A short history of financial crises · RiskAtoms Academy

By the end you will be able to

1Link the crises of 1929, 1987, 1998, 2008 and 2020 to the risk types studied later in the course.
2Describe in a few sentences what happened in each crisis.
3Explain how leverage turns small price falls into large losses.
4Name rules and tools that came out of these crises.

Why it matters

Risk management is largely a list of lessons learned the hard way. Almost every rule a bank, insurer or fund follows today can be traced back to a crisis. Knowing the crises tells you why the rules exist.

Core explanation

Five crises, seven kinds of risk

Crises look different on the surface: a stock market crash, a hedge fund collapse, a housing bust, a pandemic. Underneath, the same few forces turn up again and again. This course sorts them into risk types, and each gets its own lessons later on.

Risk type	In plain words
Market risk	Losses from moves in market prices: shares, rates, currencies, commodities.
Credit risk	Losses because a borrower does not repay what it owes.
Liquidity risk	Being unable to sell assets, or to raise cash, quickly without large losses.
Counterparty risk	Losses because the other side of a trade fails before it has paid or delivered.
Model risk	Losses from relying on a model whose assumptions turn out to be wrong.
Operational risk	Losses from failed processes, people or systems, or from outside events.
Systemic risk	The risk that trouble at some firms spreads and damages the whole financial system.

Two forces show up in nearly every crisis and make everything else worse. The first is leverage: borrowing to hold more assets than your own equity could buy, so that a small fall in prices wipes out a large share of your capital. The second is the liquidity spiral from L1.1.07: forced sellers meet vanishing buyers.

Step through the five crises. Use the filter to see where each risk type struck.

Pick a risk type to see where it struck:

No filter. Every crisis involved several risks at once.

TimelineFive crises

1 / 5

1929

The Wall Street Crash and the Great Depression

Through the 1920s many Americans bought shares on margin, putting down a small part of the price and borrowing the rest. When prices turned in October 1929, brokers demanded more collateral, and forced selling drove prices down further. From its 1929 peak to its 1932 low, the Dow fell 89%.

The crash fed into the Great Depression. Thousands of US banks failed between 1930 and 1933, many through bank runs, and lending dried up.

Market riskLiquidity riskCredit riskSystemic risk

The falls in share prices give a rough sense of scale, though they measure only one corner of each crisis.

ExploreHow far shares fell

Peak to low (for 1987, the one-day fall), from index closing levels. Click a bar for the detail.

S&P 500, 9 Oct 2007 to 9 Mar 2009

1,565.15 → 676.53 (-888.62 points, -56.8%)

The longest decline of the five: about 17 months from peak to low, with the banking system at the centre.

What the crises have in common

Borrowed money. Margin loans in 1929, LTCM's leverage in 1998, banks' thin capital in 2008.
Everyone heading for the same exit. Portfolio insurance in 1987, the rush to safe assets in 1998 and the dash for cash in 2020.
Models that assumed the past would repeat. Correlations and price patterns broke down just when they mattered most.
Contagion. Trouble at one firm spread to others through loans, trades and fear.
A central bank as the last line of defence. In 1987, 2008 and 2020 the central bank acted as lender of last resort. In the early 1930s, it largely did not, and the damage was far greater.

Sort itWhich risk type is this?

0 of 6 right

The Dow falls more than a fifth in one day (1987).
Russia stops paying interest on its rouble debt (1998).
Banks stop lending to each other, even overnight (2007–08).
LTCM's models assumed price gaps would behave as they had in the past.
US subprime borrowers fall behind on their mortgages (2007).
Dealers cannot absorb a flood of Treasury sales (March 2020).

Worked example

How leverage turns a small fall into a disaster

A fund has $5 billion of its own money and borrows enough to hold $125 billion of assets, roughly the scale LTCM reported at the start of 1998. Compare it with a firm that holds $100 billion of assets on $10 billion of equity. Amounts in US dollars; illustrative. Try each step before revealing it.

