The Reasons for the Recent Global Financial Crisis - Essay Example

? The Reasons for the Recent Global Financial Crisis and number submitted The Reasons for the Recent Global Financial Crisis Introduction The causes of the recent global financial crisis fall into three broad categories and several sub-categories. The first category is the macro-economic failures, which include monetary policies, fiscal policies, global imbalances and housing booms. The second category includes the failures in the financial sector supervision and regulatory policies and practices (Moshirian 2011, 502). The third one includes the multiple misunderstood innovations in financial engineering, which, in turn, include sub-prime mortgages, credit default swaps, new forms of securitization, and lack of responsibility in large private financial institutions, which operate globally. Many analysts conclude that the crisis was because of poor financial engineering innovations and failures in the financial sector regulations and supervision (Moshirian 2011, 502; Casu et al. 2006, 58). Fiscal policy in the United States led to low saving rate and monetary policy, which was persistently simple (Casu et al. 2006, 58). Other countries affected by monetary policy problems include several countries in Asia, the United Kingdom, Switzerland and some countries within the Euro zone, which had issues with the real interest rates. Many countries, like Korea, had policies that led to large amounts of foreign exchange reserves. The policies also led to global imbalances and distortion of international adjustment process. These reserves put pressure on the macro-economic policies of many countries including the U.S. global imbalances phenomenon. This, however, was not a main cause of the recent economic and financial crisis. The imbalances and the crisis happened simultaneously as a result of faults in design and implementation of macro-economic policies in the world. This led to increase in global credit. It also led to housing booms in the U.S. and other places accompanied by a rise in equity prices and other factors that cause inflation. Financial sector regulation and supervision also caused the crisis, but the errors were not necessarily committed during that period (Moshirian 2011, 504). Bad financial conditions lead to too much lending and credit standards. Financial sector supervision could have reduced the excesses, but this was not the case anywhere in the world. Innovations in financial engineering have become partly blamed, but they existed even in the past (Moshirian 2011, 504). In most cases, the innovations were not clearly understood, thus leaving the risks involved unnoticed, which is important in financial risk management (Moshirian 2011, 34). Financial innovations did not cause the crisis, but they intensified through market dynamics and distorted the incentives for financial institutions (Moshirian 2011, 505). As such, large private financial that operated globally had an upper hand in this because they played a significant role in exacerbating the crises. The failure of these institutions was not due to lack of national supervisors, but because they absconded their responsibility. Furthermore, their global scope was not the cause of failure, but their large size and complexity. Cases were unique, but the institutions were extremely large. Managers of these institutions became deceived that unfavorable economic and financial crisis would persist indefinitely or until they complete their tasks. However, most of them were wrong (Guerrera and Thal-Larsen 2008, 65). A key element in the existing confusion was as a result of liquidity risks, which culminated into the disintegration of Bear Stearns and Northern Rock (Longstaff 2010, 45). These two made it clear that the risks involved with the reduction of liquidity had previously gone unnoticed since they had enough capital resources back then. The context of deregulation has greatly contributed towards development of these financial products for the last few decades. For example, the different regulations controlling the actions of financial institution in both the UK and USA have been loosening up. This includes Glass Steagall, which had become instituted to disjoin the people’s savings from the riskier operations of investment banks. The banks resulted in the creation of the shadow banking system, which allowed them to circumvent the rule that required them to balance the risk on their books with some level of capital (Moshirian 2011, 506). The shadow banking system is what brought about the worst performing and the riskiest mortgages. These systems placed extensive pressure upon the traditional institutions forcing them to soften their underwriting standards when they started dealing with riskier loans. These banks became criticised later for breaking the rules of the financial system, though they were not accountable to the same regulatory controls (Heffernan 2005, 84). These banks were more susceptible because of maturity mismatch, implying that they borrowed short-term loans from liquid markets and bought illiquid, long-term, but risky assets (Heffernan 2005, 84). The uncontrolled practices of such banks are the core of the 2007 financial crises. In the spring of 2007, the securitization markets got their help from the shadow banking systems, leading to a more or less shut-down in the fall of 2008 (Casu et al 2006, 32). These brought about the disappearance from the