Causes and Solutions to the Global Financial Crisis - Assignment Example

Financial Crisis-2007 Introduction: The financial crisis is a critical phenomenon that has affected the global economies badly. The origin of thecurrent financial crisis is in USA and then it spread to Europe. It has now become a global economic phenomenon which has spread all over the world. When considering the possible causes for this economic situation, fundamental defect of the free market system is the prominent reason for the crisis. In the US economy, a secure and sustainable economic order is not ensured by the economic regulatory. As a result, banks and financial institutions in the developed countries are not restricted from spending more than what they can afford. This led to domination of speculative activities in the economy. Speculators are only interested in short term gain from the economy. Thus the long term yield on assets is not properly ensured. In the process of globalization, the role of nation-state has been undermined by the economies. Due to the lack of fiscal intervention of governments for ensuring sustaining growth, global finance and de-regulation were adopted by the economy as an alternative paradigm and it led to the booms and bust in the global economy. A sound long term macro economic policy was not adopted by the countries and thus the financial and economic stability affected badly and the conditions of financial crisis emerged. (Causes and solutions to the global financial crisis 2009). 2) Explain the factors that caused the current financial crisis. Discuss the theoretical views of the following three theories below and explain which are more relevant towards the current financial crisis Factors that caused economic crisis: Financial market instability in the economy is the result of defaulted free market system and capitalism. It causes booms and bust conditions in the global economy. The defaults in the operations of banking and monetary system are another root cause of the crisis situation. The rising protectionism among various countries led to rejection of free trade and thus the export opportunities were greatly reduced. As a result of the decreased export opportunities in the economy national income also reduced greatly. It led to contraction of the GDP together with currency devaluation. (Global economic crisis- a different view 2009). Excess liquidity in the market: Unsound methods of debt financing adopted by major central banks generate excess liquidity in the market. Through their irresponsible actions in the economy, increased debt financing without proper guarantee for returns has highly increased. The resulted sudden cash flow in the economy created a more risky environment. Due to the financial recession the returns to financial institutions were restricted and thus bad debts rate highly increased. It affected their financial position badly. (Karam 2008). Stock market crash: Sub prime mortgage loan and excess credit creation led to speculative economic environment. Due to the baseless marketing actions, the stock market faced severe crash situation which affected the entire economy badly. When the speculative borrowings increased it forced the banks and other lenders to tighten credit. As a result the availability of money in the economy contracted, and even to companies that can afford, loan was restricted and thus the economy subsequently contracted. When analysing the nature of the banking systems in the countries, it revealed that the baseless lending actions of the banks are the root cause of the current crisis. Through the expansion of easy credit, boom and bust cycles created in the US economy. Due to the uncontrolled monetary policy adopted by central banks and endorsed by the political regulatory through application of mechanisms of fiat money and fractional reserve banking, there emerged uncertain economic boom and bust cycles. (The global financial/ economic crisis 2008). The financial crisis is started with the mortgage issue. The uncontrolled sub prime borrowings and subsequent depression in the value of the homes leads to financial imbalance in case of mortgage lenders. The sub prime mortgage crisis leads to the destruction of the financial position of the banking organisations. As a result of these crises, credit availability in the financial market is badly affected. (Stich 2008, p. 238). Theoretical approach on the root causes of the current global financial crisis: a) Minsky Theory: Minsky's theory is focused on the understanding and explaining the financial crisis through financial instability hypothesis. Minsky argued that during prosperous times, when the cash flow in the economy is more than the need for repayment, a speculative environment is spontaneously developed. It will result in excess debt in the economy than the capacity to repay and thus a financial crisis will emerge. The mortgage market is affected by the negative amortisation loan or sub prime loan during the ponzi phase. Thus firms rely on leveraged loans, for maintaining high revenue growth and profit margin. Thus the asset price and operating profit margin for private equity firms should be going up. The markets become more risky though may appear as more stable. The falsified stability in the economy will lead investors to extrapolate stability into the distant future. As more people enter the market and become speculators, they drive up the value of the collaterals and thus financial systems inherently bear destructive phase of speculation. The decline in the assets price leads to the commencement of destabilizing process in the economy. (Tan 2008). b) Keynesian Theory: Keynesian theory is developed during the period of great depression. John Maynard Keynes, during great depression, explained that in a normal economy characterised by high level of employment the cash flow