Lessons Learnt from the 2008 Recession - Assignment Example

Lessons Learnt from the 2008 Recession The financial crisis facing America in the 2008 financial year posed the greatest economical threat that the American society had witnessed in a long time. The disaster came unexpectedly and renowned financial institutions experienced massive losses. In the years preceding the financial crisis, Americans had bestowed a high level of trust in the leading banking institutions. Esteemed customers and companies relied greatly on the reliability of the banks and had no idea that some of the big names in the banking industry would experience a downfall. When the criticality of the matter dawned on the American society, it was difficult to accept the dire consequences of the downfall. Organizations deemed stable enough to survive any surging economic pressure proved to be at the verge of collapse in the 2008 scenario. President Obama had to help America resolve the issue, and settling it needed firm decisions taken in good time to save the average American from the consequences resulting from the crisis. This is how the Dodd-Frank law surfaced as a potential solution to the imminent financial collapsing of the great economy. It is of essence to highlight the critical lessons learnt from the crisis and doing that is the sole purpose of this paper. Causes of the 2008 Recession An analysis of the real situation in 2008 and highlight the main causes of the collapsing of big financial institutions. One fact about the issue is that Americans had build too much trust on some of the banks that they did not see the crisis, coming and this is the main reason why Americans became victims. This does not assert that people should not trust banks but should do so after judging their credibility based on their financial reports. At least people should make an informed choice be ore trusting financial institutions. However, banks successfully managed to underreport their risk rates and won the trust of the people easily. It was easy for the people to believe in the stability of some banks based on their performances and the stated risk values as Davis and Tracey highlighted. It became a common belief that these banks were too stable and stood out among their competitors and this was reason enough for them to remain sanding irrespective of financial hardships. Understanding how banks operate is essential in analyzing how the recession resulted. All banks often make investments that can turn to be failures. If that happens, experts can calculate the asset value and these banks can receive recapitalization for the loss. However, the level of trust is very fundamental in determining whether a bank is worthy of recapitalization. Its performance in the market must prove that it is not subject to sudden collapsing. Banks deemed stable enough in the market have resulted to a form of pathology as Fischer described in his recent speech. These banks reached a point whereby assessing how much they lost in bad investments became a challenge. Before the onset of the recession, these banks were safe havens for most people. Majority of financial experts thought that these banks only suffered losses via mortgage insecurities. However, facts reveal that other toxic investments increased the losses incurred by banks. The bigger banks stand better chances in the market because of the privilege they have. Their stability in the market becomes a crucial factor that serves to reduce chances of bankruptcy declaration. While the less stable banks have a great fear of taking great business risks in fear of ending up bankrupt, the bigger banks can take costly risks much more easily as Arcand, Berkes and Panizza mentioned in their working paper released in 2009. In 2006, big banks sought to take advantage of the declining house prices hoping to make profits in the secondary market as Feng, and Serilitis in their research paper in 2009 on efficiency and technical change in U.S banks. Their investment in housing had its basis on mortgage security. Predictions were that housing prices would go high in a short while and banks expected huge profits. In addition, the favorable prices saw many people buy homes with the aid of bank loans. However, the predictions turned out to be wrong and the situation brought about the financial storm that resulted in the years that followed. Moreover, the financial storm exposed an additional reality of the banks deemed stable in the market. During a time when the world expected the banks to offer new opportunities for growth in order to recover the immense losses, the banks minimized their lending services. Without banks lending any money to potential investors, there was little hope of growth. The reason why banks refrained from lending was the fact that they suffered losses when most of the homeowners sold their houses at the onset of the recession. The losses incurred by banks during this time were not negligible and caused the collapse of some renowned banks. Most of the critics have blamed banks and homeowners as the key contributors to the crisis. Banks were greedily looking for more profits while many homeowners recklessly made purchases of homes on loans. These factors led to the recession that was strong enough to bring down other sectors of the economy as Cecchetti and Kharroubi revealed in their working paper titled “Reassessing the impact of finance on growth”. In a bid to make recoveries of the losses and restore economic stability, the U.S government opted to draft new regulation acts to augment the preexisting law. However, an outline of the asset ownership in the banking industry will serve to help evaluate the efficiency of regulation through monetary policies. In the earlier debate, everyone thought that the drafted Modd-Frank was the best solution. Big companies constitute of 0.2% of financial institutions but command an average of 70 % of the industry’s assets and Wheelock and Wilson elaborated. The smaller institutions account for 98% but command the remaining value of the industry assets. This is an ample explanation why the collapsing of a single of the big banks has a high likelihood of affecting the entire economy. The financial crisis highlighted a new need for more effective ways of regulation. It raised questions as to why the smallest percentage of financial institutions had the privilege of controlling almost three quarters of the total financial assets. In his efforts to save his country from a recurrence of the disaster, president Obama signed in the Modd-Frank regulation. Americans embraced the regulation policies with the hope that it would change the financial situation. There are many criticisms regarding the efficiency of the regulation and its emphasis is fading with time. Lessons Learned From the Recession One thing is for sure that there are multiple lessons learnt from the financial crisis. Many analysts have revealed that people do not trust banks any more. The trusted banks disappointed these people after a collapse that nobody had anticipated. To the majority of them, these big banks may be ‘black boxes’ that are storing up more misfortunes for them in the future. Although