Global Financial Crisis and Governmental Responses

Introduction

The 2007-2008 global financial crisis constituted a defining moment of the US economic business cycle. It initiated in spring 2007 following a housing slump. Later, it grew into a crisis of global economies during the late summer of 2007. In autumn, nations such as the UK experienced credit crunch repercussions through the monetary catastrophe that resulted in the collapsing of businesses together with the erosion of consumer confidence during winter (Finn 2008). However, by 2010, it sounded relieving to many businesses in the UK and the US as signs of the first phases of the crisis began to fade. However, the damage that was done on economies and their prospects were irreversible (Finn 2008). Indeed, many nations viewed the crisis as the worst predicament ever since the great depression. This paper discusses and offers comments on the responses to the global financial crunch. However, it begins by offering an overview of its effects. It also discusses policies that were implemented to enhance the recovery process whilst highlighting their effects on the US administration.

Effects of the Global Financial Crisis

The global financial crisis increased susceptibility of economic systems to credit risks. This form encompasses risks that are perceived by investors as accruing from the failure of borrowers to make payments as agreed. Precisely credit risks include ‘the risk of loss of principal or a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation’ (Cornett & Saunders 2006, p.36). The risk has negative ramifications since some structures of a financial organisation may collapse in totality upon the occurrence of a fiscal crisis. For example, as depicted in figure 1, the 2007-2008 global financial crisis affected the US securitisation markets severely.

Effects of the Global Financial Crunch on Securitisation Markets
Fig. 1: Effects of the Global Financial Crunch on Securitisation Markets

Financial organisations in the European Union borrow money from SSUs (surplus spending units) and then lend it to DSUs (deficits spending units). SSUs place their finances in monetary institutions in an effort to get a fixed rate of interest on their savings. They also look forward to being free from various risks of investments. Eken, Selimler, and Kale (2012) assert that DSUs make efforts to borrow money from the banking industry in an effort to fix costs that are associated with their borrowings. They also aim at protecting themselves from potential risks that arise from an eminent financial crisis. Such an effort is crucial in helping the DSUs and SSUs to deal with financial uncertainties. During the global financial crisis, SSUs and DSUs pushed banks to assume unwanted risks in the EU banking system.

Through strategies such as availing clients with various intermediations, financial institutions acquire certain threats, which are not welcomed by clients. Consequently, one of the major concerns for banks is to manage their risks in an efficient way in an effort to gain returns on investments whilst also protecting the equities of the shareholders. This goal is realised when there is financial prosperity within different countries.

Global financial crisis exposed banks to major threats in their efforts to mitigate risks and/or increase their profitability and market value. However, it is important to note that financial crisis affected diverse economic systems differently depending on their risk resilience capacities. Sensitivity and volatility constitute the building blocks of financial risks. Risk-prone banks have high levels of sensitivity and low levels of volatility. This situation implies that banks, which were risk-prone during the global financial crisis, were negatively affected more seriously in comparison with the risk-averse ones.

Global financial crisis resulted in the rising up of volatility levels, which had the impact of shrinking investor preferences in terms of assuming risks at minimal levels (Eken, Selimler & Kale 2012). In such situations, risk-prone investors also make strategic decisions to deploy risk-averse strategies in the effort to keep exposure to non-financial and financial risks at the lowest levels. Directly congruent with this assertion, De Haas and Van Horen (2011) confirm that financial crises force economic financial systems to raise their efforts to conduct thorough scrutiny of borrowers to ensure that they eliminate the risks of loan defaults. Ivashina and Scharfstein (2010) support this line of argument by adding that banks reduce their lending activities during any global financial crisis. For instance, during global financial crisis in 2007-2008, the principal decline in the lending occurred for financial bodies that had low accessibility to monetary savings.

