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Financial Crises and the Subprime Meltdown Problem Solution Essay

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Updated: Jul 31st, 2019

Introduction

Financial crises greatly disrupt financial markets “characterized by sharp declines in asset and firm failures” (“Financial crises and Subprime Meltdown” 196).

Starting from August 2007, the defaults in subprime mortgage markets in the U.S shook the financial markets, contributing to the most horrible financial crisis from the time of the Great Depression and to several banking crises all over the world.

Allan Greenspan, the former chairman of the United States Federal Reserve gave a description to financial crises as “a once-in-a-century credit tsunami” (“Financial crises and Subprime Meltdown” 196). Moreover, the commercial banks as well as Wall Street firms incurred big losses.

The households as well as businesses faced a situation in which they had to pay increased rates on their loans and it was more difficult to obtain credit. There was crashing of the financial markets across the world which fell by more than forty percent from their peak (ADB 1).

A large number of the financial companies, encompassing the investment banks and commercial banks among others “went belly up” (“Financial crises and Subprime Meltdown” 196).

In this paper, there is going to be a review of literature concerning the financial crises and Subprime meltdown and this will be followed by a discussion on the relevant tools for tackling the problem of financial crises and the policy implications. The conclusion section will provide a summary of the main points in the discussion.

The Financial Crises and Subprime Meltdown

A financial crisis comes about when a rise in “asymmetric information from a disruption in the financial system causes severe adverse selection and moral hazard problems that render financial markets incapable of channelling funds efficiently from savers to households and firms with productive investment opportunities” (“Financial crises and Subprime Meltdown” 196).

When the financial markets do not work in an efficient manner, there is a sharp contracting of economic activity.

To get the knowledge about the reasons why there is occurrence of the finical crises and how they contribute towards contracting the economic activity, there is a need to look at the factors which cause them.

There are six classes of factors which play a significant part in financial crises and these include; “asset market effects on balance sheets, deterioration in financial institutions’ balance sheets, banking crises, increases in uncertainty, increases in interest rates, and government fiscal imbalances” (“Financial crises and Subprime Meltdown” 197).

“Assets Market Effects on Balance Sheets”

A big decline in stock market is among the factors which can bring about grave deterioration in the balance sheets of the borrowing firms. Subsequently, deterioration can bring up the level of adverse selection as well as moral hazard issues within the financial markets and trigger a financial crisis.

A stock market decline implies that the “net worth” of companies has gone down, since the share prices “are the valuation of a corporation’s net worth” (“Financial crises and Subprime Meltdown” 197).

The decline in the net worth causes the lenders to have little willingness to lend and this is for the reason that a firm’s net worth plays a role which is similar to the one played by collateral.

In case the collateral value declines, it offers reduced protection to the lenders, implying that there is likelihood that the losses that are incurred on loans will be harsher.

Since lenders have now less protection against the effects of adverse selection, they bring down the level of their lending which subsequently results in a decline in aggregate output as well as investment (“Financial crises and Subprime Meltdown” 196).

“Deterioration in Financial Institutions’ Balance Sheet”

The financial institutions, especially banks, play a very big role in the financial markets for the reason that they are in a better position to take part in the “information-producing” activities which help in facilitating fruitful investment (“Financial crises and Subprime Meltdown” 197).

The state of the balance sheets of banks as well as other financial institutions significantly affects lending. In case there is a deterioration in the balance sheets of financial institutions experience, this will lead to great contraction in these institutions’ capital.

These financial institutions have reduced resources to lend and there will eventually be a decline in lending. The contracting lending subsequently contributes towards having declining investment spending and this brings down the level of economic activity (“Financial crises and Subprime Meltdown” 196).

Banking Crises

In case the deterioration in the balance sheets of the financial institutions is severe to a high level, these institutions will begin failing; TV-Here can be spreading of fear among institutions and even making the health one “to collapse” (“Financial crises and Subprime Meltdown” 198).

For the reason that banks do have deposits which can rapidly be pulled out, they are especially vulnerable to infectivity of this kind. A “bank panic” comes about when a large number of banks experience failure at the same time.

During a panic, those who deposit, having fear for their deposits’ safety and not having knowledge about the quality of loan portfolios of banks, engage in withdrawing their deposits to a level that banks fail.

In case some banks are not able to succeed within a short span, there will definitely be a loss of information production that may occurs in the financial markets, so there is also direct loss of the financial intermediation of banks (“Financial crises and Subprime Meltdown” 198).

A reduction in bank lending in the course of banking crisis causes a reduction in the supply of the funds that are available to the borrowers, which contributes towards having increased interest rates. The bank panics cause a rise in adverse selection as well as moral hazard issues within the credit markets.

These issues or problems create an even increased decline in lending in order to facilitate “productive investments and lead to an even more severe contraction in economic activity” (“Financial crises and Subprime Meltdown” 198).

