finance

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The Financial Crisis Impact on Financial Institutions

As the financial crisis bites on, financial institutions appear to be worst-hit. A large number of them around the world have either been taken over or merged with another financial institution; nationalized by a government or central bank; or declared insolvent. Many banks in the US have been bankrupt, filed for bankruptcy or closed and received by the Federal Deposit Insurance Corporation, FDIC.

The financial crisis 2008 observed the failures of American giant financial institutions that collapse one after another. Actually, earlier in the financial crisis period itself, the collapse of Bear Sterns, the third or fourth large bank, indicates the follow-up failure of other financial institutions. American Government takes over the bank. Rumors started spreading around that yet another bank would follow the trend and next turn out would be another big investment bank, the Lehman Brothers. The government chose to take a strong stand this time as they think that the bank should responsible for the unfavorable outcomes of its financial transactions faulty. As a result, Lehman Brothers filed for Chapter 11 bankruptcy protection on September 15, 2008. And, the bankruptcy of Lehman Brothers is the largest bankruptcy filing in U.S. history

Two other huge financial institutions that act as guarantors of mortgage loans, which are Fannie Mae and Freddie Mac, were taken over by the government. The government declared its action on the ground that if the guarantors failed, it would threaten the entire mortgage loan business. Thus, to avoid the serious circumstances, the government lends a hand to help them. Another big blow followed as AIG (American Investment Group), the biggest insurance company with worldwide network, faced financial bankruptcy. The Federal Reserve Bank salvaged AIG in term of 80 per cent of the value of its financial burden exchange for government ownership of the company stocks in the same proportion.

Thereafter who follow the suits were three other well-known investment banks—Goldman Sachs, Stanley Morgan Investment and Merrill Lynch. The former two were converted into holding companies while the latter one was taken over by the Bank of America. Next on the chopping board was Washington Mutual which is the biggest bank that receiving deposits from and lending to ordinary clients. The end result of Washington Mutual was being nationalized.

The American Government and the Federal Reserve soon realized that dealings with individual financial institutions as and when they collapsed was not the right way to resolve the problem thoroughly. The failure of these big institutions had caused the entire financial world become panic. It caused loss of confidence within the financial institutions itself. Banks were not willing to lend to each other or enter into transactions and this result in the frozen of the entire credit system. 

In the meanwhile, the complication of the American crisis had spread to Europe as well. Northern Rock, a medium-sized British bank, becomes one of the first victims of the crisis. In February 2008, it was taken over by government. Northern Rock's problems can be said as an early signal of the troubles that would soon befall other banks and financial institutions. Those directly involved in home construction and mortgage lending are the companies that had been impact initially. Northern Rock and Countrywide Financial are examples of those companies as they could no longer obtain funds through the credit markets. 

Thereafter another Britain’s big banks, Bradford and Bingly follow the trend, was failing. It was taken over by the government like what happened to Northern Rock. And then, this was followed by financial crises in the HBOS, Lloyds Bank of Scotland and TSB Barclays to which receiving a bailout of £ 50 billion from British government. Besides, Fortis, a big bank in Belgium, also started falling though owning a financially secure business and eventually had been acquired by the combined support of the Government of Netherlands, Luxemburg and Belgium. 

Apart from US and Britain, financial institutions in other countries also were greatly impact by the financial crisis 2008. For instance, a Scandinavian country, Iceland, saw a complete collapse of its banking system. As a consequence, its President had a heart attack and its Prime Minister asked his people to go back to fishing. Besides, the German Government gave a bail out of $ 50 billion to its banking system.

Overall, the International Monetary Fund reckon that large U.S. and European banks incurred loss of more than $1 trillion on bad loans and toxic assets from January 2007 to September 2009. These losses are expected to reach top of $2.8 trillion from 2007 to 2010. European bank losses are predicted to reach $1.6 trillion while U.S. banks losses were predicted to hit $1 trillion.

3.2 Effects on shadow banking system

Many shadow banking [1]  institutions and vehicles have emerged in American and European markets, between the years 2000 and 2008, and is crucial in providing credit across the global financial system. Bear Stearns and Lehman Brothers are examples of shadow institutions and hedge funds, structured investment vehicles, special purpose entity, money markets, investment banks, bond insurance and other non-bank financial institutions comprised other entities of the system. 

