Group Members: Robard Jerry Ismaila Adeleke Oyedamola Oyeniyi Ibrahim Sale Jakob Smith Course: Introduction to Financial Markets Group Work Project: Financial Markets Submission 1: The Global Financial Crisis2 Abstract This article will systematically describe the global financial crisis, and the major policy and regulatory responses to it. The paper will also give an overview of the primary causes, the market features, the regulatory and risk management framework failures. The paper will also touch on the response of policymakers and regulators to the global financial crisis thereof. Literature from the IMF Working Paper suggests that the three factors that may have had a major contribution to the global financial crisis and to the build-up of financial imbalances were: (i) monetary policy that might have been too loose, (ii) rising global imbalances (capital flows), (iii) inadequate supervision and regulation 1. The build-up of financial imbalances is found to have been driven by capital inflows and associated compression of the spread between long and short rates 2.
The influence of capital inflows on the build-up is amplified where the supervisory and regulatory environment was moderately pathetic. By contrast, differences in monetary policy cannot account for differences across countries in the build-up of financial imbalances ahead of the crisis. Governments implemented different financial saving plans with the aim to fight the crisis. This meant that governments would spend stimulus packages, and aggressive monetary policies where enforced 3. Financial markets must be effectively regulated and supervised so that future crisis is avoided. Governments must also see to it that the global trade is balanced and a better financial system is put in place. Keywords – monetary policy; global imbalances; global financial crisis; financial markets; regulatory responses 1. Introduction Global financial crisis (also known as the financial crisis of (2007/2008), is a world financial crisis that hit international financial markets and world economy.
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The crises almost affected each and every country, regardless of big or small, rich and poor. In a financial crisis, the value of financial institutions or assets drops rapidly. A financial crisis is often associated with a panic or a bank run, where investors sell off assets or withdraw money from savings accounts because they fear that the value of those assets will drop if they remain in a financial institution. In the 2007/2008 financial crisis case, the financial institution, especially banks, engaged in profitable sell of mortgage and demanded more mortgage institutions to participate in the trade. Banks created more money from the loans they made. Whenever Banks made loans, new money were created 4.3 The global financial crisis began as the U.
S “subprime” crisis in the summer of 2007 1. It spread to a number of other advanced economies through a combination of direct exposures to subprime assets, the gradual loss of confidence in a number of asset classes and the drying-up of wholesale financial markets. In this process it came to expose “home-grown” financial imbalances in a number of advanced economies, typically characterized by an overreliance on wholesale funding sources by the banking system and asset bubbles in residential property markets 5. The financial crisis has forced the insolvency of many banks and financial institutions in the U.S. and the world.
2. Main Primary Cause of the 2007/2008 financial crisis Information from literature suggests that the 2008 financial crisis was the worst economic disaster since the Great Depression of 1929 5. The crisis was the result of a sequence of events, each with its own trigger and culminating in the near collapse of the banking system 4. Many events or actions led to this historic disaster, but the primary cause of the crises was the deregulation of the financial industry 6. 2.1 Deregulation of financial industry In 1999, the Gramm-Leach-Bliley Act repealed the Glass-Steagall Act of 1933. The repeal allowed banks to use deposits to invest in derivatives 7. The following year, the Commodity Futures Modernization Act exempted credit default swaps and other derivatives from regulations.
This federal legislation overruled the state laws that had formerly prohibited this from gambling. It specifically exempted trading in energy derivatives 7. This allowed banks to engage in hedge fund trading with derivatives. Hedge funds are privately-owned companies that pool investors’ dollars and reinvest them into complicated financial instruments 7. Their goal is to outperform the market, by a lot. They are expected to be smart enough to create high returns regardless of how the market behaves. Banks then demanded more mortgages to support the profitable trade for these derivatives. They created interest-only loans that became affordable to subprime borrowers.
2.2 The Growth of Subprime Mortgage Market Regulations and policies brought large number of mortgages to the market. Banks demanded more mortgages to participate in the profitable trade. The U.S government pushed into residential housing with a variety of policy changes that dramatically increased the demand for housing 5. Due to this profitable trade, banks made a huge sum of money from loan. In 1995, the US Housing and Urban Development (HUD) agency set target goals for Fannie and Freddie to raise home ownership rates among low-income groups, which significantly expanded the market for subprime borrowers 5.4 2.
