Question

The Global Financial Crisis 1. What is the aftermath of a banking crisis on the housing market? Equity prices? 2. What is the aftermath of a banking crisis on unemployment? GDP? Debt?

Answer 1

Global crisis started a credit crunch, which is when banks tighten their lending requirements and obtaining finance becomes difficult. This financial crisis had several negative impacts on banks, financial institutions, households, businesses and the global economy. For instance, many banks incurred substantial losses, and some were even forced into bankruptcy, like Lehman Brothers. In addition, banks lost a large amount of capital as consumers lost faith in the entire system. As consumer deposits are one of the sources of funds for banks, a fall in consumer confidence translated in a shortage of funds. In addition, it affected banks’ future profits, as regulatory and capital requirements became stricter, thus reducing some previously profitable opportunities. This is because many of the banks’ losses were hidden, as some of their activities were off-balance sheet (OBS) activities such as securitised loans. The effects of the crisis are shown in the diagram below. Between 2007 and 2008, banks’ profits plummeted.

Moreover, one of the consequences was that many non-bank financial institutions such as pension funds, insurance companies and finance companies are now subject to stricter regulatory requirements due to the introduction of new rules and regulations. Furthermore, the financial crisis affected households significantly as consumer confidence fell, thus this reduced consumption. Consequently, the profits of many firms fell, meaning that they began to lay people off and hence unemployment increased exponentially. Households had a lower disposable income or had to sign up for unemployment benefits. Unemployment rose sharply in the US and the Eurozone.

In addition, the crisis affected businesses worldwide as the demand for their goods and services fell on account of consumers being reluctant to spend due to uncertainty regarding the state of the economy and job prospects. Hence, the financial crisis affected the economy globally – the total value of goods and services produced fell worldwide. Consequently, unemployment rose in many countries and government revenues (which partially comes from income and corporation taxes) fell during the financial crisis. This is shown in my diagram below as more economically developed countries (MEDCS), less economically developed countries (LEDCS) and emerging economies all experienced a fall in GDP and further increases in their budget deficits.

Therefore, the crisis resulted in a global downturn in economic activity, causing increases in unemployment, a fall in businesses profits and increases in government’s budgets deficits.

To a large the extent, the crisis was caused by selfish interests. First, the world of finance and particularly investment banking tends to attract individuals who are hard working, driven and money motivated. Therefore, prior to the crisis, there was excessive risk taking by investment bankers, traders and bank executives. At the pinnacle of the financial crisis, the bonus culture was predominant and these groups were not focused on building a long-term relationship with clients but instead wanted to sell them as many financial products, particularly loans (known as sub-prime mortgages) to even the most poorly rated credit borrowers and other complex financial products and instruments such as derivatives. Whether the client or borrower defaulted, this was of little interest to banks due to securitisation, a type of financial engineering. Securitisation is when an asset or group of illiquid assets are transformed to a security which can be sold to investors. More importantly, securitised financial assets didn’t remain on banks’ balance sheets as, although created by the bank, they could be transferred to a special purpose vehicle (SPV) which handled the claims related to these assets. When these borrowers defaulted and the owners of these financial assets (financial institutions, investors, pension funds, insurance companies) realised that these products were essentially worthless, many firms incurred losses, individuals loss their homes and were declared bankrupt and many investors also suffered from losses.

Besides, many bank executives were focused on achieving sales and bonus targets instead of thinking long-term performance and sustainability. Hence, different interests by not only investment bankers, traders and other parties, but by bank executives and managers too, led to the financial crisis.

Furthermore, credit rating agencies also had a part in it. The role of credit rating agencies is to rate the securities in terms of riskiness and the debtor’s ability to repay the debt issued. Hence, credit rating agencies gave financial institutions and investors information on the riskiness, safety and quality of securities issued. The three main credit rating agencies are Standard & Poor’s, Moody’s and Fitch. They rate the quality of a wide range of securities such as government & corporate bonds, mortgage-backed securities (MBS), collaterised debt obligations (CDOs) and other asset-backed securities (ABS).