As shadow institutions do not accept deposits like a depository bank, they are not subject to the same safety regulations as depository banks. They don’t have required reserve and thus they do not keep reserve. In other words, they can have a very high level of leverage, with a high ratio of debt relative to the liquid assets available to pay immediate claims. High leverage gears up profits during boom periods and losses during downturns.

Shadow institutions such as investment banks used to borrow from investors in short-term and liquid markets. On the other hand, the funds were loan out to corporations or were invested in long-term asset. They usually invest in mortgage-backed securities. This type of securities was called ‘ toxic assets ’ as the value of assets dropped dramatically when housing price decline and foreclosures rise during the financial crisis 2008 period. 

Investment banks’ dependence on short-term financing required them to return periodically to investors in the capital markets in order to refinance their operations. However, as the financial crisis 2008 set in, housing market began deteriorated, the ability of investment banks to pool funds from investors through investments such as mortgage-backed securities had decline. As a result, these investment banks were unable to fund themselves. The refusal or inability of investors to provide funds through short-term market such as money market contributed to the failure of Bear Stearns and Lehman during 2008.

Shadow banking institutions are exposed greatly to liquidity risk as their long-term assets that are illiquid most probably cannot response immediately to the claims for their short-run liabilities. In addition, they do not have direct or indirect access to their central bank’s support of that play a role as lender of last resort. Therefore, during periods of market illiquidity, they might face bankruptcy if they were unable to refinance their short-term liabilities. As they have a high level of leverage, the disruptions in credit markets would cause them subject to rapid deleveraging. As a result, they would have to settle their debts by selling their long-term assets. 

The shadow banking system that pioneer the securitization market started to dcline in numbers in the spring of 2007 and nearly shut-down in the fall of 2008. More than a third of the private credit markets thus were no more the funds’ sources. In February 2009, Ben Bernanke stated that securitization markets remained effectively shut, with the exception of conforming mortgages, which could be sold to Fannie Mae and Freddie Mac.

Subsequent to the subprime meltdown in 2008, the activities of the shadow banking system came under increasing scrutiny and regulations. Paul Tucker [2] of Bank of England has been taking the issue of financial stability with seriousness. In this speech, he looks at shadow banking. He says we need to bring them in the regulatory ambit and keep looking out for regulatory arbitrage. The followings are the speech of Paul Tucker [3] regarding the regulations for shadow banking system:

“For those forms of financial intermediation that are dependent on banks for leverage and liquidity, it may be that we can develop macroprudential instruments that could be deployed to restrain excess by influencing banks’ supply of credit to them. That is another major area of work.

But where a form of shadow banking provides an alternative home for liquid savings, offering de facto deposit and monetary services, then I think we should be ready to bring them into the banking world itself. In the latest episode, constant-Net Asset Value, instant-access money funds and the prime brokerage units of the dealers seem to have been examples of that.

We have not seen the last of regulatory arbitrage. So we need policies and principles that stand in the way of its weakening the resilience of the system, while allowing enterprise and our capital markets to flourish.”

3.3 Wealth effects

The financial crisis that blew out in the United States around the summer of 2007 and approaching the top around the autumn of 2008 had destructed US$34.4 trillion of wealth globally by March 2009, when the equity markets dwindle to their lowest points. 

After being hit by financial crisis, by early March 2009, the total market value of publicly traded companies around the world had dropped to $28.6 trillion [4] . The lost $34.4 trillion in wealth was exceeding the combination of US, European Union and Japan’s 2008 annual gross domestic product. This resulted wealth deficit effect would take at least a decade to replenish. For instance, it would take more than 10 years to recover the lost wealth in the US economy with an optimistic compounded annual growth rate of 5%, 

In the US, the market capitalization dropped by almost half to $7.9 trillion by March 2009. Due to the subprime mortgage crisis 2008, US households lost almost $8 trillion of wealth in the stock market on top of the $6 trillion loss in the market value of their homes. The total wealth loss of $14 trillion by US households in 2009 was equal to the entire 2008 US GDP. 

Apart from US, UK had been hit by a steep reduction in the value of household wealth as an effect of financial crisis 2008. The BBC reports that “in the course of 2008 alone, £815bn was ceased the wealth of households in the UK. That amounted to an average of nearly £31,000 for every household in the UK.” There was a 9% cut in the market value of all residential property, from £4,077bn to £3,693bn. Besides, the financial assets of households, such as the value of investments and pension funds, also dropped by 9%, to £3,687bn. 


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