How does a deterioration in the balance sheets of financial institutions and the simultaneous failures of these institutions cause a decline in economic activity?

Financial liberalization refers to the concept of liberalizing domestic rules. It makes the availability of credit easier for the borrowers. Interest rate differentials are ended.

Financial liberalization refers to the concept of liberalizing domestic rules. It makes the availability of credit easier for the borrowers. Interest rate differentials are ended.

The money can be borrowed from another country freely. The interest rates are freed up.

Due to financial liberalization, the financial institutions would start lending without restrictions leading to a credit boom.

Gradually losses will accumulate, and the asset side of the balance sheet falls in comparison to liabilities.

This would result in a fall in the net worth of the financial institutions. Finally decrease in capital would affect money lending significantly which in turn would have an adverse impact on the economy.

Therefore decrease in bank lending during a banking crisis decreases the supply of funds available to borrowers, which leads to higher interest rates, increases asymmetric information problems, and leads to a further contraction in lending and economic activity.