However, these credit rating agencies charge a fee to banks and other financial institutions to rate these financial products. Hence, during the financial crisis, the incentives for the agencies were to continue to stay profitable and therefore give positive ratings to many of these securities, even though they were high-risk and poorly performing.

Therefore, to a large extent, the crisis was caused by the different interests of investment bankers, traders, bank executives and credit rating agencies. On the other hand, there are several other major causes.

One major cause was a lack of financial education. Many households were taking out several loans but didn’t have an understanding of how changes in interest rates can affect their repayments or the financial terms and conditions in the contracts they signed. When interest rates changed, many borrowers defaulted. In addition, many investors and other financial institutions did not fully understand the financial products sold to them. Hence, when the housing bubble burst and many of homeowners defaulted, these securities were of little value.

Another major reason were the monetary policies leading up to the financial crisis, particularly in the US. Monetary policy is the use of interest rates and the money supply (via quantitative easing) in order to influence the economy and aggregate demand. Interest rates are the costs of borrowing and the reward for saving.In the years leading up to the crisis, the Federal Reserve kept interest rates very low. Therefore, the cost of borrowing was low. Consequently, many individuals decided to take out mortgages in order to own their homes or to make a profit from the capital appreciation of the property’s value. However, when interest rates eventually rose, many individuals couldn’t afford the changes in their repayments and consequently defaulted.

Additionally, another major cause was inadequate regulation. Regulation is the set of rules that financial institutions must comply with. Prior to 2007-2008, regulation was not strong enough and banks had more freedom. This was the case particularly in the USA and this is important as the financial crisis stemmed from the US and the filtered through to other major economies. In the US, the Glass-Steagall Act was introduced in the 1930s after the great depression and the stock market crash in order to separate commercial banking from the more risky investment banking. Once the Glass-Steagall Act was revoked before the 2000s, banks began to engage in risky and complex financial products such as derivatives with depositors funds. Consequently, facing the crisis, many banks were on the verge of bankruptcy and some failed. Furthermore, a bank’s assets and capital are meant to act as a cushion against losses and therefore a safety net. Prior to the crisis, bank capital requirements were low and the assets which met regulatory requirements were low quality. Hence banks’ balance sheets were not strong enough and therefore couldn’t accommodate the risks they were taking and the subsequent losses they incurred.

However, many changes have taken place ever since. For instance, in the UK, the Financial Services Authority (FSA) has been replaced by three new regulatory bodies monitoring the system this is the Financial Policy Committee (FPC), Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA). The PRA is a subsidiary of the Bank of England (BoE) and is responsible for the regulation and supervision of banks, credit unions, building societies, investment firms and insurance companies. Likewise, the FCA is responsible for the conduct of all financial institutions in the UK but is not a subsidiary of the BoE. Finally, the Financial Policy Committee (FPC) is a subsidiary of the BoE and is responsible for macro-prudential regulation and thus monitors and identifies any potential threats to the financial system as a whole.

Also, other changes have been implemented. In the UK, retail banking is separated from investment banking to protect depositors. The Basel Committee on Banking Supervision (BCBS) which focuses on assisting the central banks for rules and regulations to impose on banks and other financial institutions also took part in regulatory reforms. For example, the Basel Committee increased the level of capital banks have to hold, enhanced the definition of bank capital to ensure banks assets are of better quality, required banks to increase their liquidity coverage ratio and other changes such as introducing a capital conservation buffer requirement, which acts as a further layer of protection.

Therefore, the global financial crisis brought numerous changes in order to enhance the future sustainability of the financial system. Ultimately, it is difficult to determine whether these changes have helped, as many take time to come into effect. They may have little or no effect due the inherent nature of the type of characters the world of finance attracts and the difficulty in monitoring and regulating banks, as regulation itself may lead to financial innovation which resulted in securitisation, a major catalyst of the financial crisis. Therefore, the desired effects of these reforms can only be truly judged further in the future.