The financial crisis that was bringing devastation of the financial markets in the United States and the world originated in an inflated asset price together with the financial novelties that masked risk. Kunt, Evanoff, and Kaufman say that the lack of capital or excessive leverage was only one of the culprits in the disaster. Moreover, raising capital requirements was an important step towards a more stable financial sector (59).
The causes of the global financial crisis were rather complex. Sun, Stewar,t and Pollard say that the global financial crisis began with the United States subprime mortgage crisis in 2007, which was triggered by the bursting of a housing bubble in the United States at the end of 2006 (2). The subprime mortgage crisis was both a real estate and financial crisis and was marked by a sharp rise in mortgage delinquencies and foreclosures and dramatic decline in the market value of subprime mortgage backed securities (Kunt, Evanoff, and Kaufman 59). There was a large drop in the capital and liquidity of many banks and financial institutions, as well as widespread tightening credit (Sun, Stewart, and Pollard 2).
According to Sun, Stewart, and Pollard, the financial crisis originated from the credit crunch in the United States, spread quickly to other sectors and countries and caused a series of financial and economic crises, such as the collapse of United States and European housing markets, in a domino effect (2). Sun, Stewart, and Pollard also noted that the financial crisis led to the collapse of the global financial systems, financial markets, and many large banks and financial institutions (2). The cost of the negative consequences of the financial crisis was immense.
According to Kunt, Evanoff, and Kaufman, the G20 leaders in 2008 noted that the financial crisis was caused by market participants who sought bigger products in absence of enough gratitude of the dangers and failed to use appropriate due carefulness (59). Also, feeble guaranteeing principles, unsafe risk mitigation measures, progressively more multifaceted and obscure monetary stuff, and consequential unwarranted influence combined with generating loopholes in the coordination (Kunt, Evanoff and Kaufman 60).
Laws and policies which lead to the crisis
Baker and Nofsinger contend that monetary and housing policy played a notable role in the financial crisis and encouraging a housing bubble (249). To this view, the policy makers kept short term interest rates too low before the crisis and, thus, encouraged too much debt to be built up in the housing sector along with the development of riskier financial strategies such as borrowing short and lending long. Baker and Nofsinger say that the monetary policy was appropriate before the crisis and did not lead to the housing collapse (249).
The financial crisis demonstrates that the outcome of the monetary and housing policies put both the mortgage markets and homeowners at greater financial risk. Baker and Nofsinger say that these policies had the effect of bringing many financially vulnerable households into the market at the peak of the housing boom when homes were least affordable (250).
Research shows that small interest charges on loans and a growth of monetary and venture prospects in the United States and Europe, which were the result of the invasive credit expansion, increasing complexity of mortgage securitization, and loosening in underwriting criterion that were pooled with extended connections, were some of the effects of the monetary policies that led to the financial crisis. This fast rate of expansion led to the rise of the values of equities, commodities, and real estate. The mixture of higher commodity prices and rising housing costs pinched consumer’s resources and they started decreasing their expenses, which led to the contradiction in the prices of housing (Jackson 8).
Within the housing policy, it was noted that the loss of trust in credit markets, which was coupled with a slide in the United States housing market, was triggered primarily by rising defaults in the subprime mortgages (Jackson 8). A strong slide in the in mortgage markets commonly negatively impacts the parts of the economy; however, the present financial crisis rapidly grew to a more general crisis of liquidity, which extended far beyond the subprime mortgage market.
The shadow banking system
The banking system played an important role in the financial crisis. In his studies, Jackson indicated that the economic crisis that started in the United States and extended to European banking system via the effects that were experienced in the market for asset backed commercial paper (ABCP). This happened on the basis that the Eastern banking systems were either honestly holding the bonds or having them obliquely through conduits and clearly formulating investment vehicles with similar affluence (Jackson 9). As the ABCP market crashed, the financial institutions holding such guarantees were forced to step in with supplementary subsidy, which constricted liquidity in the global fiscal marketplace through the interbank market (Baker and Nofsinger 251).
