How the Global Financial Crisis Affected the Banking Sector - Assignment Example

Global Financial Crisis Name: Course: Lecturer: Date: Question 1 Causes of the Global Financial Crisis The global financial crisis occurred in 2008, it was marked by a fall in the monetary policies and increase in macroeconomic imbalances in the world economy. This is because each country was trying to come up with a way to deal with the poor performance in the economy but ended up creating a situation that affected the performance of their financial institutions and monetary policies. The global financial crisis was an impact of increasing deficits in current account that made most people resolve to investment in assets. It resulted from a combination of factors that t affected the regulatory framework and policies determining liquidity in the financial market. The effect on liquidity policies and regulatory framework in financial institutions affected interest rates and exchange rates. These factors included credit bubble, imbalances in international trade, real estate bubbles, and bad choice of fiscal policies and bailing of troubled financial institutions. However, the three main causes of the global financial crisis are real estate bubble, bad choice of fiscal policies and credit bubble (Reinhart & Rogoff 2009). Real estate bubble According to Crotty (2009), the effects of real estate bubble were seen in both the ownership of homes and the mortgages that were used to finance these homes. In the United States housing increased drastically from 2000 to 2006 at a rate that could not be explained in many states. This was due increase in population in these states and the demand for houses went up. The price of the houses went up and so it took a larger portion of each household’s income. The buying of houses was made possible by the availability of easy financing. The mortgages became too available and people were allowed to borrow enough money to buy expensive homes. This was the housing bubble since it also made the owners to refinance their mortgages at lower rates interest rates this prompted people to take more than one mortgage. The idea later spread across the world resulting to the global financial crisis. Change of fiscal policies As Reinhart & Rogoff (2009) point out, there were so many innovations in financial institutions and financial instruments. These were reengineered so fast that the existing market structures, policies and system were not adequately ready for these new developments. Bankers, fund managers and insurers had anticipated that these developments would boost their income, hedge monetary and financial risks as well as remove regulations and pass risks to other parties. These new instruments were found to be too complex such that they hindered investor’s judgments. They also increased the risk of investments. Mortgage brokers and banks “securitized” mortgages after realizing that they could make extra money from it. Thus, mortgages securitization became an important aspect of the financial market. This led to lack of measures on the mortgages and loans in case of default and consequently led to high risks and fraud in the mortgage industry. Mortgage lenders initiated fraud and misrepresentation with the aim of maximizing their income, resulting to the global financial crisis (Crotty 2009). Cheap Loans and Low Interest Rate From year 2000 to year 2005 there was a major reduction in interest rates in the United States. This was due to high deficit in the trade current account. As such, the United States increased its borrowings in order to finance its deficit. Increasing foreign funding lowered the interest rates. This forced the United States to loan back the funds consumers and financial investors in the country. Thus, most inventors opted to invest in treasury securities and the high risk mortgages this resulted to the global financial crisis since there was increase in domestic lending (Taylor, 2009). Question 2 Consequences of the Global Financial Crisis Shiller (2008) points out that, the effects of the global financial crisis were felt in macroeconomic factors of most countries in the world. The effects lowered investor’s confidence in these macroeconomic factors such that the rate of investments declined resulting to poor performance in the economy. As a result of the effects of the crisis on monetary policies, consumer’s confidence was reduced resulting to reduced rate of consumption. This resulted to decline in commodity prices so as to attract customers and increase consumption. Since one of the causes of the crisis was increased lending, due to the low interest rates banks and other financial institutions have reduced lending so as to deal with these effects. Due to reduced borrowing and lending investors involvement in project was reduced due to lack of funding. Regulation and behavior of banks contributed significantly to the global financial crisis and they suffer the greatest consequences on the crisis as a result. Another consequence of the global financial crisis is the financial shock which negatively impact on the values of the stock market from the baseline. There was also a major impact on investment because of the housing bubble as mortgages became too attractive. High risk in investment made people to shift their investment to domestic assets like government bonds and housing. This caused a decline in investments. The growth domestic product (GDP) dropped considerably especially due to decline in consumption. This indicated poor performance for the economy. The united states GDP was the most affected as it fell to negative 3.5 percent which is lowest GDP rate United States economy. After the crisis individuals opted to hold their money since there was no utility in