Causes of Global Financial Crisis

Discuss about the Global Financial Crisis.

The assignment provides an overview about the causes and impact of global financial crisis (GFC) among various countries.  The study also focuses on the examples of the GFC events that occurred during this period. The financial crisis during the period 2007-2008, also termed as GFC and is also considered as the worst crisis since the occurrence of great depression of 1929. It is the most significant economic catastrophe that adversely influenced several countries in the world (Ait-Sahalia et al. 2012).  This crisis started in the year 2007 with the subprime mortgage crisis in the US, which further developed into international banking crisis along with collapse of investment bank named as Lehman Brothers. Owing to this subprime mortgage crisis, several investors in US lost their confidence in making their investment in business, which in turn caused liquidity crisis. This GFC had also worsened owing to crash and high volatility of the stock market. In fact, huge bail out of the financial organizations and other monetary as well as fiscal policies had been integrated by the policymakers in order to prevent collapse of the global financial system (Berkmen et al. 2012). This global crisis was followed by the economic downturn also known as Great Recession.  In fact, the individuals having fear of their wealth also contributed to this GFC by demanding that the financial institutions as well as banks repay their money as much as possible. By meeting the demand of customers causes these banks to liquidate financial assets holdings. In fact, some of the reforms that eventuated during this period are also highlighted in this study.

Possible causes of global financial crisis (GFC)

The global financial crisis was mainly caused owing to deregulation in financial sector. This allowed the banks and financial institutions to engage in trading hedge fund with the derivatives.  The banks in turn demanded higher mortgages in order to support profitable derivatives sale. In fact, these banks in turn created interest on loan, which became affordable to the borrowers (Barakova, Calem and Wachter 2014). In the year 2004, this nation’s Federal Reserve increased the funds rates on these mortgages reset. The housing prices began to decline as supply of houses outpaced demand. This in turn trapped those households who couldn’t afford to make the payments as well as sell their residence. However, when these derivatives value deteriorated, the banks and financial organizations stopped lending the money to each other. The four underlying reasons that caused global financial crisis includes-

• Deregulation- Historical evidences reflected that the regulation of bank based on Bassel accords motivated unconventional business practices and this reinforced financial crisis. There are some cases where the laws had been changed in the parts of financial system. For example, in the year 1999, the president of US has signed a law (Gramm-Leach –BilleyAct) that repealed Glass Steagall Act provisions, which restricted the bank holding institutions from owing other organizations. This repeal in turn removed division, which existed previously between the investment banks and the depository banks. However, investment banks trusted into competition with the scheduled commercial banks. Thus, this repeal contributed to GFC.
• Housing bubble growth- During the period 1998-2006, the house price increased by near about 124%. This resulted to numerous homeowners to refinance their residence at lower rate of interest or financing consumer expenditure by taking mortgages (Cheng, Raina and Xiong 2012). The huge amount of money sought higher yields than that offered by treasury bonds.  The investment banks connected this money to this nation’s mortgage market. In the year 2003, the mortgage supply exhausted and hence huge demand reducing lending standards. By the year 2008, this housing prices declined by 20% and hence borrowers face difficulty to refinance for avoiding higher payments relating to higher interest rates. Hence, all outstanding mortgages became delinquent.
• Easier credit conditions- Low rate of interest in banks encouraged borrowing. During the period 2000-2003, the US Federal Reserve decreased their funds rate from 6.5% to 1%. However, in the year 2002, it was seen that this credit conditions was fueling housing rather than business investment (Haas and Lelyveld 2014). Moreover, rising current account deficit created downward pressure on banks interest rate. This deficit in current account increased by around $650 billion and hence recovering this deficit required them to borrow money from other nation. Huge amount of capital reached this financial market and hence US households utilized these funds borrowed from foreigners for financing consumption. However, Fed increased funds rate in the year 2006, which in turn increased adjustable rate mortgage (ARM) rates.
• Predatory lending- This refers to as the unscrupulous lenders practice that entice borrowers to move into unsafe secured loans for bad purposes.  The US banks provided loans to several borrowers who have taken money for unfair business practices. However, this deteriorated financial condition of this nation.

Possibility of Occurrence of GFC in Future

Possibility of occurrence of GFC

According to my opinion, there is a possibility of occurrence of GFC in future. The reason behind this is the ‘business cycle’, which basically signifies terms of expansion or recession periods. It is referred to as the variation in economic activity, which the nation experiences over certain time period. There are mainly five phases of business cycle namely- expansion, peak, recession, trough and recovery.  During the expansionary phase, the economy of the specific nation grows at steady rate and this continues until conditions in economy are favorable.  The peak phase arises when the growth in expansion phase slows down and business cycle growth rate achieves maximum limit (Fratzscher 2012). In this phase, the demand for products decreases owing to rise in its prices. Recessionary phase occurs when decrease in product demand becomes rapid and all economic factors including prices, investment, production begins to decline. In the trough stage, economic activity of a particular nation decreased below normal level and hence economic growth rate becomes negative. Once the economy reaches lowest level, it again starts to recover. This in turn leads to reversal of business cycle procedure, which in turn completes the business cycle. As the economy is stable and stronger, it signifies that it is in expansionary phase. However, it is predicted that after the economy reaches the peak phase, it will again move towards recessionary phase.  Hence, GFC might occur again.

