The financial crisis of 2008-09 may have started due to liquidity problems and bad decision making by banks, but was greatly exacerbated by loss of investor confidence in such institutions and banking system as a whole. And since the banking system plays a major role in financial markets, the markets tumbled, which ultimately affected even the real economy and other sectors.
Investor confidence was eroded during the early phase of the crisis, when it became clear that the banks, and investment banks in particular, had become too unstable to manage their liquidity position. This sentiment spread like a wild fire and in a few weeks, almost all banks were caught by investor selling spree (Tonkiss, 2009).
Loss in investor confidence created a sense of panic in the markets, with people unsure about the safety of their money, even in erstwhile ‘extremely safe’ government securities. This sense of panic resulted in institutions witnessing more than 50% erosion in their market capitalization.
Investor confidence degradation meant that treasury and Fed had to intervene with more drastic measures than they would have wished. These measures included the government bailing out several institutions with taxpayer money and infusing significant amount of capital in banks. These measures were supposed to replenish investor confidence and trust and prevent other banks and financial institutions from failing. But the strategy hardly paid any dividends (Tonkiss, 2009).
The situation could have been better managed through more straight forward communication from the banks, Fed and the treasury. Investor confidence was hit the most by the sense of fear that the common people had about the future of these institutions and the economy as a whole. Timely and unambiguous communication through proper channels by Fed and Treasury could have restored investor confidence, thus buying them more time and room to handle the crisis more effectively.
References
Tonkiss, F. (2009, July/August). Trust, Confidence and Economic Crisis. Intereconomics, 196-202.
