Discuss the Different Reasons and Causes of the Financial Crisis
When examining the causes of the 2008 financial crisis, the facts present a logical sequence of events of a housing bubble that burst in the United States. From this perspective, the logical conclusion would be a crisis in the housing sector. However, as it turned out, the crisis was in the entire financial sector and its effects were not just in the United States, but throughout the world.
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The linkages of the housing bubble and the financial crisis emerge when observing two factors. First, there were assets like securitized mortgages placed temporarily in off-balance sheet entities. They remained visible during general scrutiny in their temporal placement. Secondly, banking regulations were revised to lower the ratio of capital versus assets, as reflected in the balance sheet.
Banks only needed to move as many assets as possible out of the balance sheet for them to have as much reduction in their capital requirements. Overall, the trend led to a significant reduction in the amount of capital that banks held against their balance-sheet assets.
When destabilization occurred in the market, many banks were exposed to difficulties of meeting their trading obligations. Too much unregulated bank capital was tied to the sub-prime mortgages, thereby explaining the link between the housing bubble and the financial crisis.
The following section takes an in-depth look at different reasons and causes of the financial crisis.
The 2008 financial crisis acted as a foundation to the 2010 crisis that most affected the European countries. Besides that, the IMF identified 124 systemic banking crises that occurred between 1970 and 2007 (Laeven & Valencia 2008). The key characteristic of all financial crises is the fact that they lead to a lack of liquidity in the financial market of the affected countries, causing some financial institutions to become technically insolvent.
What the above facts denote is a bank crisis, where a country’s corporate and financial sectors suddenly have to deal with heightened amounts of defaults. At the same time, during a banking crisis, financial institutions and corporations are unable to pay contracts on time.
A combination of these events and factors leads to a situation where the sector experiences a surge in non-performing loans. Non-performing loans exhaust the banking system capital and could also lead to depressed asset prices. For example, there could be a reduction of prices on real estate equity. The rapid decline happens after a sharp increase in the asset prices.
The economic situation of an industry usually looks very prospective prior to a financial bubble burst. However, signs of a looming crisis are evident in the high real interest rates present at the moment.
The actual cause of the crisis can be a single incident of a large depositor going to the bank for withdrawal, which leads to a series of borrowings among banks as they try to meet their obligations. Panic then ensues, which causes more depositors to withdraw and further exhaust the available capital reserves of banks, causing the distress.
According to Laeven and Valencia (2008), a currency crisis occurs when there is a normal depreciation of the currency of a country by at least 30 per cent, while the rate of depreciation is an increase of 10 per cent or more as compared to the previous year. Currency crises are more common than banking crises. They can also be attributed to large devaluations of a country’s currency, which temporarily destabilizes currency markets.
In the following section, this paper concentrates on financial crises that mainly affect a banking sector. Going back to the introduction section of this paper, the housing sector bubble in the United States caused an increased demand for deposits from banks because the sector could no longer assure investors the returns that they eyed.
In addition to that, the sector’s assets were attached to bank assets in a previous credit boom that made it easy to obtain financing for assets in the housing sector, such that a drop in asset value led to a collapse of the attached asset value.
Within the housing sector, there were mortgages given to people who technically were not able to pay them back and were, therefore, not ideal customers in the first place.
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Nevertheless, the poor lending habit persisted because the assets were being temporarily shielded from the balance sheets of the banks. That explains why the crisis’ unfolding was under wraps for a while, before finally blowing up as an ugly event in the financial market sector.
Mortgages alone were not the only cause, despite the fact that they had a significant effect due to the hoodwinking of investors using AAA ratings (Acharya & Richardson 2009). Unlike the 2000 crash, the 2008 crash was escalated by large, complex financial institutions. These included universal banks, investment banks, insurance companies, and even hedge funds.
These institutions dominate the financial industry, thus they create a crisis for the entire industry when they all subscribe to a trend that leads to challenges in liquidity. In the case of 2008, these financial institutions disregarded securitization and preferred to go with a transfer of the credit risk to investors.