Figure1: phases of business cycle

Source: (Fratzscher 2012)

This GFC had adversely affected the growth rate and performance of several nations, specially the developing and emerging nations. These countries were affected by this GFC in developed nations through financial market channel as well as trade. Prices of the products had declined, which also highlighted sharp downturn in non food products demand. Even the  rate of inflation also declined owing to sharp fall in economic activities. Moreover, decline in prices of commodities also influenced the consumer purchasing behaviour (Dominguez, Hashimoto and Ito 2012). In the developed economies, the inflation rate recorded to 3.5%during this GFC period. In addition, this financial crisis also increased unemployment rate as well as outer gaps, which in turn led to deflation risk in most of the countries. Developments in both the emerging markets and developing economies reflected mixed picture due to this GFC. While  inflation rate has reduced in several nations, the pressure of price in few nations remained strong. This however highlighted that stickiness of price in the commodity market and lagged affect of increasing wages as well as input cost. This turmoil in the financial market had spread across the emerging and developing countries. The corporate industry of these countries was also largely affected by increasing funding issues and lossess in foreign exchange. As the exporters in many nations had taken open currency positions against US currency, it gave rise to issues relating to liquidity as well as solvency in the non financial industry. Another vital impact of GFC is substantial decline in the exports of the countries because of increasing pace of expansion in trade declined sharply. It has been projected by  IMF that, the volumes of world trade during this period reduced to 4.1%in the year 2009 from 9.3% in the year 2006. However, this GFC also led to adverse shocks of investment in the emerging economies. In addition, FDI( foreign direct investment) also declined  at huge amount due to  this economic shocks. It has been also noted from the historical data that, the GFC reduced demand for products, which in turn led to decrease in export earnings.

Impact of Global Financial Crisis on Different Countries

The impact of GFC on Australia had been significantly less as compared to other nations. This nation had recorded better growth outcomes in comparison with other advanced economies (Frankel and Saravelos 2012). The Australian bank had continued to remain profitable and even did not require additional capital from government. But this crisis affected several Australian households owing to huge decrease in the equity prices. This in turn decreased the wealth of this nation’s households by near about 10% during the year 2009. Additionally, this nation’s currency depreciated rapidly as GFC intensified, thereby decreasing by over 30%.

• Subprime mortgages crisis- The subprime mortgage crisis was mainly triggered by huge decline in prices of residence after the crumple of housing bubble. This lead to mortgage delinquencies and devaluation of securities relaying to housing (Brueckner, Calem and Nakamura 2012) There were several reasons of this crisis, out of which subprime lending and rise in speculation of housing were two proximate reasons. Other causes includes – homeowners inability to make mortgage payments, risky mortgage goods, high level of corporate as well as personal debt, bad housing policies, imbalances in international trade and improper regulation of government of this nation.
• Collapse of Lehman Brothers- During the GFC, Lehman Brothers was filed for bankruptcy. With more than $639 billion in total assets and $619 billion in debt, this investment bank collapsed as their assets surpassed that of the bankrupt giants. This seminal event had contributed to erosion of $10 trillion in the capitalization of market from the world equity markets. Eruption of credit crisis with failure of hedge funds, the stock process of this investment bank fell sharply. During that period, this bank eliminated more than 2500 mortgage related jobs and also shut down their BNC unit. In the last quarter of 2007, their stock rebounded as the world equity market had reached at new height and their fixed income assets prices took temporary rebound (Cukierman 2013). Their high level of leverage as well as huge mortgage securities portfolio made it vulnerable to the market conditions. However, their shares fell to near about 48% and hence led to collapse.

Some of the proposed reforms eventuated during GFC in order to understand their shortcomings. These reforms included-

• Adoption of Basel III requirement of capital, that includes countercyclical capital shield as well as surcharge for vital financial institutions (Haas and Lelyveld 2014).
• They have reached the agreement in adopting the liquidity standards including -The Liquidity Coverage Ratio ( LCR).
• Improvement of the securitization framework
• Implementation of principles for the compensation practices for avoiding perverse risk taking incentives.
• Agreement in few principle on some kind of US financial transactions that includes- GAAP (Generally Accepted Accounting Principle) and IFRS ( International Financial Reporting Standards).
• Closure of few data gaps for example, beginning of gathering of consolidated data mainly on bilateral counterparty, risk of credit of huge systematic banks etc.

Conclusion

This GFC had influenced the countries both positively and negatively. The positive effects of this financial crisis were- end to domination of magnate in foreign financial relations, redrafting of laws as well as rules that regulated world financial institutions mainly IMF (International Monetary Fund), WTO ( World Trade Organization),absence of large financial organization that dominated stock market around the globe. The negative effects include collapse of banks as well as financial sector, decline in GDP growth rate, rise in unemployment rate etc. Overall, this crisis lowered the economic growth of several countries. In addition, it enabled the government of various nations to change their regulatory policies and implement stimulus measures

References

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