spending it. Due to the low interest rates in banks investors considered it unprofitable to keep their money in banks. This resulted in reduction in household wealth as their equity declined (Puri et al 2011). Question 3 How the Global Financial Crisis Affected the Banking Sector After the global financial crisis, most effects on the banking sector in Australia were on the efficiency of their profitability and did not affect their cost efficiency. This made it possible for the banking sector in Australia to put up with the shocks caused by the crisis. As such, banks with Australian ownership continued to report impressive profits. This is because these banks were not much exposed to the shocks since they had concentrated on domestic lending. Unlike banks in the United States, Australian banks have been in a position to raise extra capital for the private sector and even to increase their credit rating to AA or above. One of the reasons for the good performance during the global financial crisis is the accumulation of trade securities during the crisis since Australian banks were concentrated on lending domestically. Another reason is that the mortgage and housing markets were not over extended as those in the US (Colander et al 2009). In comparison to Australia banks and financial institutions in the United States experienced shock from the global financial crisis thus resulting to negative effects for these banks. They concentrated so much on mortgages thus unable to raise additional capital for lending to private sector. The banks were also afraid of lending amongst themselves which resulted to high interest’s rates thus a reduction in borrowing. This made the amount of funds in circulation to decrease appreciably. The US banks were also leading in securitization and this affected their financial systems yet Australia did not take part in it thus their financial system remained intact and so their banks did not experience the adverse effects of the global crisis (Shin 2009). Question 4 Financing that the Commonwealth Bank will raise a) Financing Issues = 500 Maturity = 5 years Coupon rate = 6% annually Face value = $1,000 Amount of financing the bank will raise = face value x issues = $1,000 x 500 = $500,000 Cost of the finance = amount raised x coupon rate x maturity = $500,000 x 6% x 5 = $150,000 Bonds of similar risk and maturity = $500,000 x 7% x 5 = $175,000 The difference = $175,000 - $150,000 = $25,000 b) Effects on the price of the bond when credit rating increases Increasing the credit rating of the commonwealth bank from AA to AAA will result to a change in the price of the bonds. The increase in the credit rating is a positive effect for the bank, thus, the bank will issue bonds to investors at a higher price which will increase the price of the bond. This will increase investor’s confidence, which will raise the demand for bonds due thus the change. Question 5 Bank Bills on the Money Market to Raise Short-Term Financing a) Financing Maturity Period = 180 days Face value = $50 Coupon Rate = 5% Amount of financing = face value x acceptance fee = $50,000,000 x 50 = $250,000,000 b) To issue a commercial paper or banks bills According to Becker & Milbourn (2011), Apple Inc. should have issued commercial papers rather than the banks bills because they mature faster and cheaper. They enable an investor to take advantage of fluctuations of the interest rates in the market. They are easy to dispose and therefore provide the investor with an option to exit at any time of the period even before maturity. Commercial papers also have a varied and wide range of maturity and their rating reduces capital costs making the investment attractive compared to bank bills. As such, I propose that the bank should issue commercial papers rather than the bank bills. Question 6 ANZ Bank Shares I would not buy the commonwealth shares because ANZ Bank has shares with a very attractive growth rate that is expected to increase forever. Thus I would take time and evaluate the performance of the ANZ Bank shares. I would then compare them with those of the commonwealth bank and establish the option that is best for investment. Based on the current market data for commonwealth bank shares, I would not purchase the shares since ANZ Bank provides a good value for investment in the long term. The future growth and returns of both banks will be different. Therefore, it is important to study their performance in the markets before buying the shares and thus make an informed decision. References Becker, B, & Milbourn, T, 2011, how did increased competition affect credit ratings, journal of financial economics, 101(3), 493-514. Colander, D, Goldberg, M, Haas, A, Juselius, K, Kirman, A, Lux, T, & Sloth, B, 2009, the financial crisis and the systemic failure of the economics profession, critical Review, 21(2-3), 249-267. Crotty, J, 2009, structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’, Cambridge Journal of Economics, 33(4), 563-580. Puri, M, Rocholl, J, & Steffen, S, 2011, global retail lending in the aftermath of the US financial crisis: distinguishing between supply and demand effects, journal of Financial Economics, 100(3), 556-578. Reinhart, C, M, & Rogoff, K, S, 2009, the aftermath of financial crises (No. w14656), National Bureau of Economic Research. Shiller, R, J, 2008, the subprime solution: how today's global financial crisis happened, and what to do about it, Princeton University Press. Shin, H, S, 2009, reflections on northern rock: the bank run that heralded the global financial crisis, the journal of economic perspectives, 23(1), 101-120. Taylor, J, B, 2009, the financial crisis and the policy responses: an empirical analysis of what went wrong (No. w14631), National Bureau of Economic Research. Read More