Financial Markets 2018/07 Timezone Group 3 – A Group Assignment: What was the Global Financial Crisis, and what were the major policy and regulation responses to it? Introduction: The global financial crisis or global economic crisis is commonly believed to have begun in July 2007 with the credit crunch, when a loss of confidence by US investors in the value of sub-prime mortgages caused a liquidity crisis.
This, in turn, resulted in the US Federal Bank injecting a large amount of capital into financial markets. By September 2008, the crisis had worsened as stock markets around the globe crashed and became highly volatile. Consumer confidence hit rock bottom as everyone tightened their belts in fear of what could lie ahead. The housing market in the United States suffered greatly as many home owners who had taken out sub-prime loans found they were unable to meet their mortgage repayments. As the value of homes plummeted, the borrowers found themselves with negative equity. With a large number of borrowers defaulting on loans, banks were faced with a situation where the repossessed house and land was worth less on today’s market than the bank had loaned out originally. The banks had a liquidity crisis on their hands, and giving and obtaining home loans became increasingly difficult as the fallout from the sub-prime lending bubble burst. Although the housing collapse in the United States is commonly referred to as the trigger for the global financial crisis, some experts who have examined the events over the past few years, and indeed even politicians in the United States, may believe that the financial system needed better regulation to discourage unscrupulous lending.
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This research seeks to shed light on the Global Financial Crisis, and what the major policy and regulation responses to it were. We shall address this research under the following sub-topics 1) The primary causes of the Global Financial Crisis 2) The market features and conditions that constitute a financial crisis in general. 3) How the primary causes of the Global Financial Crisis led to the features of a financial crisis. 4) The response of policymakers and regulators to the global financial crisis. 5) The intended effects of policymakers’ and regulators’ responses.6) The downsides and unintended consequences that can occur when applying regulation and policy to the financial markets.
7) The features of financial markets which often need regulation. 1) The primary causes of the Global Financial Crisis The 2008 financial crisis is the worst economic disaster since the Great Depression of 1929. It occurred despite Federal Reserve and Treasury Department efforts to prevent it. The proximate cause of the financial turbulence was attributed to the sub-prime mortgage sector in the USA. At a fundamental level, however, the crisis could be ascribed to the persistence of large global imbalances, which, in turn, were the outcome of long periods of excessively loose monetary policy in the major advanced economies during the early part of this decade. The first sign that the economy was in trouble occurred in 2006.
That’s when housing prices started to fall. At first, realtors applauded. They thought the overheated housing market would return to a more sustainable level.
Realtors didn’t realize there were too many homeowners with questionable credit. In addition, one can say that the financial crisis was primarily caused by deregulation in the financial industry. The deregulation in the financial industry permitted banks to engage in hedge fund trading with derivatives. Banks then demanded more mortgages to support the profitable sale of these derivatives. Excessive risk-taking by banks such as Lehman Brothers helped to magnify the financial impact globally.
The fall of U.S. investment bank Lehman Brothers on September 15, 2008 unleashed shock waves that shook the financial markets and destroyed trust in the banking system. Governments around the world struggled to rescue giant financial institutions as the fallout from the housing and stock market collapse worsened.
Many financial institutions continued to face serious liquidity issues. The crisis lead to unprecedented government intervention in the markets as it developed into the worst global recession since World War II.2) The market features and conditions that constitute a financial crisis in general. 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. One prominent feature of financial Crises is that they’re not necessarily driven by rational decision-making. Instead, they are driven by fear and somewhat driven by greed. Below are some features that constitutes a financial crisis: I) Financial innovation: The innovation in the financial industry; originate-and-distribute banking model, created new complex and opaque instruments for trading, shadow banking system to permit a lot of securitization, more leverage and risk-taking, new practices and excessive lending II) Globalization of finance: Globalization of finance is challenging for policy making.
III) Global imbalances and savings glut is yet another feature of financial crisis as well as loose monetary policy IV) Asset price decline V) Financial institution insolvencies 3) How the primary causes of the Global Financial Crisis led to the features of a financial crisis: It is on record now that the 2007 financial crisis led to the breakdown of trust within the financial system and this was caused by the subprime mortgage crisis, which itself was caused by the use of derivatives. This timeline includes the early warning signs, causes, and signs of breakdown. It also recounts the steps taken by the U.S. Treasury and the Federal Reserve. Unfortunately, it was not enough to prevent the 2008 financial crisis and the Great Recession. Below are some of the primary causes of the global financial crises that led to the features of a financial crisis: a) Institutions or assets being overvalued b) Irrational behavior of investors c) Rapid string of selloffs which can further result in lower asset prices or more savings withdrawals d) Primary causes of global financial crisis is left unchecked.4) The response of policymakers and regulators to the global financial crisis: In general, financial market regulation is aimed to ensure the fair treatment of participants.