market of more than a third of the private credit market (Moshirian 2011, 507; Barrell et al 2010, 45). Figure 1 shows how Asset-backed securities (ABS) market came near shutdown during the crises. Figure 1: Decline of Asset-backed securities market (Barrell et al 2010, 46) Between 2004 and 2006, the market for subprime loans expanded significantly as shown in Figure 2. As a result, the European and the US banks wrote off a huge amount of financial assets as the securitised mortgages became illiquid (Dabrowski 2010, 43). Governments used public money to bail out financial institutions that got entangled in the crises. Although it is usually a regulatory requirement to undertake credit rating on securitised assets, credit rating agencies contributed towards the subprime saga by offering undeservingly higher ratings on debt parcels (Longstaff 2010, 45). Figure 2: US Subprime lending expansion between 2004 and 2006 (Longstaff 2010, 45). Both organizational and household credit played a role in the financial crises of 2007. When the amount of credit that the private sector can obtain from a bank becomes increased significantly, the banks tend to experience crises (Demirguc-Kunt and Enrica 2002, 1373). Nationally, credit expansions get stimulated by highly optimistic future expectations in reference to asset prices and income and sometimes by capital inflows and liberalizations. All these factors played some role, in different degrees, during run-up to the 2007 credit crises. What followed this credit expansion is that firms and households accumulated significant amounts of debts, though income did not increase in an equal measure. An increase in non-performing loans and defaults culminated from the decline in asset prices or income, accelerating the global financial crisis (Longstaff 2010, 45). As shown in Figure 3, sub-prime mortgages grew from $173 billion in 2001 to $665 billion in 2005 – which was a record 300% increase, in just four years (Demirguc-Kunt and Enrica 2002, 1374). Figure 3: the growth of subprime mortgage between 1994 and 2006 (Demirguc-Kunt and Enrica 2002, 1374). The 2007 financial crisis is also attributable to a boom in the housing-market, which started in the U.S.In both UK, and US there is a market of mortgage called sub-prime, which becomes given to underprivileged customers with poor credit ratings. Just before the 2007 financial crisis, many financial institutions had allocated a large amount of such loans to their customers. The probability of defaulting on such loans was obviously seriously high. An obsession for home ownership developed as a result of the rising house prices, which led to a housing bubble. At the same time, speculations of instruments such as CDOs significantly developed in the financial sector. Figure 4 below shows the worsening status of mortgage in the UK from 2001 to 2007 (Longstaff 2010, 47). Figure 4: mortgage in the UK from 2001 to 2007 (Longstaff 2010, p.47). Ideally, people used different instruments to speculate including money, pension funds, CDO and many others. All these instruments were extremely risky from the very beginning, especially because they encouraged people to borrow money they could not afford to pay back. To counteract this effect, the spreads became used to reduce risk, which also resulted in “long chains of risk passing so that no one knew who was ultimately holding the risk” (Erturk et al., 2005, 25). However, when confidence abated, people could not tell who was holding risky subprime assets. The credit crunch resulted when the financial institutions hesitated from lending to each other. In effect, the financial system stopped working, exposing financial institutions into enormous difficulties – the financial institutions could only depend on loan swapping merry- go- rounds, most of which effectively disintegrated. What followed was a replication of a similar situation across the economy. For example, General Motors became entangled into this bizarre when it came to depend on banks that, out of the blue, were reluctant on lending (Longstaff 2010, 48). When the crisis broke out, people believed that the United Kingdom economy would not fall to the financial turbulence. This was because of the thriving real economy that was strong on export growth and substantial financial position of businesses and households. This, however, changed in late 2008, following the rescue of Fannie Mae and Freddy Mac, the subsequent bankruptcy of the Lehman brothers and the growing fear of the Insurance power house, American International Group (AIG) dragging down leading financial institutions in United Kingdom and the United States of America in its wake. Market valuations of financial institutions disappeared; panic emerged in stock markets as investors ran for the sovereign bonds. The financial crisis was now a reality. Banks became forced to restrain credit allocation. Asset markets fell rapidly in UK. With the trade credit getting expensive, firms saw their sales fall and stock pile up (Moshirian 2011, 511). The governance of the financial regulation, the system that should design, implement and reform financial policies contributed highly to the crisis faced in the United States and United Kingdom (Guerrera and Thal-Larsen 2008, 50). The senior most officials got blamed for repeatedly designing implementing and maintaining policies that destabilized the financial markets. The Financial Guardians maintained the same policies even after