The intention of securitization is to reduce risk by providing securities that should compensate asset losses (Acharya & Richardson 2009). Securitization helps banks to spread the risk to other investors in minimal concentrations.
Unfortunately, for the 2003 to 2007 period just before the crises of 2008, the banks’ option to use the securitization option was mainly due to the need to go around the capital-adequacy regulations, which have been mentioned earlier in the paper.
They included the requirement for banks to hold capital reserve in proportion of their balance sheet assets. Thus, moving the assets away from the balance sheet by spreading them to investors was a way to reduce the capital reserve requirement for a particular bank (Acharya & Richardson 2009).
In mid-2007, there was an industry wide fall in syndicated loans. The use of syndicated loans denotes a shadow banking system that was in development for the last three decades (Gorton 2009). A syndicated loan is created when a major bank recruits other financial entities to partake of the loan.
While that happened, the United States banks witnessed a surge in commercial and industrial loans on their balance sheet as corporate borrowers placed drawdowns on existing credit lines. A run on the banks emerged following many borrowers going for the credit-line drawdowns. In this case, the situation was not that of uninsured depositors running to the banks to withdraw their money in fear of it going away.
Instead, this bank run was due to short-term creditors, counterparties, and borrowers who wanted as much liquidity as possible on their part because they had concerns about the actual liquidity of the banks and their solvency.
In addition, those who already held debt assets payable by the banks refused to roll them over to allow banks additional time to pay. With a rollover, the banks are able to maintain their liquidity.
On the other hand, the lenders to banks demanded more collateral to back loans and trades. Every activity in the industry was causing a drain on the liquidity of banks and the banks were facing insurmountable challenges of obtaining additional funds to boost their liquidity levels (Gorton 2009).
According to Acharya and Richardson (2009), banks with more deposit financial cut theory syndicated lending by less than their counterparts with limited access to the same facility. In a typical bank run, the banks with more deposits would be adversely affected as they experience surges in withdrawals.
However, as indicated above, the 2008 crisis was different because the bank run was not caused by depositors. Here, the banks with low deposit levels were the most affected because they did not have enough reserves to tap into temporarily to cushion their low liquidity exposure.
Financial crisis in Europe
The European situation for banks was different from that of the United States. In Europe, cross-border banking was the main characteristic of the crisis. In the past decade, cross-border mergers and acquisitions gained prominence in Western Europe. Meanwhile, in the same period, many state-owned banks and mono bank systems transferred to foreign-bank dominated systems (Allen et al. 2011).
The move towards multinational banking was advised by its implications for stability. Banks were attracted by the option of lending funds through local subsidiaries and branches with longer maturity than to go through the option of cross-border lending.
There are less regulatory impediments to the interbank movement of funds to subsidiaries for subsequent lending than it is the case when moving from one institution to another in different national jurisdictions.
With an internal capital market that exists in global banks, it is possible to reduce shocks of liquidity and complement funding from external sources (Allen et al. 2011). Also, in Europe, just like the in North America, big banks opted to move away from a position of originating loans and holding them to a position of originating and distributing the loans.
Securitization tendencies also increased, which moved loans away from balance sheets into structured investment vehicles. There were also sales of derivatives of assets in the form of collateralized obligations (CDOs).
The financial innovation ensured that there was risk diversification and a myriad of new investment opportunities (Allen et al. 2011). These two factors contributed to the popularity of the various aspects of the innovation, which are described above.
The chain lengthened on the intermediaries that were taking part of the risk of the loans and selling them as investment assets to other investors. With a full uptake of the securitized loans from the original lenders, it became less demanding for banks to scrutinize lenders’ ability to repay.
Screening and monitoring systems became lax and the legal obligation for banks was not there. Just like the U.S. situation, most of the assets with distributed risks were off the balance sheet and they did not require an underwriting bank’s reputational obligations.
However, after the reputation of banks came into question, many banks had to bring back the assets into their balance sheets, thereby exposing themselves to scrutiny from investors and regulators.
