Financial Crisis - Bank of England - Literature review Example

Financial Crisis Report for the Bank of England Introduction On the 7of January of the BBC has published an article stating that the Bank of England (BoE) was not aware of the impeding danger (BBC News, 2015). According to the minutes of the Bank, the major concern in July 2007 was the liquidity issue. Despite this clearly identified concern, no actions were taken in order to address it. Moreover, the governors of the BoE have missed the interconnectedness of the global financial system and potential “domino effect” (BBC News, 2015). This report was prepared for governors of the Bank of England who, according to the article published on the BBC were unaware of the impending financial crisis in July 2007. The aim of this report is explain the key aspects of the financial crisis, to analyse how the financial crisis can be predicted and to discuss the key lessons learned from the crisis of 2007-2009. The remainder to the report is structured as follows: Section 1 provides a general overview of a financial crisis; Section 2 provides a literature review on the predictability of financial crises; Section 3 summarizes the key lessons learned from the crisis of the 2007-2009 and related to the regulation of banks and financial markets; and a concluding part summarizes the key findings of the report. Section 1: Definition of the financial crisis Financial crises usually have two features: (1) a credit boom, which leads to the leveraging of financial institutions, and (2) an asset bubble, which increases the probability of a large price shock (Acharya, et al., 2009: 90). Even though financial crises have common features and elements, they can take many different forms (Claessens and Kose, 2013). Thus, for example Reinhart and Rogoff (2009) have identified two types of crises: those dependent largely on judgemental and qualitative analysis; and those classified using only quantitative definitions (cited in Claessens and Kose, 2013). The first group is mainly referred to debt and banking crises, while the second group to sudden stop and currency crises (Claessens and Kose, 2013). As the financial crisis of the 2007-2009 is referred to the first category, the focus will be made on analysis of this specific type of crisis. Claessens and Kose (2013: 12) explain that “in systemic banking crisis, actual or potential bank runs and failures can induce banks to suspend the convertibility of their liabilities or compel the government to intervene to prevent this by extending liquidity and capital assistance on a large scale”. The global financial crisis was triggered by a 2007-2008 failure of the subprime mortgage markets in the US (Gieve and Provost, 2012; Savona, Kirton and Oldani, 2011). In 2005, mortgage borrowers were able to make loans with no verification of their income and ability to pay out regular loan payments (Savona, Kirton and Oldani, 2011). Artificially low interest rates and mass tendency have both increased demand among mortgage lenders (Savona, Kirton and Oldani, 2011). As it often happens in the market environment, the great demand for housing led to high prices. All these aspects have eventually led to the housing bubble. Thus, high credit growth facilitated by the low interest rates and lax monetary policy in the US was one of the major factors that greased the boom behaviour (Furceri and Mourougane, 2009). Huertas (2011) believes that there are two major factors of recent financial collapse, including: macroeconomic policy and a financial system built on the assumption that there will never be too little liquidity. Despite the fact of housing bubble, both regulators and financial institutions were unaware of the wide extent to which mortgage markets had been securitised (Savona, Kirton and Oldani, 2011:21). Moreover, they did not understood that these securitised instruments were used further in order to support other financial products, such as derivatives, insurance products, etc. (Savona, Kirton and Oldani, 2011). Financial crisis of 2007-2009 was a crisis of the “shadow banking sector”, where financial institutions mostly looking like banks “borrowed short term in rollover debt markets, leveraged significantly, and lent and invested in longer term and illiquid assets” (Acharya, et al., 2009: 94). Even though this situation has occurred in the United States, technology development and integration/consolidation of the international financial markets also facilitated in easing credit conditions across the globe (Furceri and Mourougane, 2009; Savona, Kirton