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Role of International Financial Institutions in 2008 Financial Crisis Cause and Effect Essay


Introduction

Late towards 2007, the earliest effects of 2008 financial meltdown were already being felt at some sectors of economy in several countries, notably in Europe and America. The financial crisis that would later become apparent throughout the year 2008 did not only catch the world unaware but would later turn out to be the worst in recent times.

The 2008 credit crunch did not only result to worldwide financial crisis but also caused slowed economic growth of the world’s largest and leading economy that eventually triggered the global recession that started as early as 2006 (Hines, 2008).

In fact, the global credit crisis that is just ebbing away has its roots in United States banking system and more specifically as a result of lending towards mortgage housing and credit lending in general as we shall get to see in the following chapters.

In 2005 the United States housing industry flourished and reached its peak in terms of value and business bustle, by then the banking industry had aligned their lending funds towards this end as a result of the positive and sustained growth in the housing industry.

This is the point from which we shall trace the major root causes of the 2008 financial crisis; this paper intends to show that the current regulatory standards instituted by various financial institutions internationally largely contributed to the 2008 financial crisis.

Even more disappointing is the fact that the financial regulatory standards that were in place were unable to anticipate and therefore avert the ramifications of the financial crisis before it happened as should have been the case.

Background to the Financial Crisis

In order to understand how the financial crisis came about it is important to review the factors that culminated to the widespread credit crunch that finally caused the 2008 financial crisis. By reviewing these factors it will be possible to identify specific financial regulatory standards that can be directly attributed to the crisis.

But first let us briefly define what the term financial crisis implies in this context, which incidentally is our first indication that the recent financial crisis was largely a function of the failings of the international financial institutions policies.

Credit crisis is a term that has been coined to describe the situation whereby accessibility of loans or credit finance becomes limited due to their unavailability. It is a trend that results to financial institutions reducing the amount of loans that they can disburse to clients irrespective of increased interest rates that they can charge on such loans (Pattanaik, 2009).

In these circumstances, prerequisite conditions that are necessary before the loan can be disbursed are therefore reviewed and made stricter in order to limit the amount of credit finances that can be disbursed (Graham, 2008).

Credit crisis is said to occur when the relationship between interest rates and credit loans being disbursed are heavily skewed, or when there is a general reduction of loans available in spite of increased demands (Pattanaik, 2009).

Ideally the relationship between interest rates and availability of financial credit is such that increased interest rate in the market means that financial institutions are willing to increase lending in order to increase profits. Thus, because financial institutions are regulated by internationally accepted financial standards, their failure is therefore a reflection of these international financial regulatory standards.

In a journal article by Acharya et al that sought to investigate the causes of 2008 financial crisis, it directly attributed the crisis to have been triggered by the housing market collapse which occurred as early as 2006 (Acharya, Philippon, Richardson and Roubini, 2009).

It is during this period that two prominent financial players in the housing market collapsed; the Ownit Mortgage Solutions Company and New Century Financial in what should have signaled to the policymakers that housing market was crumbling (Acharya et al, 2008). But instead no body realized this and the financial situation continued to aggravate further.

By the time in what is now referred as housing bubble busted most banking institutions have invested significant amounts in the housing industry that had accumulated over time in a sort of loose credit lending.

The aftermath was increased mortgage payment defaults and foreclosures on existing loan repayment that was taking place on large scale. The steps that led to increased forfeiture of loans by lenders can be analyzed in the following steps.

The first step was the induced easy loan terms and reduced interest rates by the banks tailored for housing finance (Hines, 2008). These incentives nudged borrowers to take up substantial mortgages with prospects of future renegotiation on mortgage terms and rate with hope of easier rates.

In addition due to growth boom in the housing industry borrowers easily took up mortgage loans as an investment option with intention of selling the properties at higher values at a later time and this kept on happening (Hyoung-kyu, 2007). As we shall later discuss in this paper, this should not have happened with strong financial regulatory standards in place.

