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Main causes of global financial crisis

This essay is about the main causes of the global financial crisis and the steps the UK government could take to reduce the dangers of another crisis. The current financial crisis started in late 2008 in USA with its banking system getting collapsed, from there on it has spread all over the world. There are lots of opinions on what went wrong, who was wrong and what can go wrong in the future and how to avoid another crisis of this magnitude (Anon, 2009). There are many reasons due to which the crisis has occurred, such as macro imbalance, financial liberalization, financial innovation, easy monetary policy, collateralized debt obligations (CDOs), sub-prime mortgage, repeal of the Glass Steagall Act, securitization, rating agencies, and many more. The internal structure of major banks is a major issue as well (Treasury Committee, 2009). Due to the above reasons customer demands plummeted, big financial institutions filed for bankruptcy and many more events occurred and the first crisis of this century began (Anon, 2009). One of the worst affected countries in this crisis is UK. The government has spent more than 2 billion pounds in order to control the crisis for not deteriorating further. Government plays a key role in providing a stable economic environment for the future (ACCA, 2009). There are few ways the UK government could avoid avert future crisis, such as working with the policies set by the Basel committee as well as greater and stronger role of Financial Service Authority (FSA) (Turner, 2009).

According to some of the experts the reason for financial meltdown was simply because the banks lost control. However, many analysis of during a number of past financial crisis suggest that there are many factors which lead up to a major crisis (Anon, 2009). One of the factors in this current crisis is macro imbalances. There were large current account surpluses with countries such as China and Japan and large current account deficit with countries such as USA and UK. These imbalances influenced the financial market developments. The countries with surpluses were investing in near risk-free government bonds on a long-term real interest rate basis. This in turn led to the rapid growth of credit extension in some developed countries particularly in UK and USA especially for residential mortgages which in turn lead to degradation of credit standards, fuelling property price booms and increase in the leverage of major financial institutions such as investment banks and their activities (Turner, 2009).

This rapid growth lead to credit to spread to a wide range of securities as well as the banks and hedge funds were increasing with high profits and bonuses and thus strengthening management certainty that they are doing the right thing. However, the rapid growth lead to a potentially more economically destructive of securitized credit instruments. The banking system has transformed through the practice of securitization that is, turning assets into securities which can be traded in the markets. One of the arguments in favour of securitization was that it would reduce risks not only for individual banks by passing on the credit risk to diversified set of end investors but also for the whole banking system (Turner, 2009). However, there are some concerns regarding securitization. More recent and best form of securitizations are (Davis, 2009) the CDOs as well as Mortgage-backed Securities (MBSs) which are a part of structured finance market (Standard and Poors', 2007). The structured finance products are rated by rating agencies. One of the advantages of having a higher rating is, higher the rating safer the CDOs and MBSs, also under the Basel 1 agreement banks are required to maintain minimal capital. High ratings means apart from low capital requirement, there is higher leverage, higher profit and higher bonuses. However, rating agencies are influenced by the investment banks to rate their products high. Therefore, the profit of rating agencies depends upon whether they keep the banks content. The recent financial boom and crisis might have not occurred if rating agencies wouldn't have given absurd ratings to illiquid, non-transparent, structured financial products such as MBSs and CDOs (Crotty, 2009).

The current origination of the current crisis is due to the bust of the housing bubble which in turn was due to excessive liquidity. The excessive liquidity was the result of three forces, that is, financial liberalization, financial innovation, and easy monetary policy. The financial liberalization allowed financial institutions to set off new financial activity based on the discretion of the banks to dispose of their loan portfolio in agreement with risk management. The second force is financial innovation which emerged through financial liberalization. The financial innovation is regarding the issue of financial structured products such as CDOs. Financial innovation in turn set the development of easy monetary policy; it focused on monetary policy rather than fiscal policy which gave more emphasis on frequent interest rate changes to control inflation. These forces played an important role in inflammation of the sub-prime mortgage crisis. (Arestis and Karakitsos, 2009).

The impacts of aforesaid causes lead to sub-prime mortgage crisis. The cause of the current crisis was the subsequent developments in the sub-prime mortgage market. The free market conditions encouraged more financial liberalization policies, which saw new financial development which was creating huge liquidity crisis and debt. The repeal of the Glass-Steagall Act allowed the merging of commercial and investment banking which enable financial institutions to separate loan origination from loan portfolio. Also it encouraged banks to provide risky loans without checking the credit history of the borrower or taking any collateral which created distinct growth of the sub-prime market. This created ‘shadow-banking' working in parallel to banking but outside the regulatory umbrella and sowed the seeds for the sub-prime mortgage crisis or the origination of current credit crisis (Arestis and Karakitsos, 2009:6). The root cause of the current crisis was linked to the sub-prime mortgage business in which banks gave risky loans to people with poor credit histories (BBC, 2009). The blame for the crisis should be shared by bankers, central banks, finance ministers and academics across the world as they failed to identify that the whole financial system was loaded with risk, the warnings were ignored and there were less regulations (Turner, 2009).