and Oldani, 2011). In Europe, financial institutions and banks also were involved in the sub-prime market through investments in securitised sub-prime mortgage as well as investment through the various derivatives based on the sub-prime securities (Savona, Kirton and Oldani, 2011:21). All economic crises are costly as they depress output, reduce employment, wreck the public finances, and impose substantial losses on investors and national economies (Huertas, 2011). It may take quite a long period for the economy to recover after a financial crisis. The crisis of the 2007-2009, is recognized to be one of the most costly crises in the history (Huertas, 2011). Financial crisis has strongly shattered the economic situation in Europe and incurred significant costs. As the Europe was heavily reliant on the exports to the U.S. to support domestic growth, economic recession in the U.S. has led to reduced demand for European products (Savona, Kirton and Oldani, 2011). According to cumulative calculations, the crisis of 2007 has caused a loss of $9 trillion in global output (Huertas, 2011: 1). Moreover, these losses are not over, as the effect of crisis is expected to continue and grow up to $20 trillion loss. Section 2: Literature review on the predictability of financial crises Capability to detect the likelihood of a financial crisis could be very helpful in preventing crisis and/or in minimising potential negative impacts of economic recession. Unfortunately, to predict a timing of a financial crises is quite a challenging task (Claessens and Kose, 2013; Fromlet, 2012). However, there exists a wide range of the models, enabling to predict the likelihood and timing of a financial crises. While there are proposed many different ideas/concepts/approaches, there is no unified set of indicators that could be used in order to predict the timing of a crisis. Below is provided a brief overview of existing approaches and models. Some of the earliest crisis prediction models are focused on the imbalances of macroeconomic and financial indicators (Claessens and Kose, 2013). Kaminsky et al. (1998) have identified a set of leading indicators of currency crises, and proposed an early warning system. This system suggested tracking and monitoring the evolution of several macroeconomic indicators such as exports, the ratio of broad money to gross international reserves, equity prices, output, deviations of the real exchange rate, etc. If these variables exceeded an established/expected/historical threshold value, it could be viewed as a warning signal, predicting crisis within the next 2-years period (Kaminsky et al., 1998). The next generation of crisis prediction models are focused on the balance sheet variables (Claessens and Kose, 2013). Thus, for example, Berg et al. (2004) have suggested that substantial short-term debt, rapid real exchange appreciation, increases in stock prices, domestic credit expansion, and current account deficits were some of the indicators preceding crisis. Later versions of crisis prediction models were based on a combination of variables, which could be helpful in predicting financial/economic collapses (Claessens and Kose, 2013). Frankel and Saravelos (2012) have carried out a meta-analysis study, examining the existing crises prediction models. These authors identified the following set of warning variables: foreign exchange reserves, growth of credit, GDP growth, the real exchange rate, the current account to GDP, and growth of current account deficits (Frankel and Saravelos, 2012; Claessens and Kose, 2013). While all of the above mentioned models and variables are referred to a specific country/economy, there are also global factors that could be used for predicting global financial crisis. This aspect indicates on the fact that traditional financial models can no longer be applied as nicely as it could be applied in the past (Fromlet, 2012). Some of the major factors applicable for the global financial market analysis include the following: shocks to world interest rates and commodity prices, as well as deterioration of trade (Claessens and Kose, 2013). According to Borio and Lowe (2012), asset prices, investment and credit data can be very useful in predicting crises on the basis of a credit boom. Therefore, sharp increases in house prices, large booms in residential investment, deterioration of current account balances could definitely serve as “worrying” signals for a global community (Cardarelli, Elekdag, & Lall, 2009; Claessens and Kose, 2013). Taking into consideration the above given