Underlying all this was the fact that more housing constructions were taking place as investments funds that financed housing sector flowed from every other sector of the economy.

By the time the housing bubble eventually busted many players had invested substantial amount of money in the industry that could not be written off easily without encountering huge losses that would lead to bankruptcy. This is because the housing value plummeted at a rate that had not been foreseen.

The bank reacted immediately by increasing mortgage interest rates and phasing of earlier easy mortgage packages, additional lending on mortgage was tightened and all forms of lending in general almost halted (Acharya et al, 2009).

The borrowers on the other end moved to dispose-off housing properties and salvage finances that could still be obtained from the mortgages, thereby triggering drop in house values. In the resulting scenario many borrowers choose to forfeit their mortgage to the banks rather than sell the houses in a collapsed market since it would have eventually cost them additional funds to settle the difference (Hines, 2008).

The other option of financing the full cost of the mortgage was now complicated by increased interest rates, and so now the credit crunch nightmare had began. In fact, housing industry is not the only sector that hoodwinked consumers to apply for large chunks of loans; it was the same case in automobile industry and in credit cards.

Increased availability of liquid cash from foreign reserves had prompted the financial sector to invent financial packages such as Mortgage-backed securities (MBS) and others like Collateralized-Debt Obligations (CDO) (Rose and Spiegel, 2010).

Both of these are forms of funds that allowed investors to finance the housing industry and gain financial returns through banking institutions.

The consequences of housing industry collapse was therefore greatly felt by the banking institutions that had advanced loans in all the three sectors that were hardest hit, these sectors were the first to announce financial losses (Rose and Spiegel, 2010). It is from such financial reckless practices as this that exposed further the financial institutions to the shocks of financial crises similar to the one experienced at the time.

Thus even at this point we get to see how lack of financial regulatory oversight failed and thereby directly contributed to the financial crisis itself, which is a factor that would become even more apparent as we discuss the major factors that caused the financial crisis itself.

Major Factors Attributed to Financial Crisis

To understand how the international financial regulation policies might have contributed to the financial crisis, let us discuss the major factors that significantly contributed to the financial crisis and investigate the failure of financial regulatory oversight for each of them. Credit crisis is a phenomenon that can be triggered by any of the various factors in the financial sector or combination of several such factors.

There are mainly five reasons that directly affect financial institutions loans and which in extension can trigger a credit crisis assuming they happen all at once. One of the reasons is anticipated fall in value of collateral assets that are used by creditors to obtain loans from banks (Graham, 2008).

In this case the financial institutions become reluctant and unwilling to give out loans that are secured by such assets where all indications points to their market values plummeting.

Other reasons could be sudden exogenous adjustment in regulation by central bank that touches on lending requirements by banks or which elevates reserve requirements (Graham, 2008).

In both these two circumstances, Basel I and Basel II guidelines have been specifically developed to address this challenges by setting levels at which financial institutions should maintain their Capital Adequacy Ratio (CAR) and Capital to Risk Assets Ratio (CRAR) (Claessens, 2008).

Capital Adequacy is a financial term that is used to define the regulatory guidelines that requires financial institutions such as banks to reserve certain percentage of their Primary Capital Base that is consistent with the institutions lending (Basel.org, 2000).

A bank must ensure that its capital base assets are at a minimum of 8 percent of its assets; the rule of thumb that applies is lending of $12 for each single dollar of the bank’s capital (Scott, 2005). The purpose of calculating capital adequacy is to ensure that a bank is not exposed to financial risks that are caused by the lending policy of the institution.

These regulations were developed by the Basel Committee on Banking Supervision which redefined the international Capital Adequacy standards on 2004 that are now used to regulate financial institutions all over the world (Rasmusen, 1988). As we can therefore infer from the happenings of the 2008 financial crisis, most banks were not adhering to these standards as set out by Basel II guidelines.