Scrutiny led to compromises on solvency and liquidity positions. Nevertheless, the securitization was still serving its purpose of regulatory arbitrage. Assets that were not really prime received AAA ratings, which meant that banks and investors could get funding based on these securities without the need for capital charge. To this point, everything went on fine in Europe, until the cross-border operations came into the picture.
The three decades of changes in the major banking institutions in Western Europe that led to their multinational operations also exposed them to the U.S. market conditions.
A good number of the European banks, among other banks around the globe acquired their securities using the “subprime mortgage loans” in the US (Allen et al. 2011). From 2003 to 2007, banks were opting for the wholesale market to seek financing in the global level, instead of concentrating on their national levels.
While intermediation chains increased, the international banks in Europe increased their search for large scale economies. Merging or acquisition became the preferred growth mode and entry into new markets. The emerging economies in Europe had their banks acquired by the dominant banks in Western Europe. After a short while, the largest multi-country banking groups controlled the cross-border bank flows.
As Haldane (2009) explains, the five largest banking groups in Europe controlled more than 16 per cent of the banking assets in 2008. The new figure was more than double of what the banks had a decade earlier. With the ease of moving into new country markets, the big banks were able to cut their lending rates in their host countries by increasing their competition and relying on their cost efficiencies (Haldane 2009).
Consolidation on a multinational scale led to the existence of systematically important financial institutions (SIFIs) (Allen et al. 2011). Moreover, most of these SIFIs also dominated cross-border banking activities among nations. Given these large institutions were from a few countries, the resulting composition of the market was dominated by a small number of countries.
France, Germany, the US, UK, Switzerland, and the Netherlands were home to the largest banking institutions. They, indeed, became the dominant countries for cross-border banking. About 50 per cent of cross-border liabilities were divided among these countries, with the addition of Japan.
There were differences in the manner of operation within the multinational banks. The Spanish banks were highly decentralised, while the Swiss, the US, and Canada banks relied on intragroup funding (Allen et al. 2011). The parent bank was the main source of funds for many Japanese subsidiaries, while Germany and French banks chose to spread their liabilities away from the bank (Allen et al. 2011).
As international banking activity increased, it also led to expansion in international financial markets. A bank plays a key role in enabling organizations to acquire foreign securities. Banks also issue foreign securities and source their credit from different banks. At the same time, the use of the Euro currency in Europe positively influenced the increase in cross-border financial activity.
The financial crisis across the globe
Bank flows were a characteristic of Europe’s cross-border flows. Many other markets in the world also experienced similar changes and their securitization processes mainly included buying or selling of assets as investment vehicles to European banks. Cross-border purchases of securities remain attractive because they provide banks with liquidity options beyond their national boundaries.
As such, banks can still weather shocks in their local economies. However, most of the assets of the euro area banks remained domestic; therefore, buying of securities from these countries would expose the international banks to liquidity challenges that would arise in Europe.
The dominance of foreign banks in the major lending markets also meant that financial industry in the non-western countries were tightly integrated with the activities of the Western European financial market. In turn, these activities were tied to their exposure of subprime mortgage assets offered by financial institutions in the United States.
The increase in efficiency and outreach caused by the entry and the dominance of foreign banks led to increased financial deepening of a country’s financial sector into the international sector.
Ease of access to credit facilities brought by economies of scale of foreign banks also led to an increase in household credit after year 2000. Many banks opted to fund their loan books with non-deposit sources to cope with the high demand of credit. Lending internationally increased and contributed to lending in foreign currency trends.
Getting funds in foreign currency terms meant lower interests for the institutions that were borrowing and bigger profit margins when the same banks loaned within their economies. The lenders on the supply side also favoured using the foreign currency because it eased the funding structure.
This exposure to foreign currency loans also contributed to sufferings by local banks in countries that were, otherwise, geographically detached from the United States and Europe. The interconnections exposed all participants to the vulnerabilities of challenges occurring on either side of the market.