3 Securitization/mortgages – backed Securities The creation of mortgage-backed securities and the secondary market ended the 2001 recession 7. Mortgages were grouped together into a bundle and formed a new financial instruments called mortgage-backed securities. If you get a mortgage from the bank, the bank sells it to the secondary market. Banks engaged in mortgage-backed securities and made huge amount of money.
2.4 Low Interest by Fed US Federal Reserve low interest rate encouraged mortgages lending. In June of 2000, the US federal funds target rate was 6.5%. By June 2003, in response to the collapse of the technology bubble, the Fed had reduced the federal funds rate to 1.
0% 5. The implications of low interest rate meant low interest rate on mortgages, with cheap loans people bought homes as an investment product. As a result, the percentage of subprime mortgages doubled, from 10 percent to 20 percent, of all mortgages between 2001 and 2006. By 2007, it had grown into a $1.3 trillion industry 7.
In 2004 the Federal Reserve start to rise interest rate. Homeowners were hit with payments they couldn’t afford. Housing prices started falling after they reached a peak in October 2005. This prevented mortgage owners from selling their homes as they could no longer make payments. The housing market bubble burst: This led to the 2007/2008 banking crises because people could no longer repay their loans, hence banks could no longer make the huge sum of money that they used to make from these loans. Therefore, Banks found themselves in danger of bankruptcy and as a result were forced to stop lending money. This resulted in the economy to tip into recession.
This phenomenon contributed greatly to the global financial crisis of 2007/2008. 3. The Response of Policymakers and Regulators to the Global Financial Crisis Regulators and policymakers all over the world responded via different methods with the aim of controlling the situation.
Governments took desperate steps to save the financial system. Several programs had been launched to try and save the system, for example the commercial paper finding facilities, discount windows etc. In the US, the Federal Reserve extended $16 trillion in support for global financial markets 5.
Central and Reserve banks all over the world launched excessive Quantitative easing(QE) to save the system. The Quantitative easing dramatically expanded the balance sheets of these institutions with newly printed money and purchased a variety of assets—especially troubled MBS 5.5 During the late October 2008, the seriousness of the economic and financial problems triggered by the collapse of Lehman Brothers. during the era of “the Great Moderation” up to the summer of 2007, distortions grew due to rising asset prices and widening current account imbalances 2. During this period, the United States and a number of European countries experienced stable high growth with low inflation and interest rates, which encouraged financial institutions to keep taking on greater risks, leverage and credit. References 1 A. N.
Mohammad Ramadhan, “The Global Financial Crisis: Causes and Solutions,” Kuwait, 2015. 2 L. K. Stijn Claessens, “The Regulatory Responses to the Global Financial Crisis: Some Uncomfortable Questions,” Research Department and Institute for Capacity Development, 2014. 3 T. Nekao, “Response to the Global Financial Crisis and Future Policy Challenges,” Havard Law School and the International House of Japan, Hakone, 2010.
4 investopodia, “Financial Crisis,” 2018. Online. Available: https://www.investopedia.com/terms/f/financial-crisis.asp/. Accessed 4 July 2018.
5 R. Rimkus, “The Final Crisis of 2008,” 17 August 2016. Online. Available: https://www.econcrises.org/2016/08/17/the-financial-crisis-of-2008/. Accessed 12 July 2018. 6 E.
N. Quarda Merrouche, “What Caused the Financial Crisis? – Evidence on the Driver of Financial Imbalances 1999 – 2007,” International Monetary Fund, 2010. 7 K. Amadeo, “Causes of the 2008 Global Financial Crisis,” 2018. Online. Available: https://www.thebalance.
com/what-caused-2008-global-financial-crisis-3306176. Accessed 6 July 2018. 8 Online. Available: http://positivemoney.org/issues/recessions-crisis/.
9 “Group of Governors and Heads of Supervision announces higher global minimum capital standards,” 12 September 2010. Online. 10 D.
J. Elliott, “Basel III, the Banks, and the Economy,” 26 July 2010.