusive. This stems partly from the complex, multidimensional nature of financial crises, but also from the diversity of perspectives on human behavior and how financial systems operate. Specifically, the main perspectives for viewing financial crises, centered on bank crises, can be broadly classified into four categories. These perspectives are not mutually exclusive, but they are important because the diagnosis of causes and opinions on policy responses differ depending on which viewpoint is central to interpreting the financial crisis.
First, there is a perspective that emphasizes the phenomenon known as ‘self-fulfilling expectations’: when many depositors anticipate a bank’s solvency is weak, the bank’s solvency actually becomes weak. The fractional reserve system, where banks hold only a portion of deposits as reserves to meet withdrawal demands, is an essential feature of the modern banking system. Under this system, even if a bank’s fundamental financial health remains unchanged, a shift in depositors’ expectations can trigger large-scale withdrawals. Deposits are a unique form of debt with no maturity date and are paid out on a first-come, first-served basis. Therefore, it is rational for someone who expects the bank’s solvency to weaken and its inability to pay deposits to withdraw their money before others. For this reason, when a run on deposits occurs, banks have no choice but to increase their cash reserves to meet withdrawal demands. If banks then competitively sell assets like bonds, stocks, or real estate to do so, asset prices fall, ultimately reducing the banks’ actual solvency.
Second, there is a perspective emphasizing banks’ excessive risk-taking. Shareholders of a corporation hold claims on the residual asset value after all company debts are repaid and typically bear limited liability. Therefore, while the profits accruing to shareholders increase as the company’s asset value exceeds its debt, in the event of bankruptcy, shareholders’ losses are limited to the amount invested in the company’s stock. This asymmetric profit structure ⓐ makes shareholders sensitive to profits but insensitive to risk, leading them to favor high-risk, high-return ventures. This ultimately shifts the risk shareholders must bear to achieve higher returns onto creditors, and this incentive grows stronger as the equity ratio decreases. Since financial intermediaries like banks are mostly structured as corporations with very high debt ratios, this incentive inevitably operates strongly.
Third, there is a perspective emphasizing bankers’ bank raiding. Traditional economic theory has primarily understood bank insolvency as the result of excessive risk-seeking. However, recent research increasingly supports the view that banks are raided due to bankers’ pursuit of private gain, leading to their insolvency. While excessive risk-taking involves choosing actions that may worsen a bank’s financial health to boost its profitability, bank raiding involves bankers choosing actions that cause losses to the bank to maximize their own private gains. Examples include bankers obtaining loans from the bank they control on more favorable terms than others, or pursuing short-term performance solely to increase their own bonuses, even knowing it will cause long-term losses to the bank. Thus, when a banker holding a dominant shareholder or senior management position privately exploits their control over the bank, this can be termed ‘banking predation’.
Fourth, there is a perspective emphasizing irrational exuberance. Unlike the previous three views, this perspective is grounded in the realistic observation that economic agents do not always act purely rationally. Many people tend to expect that if asset prices rise for a certain period, they will continue to rise, and if they fall for a certain period, they will continue to fall. This pattern of expectation formation triggers a process where rising asset prices induce increased debt, and that increased debt in turn fuels further asset price increases. This upward spiral becomes the driving force behind bubbles and, when economic actors accumulate excessive debt, makes the entire financial system vulnerable. Consequently, when the bubble bursts, the financial system is severely shaken, and the conditions for a financial crisis become significantly heightened.
Thus, financial crises can be explained through four distinct perspectives: self-fulfilling expectations, excessive risk-seeking, bank runs, and abnormal overheating. These perspectives illuminate the complex nature of financial crises from multiple angles. When each perspective is central, the causes of the crisis and the countermeasures proposed also diverge. Therefore, to understand financial crises, it is necessary to view these four perspectives in a balanced manner and comprehensively consider the structural risks facing today’s financial system.