“Increase in Uncertainty”

A remarkable rise in uncertainty within the financial markets, possibly as a result of an outstanding financial institution, or a recession or a crash in the stock markets, causes it to be difficult for the lenders to be able to engage in screening bad as well as good credit risks (Stiglitz 133).

The consequential lack of ability of lender to be able to find a solution to the problem of adverse selection causes them to have less willingness to lend and this contributes towards having a reduction in lending as well as investment and total economic activity.

“Increases in Interest Rates”

The businesses as well as individuals having the most risky projects are those that have the willingness of paying the “highest interest rates” (“Financial crises and Subprime Meltdown” 199).

In case higher demand for credit or a reduction in the supply of money causes an increase in the interest rates adequately, “good credit risks” have a low likelihood to be willing to borrow. On the other hand, “bad credit risks” still have the willingness to engage in borrowing.

Due to the consequential rise in “adverse selection”, the lender will not want to make loans any longer. The remarkable reduction in lending will contribute towards having a remarkable reduction in investment as well as in the overall economic activity (Minsky 22).

The increases in the rates of interest also serve to promote a financial crisis via the effect they have on cash flow, the difference that is there between the expenditures and cash receipts.

A business organization that has enough cash flow can fund its projects within, and there exists no “asymmetric information” for the reason that it has knowledge about “how good its own projects are” (hdgnn199).

In the presence of increased “adverse selection” as well as moral hazard, a bank may make a choice not to lend even in the cases where firms which are “good risks” and have the willingness to carry out prospectively gainful investments.

Therefore, in case cash reduces following a rise in the rates of interest, the moral hazard issues as well as adverse selection turn out to be more severe, once more limiting investment as well as lending and economic activity.

“Government Fiscal Imbalances”

In the emerging economies, the “government fiscal imbalances” may serve to “create fears of default on government debt” (“Financial crises and Subprime Meltdown” 199).

Consequently, the demand for the individual investors for the government bonds may go down and this will cause the government to engage in forcing the financial institutions to buy these bonds.

In case the price of the debt goes down, the balance sheets of the financial institutions will become weak and there will be contracting of their lending.

The fears regarding government debt default, can as well ignite a “foreign exchange crisis” where the domestic currency value goes down greatly for the reason that investors “pull their money out of the country” (“Financial crises and Subprime Meltdown” 199).

A reduction in the value of the local currency will in turn contribute towards damaging the firms’ balance sheets with big amounts of “debt denominated in foreign currency” (“Financial crises and Subprime Meltdown” 199).

Such balance sheet issues contribute towards having a rise in adverse selection as well as in “moral hazard problems”, a reduction in lending and reduced economic activity.

Recommendations and Policy Implications

It is true to point out that the capital market is a significant component of the “financial system” due to its unique roles in any country’s economy.

These roles were identified by Levine as “raising capital for business, mobilizing savings for investment, facilitating company’s growth, redistribution of wealth, promotion of corporate governance, creating investment opportunities for small investors, government capital raising avenue for development projects and barometer of the economy” (Levine 1445).

Serving a role as a big source of suitable long-term finances, the capital market is clearly critical for the economic development of any country across the world.

This market plays a major role in facilitating economic growth by, for instance, mobilization of savings from various economic units like institutional investors, governments and individuals for users like the private sector and the government.

It as well serves to bring improvement in the capital allocation efficiency through a pricing mechanism that is competitive.

Basing on the significant role played by the capital market, as well as the incredible negative effect of the financial crises on the development of capital markets across the world, the governments have to ensure that they restore the public confidence in this market and make sure that it is a lively capital market (Augustine, Pius and Umar 345).

Moreover, development of banks is a very important move towards improving a country’s economy. This is true especially when the undeveloped financial system is considered. There is a need to take a move to improve the level of efficiency within the banking system.

No bank is supposed to be allowed to fail. Such a move is regarded as being very important when it is “compared with the contagious effect associated with bank failure” (Augustine, Pius and Umar 345).

But on the other hand, an efficient financial system is not formed by just banks; the capital market is as well a vital part of the system. Researches that have been conducted indicate that the stock markets as well as banks complement one another in the attainment of economic growth and development.

Following the financial crises, banks and the stock markets were affected negatively. But on the other hand, some governments were quick to protected the depositors in banking sector and at the same time allowing those investing in the stock market “to their fate” (Augustine, Pius and Umar 345).

Such particular action has the power to weaken the stock market development. The affected investors will go on shying away from undertaking investment in the capital market. This can have two policy implications for a country’s economy (Krugman 11).

The first implication is that firms will just have a single funding source which is the bank. The effect of this is that “the long-term end of financial system will remain atrophid and firms will be highly levered which translates to higher risk” (Augustine, Pius and Umar 345).

At the end, this will contribute towards firms disappearing. The second implication is that a country’s economy can suffer from issues which are linked to economies that are bank-based. In the course of funding firms, banks are able to access information which is unavailable to other lending institutions.

The banks can utilize information like that to engage in extracting rents from the firms. At the point of undertaking fresh investments or renegotiation of debts, the banks may be able to have “bargaining power over a firm’s expected future profits” (Augustine, Pius and Umar 345).