Effectiveness of the Policies and Actions Implemented in Response to the Crisis
This second part of the paper looks beyond the financial crisis and delves into the interventions by policy makers, institutions, and governments to prevent other crises and to mitigate the effects of a crisis.
The section highlights the rationale behind various intervention measures. Some measures are already typically used in the overall sector management, while others like the bailout being special intervention measures to deal specifically with the financial crisis.
The aftermath of the banking crisis in the US spread to the rest of the globe. Europe was a major casualty as compared to other regions. The transfer of vulnerabilities during the crisis from 2007 to 2010 happened rapidly to every interconnected country because of the financial integration of the world. Western Europe experienced a large reduction in cross-border flows.
Elsewhere, the suffering corresponded with the level of integration with the internal financial market. In the U.A.E, the shocks of the crises were felt in the economy due to drop in oil prices and destabilization of overextended domestic banks.
The exposure of local banks meant that they could no longer rely on non-deposit sources of funds from the international market for subsequent lending to their domestic sectors. The lack of liquidity caused the real estate bubble of the U.A.E. to burst.
The fiscal policy response for the U.A.E, just like in many Gulf States affected by the crisis, has been expansionary. The major aims are to stimulate demand and to stimulate activity in the private sector. Fiscal prudence is a natural response to the crisis, as countries realize that the lack of monitoring and adequate scrutiny of banking activities contributed to the extent of losses suffered (Reinikka 2010).
Macroeconomic policy responses to banking crises
There are clear causes that are associated with the 2008-09 financial turmoil. These causes chartered the responses that the crises elicited. These include the global imbalances, low world interest rates, loose monetary policies in the advanced countries, among other probable causes (Serven 2010).
A key lesson from the crisis was the need to have in place adequate focus on systemic risk. The existing regulations focused too much on the management of risk at an individual financial institution level. Compliance with these regulations meant that an institution was well secured and protected against risks in the books; however, the reality as shown by the crisis was different.
Systemic risk acts as a negative externality imposed by all financial firms to the system. The social cost of failure of a financial institution is very high because it causes losses that exceed the private costs of the collapsing institutions. In response, prudential regulation can focus on the micro or macro levels of regulation.
At the micro level, the regulations look at the resilience of individual institutions to exogenous risks (Serven 2010). At the macro level, the regulations look at the management of endogenous system-wide risks (Serven 2010).
The review of the regulations to focus on the endogenous situation of the overall system comes after realizing that actions meant to enhance the stability of individual institutions can actually weaken the stability of the financial system.
For example, the regulation to have capital reserves match the balance sheet assets was one of the reasons that promoted the securitization and use of syndicated loans by institutions in the developed countries. Another example is that an institution, cutting lending as a way of coping with its risk exposure regulations actually ends up weakening other institutions that need funding.
Proposals on reforms look at capital, liquidity of assets and liabilities, leverage, size of complexity, and interconnectedness. There is a view of risk distribution across the financial system. In addition, there is a view of systemic risk evolution over a cycle. Therefore, an intention of new regulations is to have institutions internalize their contribution to the system-wide risk.
They can do this by having capital requirements, using taxation measures, and having other related regulatory changes matching systemic impact. The regulators are able to look beyond the balance sheet of a bank by focusing on systemic rather than big. This comes after Lehman Brothers’ fall. The institutions were relatively small, but had very deep integrations to the financial system that collapsed (Serven 2010).
Another realization that informs the view of regulations as part of a cycle of events is that financial crises are not random events. They always follow booms and the goal is to have booms decelerate gradually to prevent panics and irrational decisions in the market.
Nevertheless, fundamental will always be pro-cyclical. Investment opportunities and credit demand increase when the market is on the upswing. At the same time, riskiness of prospective borrowers reduces because it is measured in relation to market performance. Lack of adequate regulatory policy contributed to the cyclic behaviour as risk-weighted capital requirements decline in a boom and rise in slump periods (Reinikka 2010).
