Global Financial Crisis - Assignment Example

Global Financial Crisis Introduction The financial crisis that was witnessed in 2008 yielded the worst recession since the Great Depression of 1929. The 2008 financial crisis started as the U.S. “subprime” crisis within the summer of 2007 that spread to several other advanced economies via a combination of direct exposures to subprime assets, the continuing loss of confidence in several asset classes, and the drying-up of wholesale markets. The first indication of the crisis registered in 2006 when the housing prices started to drop. This emanated, in part, from the fact that considerable number of homeowners with doubtful credit possessed loans for 100% (or more) of their home’s value. Many home owners who had purchased sub-prime loans realised that they could no longer meet their mortgage repayments. Banks had resold these mortgages in packages as part of mortgage-backed securities. At the onset of the crisis, the Federal Reserve attempted unsuccessfully to contain and seclude the damage from the subprime mortgage crisis to housing (World Bank 2008, p.95). Since the initial mortgage had been split up and resold in bits, the actual derivatives were unfeasible to price. The main motivation for purchasing of such risky assets (toxic assets) was the perception that pension funds were shielded from any downside risk since they owned insurance in the type of credit default swaps. The loss of confidence by U.S. investors in the worth of sub-prime mortgages led to a liquidity crisis, which, in turn, resulted in the U.S. Federal Bank injecting significant amount of capital into the financial markets (Helleiner 2011, p.67). The spectacular collapse of Lehman Brothers marked a turning point within the global financial crisis as governments struggled to rescue financial institutions. The failure of Lehman Brothers was indicative of how interlinked debt had become among key banks. Roots of the Banking Crisis in the UK The origins of the banking crisis were numerous and diverse, including low interest rates, a pursuit for yield, excess liquidity, and a misplaced confidence in financial innovation. These constituents amalgamated to fashion an environment rich in over-confidence, over-optimism, and interplay of contrary opinions. Albeit, the uncertain environment, some of the banks can be considered to have been primary authors of their own demise by undertaking risky business endeavors. The cultures within sections of the banking industry were increasingly inclined towards risk taking, which eventually yielded the meltdown of the financial system (Cline 2010, p.236). Nevertheless, this was not only a breakdown within individual banks, but also of the supervisory system fashioned at shielding the public from systemic risk. The collapse of the banking industry in the UK was dramatic given that on 2 April 2007, nine banks occupied places within the FTSE 100 all share index with a capitalization of £316.9 billion. By 7 April 2008, Northern Rock and Bradford & Bingley had dropped out of the index and capitalization stood at £245.1 billion. By 6 April 2009, the FTSE top 100 banking sector was now valued at only £138.1 billion. Capital and liquidity indiscipline were at the centre of the banks downfall, compounded by banks unbecoming tendency to over-reach. Factors that orchestrated the Collapse of the Global Banking Industry in 2008 Imprudent Mortgage Lending Against a background of plentiful credit, low interests rates, and increasing house prices, lending standards were significantly relaxed to a level in which many people were able to purchase houses that they could not afford. The falling of the housing prices started delivered a shock to the financial system. It is no doubt that imprudent lending played a critical role in aggravating the financial crisis. The housing bubble that was created by easy polices in which the Federal Reserve allowed housing prices to increase to unsustainable levels also facilitated in the making of the crisis (International Monetary Fund 2008, p.6). Global imbalances in financial flows (in which some countries such as China, Germany, and Japan run huge surpluses each year while others such as U.S. and UK run deficits) reflected internal deficits within the household and government sectors. The resultant stress underpinned the financial disruptions. Securitization Securitization advanced the “originate-to-distribute” model in which diminished lenders’ incentives to be prudent mainly in the face of immense investor demand for subprime loans delineated as AAA bonds. The ownership of the mortgage backed securities was broadly dispersed yielding repercussions that spread throughout the global system when the subprime loans went bad (Shiller 2012, p.39). Major financial institutions were exposed to toxic shock by securitization was a significant cause of the banking crisis. Hence, the regulatory response should require that those carrying out securitization withhold a tranche of the commodities they trade. The lack of transparency intrinsic in over-the-counter trading shapes one of the numerous reasons why “toxic” assets possessed such an overwhelming impact since they had a wobbly grasp on where they were, what they encompassed, and what their value was. Their