The banks that are more powerful can disproportionately big profit share, in order that the firms will have very less motivations to carry out “high risk and profitable projects” (Augustine, Pius and Umar 345).

Moreover, when the banks make a move of entering a debt contract with the firms, they naturally have an inclination towards “low risk projects that have high profitability of success” (Augustine, Pius and Umar 345).

However, the problem of this conduct is that the projects classified as “low risk” are, in general, low-return investments. Thus, the systems that are bank-based can limit technological innovation as well as long-term economic growth. Evidence has been found by Weinstein and Yafeh which supports the two points.

These researchers indicate that, as on one hand intimate relationship between firms and banks bring up the level of capital availability to the borrowing companies, on the other hand, they do not essentially contribute towards growth (Weinstein and Yafeh 635).

As a matter of fact, the firms’ capital cost with close bank links is greater than “that of their peers, which suggests that most of the benefits from these relationships are appropriated by banks” (Augustine, Pius and Umar 346).

The slow bank customer rate of growth also serves to show that banks put off firms from undertaking investment in projects that are classified as risky but profitable.

In addition, the banks that are powerful can engage in colluding with managers against the outsiders and this eventually hinder competition as well as corporate controls, new firm creation and therefore leading to the economic growth in the long term.

Evidence is offered by Wenger and Kaserer from the Germany where there is misinterpretation of the firms’ balance sheets by the banks to the public and they give encouragement to the managers of the firms to engage in misbehaving (Wenger and Kaserer 13).

Moreover, an argument is presented by Allen and Gale that, even if intermediaries can be effectual at doing away with duplication of the processing as well as gathering of information, they can achieve less success in handling uncertainty as well as innovation and fresh ideas (Allen and Gale 70).

For instance, new technology evaluation is difficult because of lack of the availability of adequate information regarding the potential returns since it is hard to judge the information itself “without some expertise” (Augustine, Pius and Umar 346).

The broad possibility range and the absence of hard data imply there is always remarkable diversity of views.

The “bank-based financial systems” involve “underfunding of new technologies” (Pius and Umar 346).

Since these systems make it possible for individuals to either reach an agreement or disagree, and thus enable coalitions of people having same views to come together in order to fund projects, markets are quite effectual at funding new industries or industries in which there is limited availability of information and where there is persevering of opinion diversity.

Based on this, it can be recommended that governments are supposed to engage in exploring ways of how to win back the confidence in the capital market. The governments are supposed to engage in reinforcing sufficient regulatory supervision.

This can be realized by greatly enhancing the double role of effectual regulatory supervision and development of capital markets. This calls for dealing with weak governance as well as inadequate ability as seen in market in the recent times.

Conclusion

The financial crises bring about big disruptions to financial markets marked by sharp reductions in assets and lead to firm failures.

The financial crises are caused by the effects of the asset market on balance sheets, worsening of the financial institutions’ balance sheets, the banking crises, rise in the level of uncertainty, increases in the rate of interest, and government financial imbalances.

Considering the important function played by the capital market, and the great adverse effect of the financial crises on the growth of capital markets all over the world, the governments are supposed to make sure that they bring back the confidence of the public in this market and also ensure that it is a lively capital market.

Works Cited

ADB. The Impact of the Global Financial and Crisis on Africa, 2009. Web.

Allen, Frederick. and David Gale. “Diversity of Opinion and Financing of New Technologies”, Journal of Financial Intermediation 8.1 (1999): 68-89.

Augustine, Ujunwa, Salami Pius and Ahmed Umar. The global financial crisis: realities and implications for Nigerian capital market. American Journal of Social and Management Sciences, 2.3 (2011): 341 – 347.

Financial crises and Subprime Meltdown. n.d. Web.

Krugman, Peter. What Happened to Asia? Cambridge: Massachusetts Institute of Technology, 1998. Print.

Levine, Robert. “Stock Market, Growth, and Tax Policy”, Journal Finance, 46.4 (1991): 1445-1465.

Minsky, Philip. The Financial Instability Hypothesis. Working Paper No 74, May 1992. The Jerome Levy Economics Institute of Bard College. Handbook of Radical Political Economy. (eds.) Philip Arestis and Malcolm Sawyer, Edward Elgar. New York: Aldershot, 1993.

Stiglitz, John. “Credit Markets and the Control of Capital”, Journal of Money, Credit, and Banking, 17.1 (1985): 133-152.

Weinstein, Daniel. and Yusuf Yafeh. “On the Costs of a Bank-Centered Financial System: Evidence from the Changing Bank Relations in Japan”, Journal of Finance, 53.4 (1998): 635-672.

Wenger, Edward. and Charles Kaserer. “The German System of Corporate Governance: A Model Which Should not be Imitated”, in S.W. Black and M. Moersch (eds.), Competition and Convergence in Financial Markets: The German and Anglo- American Models. New York: North Holland.

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