Causes of the Global Financial Crisis of 2008 - Case Study Example

University Name Department Business Essay Student name & Admission number Date of Submission TASK: Q2. Introduction Financial crisis, especially the credit risk in banking sector is not a new phenomenon. The past financial panics and disasters, most notable, the Wall Street Crash in 1929, OPEC oil crisis of 1973, Black Monday in 1987, Asian Banking Crisis of 1997, Russian Crisis of 1998, Dot-com Bubble crisis of 2000 and the most recent Global Credit Crunch of 2008 (Ghon, 2008) which give lessons to banks and other lending agencies to be more proactive with the issue of credit risk management. The world economy has had to endure it in different occasions, and the Global Financial Crisis of 2008 is the most recent crisis whose effect was harshly felt worldwide since the Great Depression in early 1930s (Cristopher, 2008). Causes of Global Financial Crisis of 2008 The main factors that contributed to global financial crisis include macroeconomic setbacks, failures in financial markets and deficiency in the implementation of policy. The growth and development of financial sector has complicated issues making it hard for regulators to control the intricacies in the system (Cristopher, 2008). The anatomy of global credit crunch in 2008 emerged from the American housing market, in sub-prime mortgage. The house prices had increased steadily since 2004, thus many investors were attracted in the sector, and however in 2006 it peaked and then had a drastic drop of more than 30%. This had adverse effects not only in U.S. banks and other investment banks in Europe, but went out of control and spread globally. It is supposed that during 2007 sub-prime mortgages had started experiencing some losses after a rapid growth at the financial markets (Brunnermeir, 2009). This forced some institutions like BNP Paribas to freeze their redemptions in three funds that had been invested in structured products, as it became hard to estimate the portfolio held. Also because of losses in sub-prime mortgage, the counterparty risk for U.S. banks and Euro Zone rose sharply, leading to increase in interbank rates; interest rates banks are charged when they borrow from one another (Brunnermeir, 2009). The issue of losses in the housing sector in U.S. caused loss of confidence in government sponsored businesses, and later a global loss of trust in the whole financial system. The proximate cause in the financial markets for the credit risk was catalyzed by banks on basis of two choices. First, considerable sum of mortgage-backed securities that encompassed sub-prime risk were incorporated in bank’s financial statement, despite the fact that banks were supposed to transfer the risk than hold it as hypothesized in originate and distribute model as commonly envisaged in unleveraged pension funds. Secondly, banks had resolved to finance credit risk and other risky assets with quick-fix borrowings from the market, leading to spread of TED as shown in Figure 2 below. According to Ghon (2008) this operation became hard for the banking system, with decline in housing market leading to a rise in seeming risk of mortgage-backed securities, thus complicating further the issue carrying forward the temporary loans aligned with the securities. As a result, banks were required to sell out the assets they were unable to finance, despite the decline in price at the market that was below their real values. Figure 2: TED Spread in 2008. Source: Reischauer D. R., (2010), Subprime Mortgages. The valuation losses weathered bank capital further as banks perceived each other as riskier counterparty because of the spread of TED, and this strained possibility of acquiring short-term finances as it generated a downward spiral (Barnett et al., 2010). The funding problems for banks spread over to borrowers, as banks trimmed down the issuing of loans to preserve liquidity, in so doing slowing down the entire economy. In March, 2008, the situation became hard to financial giants could not bear the earliest wave of the crisis and casualty number one for acquisition was Bear Stearns, an investment bank by JPMorgan Chase with value of $2.2 billion. Federal government came in swiftly by FDIC to safeguard it assets to avoid total loss and later sold to JP Morgan for figure slightly higher than $1 billion. The sale of Washington Mutual to JP Morgan did not stop the crumple from eating away part of FDIC insurance fund (Reischauer, 2010). But this guaranteed little comfort to Americans who faced stringent lending as they stared helplessly to their portfolios stock sink in the country’s largest financial crisis that befell the nation since the Great Depression. The wave of collapse of financial giants shaken the world economy and the uncertainty also affected the financial markets in Europe and Asia with Malaysia and Indonesia being also the casualty. The commercial and investment banks in US and Europe were the ones that experienced huge losses of sub-prime related mortgages (Antif M. & Amir 2008).the mortgage crisis distressed banks in the Middle East and Asia. Banks in Persian Gulf announced sub-prime losses of about $1.5 billion, a month’s later, it was speculated that banks in the region were hiding the truth regarding their exposure to sub-prime losses. China was not seized in this quagmire, as its leading bank, Bank of China Ltd was forced to write down a substantial amount of $1.3 billion as a result of its exposure to sub-prime mortgage of U.S origin in 2007. Singapore watched helplessly as its autonomous wealth it had invested in Citigroup and UBS went down by 30 percent and 50 percent respectively. The case of Malaysia and Indonesia during the Asian Financial Crisis of 1997 The crisis had severe economic predicaments like going bankruptcy of multinational corporations leading to rise in unemployment in the region. Malaysian government came in handy to safeguard the situation from worsening by using available internal and external resources to overcome the crisis (Antif M. & Amir S., 2008).The situation had worsened in 1997 because wrongly formulated policies, anti-market rhetoric, panic and huge risk-taking in financial institutions. Situation was similar in Indonesia despite foreign investors being abreast with Indonesian technocrats that economy was strong besides the Asian region showing worrying signs of financial storm. Later on the reality had dawned on Indonesia as pressure piled on its rupiah having been strong during the crisis when