in the economy is in circular nature. In reverse market conditions such as stock market crash, declining asset price, the consumer confidence will be affected and thus the cash flow will be restricted. To overcome the financial crisis resulted from the stuck cash flow circle, government have to spend more amount of money in the economy to maintain the consumer confidence. Thus the circular flow of money in the economy would be re-established. (A review of Keynesian theory). c) Monetarist Theory: Monetarists consist of group of economists having greater experience with money and its effects. Milton Friedman is a prominent monetarist who framed certain theories on financial conditions through a new economic phenomenon stagflation which is the combination of stagnation and inflation. His theory is focused on the role of expectations in the inflation in the economy. (Monetarists- introduction) If the increase in money supply is faster than the rate of growth of national income, it will lead to inflation in the national economy. If the money supplies increase corresponding to the inflation, inflation will disappear. Monetarists have the view that institutional factors have greater influence on the rate of money and inflation in the economy. They argued that the out put is fixed on long term basis. (Monetarist theory of inflation) The discussion on the three theories stated above reveals that the Keynesian theory is the most suited theory for explaining the causes of the current economic situation. When considering the root causes of the present economic situations such as stock exchange recession, financial downturn in the economy resulted from credit crunch, it can be seen that the Keynesian theory is best explaining the causes of the present economic crisis situations. 3) Problems with securitizing. Heavy demand for securities. The risks, shocks, and excess capital in the economy. The credit crunch (graham turner 2008): Securitization: While looking into the causes of financial crisis it is seen that crisis started in real estate market. The real estate bubble was developed due to the high demand for financial securities and this real estate bubble led to financial crisis. Securitization literally means that it is a process by which something is converted into a security. "Securitization involves selling the rights to an expected revenue stream to investors in "return for an immediate influx of cash." (Securitization- breaking the promise 2002, p.2). It is very important in lending market and capital market. It builds a bridge between the capital market and applicable fund market. It is commonly practiced in most of the countries. Mortgages are considered as securities and sold to investors. It helps in diversification and eradication of risk. Investors were unaware of the securitization at first. As investors became aware of the higher returns generated by the mortgages, it was offered at higher rate. Thus Mortgage Backed Securities was developed with sub prime mortgages. The key problems associated with securitization of mortgages are as follows: securitization is associated with systematic risk and thus borrowers of mortgages started defaulting in their mortgages. The shock: Increased sub prime lending made people to become house owners. As a result there was a decline in rent and increase in house price. Thus real estate market became more significant and new houses ware constructed. There was a decline in house price in 2006, which made it difficult for the borrowers in paying mortgages. Thus the problem became more crucial in March 2007. This US sub prime spread over to other markets and there was a shake in the financial institutions. The share prices lost their value and inter bank relation was disrupted. The excess capital and heavy demand for mortgage securities: during 2000 there was excess capital and it did not expect that there would be financial crisis. The investors were concerned with making a fair return with the low risk investments. This gave way to US mortgage market and high demand for mortgage securities. Thus the mortgage guidelines changed and gave rise to stated income verified assets (SIVA) loans, no income verified assets (NIVA) loans. The guidelines became very weak and no income no assets (NINA) loans were introduced which required only credit score rather than proof. The credit crunch: former Federal Reserve Chairman Alan Greenspan calls the financial crisis as a credit tsunami. Sudden shortage of funds leads to the decline in lending loans and this is referred to as credit crunch. It occurs due to the following reasons: "A Credit Crunch can occur for various reasons: Sudden increase in interest rates (e.g. in 1992, UK government increased rates to 15) Direct money controls by the government (rarely used by Western Governments these days) A drying up of funds in the capital markets." (Credit crunch explained 2008) The current credit crunch was due to the rise in the sub prime mortgages which resulted in the shortage of funds. The credit crunch will last for a long time as there is still fall in the house price which reduced the value of mortgage loans. "One of the most striking effects of the recent credit crunch is a huge surge in stock market volatility. The uncertainty over the extent of financial damage, the identity of the next banking casualty and the unpredictability of the policy response of central banks and governments has all led to tremendous instability." (Bloom 2008, p. 21). 