Financial shock
A financial shock is an unexpected disturbance which originates from the financial sector and has a significant effect on an economy (e.g. national, regional, or global). The term is largely used to refer to events which have negative impacts (ECB, 2013).
Primary reference(s)
ECB, 2013. Financial Shocks and the Macroeconomy: Heterogeneity and Non-Linearities. European Central Bank (ECB), Occasional Paper Series No. 143. Accessed 20 March 2025.
Annotations
Additional scientific description
The term 'financial shock' generally refers to a disruptive event in the financial system, which manifests in the sudden re-pricing of assets (often in combination with a severe deterioration of economic conditions). Financial shocks are difficult to predict but tend to be more likely when borrowers are vulnerable, such as when they have taken on excessive risk relative to their repayment capacity (e.g. highly leveraged firms that have both uncertain future profits and low liquidity) (Peersman, 2015).
Financial shocks may be triggered by different factors inside and outside the financial system. They are often amplified by adverse macro-financial feedback effects, such as when a deterioration in economic conditions weakens the solvency of financial institutions and markets, which in turn results in tighter financial conditions for firms and households (Ong & Jobst, 2013). A significant economic slowdown could lead to rising business insolvencies, higher unemployment, and constrained public investment. They can morph into financial crises if a sharp decline in asset prices causes consumers and businesses to default on their loans, and financial institutions become unable to access liquidity - either in terms of cash or assets which are easily convertible into cash (Moretti et al., 2020).
For example, the collapse of the USA sub-prime mortgage market, prior to the 2007-2009 Global Financial Crisis, was largely driven by excessive leverage of borrowers, an overheated housing market, and insufficient transparency when banks re-packed and combined mortgage loans into new financial instruments, through what is referred to as 'securitization' (Jobst, 2008). Recent currency and/or sovereign debt crises also illustrate that unsustainable external imbalances, such as a deteriorating current account (which reflects cross-border economic activities) and rising foreign currency borrowing by public or private sector organizations (if suddenly unwound), can amplify and/or cause fragilities in the financial system. Examples include the cases of the 1997 Asian financial crisis and the 2007-2009 Global Financial Crisis (Claessens et al., 2014).
Metrics and numeric limits
Measures linked to financial shocks typically focus on aspects of financial stability, due to the inherent difficulty in predicting the occurrence of financial shocks (IMF, 2020a). Examples of these measures include:
Financial sector: financial soundness indicators (solvency, liquidity, asset quality) of banks and non-bank financial institutions (insurance companies, investment funds, and other asset managers), default risk (via credit ratings or credit default swap spreads).
Financial markets: equity prices, corporate bond spreads (as measure of default risk), market liquidity/volatility, and house prices (indicate bubbles/crashes).
Other sectors: measures of corporate financial risk (e.g. corporate debt), households (e.g. household debt), and governments (e.g. public debt), as well as real economic activity (e.g. GDP growth, interest rates, inflation) and external ratios (e.g. balance of payments, exchange rates).
Key relevant UN convention / multilateral treaty
Articles of Agreement of the International Monetary Fund (IMF, 2020b)
Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems (Bank for International Settlements, 2020).
Drivers
Several hazards may result in financial shocks.
Impacts
Financial shocks may result in supply chain failure and civil unrest.
Multi-hazard context
The figure below summarises common interactions between financial shock and other hazards. This information should be used with caution and not be solely relied upon in Disaster Risk Management, particularly as some interactions may not have been included. Note that hazardous events occurring together or locally in space or time may not necessarily cause, amplify, or be otherwise related to each other. Specific examples of multi-hazard context can be found in the ‘Hazard drivers’ and ‘Impacts’ sections above.
Multi-hazard diagram
Risk Management
The health and functioning of a country’s financial sector have far-reaching implications for its own and other economies. Prudential regulators and supervisors play a central role in safeguarding the capacity of the financial system – its intermediaries, markets and infrastructures – to provide deposit, credit, and other financial services to households, firms, and governments (OECD, 2010).
Designing policies that align private incentives with the public interest to facilitate market discipline and limit excessive risk-taking is challenging. In some cases, a financial institution and/or market might be considered Too-Big-To-Fail (TBTF), because their insolvency and failure could cause massive disruptions to the functioning of the financial system, resulting in a significant tightening of financial conditions and a contraction of economic activity. This situation creates an expectation that they would be bailed out by the government, via direct financial support measures, during times of stress. Safety nets, such as deposit insurance (guaranteeing bank depositors access to their money even if a bank fails), play an important role as shock absorbers, helping to maintain the functioning of the financial system during times of stress.