Indonesian firms had resolved to unhedge short-term offshore loans in dollars making this to explode (Wihlborg, 2010) The depreciation of rupiah worsened the matter as the financial institutions had rushed to buy offshore dollars as mitigation which in real sense did not help at all. The prevalence of fragile structure in the financial market and its involvement in overseas market caused Bank Indonesia to crush in the financial crisis that was looming in late 1997. This forced the government to plead for financial support from IMF to strengthen its capital and carry on with the operations (Taylor, 2009) The bailout by IMF of USD $43 Billion to restore the Indonesian rupiah came in with some basic financial reforms that worsened the matter with closure of 16 privately owned banks and the Indonesian Central Bank had been instructed to raise the interest rates, a reform package that failed the entire system. Important lessons learnt from the experience of Asian Financial Crisis of 1997 that assisted countries respond to the Global Financial Crisis of 2008 The financial crisis of 1997 illustrated to Malaysia and Indonesia the dire deficiencies in the implementation of sound risk models in the financial markets. The models could entail the evaluation of liquidity risk and counterparty risk and derive scenarios such particular risks may hold in the economy in case of the known unknowns (Antif M. & Amir S., 2008) In 2008, the risk models for the two completely succeeded to halt the known unknowns and strengthened changes that were carried out in the regulatory and structural points in financial markets. To avoid the happening of any major occurrence of global credit crunch in 1997, Bank Indonesia improved their risk management procedures with a close look at tests and scenario analysis of Europe and US markets that were heavily hit. Since the crisis in banks tend to be rooted from bank system itself, that is governance and capital structure. Indonesia and Malaysia strengthen regulatory reforms in these areas. Start with governance and then risk management in bank’s capital structure. Regulators carried out a coordinating role in circumstances where individuals’ actions within the bank become compromising to the sustainable competitive edge of the institution, like supporting the restructuring of workers remuneration package at the expense of investment strategy could have resulted on tail risk (Acharya, V., and Matthew, 2009), Cristopher (2008) argues that risk factor and uncertainty are the basic parts of any investment, be it in the financial market or not. The integral elements that cause risk are price and interest. Risk is as well caused by internal and external factors that surround an investment. In any financial market, there is strong connection between risk and return, as the investors saying goes, “the higher the risk, the higher and the return”. Risk management is an economic term referring to a process employed by investors to identify and analyze the financial risks there investment may be associated with, and then develop mechanisms to manage and minimize such risks while they maximize the returns. If the risks on the financial market can be described using another term, then it is “volatility”. Majority of the well-known investors in the Malaysian and Indonesian financial market used risk management mechanisms to minimize the risk in their investment so as to maximize on their returns (Acharya and Matthew, 2009). Additionally, precautionary measures were formulated by to two countries regulatory bodies to avoid a future recurrence or lessen the severe effects associated with credit distresses in financial markets. A natural measure to avoid a repeat of these crises was to mandate higher bank capital standards, so as to buffer the financial market setbacks which is the integral part of the economy. However, this assumed a more vital set of issues relating to institutions governance and internal supervisory concerns in banks-commonly referred to as agency problems. Conclusion Malaysian and Indonesia banking industries had improved tremendously with ready solutions to a problem. This helped the two countries to minimize the harsh effect of the financial crisis of 2008 to hit their economies drastically. Recent credit crisis has taught regulators and banks the need of adopting latest regulatory measures in the financial market which are now aided through technology evaluation in building suitable models of tackling a banking crisis. After identifying a particular risk, banks may use some four main risk management solutions: (i) avoid; try to minimize, if difficult to bear with the risk they may pull out from investment options, (ii) control: they should try to undertake mitigation measures within their disposal to minimize the risk, (iii) transfer; some banks may resolve to outsource risk management solutions either through hedging or insurance and (iv) accept; investors will undertake the investment while bearing the risks involved in mind. This is especially when the level of risk is very low and poses small harm to investment References Acharya, V., and Matthew, R. (2009), Restoring Financial Stability: How to Repair a Failed System, New Jersey: John Wiley and Sons Inc., Hoboken. Antif M. & Amir S., (May, 2008). The consequences of mortgage crisis expansion: evidence from 2007 mortgage default crisis, University of Chicago Graduate School of Business. Barnett, W.A., Geweke, J. and Shell, K. (2010). Managing investment risk: Stock market. Cambridge University Press, New York. Cristopher R.W. (2008), The Subprime Crisis - Cause, Effect and Consequences. At Indiana State University Ghon, Rhee, (2008), “The Subprime Mortgage Crisis: Financial Market Perspective,” a paper presented at the 4th APEC International Finance Conference, November 10, 2008. Liebowitz, S., (2009). Anatomy of a Train Wreck: Causes of the Mortgage Meltdown. Oakland CA: The Independent Institute. Norberg, J. (2009), Financial Fiasco: How America's infatuation with home ownership and easy money created the economic crisis, Cato Institute. O’Quinn, R. (2008). The U.S. Housing Bubble and the Global Financial Crisis: .Washington, DC Reischauer, D. R., (2010), Subprime Mortgages: Americas Latest Boom and Bust, Washington, D.C.: Urban Institute Press. Taylor, J., (2009), Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, Hoover Press. Wihlborg, C. (2010), Developing Distress Resolution Procedures for Financial Institutional, Consultant report, Swedish National Audit Office. Read More