The central bank might also trigger credit crunch through regulations that intend to tightly control financial institutions lending. In such instances the banks usually respond by enacting measures that prevent their loss or transfer their operating risks to the creditors usually through increased interest rates of loans or reduction in lending.

However these factors alone cannot by their own trigger credit crunch, more often credit crisis is caused by an array of factors that combine together over a long duration of time. The hallmarks of a credit crunch usually include extensive sustained losses by lenders caused by sloppy and hasty lending policies over given period of time as was the case in 2008.

Sometimes it is due to plummeting of collateral assets that were used to secure loans which substantially lose value overnight as it also happened to the United States housing industry. When this happens the bank sustains huge losses caused by loss in value of the assets.

The implications that follow are two parts: the bank has no adequate loan reserve that they can continue to disburse to future consumers, and two despite the availability of loans the banks becomes timid and cautious towards future lending (Hyoung-kyu, 2007).

The next phase of credit crisis is limited lending and inaccessibility of the loans by consumers and lack of funds in general that virtually affect every other sector of the economy triggering what is then referred as economic recession (Hines, 2008).

This therefore are the major factors that are likely to cause a financial crisis, some of which as we have seen were attributed to the 2008 financial crisis.

However the effect of a credit crisis last for sometime only depending on the extent of loans that were disbursed by the banking industry, and the extent in which the losses can be absorbed assuming the banks affected were not much. In the following section we are going to analyzed in detail the specific financial regulatory policies that were flaunted by the financial institutions culminating to the 2008 financial crisis.

Failure of Financial Regulatory Standards

The Bank of International Settlements (BIS) is an international financial institution body based in Switzerland that serves two important functions; develops and promotes financial policies and provides banking services. IMF on the other hand has the mandate to regulate global financial systems notably in two major areas that include balance of payments and stabilizing exchange rates.

For this reasons BIS is better placed to influence the outcome of financial crisis since it is the institution that is mandated with the responsibility of developing various monetary policies.

In fact BIS has very specific mandate to set and regulate one of the policies that is at the centre of the financial crisis i.e. CAR as we have so discussed. As a result it is the major sponsor of both Basel I and Base II financial regulations which are crucial in regulating safe lending as we shall get to see shortly

The shortcomings of Basel financial frameworks have been apparent for as long as the first guidelines were instituted. Despite the many advantages that Basel guidelines were promoting, they also had inherent advantages. When Basel I accord was implemented its focus was on setting the minimum possible capital levels for financial institutions and also ensuring that banks embraced low value assets as collateral.

The flip side of this rationale was an increased risk to financial institutions brought about by incomplete analysis of the dynamic market parameters. As a result numerous changes were required to be made on basel I frameworks which culminated with development of basel II accord.

One such amendment was in 1996 for market risk that saw the CAR expanded to incorporate the risks associated with other financial market force. However even then Basel I accord had still other inherent limitations (Basel 2000). The Capital Adequacy calculation for instance did not provide an accurate and reliable financial guideline for determination of CAR (Basel 2000).

Another disadvantage under Basel I accord was the tendency of the banks to undertake regulatory capital arbitrage which enabled them to manipulate their core capitals in order to reflect favorable capital assets that made them compliant, lastly the accord did not offer ideal risk mitigations approaches to banks (Basel 2000).

Hence Basel II was born in 2004 to address these shortcomings and incorporate other challenges that banks were facing in the financial sector. Throughout this period we can see how the BIS sponsored financial policies was wrecking havoc and promoting a culture of dubious financial dealings that financial institutions kept even after these guidelines were overhauled.

The new Capital Adequacy calculation is guided by three core principles that are referred as pillars: market discipline, operational capital requirement, and supervisory review (Basel 2000). Pillar number one pertains to regulatory capital of three critical risks that a bank encounters during it routine financial operations: market risk, credit risk and operational risk.