Pinpointing the period between the start and end of a financial crisis is possible, but specifying the exact period of the aftermath is hard. Focusing on the aftermath would concentrate on economic conditions that were challenged by the crisis, such as employment, availability of credit, and the performance of many markets within an economy.
A key distinction of emerging economies and advanced economies is the level of available social safety nets. Without safety nets, the population in emerging economies receives the biggest blow as compared to those in advanced economies.
However, they also face the biggest incentive to get back on their feet and rebuild the collapsed economy. Relying on safety nets has its drawbacks. It increases the demand for funds, away from the financial institutions affected by the crises that need available funds in the economy to shore up their liquidity (Reinhart & Rogoff 2009).
After a financial crisis, lasting effects on asset prices, output, and employment ensue. If there is a reaction caused by the crises, then it is likely to persist for at least half a decade, as the government incurs massive debts with its various efforts to increase private sector output and stimulate overall economic activity.
In theory, monetary policy should contribute to financial stability in an economy. It is usually the short-term response by governments after a financial crisis. Monetary policy is also effective as an overall regulatory tool because it can assume cyclic tendencies to cover the financial cycle.
It could be restricted in the credit and asset price boom and then become accommodating in a crash. However, most regulatory agencies do not prefer to use the monetary policy to administer controls in the financial sector because its traditional role is to manage inflation of goods’ prices (Serven 2010).
Fiscal policy measures can also contribute to financial stability. For example, the removal of widespread tax incentives to borrowing by the corporate sector eventually creates situations working against credit growth. The external policies can also play a role in ensuring financial stability. Most booms in emerging economies like the U.A.E. are preceded by surges in capital inflows.
They also come from financial reforms or overall economic productivity gains, but the share of these factors in the eventual boom is often lower than the capital inflow contribution. In the East Asia financial crisis of the 1990s, countries had borrowed massively from the international financial markets.
The crisis was then caused by foreign creditor runs that caused exchange rates to fall and caused a financial distress. The rationale for controlling inflows of capital is that regulation can help to limit exposure so that credit runs do not cause massive falls in exchange rates or jeopardize liquidity positions of local banks (Reinikka 2010).
Another option for institutions would be to self-insure against foreign creditors. The option has opportunity costs for the capital reserves held to mitigate risks. However, the position could be jeopardized by the move to international insurance that works well at first, until it also becomes intertwined just like the syndicated loans and special investment vehicle assets that caused the financial crisis of 2008 (Serven 2010).
Self-insurance allows financial institutions to deliberately avoid too many linkages with the financial markets, which could jeopardize its ability to cushion itself against liquidity shocks that arise with the collapse of one of the institutions in the tightly linked system.
In Europe, when the effects of the U.S. financial crisis were clear, regulators moved swiftly to dry up the international financial markets. Central banks in various countries moved in to provide enormous amounts of liquidity. They also enhanced availability of foreign exchange swap facilities, with some opting to become purchasers of last resort for many asset markets.
The intervention by central banks was supposed to solve liquidity problems for the involved financial institutions. The central bank’s action would allow banks to have alternative sources of capital to weather the shocks caused by credit runs by providing capital and releasing tight rules on capital reserves.
As other financial institutions refused to roll over their debt and increased their demands of interests on assets, which the concerned banks were unable to provide, the only remaining option was to refer back to the central bank for assistance.
In the United States, the government provided USD 700 billion as an emergency bailout for the banking industry (Clark 2008). A bailout works by letting the government, usually through its treasury department or central bank, to purchase the distressed securities from banks that are facing financial crises.
In the case of the financial crisis of 2008, bailouts meant buying almost all the subprime mortgage backed securities to eliminate the problem that caused the crisis.
In the UK, the government had a similar rescue package to that of the United States, but its intervention was more extensive (Werdigier 2008). Other than just buy the distressed assets and leave the affected back with a clean balance sheet, the UK government’s intervention was to offer banks 50 billion pounds to shore up their capital. The government purchased an equity stake in the banks as a return for its assistance.
