Supplementary Liquidity in America - Research Paper Example

? Financial Crisis Introduction The global financial crisis has substantially damaged the global economy. The year of 2007 brought the emergence of the global financial crisis. Many experts call it a recession as it has substantially diminished the GDP, real income, industrial production, employment and so on. The impacts of the global financial crisis were so immense that the global economy was not able to maintain its traditional growth and development. This decrease was largely contributed by numerous factors. In the United States of America, the real estate property was over-invested and the issue of sub-prime loans also emerged. During the period of late 1990s and the early years of 2000s, a considerable number of developing countries had deposited their savings in the investment and commercial banks of the United States of America. This provided a supplementary liquidity in America. The banks and other financial institutions had more funds than the avenues for the investment. The excessive liquidity convinced many financial institutions and banks to extend lending even to the individuals and institutions that did not have a favourable credit history. The attacks of 9/11 also contributed its part. Soon after the attacks of 9/11, the Federal Reserve found it reasonable to decrease the interest rates as it would motivate consumer confidence and increase consumer spending as well. In the subsequent parts of this paper, definition of recession is provided. Subsequent to that, the causes of global financial crisis segment have been included. It is followed by the portion encompassing the effects of the global financial crisis. Before the conclusion part, lessons from the global financial crisis have also been provided. Definition Roland Reagan once said that recession is when your neighbor loses his job and depression is when you lose your job (Eslake, 2008). The recent wave of the global financial crises (2007-2009) substantially destroyed the international financial environment. And a considerable number of finance experts believe that after the Great Depression of 1929, the emergence of 2007 global financial crisis left negative impacts on the global economy. There are various authors who do not disagree to term it as the Great Recession. Recession has been defined as a period recording substantial decline across a particular economy by experiencing a real decline in Gross Domestic Product (GDP), industrial production, real income, employment and in other important pillars of the economy (Nueno, 2012). This represents that the aggregate picture of the economy does not look promising and the curve shows a downward tendency instead of going upward. Causes of the Global Financial Crisis Many causes engendered the global financial crisis. In the United States of America, the issue of the real estate bubble and the sub-prime mortgage loans fundamentally provided the root causes for the global financial crisis (Lannuzzi & Berardi, 2010). Furthermore, soon after the events of 9/11, the Federal Reserve did not increase the interest rates but decreased to the level of 1 percent with a financial objective of supporting the labor market. In addition to that, in the period of late 1990s and the early 2000s, a considerable number of developing countries from Asia and Africa diverted substantial amount of their savings to the commercial and investment banks in the United States of America (Shomali & Giblin, 2010). As a result, this excessive liquidity did not become a chance to support a formal and regulatory growth of the economy, but created the concepts such as innovative finance (D’Arista & Griffith-Jones, 2008). The provision and facility of sub-prime loans existed even before the emergence of the global financial crisis. In this regard, Udell (2009) highlights that the sub-prime loans were easily accessible to the loan seekers in the United States of America even before the global financial crisis. Basically, this type of loan is extended to those customers or clients who do not have positive credit history and the commercial banks, hence, investment banks and other financial institutions do not offer loans to that type of people. Undoubtedly, if a defaulter is refused to receive loan or credit facility, he would not delay and apply for the sub-prime loans. In the United States of America, many people were unable to avail credit facility before the financial crisis. During the period of 2001 to 2006, there were a few institutions or private persons offering sub-prime loans. As the demand for the sub-prime began to increase, not only local financial institutions but also international and multi-national banks and other financial institutions initiated extending the facility of sub-prime loans which is extended with a higher interest rate than the one commonly available. The higher chances of earning in the shape of higher mark-up had convinced various financial institutions to fully utilize this opportunity. The impacts of 9/11 attacks severely affected the economy of the United States of America. The entire American economy experienced negative effects of the attacks almost on every aspect of the economy. Under such pressure, the Federal Reserve revised its monetary policy and modified the interest rates. In order to encourage more spending and consumer confidence, the Federal Reserve brought the interest rates to the level of 1 percent. The reduction of interest rates further facilitated an easy access to the sub-prime loans. The impacts of such change in the monetary