For each of this risk the accord provides various calculation techniques that set the desired level of accuracy such as standardized approach, foundation Internal Rating-Based (IRB) approach and advanced IRB for calculating credit risk (Basel 2000).

The underlying working definition of capital categorizes banks equity into two groups: tier I capital and tier II capital. Tier I Capital is defined as the actual equity inclusive of retained earnings while Tier II Capital is the subordinated debt in addition to the preferred shares (Basel 2000).

Tier I capital are financial institutions assets that can absorb financial losses of a bank during trading without necessitating the bank to enter into bankruptcy. Tier II capital are the other type of assets that are reserved primarily to absorb losses of large magnitude during the event of bankruptcy.

It is this categorization of financial institutions capital that has provided a loophole for banks to circumvent and thereby lend more than they should ideally be allowed through invention of concepts such as financialization.

For instance capital adequacy ratio is calculated by dividing the bank primary capital by the sum of the bank’s assets (Basel 2006). The core capital is a sum of both Tier I and II capital while assets in this case refers to the weighted assets or the minimum requirements as set by the banking regulator, such a ratio should not exceed the Basel accord threshold level that is set equal to or less than 8%.

The CAR is further adjusted to calculate the three other subcomponents of the capital adequacy namely: standardized approach, basic indicator approach and advanced measurement approach that offer varying degree of accuracy (Basel 2006). For this purpose the approach used in calculating risk weighting requires the bank to categorize the nature of the assets into two: fund based assets and non-funded assets (Basel 2006).

Fund based assets usually include bank investments, loans and liquid cash at its disposal, while non-funded assets include items in the Off-Balance sheet that are first taken through a series of conversions in order to ascertain their true value.

Despite these elaborate calculations it is still possible for a bank to obtain a positive ratio if factors that affect market risk are not considered. What we know for a fact is that somehow just before the 2008 financial crisis; most financial institutions have been flaunting or circumventing basel II accords en masse up to the time of the crisis.

One of the recent advanced theories in economic studies that attempts to explain the cause of the 2008 financial crisis has been advanced by Foster and Magdoff. Foster and Magdoff theory attributes the 2008 financial crisis to the broader factors of monopoly finance capitalism which is a function of a phenomenon that they refer as stagnation that is characteristic of all mature capitalist systems (Foster and Magdoff, 2008).

Foster and Magdoff describe mature capitalist system as “stagnant” because of its monopolistic nature that is caused by few corporations that dominates and control most of the available capital flow (Fostor and Magdoff, 2008).

When this happens as it has been taking place since the 1980s less capital becomes available for investment in economic sectors that are most in need while the real capital becomes restricted and unavailable, this outcome is what Foster and Magdoff also attributed to the occurrence of financialization.

The implication of this unbalanced excessive capital availability in particular sectors only creates demands for investment opportunities that offer high returns and this is where the evils of monopoly-finance capital begin. Hence, from a more general perspective based on Foster and Magdoff theory monopolistic finance capitalism which are a function of international financial policies are to blame for the 2008 financial crisis.

More specifically let us see how financial policies notably in United States which was the epicenter of the financial crisis systematically led to the 2008 credit crunch. One was the housing market boom and bubble that was characterized by low mortgage interest rates, increased availability of funds that pooled borrowers to taking unnecessary and inflated mortgages (Gjerstad and Vernon, 2009).

Borrowers and investors in the process saved less and substantial funds were channeled to this sector, by the time the housing market was collapsing more than $10 trillion dollars was approximately held in the industry.

The upshot was more than 50% of home owners that had negative equity or houses that just equaled their mortgage values which could not be sold due to house surplus in the market and cheap going prices (Gjerstad and Vernon, 2009). This was a major lax of the various financial oversight bodies that had the mandate to foresee and prevent such a ballooning financial effect that was taking place in the housing sector all this time.

It is for this reason that the 2008 European head of States seminar resolved to have “An early warning system must be established to identify upstream increases in risks” (Rose and Spiegel, 2010).

