Introduction

According to a prominent economic theory, an increase in interest rates can trigger a financial crisis
(Mishkin, 2007). This theory posits that when interest rates rise, borrowing becomes more expensive,
leading to reduced investment, decreased consumer spending, and a slowdown in economic growth.
The higher interest rates increase the cost of servicing debt, which can make it difficult for borrowers to
fulfill their obligations. The 2008 global financial crisis is a prime example of this theory in action. The
crisis was sparked by a sharp increase in interest rates. To counter the effects of the technology bubble
and the events of 9/11, the US Federal Reserve lowered interest rates to historic lows, making
borrowing cheaper and stimulating economic growth. However, as the economy started to recover and
growth led to increasing inflation, the Fed raised interest rates, leading to a slowdown in economic
activity. Banks became more cautious as a result of the higher interest rates, leading to a reduction in
lending. The housing market, which had seen significant growth, began to decline, leading to
widespread defaults on mortgages and a collapse in the value of mortgage-backed securities, ultimately
leading to a global financial crisis that impacted economies worldwide.

In the context of rising interest rates, adverse selection can occur in the lending market. Adverse
selection happens when there is an asymmetry of information between buyers and sellers in a market,
resulting in unfavorable outcomes when buyers lack the same information as sellers (Stiglitz, 1977). As
borrowing becomes more expensive when interest rates rise, borrowers with lower creditworthiness or
higher risk profiles are more likely to seek loans. As a result, lenders may face issues in distinguishing
between borrowers who are more likely to default or face financial difficulties due to the increased cost
of borrowing and those who are genuinely creditworthy. This information asymmetry can result in
lenders becoming more cautious in lending, potentially leading to a decrease in overall lending activity
and a market failure where the market becomes dominated by the more informed party.

Moral hazard is another concept that can play a role in the impact of an increase in interest rates. Moral
hazard refers to a situation where one party is protected from the negative consequences of their
actions, leading to excessive risk-taking (Holmstrom, 1979). In the context of increasing interest rates,
moral hazard can manifest in several ways. Firstly, borrowers may perceive that they can take on more
debt or engage in riskier investments due to the expectation of lower interest rates in the future or
potential government interventions. This perception can lead to excessive borrowing or investment in
riskier assets, as borrowers may believe that any negative consequences of their actions will be
mitigated by external support. Secondly, moral hazard can be observed in the behavior of financial
institutions. When interest rates rise, the value of existing loans, particularly those with fixed interest
rates, may decrease. Financial institutions may find themselves holding assets that have decreased in
value but were issued based on lower interest rate assumptions. In response, financial institutions may
engage in riskier lending practices to compensate for potential losses, as they anticipate higher returns.
This behavior can contribute to an increase in overall systemic risk.

Financial crises can be triggered by a decline in stock market prices, leading to a loss of confidence in
the economy. This can have a ripple effect throughout the economy, particularly affecting countries or
businesses that heavily rely on the stock market. For example, the 1929 stock market crash triggered the
Great Depression, as the decline in stock prices led to widespread panic selling and a loss of confidence
in the economy, leading to a decline in economic activity. During a market decline, investors may face
difficulties in distinguishing between undervalued stocks and those that are overvalued or have
underlying financial weaknesses. This information asymmetry can result in adverse selection, where
investors may be more inclined to sell off their stocks, fearing further declines and potential losses. As a
consequence, the market may become dominated by sellers with negative expectations, exacerbating
the decline in stock prices. Moral hazard can also arise when investors perceive that they will be
protected by government interventions during market downturns. This perception can lead to excessive
risk-taking, as investors may believe that any losses incurred will be mitigated by external support.
Consequently, this behavior can contribute to the volatility and severity of stock market declines.
Additionally, during periods of economic expansion and rising stock prices, financial institutions may
engage in riskier lending practices, including extending loans to borrowers with weaker credit profiles,
as they anticipate higher returns. However, when stock markets decline, these riskier loans may become
more vulnerable to default, leading to financial instability. The expectation of government bailouts or
support can incentivize financial institutions to take on excessive risks without bearing the full
consequences of their actions.
Financial crises can be attributed to several factors, including increased uncertainty, as noted by Hawley
and Williams (2015). A prime example of this is the dot-com bubble that took place in the late 1990s and
early 2000s, demonstrating how uncertainty can lead to a financial crisis (Bordo & Jeanne, 2002). During
this period, the technology sector experienced rapid growth, fueled by the emergence of the Internet
and the potential for innovative business models. Investors invested heavily in tech companies,
assuming that they would continue to expand and generate significant returns. However, as the bubble
began to burst, it created more uncertainty about the long-term sustainability of these companies,
which resulted in a decline in investor confidence and a sharp reduction in market activity.