The additional capital would help the banks deal with the liquidity problems presented by the crisis. Meanwhile, government’s intervention was meant to create positive externalities in the financial sectors. Preventing a collapse of another bank would provide stability for a whole industry and subsequently reduce chances of collapse in additional institutions.
The rationale behind the action by the UK government was that merely buying of assets was out of date. It would only provide a temporary solution that did not address the cause of the problem. The UK government was also providing 250 billion pounds to assist banks refinance their debts (Werdigier 2008). As the lender of last resort, the Bank of England would double its loans to banks through a special liquidity scheme.
The UK intervention was reacting to possible losses of asset value that would be caused by the publicity of the various banks’ liquidity problems, leading to less demand for their assets and the fall in asset prices.
A value collapse automatically led to a drying-up of credit lines because the value of the assets was attached to the credit facilities enjoyed by the banks in other intuitions. With alternative credit lines from the government, the respective banks would still be able to operate in a stable manner.
Another intervention by the United States, as part of the bailout plan, was to increase the insured limit of US bank balances from USD 100,000 to USD 250,000 (Clark 2008). In other countries, the bailouts by the United States government and the United Kingdom governments were examples to follow.
However, in other countries, asking banks to increase their capital reserves would not be possible in markets that experienced heightened credit risk avoidance. Even the cross-border banking situation of the European major banks would not suffice to change the situation; most of their assets were held in the local economies.
Besides, the international financial markets were already dry due to various actions by policy makers (Allen et al. 2011). Banks could only look for assistance from their governments (Werdigier 2008). Meanwhile, governments had every intention to offer bailouts because they wanted to limit the effects of the financial crises to their economies.
Long term responses and mitigation plans
Long-term interventions by institutions and policy regulators will likely mirror cyclically sensitive capital charges and provisioning schemes. Governments will most likely seek to make it costly for banks to use financial intermediation as a way of moving assets away from their balance sheet and escaping regulatory scrutiny.
With taxes on financial intermediation, banks would have to really consider their risk exposure and reputation of assets before they purchase or sell within the financial intermediation chains. This should contribute to a system-wide increase in risk awareness and make financial crises avoidable (Serven 2010).
Emerging economies that were exposed to the financial sectors of the developed countries and those that were affected by the global turmoil should focus more on macro sensible reforms. They should continue using fiscal policies to stabilize their financial systems.
In the U.A.E. large fiscal spending by state governments was instrumental in mitigating the effects of reduced purchasing powers in the economy as credit lines dried up due to the global financial crisis. Spending by the government also helps to increase economic activity and cushion local businesses from liquidity problems affecting banks.
It is also supposed to increase deposits to banks by organizations that are direct beneficiaries of the government spending. The overall effect is a more stabilized economy, with every sector benefiting from the government intervention to stimulate growth (Reinikka 2010).
European policy makers and individual institutions will continue to favour cross-border banking because it can positively contribute to risk diversification. While engaging in cross-border banking, domestic banks will need to take cautionary measures to ensure that they also adequately expose their capital outside their countries, as much as they can easily obtain capital from international market.
As the paper discussed, one problem with too much reliance on capital inflows is that foreign banks can decide to ‘cut and run’ (Allen et al. 2011).
To foster the benefits of cross-border banking and to limit its associated risks, policy makers continue to the present rules of engagement among financial institutions with a view of stabilizing the system, such that the entire European Union is well diversified outside the region (Allen et al. 2011).
Overall, the policy responses will rely on the nature of a crisis. As shown above, the central banks have to tighten fiscal policies, while at the same time being ready and willing to provide liquidity support. This is important because monetary policies help to contain market pressures, but they may also lead to heightened liquidity problems.
As the various examples show throughout the paper, intervention should happen quickly to avoid associated externalities of a systemic crisis (Laeven & Valencia 2008). Taking too long to intervene in the hope that an institution will recover can present unwanted stress on the entire system and cause bigger problems.
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