Leverage, step by step

Step 1 of 5

1
Measure the leverage
Fund: $125bn ÷ $5bn = 25 times. Comparison firm: $100bn ÷ $10bn = 10 times.

Regulatory lens

Each crisis left rules behind:

Crisis	What followed
1929	US federal deposit insurance and the Glass-Steagall Act (1933); the Securities and Exchange Commission (1934).
1987	Market-wide circuit breakers that pause trading after very large falls.
1998	Closer scrutiny of banks' lending to hedge funds and of counterparty risk management.
2008	Basel III capital and liquidity rules, the Dodd-Frank Act, mandatory central clearing of standard OTC derivatives, and regular stress tests.
2020	International work on the risks in non-bank finance, such as money market funds and margin calls.

Looking ahead: each risk type in the timeline has its own lessons and, later, its own rules: market risk under the Basel market risk framework, credit risk under Basel, IFRS 9 and CECL, liquidity risk under the LCR, and insurers' risks under Solvency II.

Sparks

SparkWhen oil cost less than nothing

On 20 April 2020, the May futures contract for US crude oil (WTI) settled at minus $37.63 a barrel. With storage full and the contract about to expire, holders who could not take delivery paid others to take it off their hands. Some trading and risk systems could not handle a negative price at all.

SparkThis time is different

Carmen Reinhart and Kenneth Rogoff studied financial crises across eight centuries in their 2009 book This Time Is Different. The title is the phrase they found people repeating before each crash, as they explained why the old warning signs no longer applied.

Key takeaways

Five crises, 1929, 1987, 1998, 2008 and 2020, show the main risk types at work: market, credit, liquidity, counterparty, model, operational and systemic.
Every crisis mixed several risk types; liquidity risk appeared in all five.
Leverage multiplies losses: at 25 times leverage, a 4% fall in assets wipes out all the equity.
Forced selling, models built on calm times and contagion between firms turn losses into crises.
Central banks acting as lender of last resort, and the rules written after each crisis, shape today's risk management.

Reaction

Check what stuck

Glossary

Market risk: Losses from moves in market prices: shares, rates, currencies, commodities.
Credit risk: Losses because a borrower does not repay what it owes.
Liquidity risk: Being unable to sell assets, or to raise cash, quickly without large losses.
Counterparty risk: Losses because the other side of a trade fails before it has paid or delivered.
Model risk: Losses from relying on a model whose assumptions turn out to be wrong.
Operational risk: Losses from failed processes, people or systems, or from outside events.
Systemic risk: The risk that trouble at some firms spreads and damages the whole financial system.
Leverage: Using borrowed money to hold more assets than your own capital would allow. Measured as assets ÷ equity.
Equity: The owners' own money in a firm: assets minus what it owes.
Buying on margin: Buying securities partly with money borrowed from a broker, using the securities as collateral.
Bank run: Many depositors withdrawing their money at once because they fear the bank will fail.
Subprime: Loans to borrowers with weak credit records, who are more likely to default.
Securitisation: Pooling many loans and selling securities backed by their payments.
Portfolio insurance: A strategy that automatically sells futures as prices fall, to limit an investor's losses.
Lender of last resort: A central bank lending freely to sound firms in a panic, so that fear alone does not bring them down.

Deep Dives & Origins

Deep Dives

Reinhart, C. M. and Rogoff, K. S., This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press, 2009. Intermediate.
Lowenstein, R., When Genius Failed: The Rise and Fall of Long-Term Capital Management, Random House, 2000. Beginner, narrative.
Galbraith, J. K., The Great Crash 1929, first published 1955. Beginner, narrative.

Origins

Reinhart, C. M. and Rogoff, K. S., This Time Is Different, Princeton University Press, 2009.
US Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report, January 2011.
President's Working Group on Financial Markets, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management, April 1999.
Report of the Presidential Task Force on Market Mechanisms (the Brady Report), January 1988.
Financial Stability Board, Holistic Review of the March Market Turmoil, November 2020.
S&P Dow Jones Indices, historical closing levels of the Dow Jones Industrial Average and S&P 500.

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