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The downturn of the world economy, in light of the present scenario of the global financial crisis, has resulted in the epic failure of multinationals that were once deemed infallible(Ministry Of finance, 2009). The phenomenon of post-industrialism constitutes remote causes of the crisis. Paradoxically, what was once a means to move forward has now turned into a problem that has orchestrated a worldwide collapse resulting in bankruptcy of many corporations (Davis, 2009). It may be interesting to understand how this major change which affected the real economy worldwide, also contributed to the global financial crisis which occurred at the end of this decade.
This essay will discuss the main causes of the global financial crisis and then propose various steps that the government of the United Kingdom could take to prevent another crisis
According to the statistics, at present only a dwindling 10% of the American population is employed in the agriculture and manufacturing industry as opposed to 60% in the pre-industrial era. The gradual but consistent decline of the working population from manufacturing to the service sector has a substantial repercussion on the global economic front. Furthermore people’s ability to work and earn is no longer dependent on their working skills but more on their intellect. To satisfy the needs of cost effective manufacturing, the jobs were off shored to other developing nations (Davis, 2009). An important feature of these large manufacturers (Davis, 2009) was that they were providing “job security, health insurance, and retirement benefits” to their employees but now even these “academy employers” have begun to withhold guarantees, such as their employees’ pension schemes and retirees’ health benefits (Davis, 2009)
Although it is a quite remote cause of the last financial crisis, the post-industrialisation set some of the indispensable conditions for the crisis to happen. Indeed, the employers’ will to “loosen the ties that bound employees to firms” contributed in a significant manner to the development of institutional investment. (Davis, 2009)
The introduction of the 401(k) plan saw to the demise of the ‘defined-benefit’ scheme that induced loyalty among its employees. The new ‘defined-contribution’ plans on a superficial scale were beneficial to the employers but they further weakened employee ties, adding to the effects of earlier discussed post-industrialization. The investment risks were no longer borne by the employer but by the employees. Consequently the market saw a steady rise from 6% investment in stocks by individual households in the 1980’s to an all time high of 52% investment 2001 (Davis, 2009). This substantial increase mainly benefited mutual funds (which consequently invest largely in US corporations), although it served the interests of most of institutional investors’ categories given their interconnection. Although this ‘roll-over’ of funds seemed, at first, beneficial to institutions as well as households it eventually had severe consequences with the decline of the market. (Davis, 2009)
These two major economic and (subsequent) financial changes contributed to weaken the system by excessively reinforcing the links between the real economy and the financial sphere. These ever-closer ties between institutions and households, between institutions and workers or retirees and between institutions themselves explain how a little spark could result in a highly destructive fire. It seems that the sub-prime crisis can be considered as the “spark”. (Holmes and Tamara, 2009)
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“The Federal Reserve’s accommodative interest rate policy of the early 2000’s is generally seen as what has caused the real estate bubble burst” (Bhalla,2009). The sub-prime problem arose from the fact that buyers without sufficient purchasing power were being funded by the greedy financial institutions because of their objective to maximize profits in the short run (Yandle, 2010). Debtors were also given options by the bank, wherein they could avoid the increase in the mortgage rate simply by refinancing within the stipulated time (Acharya et al., 2009) This, of course, was under the assumption that housing prices would continuously appreciate. However housing prices deteriorated at an alarming rate of 17% per year from the year 2008 and this continued to cause a chain-reaction of multitude of problems that were dependent on the ‘refinancing’ option (Bhalla,2009).
The last main “ingredient” of the turmoil is directly related to the sub-prime crisis. It may be considered as the most “poisonous” one. First, because it made the crisis hard to predict and therefore hard to assess and solve. Secondly, because it played the most significant role in diffusing the crisis’ effects quickly and at a worldwide scale. This “ingredient” is the complicated “securitization” process
According to Gerald F. Davis, the process of securitization consists of transforming assets “into securities that are traded in markets”. This practice is linked to the shift in the banking activity, from the traditional“originate to hold” banking model to a “originate to distribute” model. One type of security which is particularly relevant in the case of the financial crisis is mortgage-backed bonds, an asset-backed security that is secured by a collection of mortgages. The problem is that, if the mortgagor becomes insolvent the value of the security is likely to disintegrate. Securitization processes increased dramatically at the end of the 21st century, in reason of the demand generated by worldwide institutional investors (especially pension funds and mutual funds (Davis, 2009). Therefore the impact of the collapse was eventually significant as in the case of Fannie Mae and Freddie Mac. (Butler, 2009)
Before discussing the possible steps we have to make two distinctions. First we shall distinguish between the “emergency measures” which have been implemented in order to help the economy to recover in the short term (e.g.: bail-out packages) and those which should prevent future crises. We shall focus on the second category.
Another important point is that we shall only deal with the steps that should be implemented in the United Kingdom. Thus we will not expose solutions to solve the causes which originated in the United States such as the sub-prime crisis. Only the US government is competent to deal with this problem; ideas of changes include, inter alia, requiring licenses and state certification for all loan brokers and individual retail mortgage loan officers (Muolo, 2008)
In order to reduce the effects of another financial crisis, the United Kingdom should concentrate their efforts on three main issues: the effects of bail-out policies, the regulation of financial institutions and of institutional investors and the regulation of non-banks.