Despite the fact that financial crisis compels financial organisations to reduce lending activities out of the need to minimise the level of risks that are associated with default, financial regulators also compel them to reduce their lending activities. Such regulators increase regulations on lending requirements. Through their study on the implication of capital constraints and tightened liquidity on the capacity of various banks to lend, Barajas, Chami, Cosimano, and Hakura (2010) found that capital constraints provided more effects on the ability of a bank to lend compared to the tightened liquidity during the 2007-2008 global financial crisis.

Financial organisations provide liquidity to creditors and/or depositors by putting in place programmes for giving money on demand. A liquidity risk arises from outflows in deposits in addition to arranging for lending between banks and the associated financial plan (Barajas et al. 2010). Such arrangements include commitments that involve undrawn loans and requirements to make securitised purchases for assets. Banks lend money by developing credit commitments and credit lines on which the borrowing people tap. When borrowers take advantage of the available credit commitments, banks are exposed to higher financial risks. In fact, falling supplies in liquidity compel borrowers to draw massive money in the form of credit from accessible credit lines (Eken, Selimler & Kale 2012). During the 2007 to 2008 financial crisis, the non-financial sector organisations had no access to the short-term loans after the drying up of industrial markets for the mercantile paper. People who utilised the commercial paper resorted to prearranged credit lines from the bank to help them finance their paper whenever necessary. Since banks had the obligation to fund the loans, the available funds became incredibly limited.

Financial crisis also influences the monetary economic systems through an increase in demand for liquidity by non-financial organisations. For example, the 2007 to 2008 credit crunch forced many business organisations in the US to draw funds from their prevailing credit lines because they immensely feared potential credit market disturbances (Eken, Selimler & Kale 2012). This strategy was taken to ensure that the utility cash position was improved in the fear of credit market disturbances as the crisis progressed (Ivashina & Scharfstein 2010).

Financial institutions finance their balance sheets in valid ways. The most important ways are equity capitals and deposits. During any crisis, as evidenced by the 2007 to 2008 global monetary calamity, these interventions become limited. For instance, repos are used in financing highly risky assets among them being ‘private-label mortgage-backed securities’ (Eken, Selimler & Kale 2012, p.25). By the middle of 2007, Gorton and Mentrick (2011) inform that all these securities were possible to fund through short-term loans that were acquired from the repos.

Following the global financial crisis, the above approach changed so that only about 55 percent of all such securities were possible to fund from repos by the end of 2008. Consequently, financial organisations that deployed repos to financing them encountered unattractive choices (Eken, Selimler and Kale 2012). Hence, they suffered huge losses, as the only available option was to sell securities in a collapsing financial market. Figure 1 depicts graphically the impacts of the liquidity risks on the US financial organisations.

 Impacts of Liquidity Risks on Financial Economic Systems in the US
Fig. 1: Impacts of Liquidity Risks on Financial Economic Systems in the US

Considering the negative impacts of financial crisis on the performance of economic systems, government reserves the principal mandate of developing policies to respond to the crisis and to increase chances of the an economy to boom again or enhance the recovery process.

Government Policies and Reponses on the Global Financial Crisis

Response

Financial organisations always put up mechanisms to mitigate a wide-scale collapse due to the deteriorating financial markets. Such mechanisms constitute the ways of preventing systematic risks from occurring. Systematic risks involve instabilities in financial economic systems, which are potentially disastrous, due to idiosyncratic conditions that influence various financial intermediaries. A financial organisation comprises sub-elements that make groups of elements, which in turn are combined to constitute the whole organisation. The failure of the sub-elements may be a key contributor of the failure of the whole organisation when risks that influence them become uncontrollable. However, even though financial crisis may get out of control, governments must adopt strategies through the enactment of various policies to enhance economic recovery.

Financial hardships that were experienced during the period of economic downturns forced banks to increase their provisions for their non-performing assets. Ivashina and Scharfstein (2010) assert that during the crisis of 2007 to 2008, some banks also recorded increments in net interest margin (NIM). The authors maintain that this increase suggested that financial organisations pursued their businesses consistent with their preferences and experiences (Ivashina & Scharfstein 2010). Therefore, they endeavoured to keep up with their efforts of protecting the witnessed differences in their borrowing and lending rates in their quest to remain profitable. Such an approach is largely not sensitive to any financial crisis response.