Early warning systems for financial shocks help policymakers reduce the risk of rapid falls in market confidence and institutional solvency which can lead to widespread economic hardship, loss of jobs, and social instability. These systems work through real-time supervision and periodic assessments. At the national level, regulated financial institutions are subject to both microprudential and macroprudential oversight:
- Microprudential supervision focuses on the safety and soundness of individual financial institutions, such as banks, insurance companies, and investment funds. Supervisors complete regular on- and off-site inspections and reviews to ensure that these financial institutions are well-managed and have enough capital to absorb the impact of adverse shocks (such as a recession).
- Macroprudential surveillance elevates this concept of financial supervision to a system-wide perspective, by focusing on common vulnerabilities across all or several institutions. Macroprudential measures to mitigate risk, such as additional capital requirements, are not specific to individual firms but apply uniformly across all relevant institutions.
International institutions facilitate cross-border coordination across supervisors and regulators through agreements on common standards and peer reviews (e.g. Bank for International Settlements, Financial Stability Board) while others focus on multilateral surveillance and direct engagement with countries, often via capacity building and technical assistance (e.g. International Monetary Fund, World Bank) (IMF, 2020a; World Bank, 2020). At the international level, these activities include:
- The Financial Sector Assessment Program (FSAP) is a comprehensive and in-depth analysis of a country’s financial sector. FSAP assessments are the joint responsibility of the IMF and World Bank in “developing economies and emerging markets”, and of the International Monetary Fund alone in “advanced economies” (IMF, 2019).
- The Early Warning Exercise (EWE) is a semiannual assessment by the IMF and the Financial Stability Board (FSB) of low-probability, high-impact risks —also known as tail risks— to the global economy. It was created in 2008 when the G20 asked both institutions to work jointly on an early warning exercise to help policymakers spot tail risks and vulnerabilities that could lead to further systemic shocks (IMF, 2023).
Monitoring
Central banks, commercial financial institutions, and international organizations, such as the International Monetary Fund, Financial Stability Board, and Bank for International Settlements, monitor and produce data on the risk of financial shocks. This involves specific and system-wide supervision and surveillance of financial institutions, including measures such as asset prices, the credit gap (e.g. measures of excessive lending), and the output gap (e.g. measures of economic overheating or slowdown) (Chen & Svirydzenka, 2021). Early warning systems can pick up signals of potential financial shocks several months and even years prior to the onset of a financial shock, based on aggregated information (Chen & Svirydzenka, 2021). This information is then shared via public reporting and direct communications among financial institutions and regulators.
References
Bank for International Settlements, 2020. Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems. Accessed 17 February 2025.
Claessens, S., A. Kose, L. Laeven and F. Valencia, 2014. Financial Crises: Causes, Consequences, and Policy Responses. International Monetary Fund. Accessed 17 February 2025.
Chen, S. and K. Svirydzenka, 2021. Financial Cycles – Early Warning Indicators of Banking Crises? IMF Working Paper WP/21/116. Accessed 6 February 2025.
IMF, 2019. Financial Sector Assessment Program(FSAP), 3 June 2019. International Monetary Fund (IMF). Accessed 17 February 2025.
IMF, 2020a. Articles of Agreement of the International Monetary Fund. International Monetary Fund (IMF). Accessed 17 February 2025.
IMF, 2020b. Global Financial Stability Report. International Monetary Fund (IMF). Accessed 17 February 2025.
IMF, 2023. The IMF-FSB Early Warning Exercise. Accessed 17 February 2025.
Jobst, A.A., 2008. What is Securitization? Finance and Development, September 2008, International Monetary Fund. Accessed 17 February 2025.
Moretti, M., M.C. Dobler and A.P. Chavarri, 2020. Managing Systemic Banking Crises: New Lessons and Lessons Relearned. 11 February 2020, International Monetary Fund. Accessed 17 February 2025.
OECD, 2010. Policy Framework for Effective and Efficient Financial Regulation. Organisation for Economic Co-operation and Development (OECD). Accessed 17 February 2025.
Ong, L.L and A.A. Jobst, 2020. Stress Testing: Principles, Concepts, and Frameworks. International Monetary Fund. Accessed 17 February 2025.
Peersman, G., 2015. How much do financial shocks affect the economy? Accessed 17 February 2025.
World Bank, 2020. Global Financial Development Report 2019/2020: Bank Regulation and Supervision a Decade after the Global Financial Crisis. Accessed 17 February 2025.