Adverse selection and moral hazard also played a significant role in aggravating the effects of
uncertainty. Many investors were lured by the potential for high returns without fully understanding the
underlying risks and the possibility of a market downturn (Hirshleifer & Teoh, 2003). Some investors also
believed that government policies or central bank interventions would safeguard them from any
potential loss. However, these factors eventually led to the collapse of the dot-com bubble, resulting in a
significant decline in the technology sector and broader economic activity.

The impact of the dot-com bubble emphasizes the importance of managing uncertainty in financial
markets and ensuring that investors comprehend the underlying risks involved in their investments, as
highlighted by Shiller (2015). It also underscores the need for regulatory measures to mitigate the
adverse effects of adverse selection and moral hazard in financial markets.

Bank panic is one of the most significant threats to the stability of the financial system. It can occur due
to various reasons, including coordination problems and information asymmetries. Coordination
problem theory suggests that when investors collectively attempt to withdraw funds from a bank, it can
lead to a cycle of panic. This cycle is where more and more investors try to take their money out, which
can be particularly problematic for banks that have invested heavily in illiquid assets or have a high level
of leverage. These banks may not have enough cash on hand to meet the demand for withdrawals
(Gorton & Metrick, 2012).
For instance, during the 2008 financial crisis in the United States, the collapse of Lehman Brothers led to
a wave of bank panics as investors became concerned about the stability of the banking system as a
whole. Many banks had invested heavily in mortgage-backed securities and other risky assets that were
difficult to value and sell quickly. This made investors nervous about their ability to meet obligations,
which led to a cycle of withdrawals and a general loss of confidence in the banking system. This, in turn,
contributed to the overall financial crisis (Brunnermeier, 2009).

Moral hazard was a concern during the savings and loan crisis of the 1980s. Many banks made risky
investments in real estate and other assets, believing they would be bailed out if their investments went
sour. This led to a significant number of bank failures and a major taxpayer-funded bailout of the
industry (Kane, 1989). Adverse selection can exacerbate the effects of these theories by allowing banks
to select investments and clients that pose a higher risk. This can lead to a situation where banks take on
even riskier investments than they would in a more transparent market. For example, during the
subprime mortgage crisis, banks used increasingly risky lending practices to offer mortgages to
borrowers with poor credit histories. This eventually led to a significant number of defaults and
foreclosures (Mian & Sufi, 2011).

One of the prevailing theories regarding unanticipated declines in prices is the demand-supply
imbalance theory (Mishkin & Eakins, 2016). According to this theory, price declines can be caused by an
imbalance in the demand and supply of a particular good or service. This phenomenon occurs when
there is an oversupply of a specific commodity, leading sellers to reduce prices to attract buyers.
However, the demand-supply imbalance theory alone may not be sufficient to cause financial crises.
When combined with adverse selection and moral hazard, demand-supply imbalances can lead to
severe financial crises.

For instance, financial institutions may be tempted to lend to high-risk borrowers if they perceive a high
demand for such lending (Mishkin & Eakins, 2016). In this case, the institutions may lend as much as
possible to earn higher interest payments, resulting in an oversupply of credit in the market. This can
lead to a decline in interest rates or lending standards, which subsequently amplifies moral hazard.
During a crisis, the risk of a party taking the moral hazard of a potential loss on an investment would be
further heightened.
Furthermore, adverse selection may also undermine lenders' ability to identify sound investment
opportunities, thereby allowing inadequate borrowers to receive loans they would not otherwise be
eligible for (Mishkin & Eakins, 2016). This situation can lead to a scenario similar to the subprime
mortgage crisis in the U.S., where an oversupply of subprime mortgages resulted in a sharp increase in
defaults. As a result, there was an increase in foreclosures, leading to a decline in housing prices and,
ultimately, a financial crisis.

Conclusion