Main Causes of the Global Financial Crisis

The global financial crisis that hit world a decade before is regarded as the worst economic crisis that has been ever witnessed since the 1929 Great Depression. The economic crisis has shaken some of the largest banks of the industrialized nations and forced the American Central Bank to revolutionize the process of intervention so that it can enable the financial system to function again (Balakrishnan, Watts and Zuo 2016). The financial crisis of 2007 showed the world that economy of America cannot anymore survive by its own self and it requires the cumulated capitals from the Asian nations as well as the producing countries around the world.

The financial crisis of 2007 considered to be severe because it has touched the real estate capacities of the American households. Even though the crisis appeared a subject of concern for the US sub-prime mortgage, it increasingly extended the entire monetary markets with the help of derivative products, bank securities and distribution of credits (Dias, Rodrigues and Craig 2016). This paper assesses the possible causes that erupted the global financial crisis and swept the industrialized banks across the world under bankruptcies. The paper would assess the impact of financial crisis in economies around the world and would also propose reformations to further avoid the occurrence of catastrophic financial disaster.

The crisis of credit paved way for the failure of the US mortgage market. The commencement of the problem was in the early years of 2001 when the decision of FED was to reduce the rate interest to 1% with the objective of overcoming the adverse impact of September 11 growth in the economy (Lane and Milesi-Ferretti 2017). The action taken by the FED led to the heavy inflow of money from the emerging nations of Middle East and China that gave rise to huge amount of credit in US. Investment Banks and companies of Wall Street were looking forward to certain concrete return for their investment which were greater than the FED 1 per cent rate of interest. These investors from the Investment Bank and Wall Street took advantage of the opportunity that was presented to them by growing market of mortgage in US. Huge availability of credit enabled the Americans to purchase their own homes by getting loans from the Mortgage Lenders (Rey 2015). As a result of huge lending, a huge demand for the new houses in America was created with more number of Americans entered into the mortgage market. The real estate industry of America witnessed a boom from the period 2002-06 and the prices of houses increased to three-fold in this period.

Impact of Global Financial Crisis

The mortgage companies began packing the loans and selling it to the financial derivatives on the basis of different names and returning it to the investors across the world. In principle, the risks began moving from moving from the mortgage lenders to the Investment and finally to monetary investors (Lennartz, Arundel and Ronald 2016). The arrangement appeared risky however everything appeared normal when the monthly instalments were paid by the home owners. The mortgage lenders soon beginning running out of the applicants that were worthy of credit and commenced the process of attracting the applications that had poor history of credit.

The venture of Sub-Prime loans has placed itself in the market of mortgage for burst. The assumption was such that in the event of defaulters their home would be sold some other applicants for a higher price. However, the rate of defaulters for the Sub-Prime loans were more in numbers than it was projected by the Investment Banks and they held several houses but were unable to find any purchasers (Vazquez and Federico 2015). There was the environment of higher supply over demand and led to the bursting of bubble. The price of houses began falling and this influenced the Prime Loan owners to default as they noticed it was not worthy of making payments for the lower cost houses. The mortgage lenders were unable to find any new purchasers and ended up with high amount of borrowed loans for the useless houses. The entire financial systems was in the nutshell and frozen deeply. This paved way for the collapse of the financial system that led to several bankruptcies and closing of monetary firms not only in US but across the world.

Another example includes the failure of the Lehman Brothers. After the failure of the Lehman Brothers, an unexpected change occurred happened in the external environment. As it was in majority of the equity market economies, there was a large sell-off of the domestic equity markets by the investors of portfolio portraying deleveraging (Sui and Sun 2016). As a result, there was a huge amount of capital outflows by the investors of portfolio during the month of September and October 2008 because of the higher pressure of overseas exchange market.

Even though the foreign direct investment reflected resilience but the access to the overseas commercial borrowings and trade credits became very difficult. The net amount of capital flow was considerably lower with higher amount of depletion of reserve (Kemp 2015). There was also the huge amount of loss in reserve as it plunge down to US $38 billion from US $58 billion in 2008-09 portraying higher valuation of loss.