Poole argues that bail-out policies have an enabling impact on the behaviour of companies and financial institutions. According to him “every economist understands [that] a policy of bailing out failing firms will increase the number of financial crises and the number of bailouts”. (Poole, 2007). Indeed he explains that these practices give incentives for firms to “take too much risk and hold little capital” (Poole, 2007).In order to reduce the “safety net”, he proposes to diminish the insurance coverage of financial institutions. Although this proposal concerns the United States and is dedicated to the Federal Reserve System (the author is himself President of the Federal Reserve Bank of St. Louis), it would certainly suit the UK given the bail-out policy implemented there as well (see the government’s emergency £37bn recapitalisation of the UK banking sector (Wearden and Kollewe, 2008).
We have to keep in mind that the diffusion of “toxic assets” from the US to the world (including the UK) has been possible because of the trade of these assets on financial markets. The FSA may need to impose more severe rules on institutional investors and banks (in regards to their investment activities). It has been argued that risks linked to securities were sometimes difficult to assess. Moreover several banks acknowledged that they were unable to estimate with accuracy the quantity of “toxic assets” they had acquired. Stephen says that any company having excessive growth due to risky financial investments are the ones on high risk of a collapse (Schwarzman, 2008). The British regulators here have a very important role to play and they should improve their oversight over all the institutions participating in the securities market, as the US regulators should improve theirs over the bonds market (which played a significant part in the sub-prime crisis).
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The largely unregulated “Shadow banks” have gradually emerged as new players in the financial intermediation process (Llewellyn, D. 2009). According to Butler and Patrick (2009) the Government of UK is trying to regulate the non-banks through a process called “shadow banking” for institutions such as hedge funds, private-equity funds and insurance companies. To save tax-payers money it is necessary to have regulations in place and initiate shadow banking, however this practice has still not been implemented because of the complex mechanisms of these institutions (Butler, 2009)
In conclusion, this paper discussed the various causes of the financial crisis which started way back from the post-industrial era and led to other severe problems in terms of the defined contribution by the employers. A further factor included premature acceptance and use of securitization, and shifting of risk by major financial institutions. While it is of utmost importance to know the causes of the crisis, more emphasis must be laid on the steps taken to avoid another turmoil. Despite this range of propositions, this discussion cannot omit the paramount need for more international coordination and regulation between political and financial authorities. As Acharya and others explain, “Although cross-border banking and financial flows have expanded in scale, much of bank supervision remains national” (Acharya et al. 2009). Thus, crisis at the international scale are not likely to be efficiently withstood if national regulations are not accompanied by international ones.
Finally, and to refer to President Kennedy’s quotation, we may assert that a crisis is above all the opportunity to evaluate the dangerous nature of the current system, assessing its strength and flaws, and to improve it, when required.
Davis, G. F. (2009). The Rise and fall of Finance and the End of the Society of Organizations. Academy of Management Perspectives, 23 (3), pp. 27-44.
Ministry Of finance. 2009. Statement of G7 Finance Ministers and Central Bank Governors. [Online] Available at http://www.mof.go.jp//english/if/g7_090214.pdf [Accessed 16 February 2010]
Butler, P. 2009. Learning from financial regulation’s mistakes. McKinsey Quarterly Business Source Premier issue 3. pp. 68-74.
Holmes and Tamara E. 2009. Did they Cause the Credit Crisis? Black Enterprise; 39(6), pp. 74-77)
Bhalla, V. K 2009. Global Financial Turmoil. Journal of Management Research 9(1), pp. 43-56
Yandle, Bruce 2010. The lost trust- The real cause of the financial meltdown. Independent Review 14(3), pp. 341-361.
Acharya et al. 2009. The Financial Crisis of 2007-2009: Causes and Remedies. FinancialMarkets, Institutions & Instruments. 18(2), pp. 89-137
Butler, E. 2009. The Financial Crisis: Blame Governments, Not Bankers In: Booth. P. Verdict on the Crash: Causes and Policy Implications. 1st ed. The Institute of Economic Affairs. pp. 55-57
Muolo, P. 2008. What I Would Do About the Crisis If I Ran the Regulatory Zoo. National Mortgage News, 33(3) , pp. 5-5
Poole, W. 2007. Responding to financial crisis: What role for the fed? CATO Journal, 27(2), pp. 149-155
Wearden, G and Kollewe, J. 2008.How the banking bail-out works | Business|. [Online] Available at: http://www.guardian.co.uk/business/2008/oct/13/banking-banks [Accessed: 18 February 2010.]
Schwarzman, S. 2008. Some Lessons of the Financial Crisis. Wall Street Journal – Eastern Edition 252(107), pp. 19-19
Llewellyn, D. 2009. The Global financial crisis: The role of financial innovation In: Booth. P. Verdict on the Crash: Causes and Policy Implications. 1st ed. The Institute of Economic Affairs. pp. 129-130
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