The global financial crisis produced severe impacts on the liquidity risks. For example, for European banks, Eken, Selimler, and Kale (2012, p.23) posit, ‘before the crisis, European banks’ average liquid assets /total assets ratio was 30 percent, which later went down to 24 percent after the crisis’. Indeed, this effect was harmonious among all banks in the EU. For the XS and S banks, low ratios were maintained in comparison with the larger banks. Small bank operations were more dependent on the stored liquidity (Barajas et al. 2010). This situation implied that the banks committed more of their investments to liquid assets in comparison with the large banks whose operations depended highly on the purchased liquidity. In the case of the EU banks, small banks’ liquidity ratios were maintained low in comparison with large banks in both pre and post-financial predicament era.

After the crisis, government interventions were necessary to ensure that the crisis did not prolong. However, the financial crisis went out of control by 9th August, 2007 as interests in the money markets became extra ordinarily high (Taylor 2008). Furthermore, Taylor (2008) asserts that issues such as risks or liquidity impacts of the crisis, rather than anticipations of interest rate changes might explain such a rise. In an effort by the US government to derive the appropriate response to the crisis, it was necessary to determine the root cause of the overshooting of the crisis by August 2007. If the problem had been attributed to liquidity challenges, the provision of easier mechanisms of accessing windows permitting ease of borrowing would have been vital. On the other hand, if the challenges were counterparty risks, the most appropriate response would have been developing policies for ensuring high accountability and transparency in balance sheets from financial institutions. This strategy would have provided a direct mechanism of dealing appropriately with mortgage defaults upon the narrowing of housing prices. An alternative intervention could have been seeking strategies of ensuring that capital was availed to various financial institutions including banks (Taylor 2008).

Taylor (2008) presents diagnosis to the problem of 2007-2008 global financial crisis. After consulting agents who took part in the US interbank promotion, he reports that counterparty threat made more sense as a potential cause of the problem. However, he also informs that many of these traders concurred that the main challenge that led to the global financial crisis was liquidity risk (Taylor 2008). Due to these mixed perceptions, Taylor (2008) conducted an empirical research to investigate the probability of the risk causing the problem. Through a regression analysis, his findings indicated a correlation between Libor-OIS and unsecured loans, which implied that liquidity was a contestable cause of the problem. Therefore, according to him, counterparty risks were responsible for the global financial crises, which could only be solved through the adoption of appropriate policies that are associated with managing financial risks. However, government interventions focused on addressing the large-scale financial crisis in the context of being a liquidity challenge. The implications included a failure to address the cause of the problem, which heightened by August 2007.

Policies for Enhancing the Recovery Process

From the expositions in the previous section, the global financial crisis worsened due to wrong diagnosis. Thus, policies that were adopted by the US government to address the problem were only right for the wrong problem. Cash infusion on temporary terms, TAF, and interest rates are worth discussing here to evidence the ineffectiveness of the US government policies to facilitate the economic recovery. In February 2008, the government introduced the 2008 Economic Stimulus Act. Through the policy, the US government availed US $100 billion in the market to ensure that households and individuals increased their spending power in an effort to jump-start the nation’s economy (Taylor 2008). Perhaps, the rebate only resulted in increasing the availability of finances through borrowing, as opposed to direct monetary actions such as liquidity facilities. In this extent, this policy failed in terms of measuring up to the immediate needs of the economy recovery since it could not address the underlying challenges that led to the global financial crisis in the US. Taylor (2008) supports this assertion by claiming that the repayment had insignificant temporary effects on the spending of the Americans.