information, it is possible to suggest that the use of existing models and monitoring of economic/financial/market variables could help the governors of the UK to reduce the negative impact of the recent financial recession in the UK. Section 3: Key lessons learned from the crisis of the 2007-2009 A global crisis of the 2007-2009 is critical for analysis and understanding its consequences/implications for future policy makers (Savona, Kirton and Oldani, 2011). The recent financial crisis has demonstrated that besides numerous benefits of global markets integration, there are substantial risks associated with it. The crisis of 2007-2009 has exposed serious problems in the previous system where banks ran out of capital and liquidity (which was the major concern of the BoE) (Huertas, 2011; OECD, 2009). The crisis has made regulators to rethink the international financial architecture as well. However, there is still a necessity to clarify on how to deal with large and complex financial institutions operating internationally (Claessens and Kose, 2013). In order to avoid the risk of repeating financial crisis in the future, it is important to undertake risk-taking incentives at financial institutions and banks (Acharya, et al., 2009). Conclusion The report explained the key aspects of the financial crisis, with a focus made on the recent financial crisis of 2007-2009. There were identified the major features and factors of the global economic recession facilitated by the sub-prime mortgage crisis in the US. This crisis has incurred substantial economic losses in global scales, and led to significant slowdown of the economy in major European countries. As the research has shown there exists a wide range of the models, enabling to predict the likelihood and timing of a financial crises. Even though it is quite a challenging task, capability to detect the likelihood of a financial crisis could be very helpful in preventing crisis and/or in minimising potential negative impacts of economic recession. The governors of the Bank of England are highly recommended to take into consideration discussed above variables and tendencies and to put more efforts on monitoring relevant economic, financial and market trends. The crisis of 2007-2009 has exposed serious problems in the previous system, and revealed major gaps which should be addressed in the future. It might be very helpful to learn from the lessons of the financial crisis of 2007-2009 and to undertake necessary regulatory and preventive measures. References: Acharya, V, Philippon, T, Richardson, M, & Roubini, N. (2009), The Financial Crisis of 2007-2009: Causes and Remedies, Financial Markets, Institutions & Instruments, 18, 2, pp. 89-137, Business Source Complete, EBSCOhost, viewed 20 February 2015. BBC News, (2015), Bank unaware of financial crisis. [online] Available at: http://www.bbc.com/news/business-30699476 Borio, C. and Lowe, P. (2002). “Asset prices, financial and monetary stability: exploring the Nexus,” BIS Working Paper, no.114. Cardarelli, R., Kose, M, and Elekdag, 2010, “Capital Inflows: Macroeconomic implications and policy responses,” Economic Systems, vol. 34 (4). Claessens, S. and Kose, M. (2013). Financial Crises Explanations, Types, and Implications. IMF Working Papers, 13(28), pp. 1-66. [online] Available at: http://www.imf.org/external/pubs/ft/wp/2013/wp1328.pdf Fromlet, H. 2012, "Predictability of Financial Crises: Lessons from Sweden for Other Countries", Business Economics, vol. 47, no. 4, pp. 262-272. Frankel, J. and Saravelos, G. (2012), “Can leading indicators assess country vulnerability? Evidence from the 2008-2009 global financial crisis”, Journal of International Economics, Vol. 87, pp.216-31. Furceri, D. and A. Mourougane (2009), "Financial Crises: Past Lessons and Policy Implications", OECD Economics Department Working Papers, No. 668, OECD Publishing, Paris. DOI: http://0-dx.doi.org.wam.city.ac.uk/10.1787/226777318564 Gieve, J, and Provost, C. (2012), Ideas and Coordination in Policymaking: The Financial Crisis of 2007-2009, Governance, 25, 1, pp. 61-77. Huertas, T. (2011), Crisis: Cause, Containment and Cure. [Online]. OECD (2009), The Financial Crisis: Reform and Exit Strategies, OECD Publishing, Paris. DOI: http://0-dx.doi.org.wam.city.ac.uk/10.1787/9789264073036-en Kaminsky G., Lizondo, S. and Reinhart, C. (1998). Leading Indicators of Currency Crises. Staff Papers - International Monetary Fund, Vol. 45, No. 1, pp. 1-48. Savona, P., Kirton, J. and Oldani, C. (2011). Global financial crisis. Farnham, Surrey, England: Ashgate. Read More