Proposed Reforms to Avoid Financial Disasters

The economist and analyst have indicated a combination of factors that have led to explosion in the credit market in US and later across the world leading to the outbreak of financial crisis. The first possible cause is the imbalance world trade. After joining the WTO China gained immensely and made use of the advantages of the new international trade system as it flooded the world with cheaper exports (Obstfeld 2015). China kept the exchange rate of its Yuan very low and as result of this the export of China was very much competitive across the world market. With this, China accumulated huge amount of trade surplus whereas rest of the world and in particular US accumulated larger trade deficit. The trade deficit of US three-folded to $256 billion in 2007. The production of industrial as well as commercial goods fell sharply in the US and the American economy shifted to service economy.

Figure 1: Current Account Deficit Nations

(Source: Mensi et al. 2016)

Excess deregulation of financial markets is another possible cause of financial crisis. US acted as the leader of the financial market liberalization and to attain this it heavily deregulated the financial market and the government as well as FED relaxed its supervision and monitoring power. The concept of market liberalization swept the world following the push from the agreements of GATS (Bremus and Fratzscher 2015). This permitted US to expand its part as the leader player in the provider of financial service. As a result several financial and derivative products was introduced from the rising global trade and liberalization. This expansion led to bubble which burst and frozen the entire market of credit.

Another possible cause of crisis includes the growth in demand for the USD. From the fear of losing its stock of gold, US began printing dollar without any kind of effective regulation or criteria. This procedure resulted in huge inflow of international goods and capital to US in exchange for its USD (Dijkstra, Garcilazo and McCann 2015). This kept US consuming beyond its capabilities to continuous trade deficit. The inflow of money to the US resulted in the concept of Cheaper Money and gave rise to huge amount of credit which was used for unproductive purpose that resulted in financial crisis.

After taking extraordinary policies by the government to stabilize the financial market, the economic recovery has approached its tenth year but the significant headwinds may threaten to misplace the entire amount of progress that is made following the outbreak of international financial crisis (Kenourgios and Dimitriou 2015). However the deregulation of the financial sector coupled with uncertain Federal Reserve policy may give rise to one more financial crisis.

Currently there are six banks that are monitoring half of the banking industry assets. This includes the JP Morgan, Goldman Sachs and Citigroup having more than half of the top 100 commercial banks. Prior to financial crisis JP Morgan grew by 100 per cent while the Banks of American assets grew by more than 50% in the last ten years. Despite the growth of these banks took place in the environment of Federal Reserve severe policies but they are viewed as the financial sound and solvent (Ciro 2016). The bigger the banks is the harder they fall. Despite the financial crisis there has been greater capital and pressure testing which is against the fact that these banks are bigger today than they were previously. On the event of worst case situation originating from the de-regulations these banks can fall harder than before this time.

The regulatory agenda that was made prior to 2008 comprised of the elimination of the barriers amid the commercial and investment banks that led to the build-up of most difficult financial instruments (Cnbc2019). The examples comprises of the credit default swaps and the financial market derivatives that bought forward the needless higher risks taking abilities of the banks and mortgage lenders. The administration has decided to roll back the regulations and dismantle the part of Dodd Frank Act which simultaneously eliminates the net of safety and paves the platform for the perfect storm which may result in financial crisis again and much worse than before.

The emerging economies of the Europe were the hard hit from the crisis. The export of Russia accounted only half during 2008 while the import amounted to three-fifths than it actually was in 2008.

Figure 2: Deterioration in Russian Exports and Imports

(Source: Bremus and Fratzscher 2015)

During crisis the CIS economies such as Armenia, Ukraine, Russia, Azerbaijan etc. experienced a fall of 35% in exports while the South-Eastern European economies such as Turkey, Italy, Greece, Hungary etc. suffered a fall of 23% in their export (Bremus and Fratzscher 2015).

Figure 3: Annual export of South-Eastern European Economies

(Source: Mensi, et al. 2016)

The export oil prices of the CIS nations were hit hard during crisis as it also impacted their real GDP. US current account trade deficit balance swung in the opposite direction and the GDP of US fell to 4%. In Germany the unemployment rate increased to 7.2% and the unemployment rate in US amounted to 10.2%.

