The Roots of the Global Financial Crisis - Literature review Example

ID Number of words The roots of the global financial crisis This paper provides and overview and analysis of the major roots that have caused the recent global financial crisis. The research has shown that there are many different factors, which have contributed to the recent financial collapse. However, among a variety of factors, there is identified the root cause which comes from the housing and mortgage credit bubble initiated in the USA. Deregulation of financial markets, lax monetary policies, promotion of mass desire for material wealth encouraged bankers and investment agencies to develop new financial products. Low interest rates for borrowers and forecasted high returns for investors have resulted in excessive demand for loans, which caused excessive leverage. However, despite the forecasted returns to investors, creditors and investment brokers failed to provide trustworthy and reliable information, thus misleading many investors. The major root is viewed to be the structure of global inequality whereas the wealthy private investors pressurised bankers to develop new opportunities for yield. It is obvious that lack of sufficient government regulation enabled bankers to develop these risky opportunities, which contributed to the overall bubble. Finally, it has burst out and affected others in global scales. Table of contents 1. Introduction…………………………………………………………………………………3 2. Analysis of the roots of global financial crisis…………………………………………3 a. Financial innovation……………………………………………………………..4 b. Excessive leverage………………………………………………………………..4 c. Informational inefficiency and a mass failure of human cognition………..5 d. The structure of global inequality ……………………………………………..5 3. Recommendations…………………………………………………………………………5 4. Conclusion…………………………………………………………………………………6 5. References…………………………………………………………………………………7 Introduction For the past three decades, developed and mature economies have strongly emphasised the role of material benefits and the necessity of maximising corporate profit. Cultivation of increased consumption and increased emphasis on consumer choice have gained strategic priority in developed countries, resulting in trend of “living beyond means in the public, household and government sectors” (Matthews and Tlemsani, 2010:-336). As a result, increased tendency of living on credit and readiness of banking and financial institutions to support this trend by issuing more loans, allowing bundles of assets to be priced, and developing new pricing models has led to substantial rise in debt (Matthews and Tlemsani, 2010). Total indebtedness at all levels, starting with individual households, businesses and corporations and ending with the municipalities, the states and the public sector in the USA was estimated to reach $37 trillion (Matthews and Tlemsani, 2010). While the mortgage bubble has burst out initially in the USA, the interconnectedness and overdependence of international financial markets, facilitated with globalisation and information technology, has led to a financial crisis of global scales. Practically everybody has felt the consequences of global economic collapse. The global financial crisis has shaken the minds of many economists, regulators, bankers, and other experts trying to identify the root causes of this collapse. This paper aims to identify and explore the major roots that have caused the recent global financial crisis and based on the research findings to provide some recommendations in order to mitigate the risks of financial crises in the future. Analysis of the roots of global financial crisis There are developed many different positions aiming to explain the causes of the global financial crisis. The list is comprised of a broad variety of suggested causes, including: accounting rules, bank leverage, business education, banker’s bonuses, credit rating agencies, corporate governance, deposit insurance, financial globalization, hedge funds, financial illiteracy, government bailouts, monetary policy, macro-economic imbalances, securitization, speculation, systemic risk, subprime mortgages, etc. (Bondt, 2010). While this list can be continued, in order to find a solution for future, it is important to identify and analyse the key roots of the financial crisis. Some of the major causes are discussed and analyzed below. Financial innovation Many researchers and finance specialists view financial innovation as a potential source for speculative bubble. Thus, for example, mortgage bubble in the USA was facilitated with the emergence of new financial products, especially it relates to securitization process (Carmassi, 2009). Banks have developed complex securitized loans that were sold as low-risky but highly-profitable financial products (Carmassi, 2009). Thus, for example, the amount of structure credit products issued across the European and US market has increased 60 fold for the period from 2000 to 2008, from $50 bn to $3,000bn respectively (Creating an understanding of Special Purpose Vehicles, 2011). Such product innovations as credit scoring, loans with low down payments, derivatives, and other private mortgage securities have built additional layer in the loan pyramid, granting potential investors high returns (Kling, 2009). Deregulation of financial markets, financial product innovation, and lax requirements to potential borrowers accompanied with mass social epidemic has led to increased demand for various type of loans and credits. Thus, for example, demand for the asset-backed securities has grown significantly in US and Europe from c. $200 bn to c. $800bn in 2008 (Creating an understanding of Special Purpose Vehicles, 2011). Also, the banks increasingly relied on off-balance sheet vehicles. These vehicles are not shown on the balance sheets, and include loan guarantees, derivatives and loan commitments (Rötheli, 2010). Control over off-balance sheet vehicles in banks was not sufficient enough, and it also increased risks increased financial manipulations undertaken by banking institutions (Rötheli, 2010). Off-balance-sheet instruments by fact represent leverage (Chan, 2011). By definition, excessive leverage is recognized to be the main root of any banking crisis. When the debtors failed to pay out their interest rates and loans, the pyramid has failed as well making many affected parties bankrupts (Kling, 2009). As a result of excessive leverage, the mortgage bubble has burst out causing domino effect in international financial market (Bondt, 