Many regulations have been enacted in response to fraudulent practices. One of the key aims of regulation is to ensure business disclosure of accurate information for investment decision making. When information is disclosed only to limited set of investors, those have major advantages over other groups of investors. Thus regulatory framework has to provide the equal access to disclosures by companies. In response to the global financial crisis policymakers and regulators came up with the following resolution: ? Adoption of Basel III capital requirements, including a countercyclical capital buffer and a surcharge for globally systemically important financial institutions (G-SIFIs), both of which represent a first international attempt to institute a macro prudential tool. ? Agreement reached on one of two envisioned liquidity standards – the Liquidity Coverage Ratio (LCR). ? Some progress on reducing too-big-to-fail, with the identification of G-SIFIs, domestically systemically important banks (D-SIBs), higher capital adequacy requirements and more intense supervision, and some reforms of national resolution schemes (including bail-in instruments) so that failing institutions can be resolved without wider disruptions. ? Enhancements to the “securitization model.
” ? Adoption of principles for sound compensation practices, to avoid perverse incentives for risk-taking. ? Agreement in principle on similar treatment of some types of financial transactions under U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). ? Some closure of data gaps, e.
g., the beginning of harmonized collection of improved consolidated data on bilateral counterparty and credit risks of major systemic banks (for the major 18 G-SIBs and 6 other non-G-SIBs from 10 jurisdictions). ? Some OTC derivatives reforms.5) The intended effects of policymakers’ and regulators’ responses: While financial institutions play a significant role supporting market performance, regulations can improve further financial performance by overcoming certain market failures. Even though financial firms can reduce adverse selection and moral hazard costs by screening and monitoring applicants, it is never possible to eliminate them, so the existence of “lemons” increases the financing costs for better firms who must pay a premium to compensate investors who are unable to judge fully the quality of various investments. Regulations that make it more difficult for bad firms to mimic good firms help reduce informational asymmetry costs of this form. Further, a run induced by investors withdrawing funds at one financial institution might signal to investors that other institutions are potentially in trouble due to liquidity shortages or counter-party risk.
Financial regulatory policy therefore strives to achieve three goals: I) market efficiency II) financial stability III) Investor protection. Market efficiency ensures financial intermediation — offering a range of products desired by borrowers and lenders — is provided at the lowest cost possible. Regulations that support financial stability and investor protection create confidence in markets, helping to overcome adverse selection and moral hazard problems. 6) The downsides and unintended consequences that can occur when applying regulation and policy to the financial markets: Regulations are obviously important, but they are only one component of a full complement of measures that underpin the proper functioning of financial systems. It is important to recognize that regulation is not a panacea for problems and imperfections that arise in the financial system. For one, all official interventions in the workings of the economy have their own costs and can create distortions of market signals or have unforeseen consequences that precipitate wider problems down the road.
The end result could well be efficiency losses that are at least as substantial in economic terms as themarket imperfections the regulations are supposed to correct. A poorly designed regulation can distort market signals and result in net economic costs rather than net benefits. When problems do occur, it may prove to be the case that the correct policy prescription entails tighter regulatory control.
But it may not and policymakers should resist taking the false comfort that comes from the view that more regulation is always the solution to market failures. Instead, policymakers should seek the right balance among policy instruments. Financial policy instruments are complementary, which means that changing one measure alone could prove to be counterproductive. All components –market discipline and regulation/supervision – must work in concert to achieve desired outcomes 7) The features of financial markets which often need regulation. The features of the financial market that need to be regulated often are the following: I) financial institutions: This includes banking institution (equity, commercial, mortgage, investment, foreign banks), specialize non-bank institutions(insurance companies, finance companies, pension fund, savings institutions) II) Investors III) Borrowers Conclusion: The global financial crisis started with a collapse in the real estate industry that later spread the adverse economic instability to other sectors of the economy. The financial institutions such as banks and large insurance companies like the AIG were faced with financial troubles that threatened downfall of other large organizations in the economy.
Slow economic recovery in the United States is attributed to the inefficient economic policies implemented to realize a boom. Investors in the American economy are faced with diverse risks that were evidenced by the global financial crisis such as the liquidity, counterparty and systemic risks that pose threats of potential losses of investment in the financial markets.Reference: Annual Report 2007-2008. (2008). World Economic Forum, accessed on: 10-01-09.
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