In earlier times the commercial banks were central to the financial system and a shock experienced by a major commercial bank could spill to the entire financial system and eventually to the broader economy.
This is mainly due to the absence of the support of the taxpayers through the central bank. Before the creation of a central bank, depositors of commercial banks used to panic about the safety of their funds held by the bank. The panic might be caused by a drop in asset prices.
When assets prices drop depositors start to withdraw funds from the commercial bank. And remember commercial banks use short-term deposits to fund their positions in longer-term instruments which made them vulnerable to large-scale withdrawals. Now, for the commercial bank to be able to withstand these withdrawals they had to sell some assets. This sale of assets impacted a further drop in the prices of assets.
As the commercial bank lost capital, it was unable to fund the economy through the credit market to businesses and households, thus decreasing spending in the economy and resulting in erosion in the earnings of businesses. As the bad situation faced by the system feeds back on its self it's referred to as the «adverse feedback loop».
During the 1930s a series of banking panics occurred and it was catastrophic to the financial system and it's referred to as «The Great Depression». During these events, the Fed was 15 years old and was about to have to deal with the biggest crisis ever to be encountered by the financial system. The great depression was started by the stock market crash of October 1929, and before then the stock prices and real estate prices had registered large gains.
Major institutions were holding positions in these assets, and this contributed to the belief that major institutions were facing difficulties as the same events that occur when an «adverse feedback loop» is taking hold happened. Resulting in major institutions not being able to provide credit to the economy causing a credit crunch.
During the earlier years of the crisis, the Fed's actions were limited due to the gold standard they were under. During the gold standard regime, the value of the currency of a country was decided by the amount of gold available, although other countries instead of gold, held either the British pound or the US dollars. Countries started selling those currencies and bought gold, thus driving gold prices higher. This caused a contraction in global money stock and aggregate demand.
When the effects of the crisis were getting worse the president F.D.Roosevelt ordered the commercial bank to close for the day to sort through their problems, and this came to be known as a bank holiday and is still present even today. And the United States dropped the gold standard. The dropping of the gold standard, in effect, allowed the US dollar to depreciate, improving the competitiveness of US exports and import-competing industries.
The actions taken to counter the crisis were effective and helped the financial system and the broader economy to recover. Now that the US was out of the gold standard, the Fed introduced programs to insure the deposits made to the financial institutions and the fed also took the role as «the lender of last resort». The financial system took a big knock during the great depression, but what was important was what we learned about the events that occurred before, during, and after the growth
After the great depression, some financial crises occurred but the ones worth noting is the stock market crash of the 1990s which wiped out an estimated twenty trillion off the financial system. But its effects were less damaging than the real estate crisis of 2008, which cost the financial system a whopping twenty-five trillion. The real estate crisis had a more negative impact on the broader economy
Before the crisis, the interest rates had been low and the economy was experiencing growth and inflation was low. This made investors extrapolate that holding positions in real estate had low downside risk and provided their owners with higher yields. This prompted investors to take leverage to maximize their profits. Investors started putting funds in subprime mortgages, thus increasing their exposure to the real estate prices
Now as the real estate asset prices were thought to be overpriced, their prices started depreciating and this caused investors to have uncertainty about the financial institutions having exposure to the real estate asset, this started to spill to the global institutions exposed to the US real estate markets. With uncertainty taking hold buyers of such assets vanished and resulted in a further drop in real estate assets prices. Financial institutions with exposure to this market saw a loss of capital which resulted in them being unable to provide credit to the economy, an adverse feedback loop was underway
The Fed introduced a series of programs to counter the crisis, by replacing the loss of funding at major institutions, which helped reduce the uncertainty about the stability of the system. The fed also lowered its policy rate to support the economy. The Dodd-frank was the actions taken by the regulatory system, to put restrictions on some of the actions that the financial institutions can take, to prevent the crisis from happening again.