2010). Informational inefficiency and a mass failure of human cognition Informational inefficiency also is recognised to be one of the important root causes of global financial recession. Lack of reliable and objective information leads to imperfections of human choice, judgement and decision-making process (Bondt, 2010). This crisis has perfectly illustrated how lots of people, many of whom were well educated and very smart, perceived “mortgage related instruments as reasonably priced investments” (Bragues, 2011:176). The recent financial crisis has also revealed deficiencies not only in financial structures and monetary policies, but also in information inefficiency leading to extreme mass confidence and optimism. The situation was worsened by inefficient work of rating agencies, the forecasts of which turned out to be less optimistic compared to reality. Credit rating agencies have certified the creditworthiness of many risky projects and finally failed, misleading thus many investors (EEAG Report on the European Economy, 2009). Standard & Poor’s, Fitch Ratings, and Moody’s Investors Service were among the three big credit agencies that actually failed to warn investors about potential risks associated with investment into mortgage-backed securities (Krantz, 2013). The structure of global inequality The majority of heterodox economists believe that the root cause of the global financial crisis lies in the structure of global finance (Lysandrou, 2011). However, in contrast to this position, some researchers explain that the root cause of global financial crisis is to be found in the structure of global inequality (Lysandrou, 2011). According to Lysandrou (2011), the system really has overreached itself in creating and distributing highly toxic structured securities, but this was not the root cause, rather it was a consequence. Consequence of what? Obviously, the consequence of unequally distributed private wealth among a limited category of people, seeking for ways to secure and grow their wealth (Lysandrou, 2011). Continued accumulation of private wealth has outreached the growth of world output, and has triggered the growth of global demand for securities. Wealthy private investors were seeking for opportunities “for yield” and pressurised institutional investors to find solutions and to create extra securities and new products (Lysandrou, 2011). Under this pressure (or opportunity?) banks and other financial institutions switched to highly unconventional securitisation methods (Lysandrou, 2011). Recommendations While it is quite challenging to give any recommendations related to mitigation of risks of financial crisis in future, the findings of the research indicate on some “problematic areas” which should be addressed as soon as possible. Some of the recommendations are the following: 1) Implementation of effective and long lasting financial and monetary policies; 2) Avoidance of excessive leverage and borrowing (Chan, 2011); 3) Insurance of increased financial transparency; 4) Elimination of off-balance sheet instruments; 5) Introduction of policies, reducing asymmetric information and conflict of interests (Iannuzzi, E. and Berardi, M. 2010). Conclusion Practically everybody has felt the consequences of global economic collapse. In attempts to explain the phenomenon of global financial crisis, researchers, economists, and other experts in financial and banking industry have identified a broad variety of factors that caused this collapse. As the research has shown, financial global crisis took its major roots from the housing and mortgage credit bubble initiated in the USA. Deregulation of financial markets, lax monetary policies and promoted mass desire for material wealth have increased opportunities and encouraged bankers and investment agencies to develop new financial products. Low interest rates for borrowers and forecasted high returns for investors have resulted in excessive demand for loans, which caused excessive leverage. People were too optimistic about the situation on the loan and mortgage market and this optimism was backed up by even more optimistic forecasts of creditworthiness rating agencies. As a result, all these factors together have created misbalance on the market, causing collapse in financial markets. Globalisation of markets have led to domino effect in the banking industry, whereas banking and financial institutions have also felt the effects of housing bubble burst. The research shows that there is not one unique root cause, which led to global financial crisis, but rather it was a set of factors that came together in puzzle and played its specific role. References: Bondt, W. (2010), ‘The crisis of 2008 and financial reform’, Qualitative Research in Financial Markets, 2 (3), pp. 137-156. Bragues, G. (2011), “The financial crisis and the failure of modern social science”, Qualitative Research in financial markets, 3 (3) pp. 177-192. Carmassi, J., Gros, D., & Micossi, S. (2009). The Global Financial Crisis: Causes and Cures. Journal Of Common Market Studies, 47(5), 977-996. Chan, N. (2011), ‘Excessive leverage – root cause of financial crisis’, Speech at the Economic Summit 2012 “Roadmap to Hong Kong success”. Available at: http://www.bis.org/review/r111215g.pdf Creating an understanding of Special Purpose Vehicles, (2011), PWC Publication, Available at: http://www.pwc.com/en_GX/gx/banking-capital-markets/publications/assets/pdf/next-chapter-creating-understanding-of-spvs.pdf EEAG Report on the European Economy (2009), Chapter 2: The financial crisis, Institute for Economic Research, pp. 59-122 Ianuzzi, E. and Berardi, M. (2010), ‘Global financial crisis: causes and perspectives’, EuroMed Journal of Business, 5 (3), pp. 279-297. Kling, A. (2009), ‘The Root of the Financial Crisis’. Policy Review [serial online]. Krantz, M. (2013). ‘2008 Crisis still hangs over credit-rating firms’. USA TODAY. Retrieved 27 May 2015, from http://www.usatoday.com/story/money/business/2013/09/13/credit-rating-agencies-2008-financial-crisis-lehman/2759025/ Lysandrou, P. (2011). Global inequality as one of the root causes of the financial crisis: A suggested explanation, Economy and Society, 40(3), 323-344. Matthews, R. and Tlemsani, I. (2010), “The financial Tower of Babel: roots of crisis”, International Journal of Islamic and Middle Eastern Finance and Management”, 3 (4), pp. 334-350. Rötheli, T. (2010), ‘Causes of the financial crisis: risk misperception, policy mistakes, and banks’ bounded rationality’, The Journal of Socio-Economics, 39, pp. 119-126. Read More