Table of Contents
- Causes of current financial crisis
- Strategic complementarities in financial markets
- Regulatory failure
- Asset-liability Mismatch
- How systematic risk has spread across the globe
- Effect of financial crisis on investment and credit
- How the G20 responded to the shock
- Higher quality of capital
- Measures the Fed has implemented to ensure the flow of credit
- Capital adequacy
- Banking regulations
- Related Free Economics Essays
The Current financial crisis is often referred as the global recession or global financial crisis. The late 2000s financial is considered to be the worst financial crisis since the massive depression which took place in the year 1930. The 2000’s global crisis caused a collapse of many large financial institutions globally. It also contributed to failure of businesses and decline in the consumer wealth; all estimates were done in dollars. The 20th century financial, global crisis affected both the developed and developing countries. Governments of different countries had even bailed out their financial system using rescue packages. Global financial meltdown affected the livelihoods of almost everyone globally. High levels of inflation resulted in a change of prices of both goods and services. The high cost of goods and services affected the living standards of people negatively. The crisis began in US, in the summer of 2007, and spread to other nations affecting their economies. Three years down the line, policymakers and economists, still cannot answer what caused financial crisis. They all had different argument as to what the causes of the global financial crisis. For example, Bernanke, 2009, White, 2010, and Portes, 2009 argue that the financial crisis happened as a result of the widening global imbalance and associated capital flows. According to Taylor (2007) the global crisis happened as a result of increase in the demand of housing, sensitive to money interest rate. (Davis 60)
Causes of current financial crisis
Researchers and economists have come up with different theories to establish the cause of global crisis. Below are some of the results that they established.
Uncertainty and herd behavior,
A mistake in investment is often caused by lack of knowledge or imperfections of human reasoning. Herds’ behavior refers to how individuals act collectively without planned direction. Such activities include the stock market bubbles and crashes, street demonstration, sporting events, religious gathering, judgment and opinion-forming. Uncertainty and herd behavior can be taken to be the chief causes of financial crisis. It is one of the measures used to prevent financial crisis late 2000’s.
Strategic complementarities in financial markets
Success in investment requires application of game theory. Game theory applies where an investor makes a decision based on what the other investor’s decisions. For example, someone may think that an investor opt to buy a lot of US dollars because he or she expects the value of the dollar to appreciate in value. Therefore, he or she will have an incentive to buy the dollars. Another example, an investor may withdraw his or her funds from a bank because he expects it to fail. Therefore, causing withdraws of funds by other investors. The current global crisis was caused by the strategic complementary in financial market, some of the investors shunned from investing in other institution and asset because they expected other investors to invest. This explains why financial crisis takes the form as a vicious cycle. (Davis 100)
Leverage refers to borrowing funds in order to finance an investment. When financial institutions invest using their own funds, there high chances that they can lose their own money, putting them in critical conditions. Therefore, for it to reduce the risk it invests using the borrowed money and its own money, if the investment turns out to fail the institution could be left bankrupt. Bankruptcy means that the company will not be able to meet its obligation in payment of the borrowed funds. Therefore, it may spread the financial trouble to other firms, and it might be noticed in the whole world. In the current financial crisis leverage is seen as one of the main causes of global crisis.
It is the work of the government to eliminate the financial crisis by ensuring regulation of the financial sector. The current global financial crisis is thought to be caused by the reluctant regulation of the financial sectors in some countries. The major objective of regulation is transparency; this is making sure that the financial institutions adhere to the requirements of standardized accounting procedures. The other main objective of regulation ensures that institutions have sufficient assets to meet their contractual obligation. The regulatory failure to protect against extended ventures in risking the financial system, the international monetary fund, puts the blame on the lack of regulation which leads to the current financial crisis.
Another main cause of the global crisis is Fraud. Companies use misleading strategies and information as methods of attracting investors. Therefore, the funds borrowed end up in wrong investments. The most obvious cases were fraud in mortgage financing; the 2008 subprime mortgage crisis in the USA, the FBI had researched on fraud by mortgage and got some of mortgage financing institution involved. Fannie Mae and Freddie Mac and American International Group are some of the institution affected by fraud in mortgage financing.
This refers to a situation where the debts and assets of an institution are not appropriately aligned in accordance to the risks associated with them. Asset-liability mismatch caused the current 2008, financial crisis. For example, many markets in different countries were unable to sell bonds in their local currencies, therefore, the sell of bonds in US dollars. This mismatches currencies and their asset, this lead to fluctuation of the exchange rate as a result of the risk of sovereign default. (Davies 30)
Impact of the global crisis on the financial market and the real economy
In the year 2007, during the financial crisis the industrial average for countries increased. For example, in the USA the industrial average index exceeded 14000 point in the year 2007. After the year 2008 October, the industrial average index declined drastically and reached around 6600. (Batten 720)
The crisis had a negative impact on USA economy, the real gross domestic product. It affected the country’s annual output level. The goods and services produced by the utilization of USA resources decreased at an average rate of 6% in the fourth quarter of 2008 and first Quarter of 2009. Some of developing countries with a strong economy saw a substantial drop in the growth rate of their GDP. For example, Cambodia showed a fall from 10% in 2007 to Zero in 2009.