4) Financial crisis of Northern Rock: One of the leading Banks in England is Northern Rock. It is called the 'Lender of Last Resort' in the UK for a liquidity support competence due to problems in raising funds in the money market. The banks deal with mortgages, savings account, loans and insurance. "Northern Rock savers are right to withdraw their savings" says Aaron Coleman, CEO of financial services agency MoneyMatters.com. "The recession that has hit the US is inevitably going to affect the UK economy hard and it's time that the British banking industry admitted just how vulnerable they have been to the US sub-prime fiasco." (Harper 2007). The financial crisis recommended a failing in the world economies when a loss of assurance by investors in the value of securitized mortgage. The scope of the financial crisis is liquidity problems in equity funds, increased public debt, and the devaluation of some currencies. In 2007 the bank faced financial crisis. Due to that crisis lot of customers withdrew their savings. Large organizations provide freedom in all sectors of the finance which lead to a big failure in finance. These organizations maximize their profit and spend without any bias. "The capitals of countries were diverted to the corporate segments that can make big profits suddenly instead of putting investment in the production sector. That is the basic reason for financial crisis all over the world." (What is the main reason for financial crisis all over the world 79). The other important point of financial crisis is unemployment. According to Dennis Grainer, shareholder action group of Northern Rock suffered bad condition. He means that the Bank took lot of money into another bank to overcome the bad condition of Northern Rock. Then after 8 years the Bank achieved the objectives. That means the main objectives of every Bank is to accepting deposits and lending money. Northern Rock also does their service and maximizes the profits. (Former Rock Shareholders Still Angry 2009). The consolidated balance sheet of Northern Rock shows the situation of the banks issues in loans and advances to the customers which created crisis. (Financial crisis 2008). Note 2007 2006 Assets Loans and advances to banks 1 6 (a) Loans and advances to customers 99 87 Investment securities 6 6 Other assets 3 2 Total 109 101 Liabilities Bank of England loan 28 0 (b) Customer accounts 12 27 (c) Mortgage-backed securities 43 40 (d) Other securities 19 24 Other liabilities 4 7 Equity 3 3 Total 109 101 The story of Northern Rock can be summarized as following: In the beginning of 1999, Northern Rock adopted the method of securitization of fund for the purpose of mortgage lending. In 2004, Northern Rock reduced the standards of its mortgage lending. As a consequence of decreasing standards of lending, the security issue of Northern Rock failed in 2007. And it led to their financial failure. (Financial crisis: northern rock's balance sheet 2008). Conclusion: The uncontrolled actions of the banking and other financial institutions are the major cause of the crucial financial crisis faced by global economy presently. In order to reduce the impact of financial crisis, as per the monetarist theory, the governments have to ensure adequate flow of money in the economy which will generate confidence among the public to invest in the economy. Thus the financial situations can be improved. Adequate control measures have to be adopted by governments over the irresponsible financial actions of their central banks. Speculative activities have to be restricted from the economy in order to ensure a stable and reliable economic growth. Reference A review of Keynesian theory, viewed 24 March 2009, http://www.huppi.com/kangaroo/Keynesianism.htm Bloom, Nick 2008, Will the Credit Crunch Lead to Recession CentrePiece Spring, p. 21. viewed 24 March 2009, http://www.stanford.edu/nbloom/CreditCrunch.pdf Causes and solutions to the global financial crisis 2009, Global Research.ca, viewed 24 March 2009, http://www.globalresearch.ca/index.phpcontext=va&aid=10792 Credit crunch explained 2008, Finance Blog: Simplifying Finance, Housing and Debt, viewed 24 March 2009, http://www.mortgageguideuk.co.uk/blog/debt/credit-crunch-explained/ What is the main reason for financial crisis all over the world 79, Hub Pages, viewed 24 Mar2009, http://hubpages.com/hub/financialcrisisworld Financial crisis: northern rock's balance sheet 2008, Garethrees.com, viewed 24 Mar2009, http://garethrees.org/2008/10/18/northern-rock/ Former Rock Shareholders Still Angry 2009, BBC New, viewed 24 March 2009, http://news.bbc.co.uk/1/hi/business/7920493.stm Global economic crisis- a different view 2009, ABC Brisbane, viewed 24 March 2009, http://blogs.abc.net.au/queensland/2009/03/global-economic.html Harper, Patricia 2007, Northern rock indicates UK recession is already underway, Functionpix.com, viewed 24 March 2009, http://functionpix.com/index.php/article/Northern_Rock_indicates_UK_recession_is_already_underway/1598/ Karam, Ghassan 2008, Root causes of the current global financial crisis, Yalibnan, viewed 24 March 2009, http://yalibnan.com/site/archives/2008/06/root_causes_of.php Monetarists - introduction, viewed 24 March 2009, http://www.interzone.com/cheung/SUM.dir/econthym1.html Monetarist theory of inflation, Economics Help, viewed 24 March 2009, http://www.economicshelp.org/macroeconomics/inflation/monetarist-theory-inflation.html Securitization- breaking the promise: what is securitization 2002, American Lung Association, viewed 24 March 2009, http://www.lungusa.org/atf/cf/%7B7A8D42C2-FCCA-4604-8ADE-7F5D5E762256%7D/SECURITIZATION.PDF Stich, Rodney 2008, America's Housing and Financial Frauds, Lulu.com, p. 238, viewed 24 March 2009, http://books.google.com/booksid=MUfqyojtsgQC&pg=PA237&dq=journal+article+on+fiancial++crisis+2007&as_brr=3#PPA238,M1 Tan, Thomas 2008, Introduction to Minsky theory - stability is destabilizing, Gold Seek, viewed 24 March 2009, http://news.goldseek.com/GoldSeek/1210140240.php The global financial/ economic crisis: causes and solutions 2008, Not PC: Promoting Capitalist Acts Between Consenting Adults, viewed 24 March 2009, http://pc.blogspot.com/2008/11/global-financialeconomic-crisis-true.html Read More