A financial crisis is a severe shock to the economy, characterized by stock markets collapsing and businesses and consumers failing to meet their financial obligations. It can be caused by the failure of a large institution, like Lehman Brothers in September 2008, and is often exacerbated by the collapse of other institutions and the seizing up of credit markets. A wide range of contributing factors, such as systemic failures, unanticipated or uncontrollable human behavior, incentives to take excessive risk, regulatory absence or failure, and contagions that amount to a virus-like spread of problems from one institution or country to others, can contribute to or accelerate a financial crisis.
Financial crises can erupt when risk measures increase sharply and capital buffers insufficiently built up in good times are depleted. This can trigger panics and force broad-based chain reactions of asset fire sales that blur the distinction between illiquidity and insolvency. The severity of the turmoil can magnify as a consequence of the interconnectedness of financial markets and institutions. The collapse of the housing market and the growing reliance on subprime mortgages led to a sharp drop in the value of many assets, particularly securities backed by those loans.
In the wake of the collapse, the Federal Reserve took a series of emergency rescue operations to keep financial markets and the economy functioning. These included providing lifelines of liquidity to a range of financial firms, including banks and money-market funds; purchasing a significant number of distressed assets in the marketplace, known as “quantitative easing”; and rescuing firms that were too big to fail. It was a costly, controversial and politically fraught response, which was ultimately successful. However, political commitments and ideology made it impossible for some to admit that the bailout was needed, or that the Bush administration could have done anything differently.