The crisis being already upon the world one of the things governments around the world like the UK government, for example can do is to learn from the past and ensuring that such crisis doesn't happen again. A long term plan must be framed (Anon, 2009). A common set of principles must be agreed by all the countries which include strengthening the financial regulations (BBC, 2008). One impact of the crisis is greater regulation for the banks, (Heaney, 2008) hedge funds (Turner, 2009) as well as having minimum bank capital requirement (Heaney, 2008). The UK government should make policies on the basis of Basel Committee which addresses issues of building capital buffers at individual banks as well as achieving a universal goal of containing excess credit growth and protecting the banking sector from system-wide risk. Along with working on the policies based on Basel 2 Committee, the government should work on guidelines set up by International Monetary Fund/Bank for International Settlements/Financial Stability Board in order to identify important financial institutions, markets and instruments (Treasury Committee, 2009). A greater role for the FSA should be provided by the UK government and the Bank of England (Turner, 2009). The FSA should work on checking the banking system as well as greater market discipline, which needs to be reintroduced for realigning the incentives of bank investors and managers. As well as charging tax based on the size of the banks (Treasury Committee, 2009).

The combination of low saving rates and high debt levels in UK is one of the factors of having a culture of not saving the money. The government should encourage savings and reforms of pensions and benefit systems so as to restore the social and economic benefits of savings culture. High debts in this culture of low savings is due to increasing due to credit cards as well as banks offering many forms of credit for instance residential mortgages. Rather than through individual bank officer judgement, better credit scoring techniques should be used before offering mortgage to the customers. Additionally, better regulations to the crisis will offer fewer complexes and more transparency to end investors (ACCA, 2009). With rating agencies rating structured finance products, ratings cannot be accurate where the information provided is either misleading or fraudulent. Therefore full regulation by the government could prove counterproductive. If regulations permeate ratings with an official endorsement it would strengthen the ratings acceptance (Heaney, 2008). In UK, regulation and regulators should be finely accustomed to the danger of institutions developing serious systems risk for the banking sector (ACCA, 2009). Reforms to regulation should include effective ways for assessing and limiting liquidity risks which financial institution faced (Turner, 2009).

The world is in the midst of the crisis and lessons should be learnt to ensure such crisis doesn't occur again through sound financial/banking system. For a sound financial system, banking system needs to change (Turner, 2009) and more regulations should be at force (Heaney, 2008). Some writers suggest have the real vision is having a long-term framework so as to avoid any future crisis. However, the era of economic boom and bust will not deceased as it has done throughout the 20th century. Certain actions to avert another crisis are logical, inevitable as well as necessary. However in this uncertain time of free market conditions as the boom makes every corner of the world rise, the same way a bust will affect in some way or the other. For governments in country UK, another crisis is inevitable but the question is how much the government will be able to restrict the crisis so as not to spread everywhere (Anon, 2009).

Reference:

ACCA (2009), ‘Nine Steps to Financial Stability in 2020', The Association of Chartered Certified Accountants, December 2009, pp.1-8

Anon (2009), ‘Crisis? What Crisis? Learning the Lessons of Detecting Financial Meltdown', Strategic Direction, 25:5, pp. 18-20

Arestis, P. and Karakitsos, E. (2009), ‘Subprime Mortgage Market and Current Financial Crisis', Department of Land Economy, University of Cambridge, Working Paper 08-09

BBC (2008), G20 Urged to Reject Protectionism, Online Available: http://news.bbc.co.uk/1/hi/business/7728929.stm (Accessed on 10 February 2010)

BBC (2009), Timeline: Credit Crunch to Downturn, Online Available: http://news.bbc.co.uk/1/hi/business/7521250.stm (Accessed on 10 February 2010)

Coval, J., Jurek, J. and Stafford, E. (2008), ‘The Economics of Structured Finance' Harvard Business School, Working Paper 09-060

Crotty, J. (2009), ‘Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New Financial Architecture', Cambridge Journal of Economics, 33, pp. 563-580

Davis, G. (2009), ‘The Rise and Fall of Finance and the End of the Society of Organizations', Academy of Management Perspectives, 23:3, pp. 27-44

Heaney, V. (2008), ‘Whipping Boys', Financial World, November 2008, pp. 12-15

Standard and Poors' (2007), ‘Structured Finance', Ratings Direct, August 2007, pp. 1-16

Treasury Committee (2009), ‘Banking Crisis: Regulation and Supervision: Responses from the Government and Financial Services Authority to the Committee's: Fourteenth Report of Session 2008-09', House of Commons Report, London: House of Commons, The Stationary Office Limited

Turner A. (2009), The Financial Crisis and the Future of Financial Regulation, (Online) Available: http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2009/0121_at.shtml (Accessed on 10 February 2010)


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