judgment was additionally blurred by the deep correlation between complexity and profitability. Shadow Banking System Risky financial activities that were once restricted to regulate banks such as the use of leverage, borrowing short-term so as to lend long-term drifted outside the overt government safety net guaranteed through deposit insurance and effective regulation (Nouriel 2008, p.9). Mortgage lending, for instance, shifted from banks into unregulated institutions whereby the unsupervised risk-taking depicted a financial house of cards. Non-bank Runs The institutions outside the banking system creates financial positions based on borrowing short lending long, which exposed the institutions liquidity threat in the shape of non-bank runs (Krishna 2007, p.1). Thus, the financial institutions could easily fail in the event that the markets were to lose confidence and declined to lengthen or roll over short-term credit as was the case in Bear Stearns. Off-Balance Sheet finance Majority of the banks created off-the-books exceptional purpose entities (inclusive of structured investment vehicles) to involve in risky speculative investments. This facilitated the banks to undertake more loans amid the expansion, but also presented contingent liabilities, that, with the inception of the crisis, cut market confidence in respect to the bank’s credit worthiness (Adrian 2007, p.27). Simultaneously, the off-balance sheet finance has enabled the banks to hold minimal capital against probable losses. As a result, investors bore minimal capability to comprehend bank’s accurate financial positions. Excessive Leverage During the post-2000 period in which low interest rates and plentiful capital was the norm, fixed income yields were low. Many investors employed borrowed funds so as to improve the return on their capital, and compensate for the low yields. Excessive leverage amplified the impact of the housing downturn, while the deleveraging resulted to tightening of the interbank credit market. The banks faced a liquidity crisis whereby giving and obtaining loans became increasingly difficult owing to the credit crunch. As a result of the crisis, credit and interbank liquidity stagnated across the globe, which prompted governments across the world to attempt to bail out their failing banks. Banks declined lending to each other to avoid getting stuck with possible valueless mortgages as collateral. Consequently, interbank borrowing costs (Libor) rose significantly (Savona, Kirton and Oldani 2011, p.21). Fragmented regulation Most financial regulation such as the U.S. is dispersed among a number of agencies each with a distinct responsibility for a certain class of the financial institution. As a result, no agency was well placed to monitor emerging system-wide challenges. Furthermore, there was no systemic risk regulator with a broad control over all systemically important financial institutions. Other often cited causes include deregulatory legislation, government-mandated subprime lending, failure of risk management systems, cases of financial innovation, complexity for certain financial instruments, human frailty, ineffective computer models, relaxed regulation of leverage, credit default swaps, over-the-counter derivatives, short-term incentives, and use of tail risk (Savona, Kirton and Oldani 2011, p.51). Strategy for Ensuring that the 2008 Global Banking Industry Crisis does not Re-occur The 2008 banking crisis demonstrated the need for financial system reform and institution of sound fiscal policy. There is an urgent need to initiate restructuring that forestall the return of incidents of banking excesses that changes within the global financial system to be more resilient to shocks (Adrian 2007, p.27). The 2008 banking crisis raised a number of questions dwelling on: the role of auditors in the banking crisis; the function and regulation of credit ratings agencies within the banking crisis; the function and regulation of hedge funds within the banking crisis; potential remuneration structures prevailing in financial services, the impact of short-selling within the banking crisis, and regulatory capital and liquidity requirements. The government must start to play a central role in regulation so as to prevent banks from taking too many risks. It is clear that inadequate supervision and regulation can be regarded as prime candidates to have yielded the banking crisis. The financial crisis of 2008 demonstrated that banks cannot successfully self-regulate and devoid of strong reform, then a global crisis could as well happen (Green, Pentecost and Weyman-Jones 2011, p.51). Supervision and regulation of the financial system is a critical means to safeguard against crises, by managing moral hazard and dispiriting extreme risk-taking on the part of financial institutions. The events of 2008 demonstrated that a significant conflict of interest may arise and as such, entities should try to exercise governance in line with their guidelines on corporate governance. Any effective strategy demands significant fresh thinking regarding regulation, about responsibility and ethics. The required rules of the game should hinge on a better balance and coordination between markets and governments. Any strategic response to the banking