While attempting to foster quick recovery from the global financial crisis, the US government considered TAF (Term Action Facility) in December 2007 (Taylor 2008). This policy enabled banks to source financial aid from the Fed, rather than seeking a discounting window. The central objective of establishing TAF was to minimise spreads that occurred in the financial markets in a bid to raise credit flows while decreasing interest rates. Upon the implementation of the policy, by the end of December 2007, improvement was registered. The spreads were on a downward trend. Unfortunately, this situation lasted for a short period since the spread began to rise again (Taylor 2008). Therefore, the policy was a misplaced intervention to foster economic recovery, which explains the necessity for precise diagnosis of the cause of an economic crisis before attempting to implement policies to foster its recovery.

In mid 2008, the US government responded to the large-scale fiscal catastrophe by reducing sharply the rate of the centralised finances (from 5-1/4 to 2%). Taylor (2008) confirms that deploying Taylor’s rules, such a reduction was unprecedented and unwarranted, although its overall impacts require more economic research since it had not been done before, not even during the great depression. Nevertheless, low interests had the impact of reducing mortgage rates. Perhaps, this situation addressed some of the most crucial causes of the global financial crisis. However, the policy resulted in the depreciation of the US dollar with ramification of raising oil prices. This case suggests that interest cuts increased the cost of basic commodities, thus making life more difficult for households and individuals by July 2008 (Taylor 2008).

Economic scholarly evidence such as the study by Lipsky (2008) suggests that low interest rates increase the costs of commodities directly beyond the levels of the anticipated impacts on raising demand. Oil prices have a direct contribution to these effects. Lipsky (2008) confirms this impact by claiming that if the US dollar had retained its 2002 peak value, in 2007, oil could have cost $25 instead of $140 per barrel while non-fuel related commodities would have cost 12% lower. In fact, by the fall 2008, the world economy was sharply falling, thus prompting oil prices to go back to between $60 and $70. Unfortunately, in the US, this intervention was done too late, although the economy began to recover slowly.

Conclusion

The global economic crisis that occurred in 2007 to 2008 was one of the worst periods in financial markets since the depression of 1930s. Banking systems experienced challenges that almost resulted in the collapsing of large financial institutions. Apart from discussing various impacts of global economic crisis and the possible responses, the paper has revealed that interventions that were adopted by the US government to facilitate quick economic recovery only prolonged and worsened it. This situation occurred due to wrong diagnosis of the causes of the crisis since the government enacted policies that sought to solve liquidity problems as opposed to the actual causes.

References

Barajas, A, Chami, R, Cosimano, T & Hakura, D 2010, U.S. Bank Behaviour in the Wake of the 2007–2009 Financial Crisis, Routledge, London.

Cornett, M & Saunders, A 2006, Financial Institutions Management: A Risk Management Approach, McGraw Hill, New York, NY.

Cornett, M, McNutt, J, Strahan, P & Tehranian, H 2011, ‘Liquidity Risk Management and Credit Supply in the Financial Crisis’, Journal of Financial Economics , vol. 101 no. 2, pp. 297–312.

De Haas, R & Van Horen, N 2011, Running for the Exit: International Banks’ and Crisis Transmission, Routledge, London.

Eken M, Selimler, H & Kale, S 2012, ‘The Effects of Global Financial Crisis on the Behaviour of the European Banks: A Risks and Profitability Analysis Approach’, ACRN journal of finance and risk perspectives, vol. 1 no. 2, pp. 17-42.

Finn, B 2008, The Credit Crunch: Crunch Time For Human Resources. Web.

Gorton, G & Metrick, A 2011, ‘Securitised Banking and the Run on the Repo’, Journal of Financial Economics vol. 104 no. 3, pp. 425–451.

Ivashina, V & Scharfstein, D 2010, ‘Bank Lending During The Financial Crisis of 2008’, Journal of Financial Economics, vol. 97 no. 11, pp. 319-338..

Lipsky, J 2008, Commodity Prices and Global Inflation, Council on Foreign Relations, New York, NY.

Taylor, J 2008, The Financial; Crisis and the Policy Response: An Empirical Analysis of What Went Wrong, Stanford University, Stanford.

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