policy did not positively support the main objectives of economic growth and economic development, but it substantially increased the risk of bankruptcy and default. Moreover, the excessive liquidity in the United States of America was also contributed to the problem of the global financial crisis. During the period of 1990s and early 2000s, many developing countries from Asia and Africa deposited their savings in most of the commercial and investment banks and in the financial institutions of the United States of America. With the availability of excessive liquidity in the country, various financial institutions and banks did not take much time to provide the facility of sub-prime loans to those who did not have sufficient funds. In ordinary circumstances, the banks and financial institutions do not offer sub-prime loans due to non-availability of liquid assets. However, the excessive supply of liquidity from the developing countries convinced the financial institutions and banks to extend the sub-prime loan option. The inflow of excessive liquidity was so much that numerous financial institutions substantially compromised on the risks attached with the different types of investments. The financial institutions were so desperate to invest the availability of excessive liquidity that they totally ignored the ramifications of extending the sub-prime loans. Banks and other financial institutions began lending to those institutions and individuals who did not have better credit history. Moreover, the application of due diligence was totally compromised. The financial institutions and banks neglected the importance and practice of due diligence. Due diligence is a compliance mechanism and is defined as a process of investigating into details of potential investment by inspecting the material facts. During that time, the banks and financial institutions did not employ the due diligence process, but they deliberately avoided its application. The regulatory authorities also did not discourage the irresponsible behavior of the financial institutions and the commercial and investment banks. The regulatory authorities indirectly supported the buildup of off-balance sheet exposure of risk. During that time, banks’ risk management tools were not utilized and enforced as they should be. Banks found it appropriate to compromise on the required steps of risk management policies. This highlighted that the risk management mechanisms and supervisory authorities were also contributed to the emergence of the global financial crisis. Effects of Global Financial Crisis The severity of global financial crisis was mainly encountered by the financial institutions. Given to the severity of the global financial crisis, the financial institutions had no other way but to reduce the value of their assets. In addition to that, various financial institutions were unable to continue their corporate existence and they were forced to declare bankruptcy or were unable to repay their interest payments and they subsequently defaulted. And at the same time, the foreclosure rates were inversely attached to the housing price inflation (Taylor, 2009). Subsequent to that, the investment banks were the first to face the severe implications of the global financial crisis, disappearing from the international financial scenario and suffering acquisitions, mergers, bankruptcies and nationalization (The WTO Doha Round and Regionalism, 2009). The investment banks were substantially depending on the funds related to property investment. As their main business was being directly affected by the ramifications of the global financial crisis, many investment banks found themselves in a state of war for their corporate existence. Many investment banks were unable to continue the fight and they defaulted along with sinking millions of dollars of the investors. In addition to that, the property value did not remain the same. The value of property shrunk and collapsed to a deplorable level and reached the original cost price of these assets. Government Response Authors do not have similar viewpoints pertaining to the causes and remedies of the global financial crisis. Some authors including politicians do not disagree to support the notion that it is the decline of American capitalism and they subscribe to the regulatory mechanism establishing that the deregulation policy has fostered the diminishment of the finance. In other words, the market capitalism has failed to prove its long term vitality. On the other hand, some liberalists contend that they still believe that markets remain fully effective and efficient as they used to be, but they accuse politicians as the main source of the crisis. The Government of the United States of America announced its bailout plan. The impacts of the global financial crisis were so destructive that the Government of the USA had no choice but to announce the bailout package. Subsequently, the bailout packages provided the financial assistance to different banks, the financial and other institutions which were unable to sustain the impacts of the global financial crisis. Among the recipients of the bailout packages, American International Group, Bank of America, Citigroup and other corporations received the financial assistance from the Government of the USA. Lessons The experts have highlighted lessons from the experience of the global financial crisis. They contend that it is almost impossible to predict how the impacts of the global financial crisis will hit the different segments of the global economy. Even till this point of time, there are