crisis should incorporate undertaking of both regulatory and policy malfunctions comprehensively with the spotlight being on the relations between finance, competition and governance, and eventually on attaining sustainable growth. There is a need to promote the strengthening the governance of funds, including better oversight of investment risks and monitoring. The pursuit of a macro financial policy can be a good strategy in response to the banking crisis. The policy should operate on the arrangement of the financial institution balance sheet and behavior across the entire system. Such regulations add to the micro-prudential controls to guarantee the soundness of banking institutions. Macro-financial policy settings are designed to avail automatic stabilization analogous to that of fiscal systems, as well as significant buffers against system wide shocks and some level of leaning against strong credit upswings. Regulatory reform possesses the capability to deepen the divide between stronger and weaker banks and the growing impact of reforms will compel the industry, plus its investors, to adapt to radically diverse ROE expectations. In tightening capital and liquidity availability, new obligation should discourage many investment banking and trading strategies to depart from courting toxic assets and a push towards more stable funding models. The reforms should underline “intent,” especially centring on consumer protection regulation, which is significantly challenging to manage and will yield in considerably amplified reputational and legal risks for the banks (United Nations 2009, p.75). The banking crisis witnessed in 2008 heralded the introduction of sweeping changes dwelling in the manner in which financial regulation operates. This incorporates introduction of prudential regulator charged with analyzing systemic risks. There were also suggestions to break up the big banks for those that turn out to be too large to fail. There has been a rigorous attempt expressed at comprehending and tackling with the origins of the crisis (Great Britain 2009, p.51). Nevertheless, a critical part of the analysis that has materialized concerns with global trade imbalances that still remains a common feature within the global economic landscape. Banks should set up rigorous risk and capital management requirements are fashioned at guaranteeing that banks hold adequate capital reserve to cover the risks that they gain in trading based on supervisory review and market discipline. Conclusion It now broadly recognized that banks will continue facing significant challenges as they pursue to raise extra and better quality capital to satisfy investors ahead of highly stringent regulation. Fresh regulations should compel banks to reassess their business strategies. The banking crisis underpins the complexity of established the precise balance of light-handed versus heavy-handed control and since most financial and economic developments are imperfect, it would be unreasonable to anticipate to be able to minimize the potential for systemic crisis to zero. As such, the reform on the financial system should spotlight on regulation and supervision with the aim of guaranteeing that any prospective crisis is dealt with effectively. With minimized demand, costly funding, and tight regulations, the banking sector is likely to gain adjustment to more restrained returns. The central function of banks should centre on making credit judgments amid uncertain investment proposals and to prudently oversee borrowers’ performance and creditworthiness. References List Adrian, B., (2007). Structured Products: Implications for Financial Markets, Financial Market Trends, November, p. 27. Cline, W. R. (2010). Financial globalization, economic growth, and the crisis of 2007-09, Washington, D.C., Peterson Institute for International Economics. pp.236. Great Britain (2009). Banking crisis: reforming corporate governance and pay in the City : ninth report of session 2008-09 : report, together with formal minutes, London, TSO. pp.51. Green, C. J., Pentecost, E. J., & Weyman-Jones, T. G. (2011). The financial crisis and the regulation of finance, Cheltenham, UK, Edward Elgar. pp.51. Helleiner, E. (2011). Global financial crisis: Lessons for scholars of international political economy, The Annual Review of Political Science 14, pp.67-87. International Monetary Fund (2008). World economic outlook, October 2008: financial stress, downturns, and recoveries, Washington, The Fund. pp.6. Krishna, G., (2007). Bundesbank Chief Says Credit Crisis Has Hallmarks of Classic Bank Run, Financial Times, 3 September, p. 1. Nouriel, R. (2008).The Shadow Banking System is Unravelling, Financial Times, 22 September, p. 9. Savona, P., Kirton, J. J., & Oldani, C. (2011). Global financial crisis: global impact and solutions, Farnham, Surrey, Ashgate. pp.19-51. Shiller, R. J. (2012). Subprime solution how todays global financial crisis happened, and what to do about it, Princeton, Princeton University Press. pp.39-42. United Nations (2009). The global economic and financial crisis regional impacts, responses and solutions, New York, United Nations. pp.75. World Bank (2008). Global development finance 2008: the role of international banking, Washington, World Bank. pp.95. Read More