Perhaps one of the most blatant disregard to financial policies that took place at this time was by the financial institutions in their rush to make a killing from the booming housing market.

In fact the financial institutions are to blame for the amount of mortgages that borrowers had obtained that were purely for speculative purposes and therefore for investment only, which is not actually a bad thing unless there are no policies to regulate such a widespread speculative investment.

By 2006 the number of mortgage and houses that had been secured as investment options were approximately 40% of all the total houses in the market (Gjerstad and Vernon, 2009). This was the main factor that greatly contributed to the housing surplus that made their price falls.

Another cause was the securitization, a term that is used to describe a practice where bank can transfer the value of the mortgage to their investors and therefore continue to obtain further funds for lending to borrowers (Gjerstad and Vernon, 2009).

Ideally banks are supposed to hold on the mortgage as security until they are paid in full or forfeited; these way additional funds cannot be secured until such time when any of the two outcomes occur. But of course the banks in their rush to lend and make profit out of the interest disregarded this policy.

So as it turned out securitization system allowed banks to continue pumping funds to an already saturated sector while hoodwinking investors to believe housing industry to be thriving by transferring mortgage agreements to them. In the process the banks were able to ease the lending terms and lower rates due to availability of funds in a bid to disperse as much funds as possible and therefore make profits.

In fact, lending conditions to borrowers were even questionable verging on illegal practices, figures released by Federal Reserve indicates that 47% of borrowers did not make any down payment of the mortgages as required by law (Gjerstad and Vernon, 2009).

Over time borrowers were not required to provide evidence of income nor employment as is usually the tradition, instead banks focus was on credit score which depended mainly on the amount that a borrower had in the bank beside other factors.

The problem was that the system used to calculate credit ratings was flawed in the first place and ended up misguiding investors on the value of borrower assets.

Currently, the inflated credit ratings that were given to Mortgage-Based Securities (MBS) by credit rating agencies are now under investigations since their high ratings allowed transfer of MBS to investors who later ended up holding less valuable MBS than they initially paid for them (Gjerstad and Vernon, 2009).

The government too was to blame for some of its policies which were clearly self defeating; this was because of the government policy that had been put in place mortgage policies which had the vision of promoting home ownership among Americans across the boards through legislations such as Alternative Mortgage Transaction Parity Act (Hines 2008).

As far as 1995 the government had started issuing tax rebate to all persons with mortgage. This and other government policies that also failed to control use of adjustable-rate mortgages which do not favor borrower in the long run resulted in fueling a housing boom that was already getting out of control under the very noses of financial policy makers.

Thus, as we can see the inability of the government to intervene and enforce existing financial regulatory standards during the whole process also contributed to the financial crisis.

While the US was dishing out numerous and unsecured mortgage loans to its citizens, Britain was also experiencing increased lending of loans to finance home but not at the unprecedented rates as witnessed in United States.

For the rest of the world the global recession was hardly caused by mortgages but by collapse of industries that relied on investor funds that had now been retracted by timid investors and by international companies that were affiliated to US companies that had collapsed in the process (Saltmarsh, 2008).

For many businesses the problem was the lack of funds to sustain daily business operations due to the credit crunch emanating from United States. Most third world countries financial institutions are tied up with foreign international financial firms though they always function independently.

These local financial institutions therefore adopted strict loan disbursement policies in the wake of the subprime crisis. Without access to regular funds that medium and small businesses have always relied on, most of the businesses had to close down thereby causing unemployment. As a result the most affected businesses in developing countries were the ones exporting goods to developed countries in America and Europe.

Most of the businesses exporting commodities were the agriculture sectors, mining, and oil industry. Countries that predominantly relied on agriculture earnings through exports were required to export less due to fall in demand or suspended their exports all together. In the tourism sector the trend was the same with less people unwilling to spend in holidays.

