AN UNPRECEDENTED CRISIS
Global Financial System in Downward Spiral
The collapse of Lehman Brothers and near-collapse of American Insurance Group (AIG) in September 2008 led to a sharp rise in counterparty credit concerns among financial institutions. Illiquidity in bank funding markets (Chart 4) prompted extreme volatility and further sharp falls in the prices of risk assets in both the US and Europe. Credit spreads on both investment-grade and high-yield corporate debt widened to record levels (Chart 5).
These developments, coupled with mounting losses, led to a series of failures or near-failures of major financial institutions that threatened to bring about a global systemic crisis.
Major parts of the global financial system entered into a downward spiral of plummeting asset prices, persistent solvency concerns surrounding systemically-important financial institutions, as well as collapsing confidence.
The gridlock in interbank credit markets and falls in asset prices prompted the need for substantial deleveraging within the financial system. This process reduced credit availability, accelerating the contraction in economic activity which had already shown signs of slowing. Substantial reduction in the supply of credit and rise in effective borrowing costs began to constrain consumption and investment in the advanced economies. Wealth destruction from asset price falls put further pressure on households' and firms' balance sheets.