learning that these policies were increasing the instability of the financial system in the country. Following the dramatic rise in US interest rates, the prices of houses, particularly in strongholds of CDSs, fell down. This was to safeguard the investors. An external event struck the financial market, marking a sudden change on the direction of the economy. The housing bubble became triggered in 2006 following surging interest rates that reversed the direction of housing prices in the subprime strongholds (Longstaff 2010, 50). The borrowers that took advantage of the significant increase in home prices at extremely low interest rates, to sell or refinance homes became met abruptly with crumbling housing prices and an upsurge of mortgage payments. Following these happenings, the investors started to get concerned that the settling down of the housing market in some places would extend to the entire mortgage market and perhaps infect the entire economy. As a sign of such distress, CDSs meant to speculate on credit quality and ways of shielding the investors increased worldwide by 49%, within the first half of 2007 (Demirguc-Kunt and Enrica 2002, 65). Crash and panic are the final phase that occurs during a financial bubble, which gets characterized by swift selling of assets, hence flooding the economy with cash once again. The initial crash followed the explosion of mortgage-backed securities of Bear Steams hedge funds that occurred in July 2007. A couple of banks in Asia, United States and Europe became compelled to accept their exposure to toxic subprime mortgage when it became clear that these risk management funds could not make out the definite value of their holdings. Panic intensified among financial institutions as stern credit crunch resulted – each institution was uncertain of the extent of financial toxic waste the other was embracing (Longstaff 2010, 80). The spread of the credit crunch into the commercial paper market brought to an end the key source of finance for structured investment vehicles that banks sponsored. This exposed some of the large banks to hefty risk, resulting from credit default swaps. One of the most memorable events that occurred is the failure and successive nationalization and assistance the Northern Rock – a British mortgage lender. Consequently, the US bond insurers started to experience the pressure – their problems particularly originated from their underwriting of credit-default swaps on mortgage-backed securities (Longstaff 2010, 52). Since even the international investors were strongly participating in speculation on US mortgage-backed securities, the financial panic swiftly infected the whole world. There was fear that the global economic growth would drop to less than 2.5 percent, hence paving a way for a global recession. Much of the fear that was going around the world became surrounded by a complex and obscure scenario that it was not clear where the financial toxic was originating - this occasioned a mad rush into U.S. Treasury bills and a radical fall in lending. According to the financial analysts, the global crisis was due to poor financial engineering, innovations and failures in the financial sector regulations and supervisions. Though this was not a principal reason of the financial crisis, the faults in design and implementation of macro-economic policies in the world aggravated the situation. This increased the global credit. The bad financial conditions provided room for too much lending and credit standards. These large financial institutions also lacked national supervisors who did they work properly and had those who absconded their responsibilities. These people charged with designing, implementing and reforming financial policies facilitated the crisis further. They maintained policies that were ineffective in ensuring the stability of the financial systems in these countries. In order to prevent another crisis, financial institutions should run independently and only receive help from the Central Bank. They should also introduce a number of regional and world financial regulations, which would reduce the financial regulatory costs and lead to more stability in the Global Financial Sector. References Barrell, R., Davis, E. P., Karim, D., & Liadze, I, 2010, Bank regulation, property prices and early warning systems for banking crises in OECD countries, Journal of Banking & Finance, 34(9),2255-2264. Casu, B., Girardone, C., & Molyneux, P, M, 2006, Introduction to Banking, London: Pearson Education. Dabrowski, M, 2010, The global financial crisis: Lessons for European integration. Economic Systems, Retrieved July 18, 2013, from http://www.sciencedirect.com/science/article/pii/S093936251000004X Demirguc-Kunt, A., & Enrica, D, 2002, Does Deposit Insurance Increase Banking System Fragility: Empirical Evidence, Journal of Monetary Economics, 49, 1373-1306. Erturk, I., Froud, J., Johal, S., Leaver, A., & Williams, K, 2005, Financialization at Work, London: Routledge. Guerrera, F., & Thal-Larsen, P, 2008, Gone by the Board: why the directors of big banks failed to spot credit risks, Financial Times, 50. Heffernan, S, 2005, Modern Banking, London: John Wiley & Sons. Longstaff, F. A, 2010, The subprime credit crisis and contagion in financial markets, Journal of Financial Economics, 45-54. Moshirian, F, 2011, The global financial crisis and the change of markets, institutions and regulation, Journal of Banking & Finance, 35(3), 502-511. Read More