Overall the foreign reserves of many countries which are almost always in form of dollar shrunk affecting virtually every other sector of the economy (Saltmarsh 2008). The result was world economies hampered by lack of products market and liquidity funds to sustain growth.

As the financial crisis reached its peak in 2009 many countries sprung to action with measures to halt and reverse the economic recession phenomenon by injecting billions of funds. The United Stated was the first to undertake an assortment of measures contained in the economic stimulus package that was signed into law by President Obama (Grabel and Weaver, 2009).

The stimulus plan included $787 billion that aimed at reinstating and creating more jobs that were lost during the recession in addition to stimulating the economic activity and consumers spending (Grabel and Weaver 2009). But without restructuring the financial policies that originally contributed to the 2008 financial crisis, the world economies has been recovering at a slower rate than should have been the case.

Conclusion

As one gets to analyze the facts that caused the financial crisis the extent of the housing market speculation is notable and significant whereby all the actors in the economy from consumers to bankers continued to pump more funds in housing industry as investment options.

For this to have happened the weakness is seen to have been the breakdown of the international financial regulatory policies as we have so far discussed. Indeed, the failure of the international regulatory institutions to intervene and provide an oversight mandate is seen to be the critical factor that led to the occurrence of the financial crisis.

At present policy makers continue to investigate and implement measures in order to avert a similar financial crisis from occurring in future and ensure it does not occur unnoticed as it happened in 2008.

Meanwhile world governments remain apprehensive as the last impacts of global recession continues to recede without clear indications of what exactly needs to be done in order to insulate economies from what appears to be the failings of international institutions of financial regulations.

References

Acharya, V., Philippon,T., Richardson, M & Roubini, N. (2009). The Financial Crisis of 2007-2009: Causes and Remedies. Financial Markets, Institutions & Instruments, 18(2): 89-137.

Basel.org, (2000). . Consultative Paper Issued by the Basel Committee on Banking Supervision. Web.

Claessens, S. (2008). The Political Economy of Basle II: The Costs for Poor Countries. The World Economy, 31(3): 313-344.

Claessens, S. & Dell’Ariccia, G. (2010). Cross-country experiences and policy implications from the global financial crisis. Economic Policy, 25(62): 267-293.

Foster, J. & Magdoff, F. (2008). The Great Financial Crisis: Causes and Consequences. New York: Monthly Review Press.

Graham, T. (2008). The Credit Crunch: Housing Bubbles, Globalisation and the Worldwide Economic Crisis. London, UK: Pluto Press.

Gabor, D. (2010). The International Monetary Fund and its New Economics. Development and Change, 41(5): 805-830.

Gjerstad, S. & Vernon, S. (2009). From Bubble to Depression? Why the Housing Bubble Crashed the Financial System but the Dot-com Bubble Did Not. Wall Street Journal, 15 (9): 165-172.

Grabel, Michael., and Weaver Christopher 2009. . Web.

Hyoung-kyu, C. (2007). Do markets enhance convergence on international standards? The case of financial regulation. Regulation and Governance, 1(4): 295-311.

Hines, P. (2008). From Crunch to Squeeze: Global Impact of the Credit Crisis on Commercial and Small Business Lending. Web.

Pattanaik, S. (2009). The Global Financial Stability Architecture Fails Again: sub-prime crisis lessons for policymakers. Asian-Pacific Economic Literature, 23(1): 21-47.

Rose, A. & Spiegel, M. (2010). Cross-country Causes and Consequences of the 2008 Crisis: International Linkages and American Exposure. Pacific Economic Review, 15(3): 340-363.

Rasmusen, E., (1988). Mutual Banks and Stock Banks. Journal of Law and Economics, 31(2): 188-199.

Saltmarsh, M. (2008). . Web.

Scott, H., (2005). Capital Adequacy beyond Basel: Banking, Securities and Insurance. Washington, DC: Oxford University Press.

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