Why Are There Financial Crises? Recent Developments in Theory

In financial crises, a period of overheated credit markets turns into a credit crunch accompanied by a systemic breakdown in the financial intermediary sector. Without a deep understanding of their roots, designing policies to decrease the probability of suffering from them or to avoid the worst consequences is like flying blind. In this review, I survey the recent development of the theory of financial crises. I focus on the answers these theories provide to four fundamental questions. What makes the booming phase fragile, and what are the incentives and frictions leading to that fragility? What triggers the crisis? Why is the downturn persistent? Should policy intervene, and if so, how?