Question

‘The credit crisis has been touted as one of the greatest threats to the global financial system since the 1930s. It is not surprising, then, that the crisis has also produced unprecedented volatility in the financial markets and large losses for many investors’. (Investopedia) In the light of the above statement discuss its implications on the stability of global financial markets.

Answer 1

The credit crisis has been touted as one of the greatest threats to the global financial system since the 1930s. It is not surprising, then, that the crisis has also produced unprecedented volatility in the financial markets and large losses for many investors’.

The credit crisis affected the bond market in the beginning. The companies had to pay a higher rate of interest to borrow money for raising capital.

The yield on the Treasury bonds is considered to be safe, risk free and the return is less as compared to the other financial instruments.

However, during the crisis, the yield on the two-year Treasury bonds decreased from 5% to 1%. Yields on shorter term treasury bonds were negative. Investors were ready to pay to the Treasury to hold the money as it was considered safe.

The stock prices were highest in 2007 and sharply declined in 2008. All the major stock markets of the world: U.S., Europe, Hong Kong and Asia declined in 2008.

The banks and financial institutions also became insolvent.

The trust and confidence of the investors was completely broken.

The rich (10% of the world population) are becoming richer. They prosper and invest their savings in the financial markets.

The poor (90% of the population) borrow money and their debt increases.

The US has increased its monetary base (notes and coins in circulation plus reserves held at the central bank). The money has been invested in the stock market.

The price earnings ratio for most of the blue chip companies is between 25 and 30. The historic average is around 16. It was higher only in 1929, 2000 and 2007.

Today, the United States of America is in debt. There is a debt burden of around $40,000 per person in the nation.

The personal saving of American households has decreased and their debt has been increasing.

The stability of the global financial markets depends on global coordination.

Resilience of financial institutions: The Basel III regulatory framework will strengthen the financial institutions. They have laid out principles for effective banking supervision. There are strict requirements for the risk weighted capital of the banks.

The risks in the financial system should be reduced and it should be strengthened.

Loss-absorbing instruments have to be created to strengthen the financial institutions and provide sufficient capital in the event of liquidation.

In the event of a crisis, banks have to be liquidated in a systematic way.

Major banks should hold more capital and the capital should be of a higher quality.

Organizational measures should ensure easy restructuring and liquidation in case of a crisis.