Central banks in both United States and Europe engaged in direct injections of capital to support the banks’ balance sheets and withdrew some troublesome bank assets by buying them (Jackson 8). These attempts to buy the distressed bank assets started questions due to the value of the assets that mainly had fallen below the value that was indicated on the bank balance sheets (Jackson 9). During the financial crisis, one of the fundamental issues facing the central banks was differentiating between troubled markets and troubled institutions.
The European Central Bank granted the large amounts of reserves through the standard short and long run open market operations. Jackson says that after the reduction of the interest rates and supplying the banks with liquidity by transferring the capital directly to the banks, the Federal Reserve and other central banks in Europe broadened short run bilateral currency exchange facilities by $180 billion in order to reward dollar liquidity crisis (10). As credit markets seized up, these institutions understood that they did not have an access to short term dollar financing. European banks had difficulties obtaining US dollar funding. Jackson mentioned that preceding the financial crisis, the European banks had immensely broadened dollar accumulation on the interbank scale and from the official monetary authorities that had bought the assets of the denominated dollar (9).
The actions of the institutions involved
Research shows that the shortage of confidence in credit market and absence of liquidity also triggered anxiety over the capabilities of capital supplies of financial institutions, as well as the anxiety about the banks’ and other firms’ solvency. Institutions, such as the Central bank in Europe, responded to the currency shortage by providing currency from their own foreign exchange reserves and by borrowing it from other central banks, principally from the central bank that issued the currency. Jackson says that the International Monetary Fund (IMF) was a major institution that was involved and approved a shorter liquidity facility to help banks facing liquidity problems. The European central banks as institutions initiated other round of cuts in interest rates. At the same time, the national governments also began to intervene through their respective Treasury departments to take control of insolvent banks or otherwise to provide financial assistance (Jackson 17).
The ways in which the crisis was managed
Governments responded to the financial crisis in a way of conducting macroeconomic measures of stimulus to deaden the effects of the economic crisis. In October 2008, Federal Reserve in the US and central banks the European countries, the United Kingdom, Canada, Sweden, and Switzerland organised a coordinated cut in interest rates to improve liquidity, and announced that they had an arrangement of accomplishment to attend to the ever widening economic crisis. Jackson says that the US Treasury in association with the Federal Reserve announced its Capital Purchase program being a part of its Troubled Asset Relief Program and negotiated an infusion of capital in return for ordinary shares for eight major United States banks (15). At the same period of time, the United States Federal Reserve cut key interest rates by half a percentage point, a move that was matched by China and Norway. The financial crisis was countered through new financial market architecture at the European Union level. Baker and Nofsinger say that rapid and consistent implementation of the bank rescue plan that was established by the member states and decisive measures were designed to contain the crisis from spreading to all of the member states (250). As the financial system stabilized, the next step was to restructure the banking sector and to return banks to the private sector. In the United States, it was proposed that banks should not lent their capital straight for the borrowers but use it as a means to help them overcome the losses from lends and different bank activities.
Towards the end of the financial crisis, the national governments in Europe and Federal governments in other parts of the world suggested to consider a number of proposals to restructure the supervisory and regulatory responsibilities over the broad, which based financial sector within the United States and other countries (Jackson 3). At the same time, the international organizations such as the G20, the Financial Stability Forum, the International Monetary Fund, the Organization for Economic Cooperation and Development and the Bank for International Settlements suggested their own instructions for the international financial markets. Over the long period of time, the United States and European Union should seek a scheme of regulation, which would provide more of stability, not making one country privileged over the others.(Jackson 3).
The financial crisis and the economic downturn have become historical events. They are likely to dominate the attention of policymakers and other regulators for a long period of time. Jackson says that the administrations that have prolonged substantial funds using financial and economic course tools in order to soothe the monetary system and supply or enhance the economic state may be demanded to be gradually more creative in provision of even more incentives to their financial system and encounter political turbulence among population (3).
It is important that the United States, European Union, and other countries share a common goal in suggesting a good fiscal architecture to develop the regulations of individual institutions and international markets to avoid a repeat of the financial crisis. This implies that both the United States and European Union should invent the organization and structures within national economies that can provide oversight of the different segments of the highly complex financial system.