In the home country of Australia the impact of financial crisis was less. The main impact was on the equity market as the price of equity declined by 10%. There was also a high depreciation of Australian currency as it declined 30% after attaining peak in July 2008 (Carson, Fargher and Zhang 2017). The unemployment rate increased by two percent to stand at 5^3/4 by the end of November 2009 while the GDP of Australian slowed by half percent.

On the basis of the above analysis the section would present recommendations that may help in rectifying the mistake which allowed for financial crisis. At first WTO and global trade must be reformed and WTO should be active in balance the international trade. China must not be permitted to dominate the world by undertaking unfair means.

Secondly, the central and governments across the world must supervise and track the activities of financial companies (Obstfeld 2015). Long run efforts must be taken to clean the balance sheet of financial firms from the toxic assets. Credit lines must be provided to companies with good practices.

Finally, limits must be applied in securitization procedure. Such as restrictions can be imposed by regulators for the type of instruments that can be issued and acquired by the regulated entities. Central banks must only accept the collateral for loan commitments or rediscount the processes adequately to promote transparent class of asset-funded securities.

Conclusion: 

To summarize conclusively, there was the lack of supervision of regulatory agencies on the monetary market leading to growth of financial derivatives beyond the acceptable limits. The financial crisis not only moved the US but also the worldwide economies into huge depression. Bankruptcies and foreclosure of banks led to huge amount of layoffs. The spiral impact of financial crisis would take a period of time to heal until the new equilibrium is attained.

References:

Balakrishnan, K., Watts, R. and Zuo, L., 2016. The effect of accounting conservatism on corporate investment during the global financial crisis. Journal of Business Finance & Accounting, 43(5-6), pp.513-542.

Bremus, F. and Fratzscher, M., 2015. Drivers of structural change in cross-border banking since the global financial crisis. Journal of International Money and Finance, 52, pp.32-59.

Carson, E., Fargher, N. and Zhang, Y., 2017. Explaining auditors’ propensity to issue going-concern opinions in Australia after the global financial crisis. Accounting and Finance, pp.1-39.

Ciro, T., 2016. The global financial crisis: Triggers, responses and aftermath. Routledge.

Cnbc.com 2019. The next financial crisis: Why it is looking like history may repeat itself. (2019). Retrieved from https://www.cnbc.com/2018/09/14/the-next-financial-crisis-why-it-looks-like-history-may-repeat-itself.html

Dias, A., Rodrigues, L. L., and Craig, R. 2016. Global financial crisis and corporate social responsibility disclosure. Social Responsibility Journal, 12(4), 654-671.

Dijkstra, L., Garcilazo, E. and McCann, P., 2015. The effects of the global financial crisis on European regions and cities. Journal of Economic Geography, 15(5), pp.935-949.

Kemp, P.A., 2015. Private renting after the global financial crisis. Housing Studies, 30(4), pp.601-620.

Kenourgios, D. and Dimitriou, D., 2015. Contagion of the Global Financial Crisis and the real economy: A regional analysis. Economic Modelling, 44, pp.283-293.

Lane, M.P.R. and Milesi-Ferretti, M.G.M., 2017. International financial integration in the aftermath of the global financial crisis. International Monetary Fund.

Lennartz, C., Arundel, R. and Ronald, R., 2016. Younger adults and homeownership in Europe through the global financial crisis. Population, Space and Place, 22(8), pp.823-835.

Mensi, W., Hammoudeh, S., Nguyen, D.K. and Kang, S.H., 2016. Global financial crisis and spillover effects among the US and BRICS stock markets. International Review of Economics & Finance, 42, pp.257-276.

Obstfeld, M., 2015. After the Global Financial Crisis. POLICY CHALLENGES IN A DIVERGING GLOBAL ECONOMY, p.383.

Rey, H., 2015. Dilemma not trilemma: the global financial cycle and monetary policy independence (No. w21162). National Bureau of Economic Research.

Sui, L. and Sun, L., 2016. Spillover effects between exchange rates and stock prices: Evidence from BRICS around the recent global financial crisis. Research in International Business and Finance, 36, pp.459-471.

Vazquez, F. and Federico, P., 2015. Bank funding structures and risk: Evidence from the global financial crisis. Journal of banking & finance, 61, pp.1-14.