these institutions have strong risk assessment teams in place, it still proves difficult to see another storm coming as Hughes and Mester revealed regarding the federal bank of Philadelphia. The values stated by the risk assessment teams are no longer standards of making judgments on the survival of a bank. These lured a great majority in the past prompting them to bestow a lot of trust in these institution. Four years after the recession, the situation has not changed. People expect just anything from these banks and this has given rise to the increasing uncertainty concerning financial institutions. Although the institutions find all the reasons to convince people that they are big enough to fail, it is not an easy venture for them any more. Other reports also show that some banks are likely to underreport their risks in order to win the trust of clients. However, many people are not taking any of the stated values seriously and would rather not take easy chances with banks. Although Dodd-Frank came with the best of interests to the American society, it has worsened the scenario. Its length serves to add onto the complexity of the issue. Although regulation was a tough task prior to Dodd-Frank, its application has not resolved the situation fully. According to some people, the act serves to over-regulate the industry as Hoenig highlighted in his speech on his Speech during the American Banker Regulatory Symposium. Critics are well aware that this will achieve little success gauging from the circumstances and uncertainty in the market. There are two clear levels of uncertainty. One of these is the surging unpredictability of the market. Secondly, people are so uncertain of the stability of even the greatest of banks during adverse financial times. Despite these uncertainties, there is only one desire for Americans and the globe at large. Nobody wants to witness a recession as deep and devastating as the one occurring in 2008. A relapse into such economical desperation is beyond the imagination of any individual. This is the reason why experts have highlighted some critical issues concerning the level of regulation. It is important to take note of these concerns. Structural reform of financial institutions is top in the list of concerns in the recent debate. For financial safety, experts feel that it is worthwhile to separate investment and commercial banking activities. Such segregation would serve to ensure that if any of the units is negatively affected, it does not spread the harm to the other. This will give financial institutions a safer landing ground in times of adversity. The recession in 2008 was a real turmoil because both units were working in conjunction. Analysis shows that separating the two units is a worthwhile precaution in a bid to prevent a recurrence. This has been the focus in America, Europe, and United Kingdom although they have different policies in place. However, it worth mentioning that all the three regions is using a different approach with similar objectives. These structural reforms may also include limitation of bank sizes and formation of clusters of banks belonging to the same size. Determination of the size of banks may depend on various parameters of each individual economy as Haldane mentioned in his speech. Although this is not yet a reality, experts consider it a potential solution and preventive measure. Other experts have raised concerns concerning the gap between private and public financial institutions. The wide gap that existed between the two differently owned categories of institutions contributed to the recession that resulted in 2008. The gap result from the inequality evident in disclosure standards as applied to public and private institutions. Some analysts argue that finding an equitable way to strike a balance between the two will minimize chances of falling in to the same old trap of a recession as Admati and his colleagues in their 2011 research tackling myths in the financial industry. For example, regulation should introduce disclosure measures to private institutions. It is possible that will help an economy reap benefits. Striking a balance between the disclosure systems will enable public entities in the industry to adhere to some policies on optional basis. Conclusion As described in this article, there are numerous lessons from the devastating financial crisis in 2008. Although nations are making efforts of keeping financial activities in a stable state to prevent a relapse, it is not proving easy. Analysis of the complexity of the matter presents many causes of fear and uncertainties about the future. The Modd-Frank regulation touches on too many issues and although it came into place to save the situation, experts say it has complicated the scene. However, it is worth noting that all the current views emanate from the lessons learnt. Banks have to consider risk rates carefully before making any costly investment. The surging uncertainty has minimized trust in banks no matter how big they are. Homeowners know better than investing recklessly. It has become clear that any institution can collapse and the market trends are very unpredictable. Financial institutions are more cautious while the efficiency of monetary policies is a key concern to many people. Evidently, nobody wants a relapse of the financial disaster in 2008 but there is need for much more action in order to avoid a relapse. Bibliography Admati, A, P DeMarzo, M Hellwig and P Pfleiderer.2011. “Fallacies Irrelevant Facts and Myths in the Discussion of Capital Regulation: Why Bank Equity is not Expensive” (March 23, 2011). Rock Center for Corporate Governance at Stanford University Working Paper No. 86 Arcand, J-L, Berkes, E and Panizza, U. 2012. “Too much finance?”, IMF Working Paper 12/161. Cecchetti, S and E Kharroubi .2012. Reassessing the impact of finance on growth”, BIS Working Paper No.381. Davies, R and B Tracey. 2012. “Too big to be efficient? The impact of too big to fail factors on scale economies for banks”, Mimeo. Feng, G and Serilitis, A. 2009. “Efficiency, technical change, and returns to scale in large US banks: panel data evidence from an output distance function satisfying theoretical regularity”, Journal of Banking and Finance, 34(1), 127 – 138. Fischer, W. 2013. Ending ‘Too Big to Fail’: A Proposal for Reform Before It’s Too Late’ Remarks before the Conmmittee for the Republic, Washington, D.C., January 16, 2003. http://www.dallasfed.org/news/speeches/fisher/2013/fs130116.cfm Haldane, A. 2012. “On being the right size”, Speech given at the Institute of Economic Affairs’ 22nd Annual Series, The Beesley Lectures, October 25.  Hoenig, T.2012. “Back to basics: A better alternative to Basel Capital Rules”, Speech to The American Banker Regulatory Symposium, September 14. Hughes, J and L Mester. 2011. "Who said large banks don't experience scale economies? Evidence from a risk-return-driven cost function," Working Papers 11-27, Federal Reserve Bank of Philadelphia. Wheelock, D and Wilson .2012. “Do large Banks have Lower Costs? New Estimates of Returns to Scale for U.S. Banks.” Journal of Money, Credit, and Banking, 44(1), 171 – 199. Read More