It also had a negative impact on the employment rate in the united state. There was an increase in the unemployment population while the employment population decreased. This was mainly due to the prolonged recession which caused permanent destruction in the human capital. United States unemployment rate increased to 10.1%. This is said to be the highest level of unemployment since 1983. Also, the average working hours in a week declined to 33, estimated to be the lowest level since the government started collecting data on average working hours in a week. (Batten 721)
Inflation is the persistent increase in the prices of goods and services due to recessions in a business cycle. During the financial crisis, there was a drastic increase in the prices of goods and services; this was as a result of recession felt in 2007 and 2008. The fuel prices increased which lead to a proportional increase in other goods and services.
How systematic risk has spread across the globe
Systematic risk refers to the expected risk on the collapse of an overall market or the financial system. It can be defined as the instability of the financial system caused by conditions in the financial intermediaries or idiosyncratic events. Systemic risk can also be compared to bank run, a situation whereby the depositor withdraw funds from their bank account due to future expectation of failure of the bank. During the financial crisis, most financial institutions collapse as a result of systematic risk, depositors have been withdrawing their fund since they feel that an institution will collapse. This leads to lack of credit creation in the financial institution, therefore, leading losses or collapse of the institution.
Effect of financial crisis on investment and credit
There was an inverse relation between credit and investment. Most individuals held on to their funds because there was a high risk during the financial crisis. Therefore, they preferred not to invest since in the, near future, they believed the risk would be low. On the other hand, banks gave out credit on strict requirement. This shunned people from borrowing since the requirement asked for formalities about a depositor also the rate of interest were high. The banks put the high interest to make sure it reduces its losses from fraudulent debts. (Davies 60)
Measures implemented to prevent domino effect by Fed.
Domino effect refers to a chain of response after an occurrence in a small change, in something, causes a similar chain of changes nearby in a linear sequence. The domino effect in the financial crisis causes a sequence of similar changes globally. Since Federal Reserve is the central bank of USA, it is its mandate to ensure maximum sustainable employment and stability of prices in the economy. The Federal Reserve implemented various measures to prevent the domino effect in the financial crisis, they include the following. (Leto 110)
The fed started by lowering the rate at which banks pay each other for loans. The lower interest rate stimulates the private sector borrowing. Therefore, encourages people to borrow and spend especially when the economy is suffering from a crisis. In September 2007, after the crisis in the financial markets began it was a sign of decrease in the economic growth. This made the Federal open market committee, the body that formulates the monetary policy, to reduce the rates of federal funds. In 2008, interest rates dropped from 5.25% to 2 %. This helped the economy to recover from some of the financial crisis.
The other measure used by the Federal Reserve is to make short term loans to the financial institutions. Banks and financial institutions invest in the long term investment such as a residential mortgage and long term loans. So as, to make sure that the banks do not suffer from high risk, the Federal Reserve give out short term loans to act as assurance in their investments.
Initiation of a lending program by the Federal Reserve, which was mainly designed to free up flow of credit to household and small enterprises. (Leto 111)
The fed used another policy namely, buying securities in the open market. In this policy, the federal open market committee approved the purchase of mortgage-related securities of over $1 trillion guaranteed by the government sponsored mortgage companies. This policy helped in reducing the interest rates paid by consumers on mortgage. Therefore, the housing market will remain depressed, but the low interest rate and the prices of the houses would be affordable to consumers.
How the G20 responded to the shock
The G20 responded to the shocks of financial crisis by using the following blocks, issued by the committee and its governing body between the year 2009 and 2010:
Higher quality of capital
This is mainly about higher capital levels and common equity. This ensures that banks are able to absorb the losses associated with past crisis of the year 2007. The countries also formulated better coverage of risk to reduce it than one's used in the past; this was specifically for the capital market activities. The G20 decided to formulate an internationally harmonized leverage ratio to constrain excessive risk taking. The ratio is used as a backstop to risk-based capital measure. The G20 also discussed building up a capital buffer in proper time so that they can be drawn up during the period of stress. The G20 countries also discussed in the committee the formulation of appropriate and efficient standards for supervision, public disclosures and techniques of risk management for government institutions and other financial institution. (Davies 10)
Measures the Fed has implemented to ensure the flow of credit
Capital adequacy ratio also referred to as capital to risk. It measures the ratio of bank’s capital to its risk. The country's national regulators mostly use regulators to ensure that banks absorb an amount of loss and it adheres to statutory capital requirement. Therefore, it determines the capability of a bank to meet its liabilities and other risks such as credit risk. This requirement protects bank depositors by making sure they do not face any losses. This ratio is also useful in reducing bank run by the depositor since they are sure that their funds are properly used. Lack of capital adequacy is one of causes of financial crisis that happened in the later 2000’s. Banks were unable to meet their customers’ obligations and this was passed from one firm to another causing a chain of problems resulting to financial crisis.
These are regulations subjected to a bank by a government. The government puts down requirements, restrictions and guidelines that banks meet during operations. These regulations or requirements promote transparency between the banking institution and individuals with whom they are conducting business. The main objective of bank regulation is to reduce the level of risk to which bank creditors expose themselves. It also reduces the risk of disruption which mainly results from adverse trading conditions causing multiple bank failure. General principles of banking regulation vary widely from one nation to another and jurisdictions.