various states including the United States of America who are facing the aftershocks of the global financial crisis and they experience a slow recovery phase in which their economies are not generating the employment opportunities similar to one provided before the onslaught of the global financial crisis. Schwarch (2008) states that the system needs to have flexibility, adaptability and openness to contingencies. Stiglitz (2009) highlights that the various banks have become financially huge to be appropriately regulated and controlled as well. There must be some ways to ensure effective regulatory check and monitoring of the financial activities of these banks. Moreover, the role of the governments cannot be undermined. They are the one having regulatory authority to inspect the banking practices and procedures of the different financial institutions. Within this context, Yeoh (2009) contends that the governments must not only focus on short-term regulatory policies; the establishment of regulatory policies must be sufficiently capable enough to highlight and identify the real causes of the financial issues and problems. The check on the financial system must be a top priority. The shortcomings in the financial system were the main causes behind the global financial crisis. Some stringent measures have become highly essential and must be introduced. These measures must pertain to credit policy and the checks on this policy. It must be ensured that the credit policies are implemented as per the regulatory guidance. At the same time, strict monitoring of credit policies must be enforced particularly by the regulatory authorities. Under any circumstances, compromises or deviations in credit policy should not be neglected but they should receive appropriate retribution as soon as deviations appear. Moreover, some economic and financial analysts opine that the financial system in most developed states has become bloated. It has become highly essential to enhance accountability and transparency in operations in financial innovations and in financial inventions. In addition to that, some experts state that small and medium enterprises must be encouraged and they must be entitled to receive credit facility from the financial institutions (Griffith-Jones et al., 2008). The rationale behind this suggestion is that the SMEs do not need substantial amount of inspection, regulatory check and monitoring mechanism that is normally required for the multi-national institutions. Conclusion The global financial crisis has slowed the growth of the global economy. The effects were so severe that even large multi-national companies were forced to file for bankruptcy. The banks and other corporate institutions became so financially weak that they were coerced to apply for the financial assistance. The American Government extended the financial assistance to institutions such as Bank of America, Citigroup and so on. With this financial support, these institutions became able to sustain the impacts of the global financial crisis. Various regulatory measures must be ensured. Many experts believe that the financial system must be stringently regulated and controlled as well. They opine that the regulatory authorities must ensure tight regulatory check and strong monitoring of these institutions has become highly essential. The credit policy of the institutions should be heavily monitored. The role of SMEs has become highly essential and they should receive credit and encouragement from the governments. References D’Arista, J., & Griffith-Jones, S. (2008). Agenda and criteria for financial regulatory reform. Initiative for Policy Dialogue. New York: Columbia University.  Eslake, S. (2008). “What is a difference between a recession and a recession?” Available at: http://www.anz.com/resources/e/4/e459fa004e4a38ffa19bab93c5571dd1/CO-Article-Difference-Recession-Depression-Nov-2008.pdf?CACHEID=aca11a804e472a119579b56672659df2 [Accessed on 8 April, 2012]. Iannuzzi, E., & Berardi, M. (2010). Global financial crisis: causes and perspectives. Euro Med Journal of Business, 5(3), 279-297. Griffith-Jones, S., Ocampo, J.A., & Burke-Rude, S. (2008). Key Principles for Financial Reforms that G-20 Leader should Implement. New York: Columbia University Initiative for Policy Dialogue. Nueno, J. L. ( 2012). “The Recession: How to Come Out on Top”. Available at: http://www.europeanbusinessreview.com/?p=141 (Accessed on 8 April, 2012). Schwarcz, S. L. (2008). Understanding the ‘Subprime’ financial crisis. Duke University School of Law. Durham, Research Paper Series, Vol. 22 pp.1-26. Shomali, H., & Giblin, G. R. (2010). The Great Depression and the 2007-2009 Recession: The First Two Years Compared. International Research Journal of Finance and Economics, 59. Stiglitz, E. J. (2009). “Too big to fail or too big to save? Examining the systemic threats of large financial institutions.” Paper presented at the Joint Economic Committee of the United States Congress, Minneapolis, MN, pp. 1-10. Taylor, J. B. (2009). “The financial crisis and the policy responses: an empirical analysis of what went wrong.” Rock Centre for Corporate Governance Working Paper, 30, Stanford: Stanford University, pp. 1-30. The WTO Doha Round and Regionalism (2009). From the Board. Legal Issues of Economic Integration. Vol. 1 No.36, pp.1-5. Udell, G. F. (2009). Wall Street, Main Street, and a credit crunch: thoughts on the current financial crisis.Business Horizon, 52, 117-25 Yeoh, P. (2009). US and UK legal responses to the global financial crisis. 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