Why a Crisis Started in the United States in 2007 Spread So Rapidly to the Rest of the World - Coursework Example

University Name Department Student name & Admission number Date TASK-NO.7 The world has globalised financial markets and globalised financial institutions, but no global system of regulation. Does this explain why a crisis that started in the United States in 2007 spread so rapidly to the rest of the world? Explain what drove that spread and whether and how global governance might (or might not) have made a difference The competitive transformation in the global financial markets shows that the world has globalised financial markets and globalised financial institutions, but the lingering question were whether there is a global system of regulation based on the credit crisis that started in the US in 2007 and spread all over the world. This paper focuses on the globalised financial markets and globalised financial institutions and the significance of having a global system of regulation, and whether such system could have solved the crisis of 2007 by giving details what drove that spread and whether and how global governance might (or might not) have made a difference (Liebowitz, 2009). The past financial panics and crisis, most notable, the Asian Banking Crisis of 1997, Russian Crisis of 1998 and the most recent Global Credit Crunch of 2007 give good lessons to banks and other lending agencies to be more proactive with the issue of credit risk management and need to have global system of regulation. Causes of global financial crisis in 2007 Financial crisis, especially the credit risk in banking sector is not a new phenomenon. The world economy has had to endure it in different occasions, and the global credit crunch in 2007 is the most recent crisis whose effect was harshly felt worldwide since the Great Depression in early 1930s (Liebowitz, 2009). The main factors that contributed to global financial crisis include macroeconomic setbacks, failures in financial markets and deficiency in the implementation of policy. The growth and development of financial sector has complicated issues making it hard for regulators to control the intricacies in the system (Fried, 2012). Presently, banking system is encroached with several risks that are more prevalent than before, making it even hard for internal control to fail in some cases. The anatomy of global credit crunch in 2007 emerged from the American housing market, in sub-prime mortgage (Reischauer, 2010), the house prices had increased steadily since 2004, thus many investors were attracted in the sector, and, however, in 2006 it peaked and then had a drastic drop of more than 30%. The decline was so enormous since 1930 and resulted in the depletion of bank capital because of unexpected disruptions as housing debt started to increasing considerably in the market due to a sharp contraction in credit supply. This had adverse effects not only in U.S. banks and other investment banks in Europe, but went out of control and spread globally. It is supposed that during 2007 sub-prime mortgages had started experiencing some losses after a rapid growth at the financial markets (Liebowitz, 2009). This forced some institutions like BNP Paribas to freeze their redemptions in three funds that had been invested in structured products, as it became hard to estimate the portfolio held. Also because of losses in sub-prime mortgage, the counterparty risk for U.S. banks and Euro Zone rose sharply, leading to increase in interbank rates; interest rates banks are charged when they borrow from one another (Norberg, 2009), The issue of losses in the housing sector, in U.S. caused loss of confidence in government sponsored businesses, and later a global loss of trust in the whole financial system. Several financial institutions like Lehman Brothers, Fannies Mae, RBS, AIG, Icelandic banks, Amro almost came to collapse, thanks to federal government for rescue measures to halt a collapse of the whole global financial system (Antif, M. & Amir S., 2008etal,.) The proximate cause in the financial markets for the credit risk was catalyzed by banks on basis of two choices. First, considerable sum of mortgage-backed securities that encompassed sub-prime risk were incorporated in bank’s financial statement, despite the fact that banks were supposed to transfer the risk than hold it as hypothesized in originate and distribute model as commonly envisaged in unleveraged pension funds (Christopher, 2009). Secondly, banks had resolved to finance credit risk and other risky assets with quick-fix borrowings from the market, leading to spread of TED. According to Ghon (2008), this operation became hard for the banking system, with decline in housing market leading to a rise in seeming risk of mortgage-backed securities, thus complicating further the issue carrying forward the temporary loans aligned with the securities. As a result, banks were required to sell out the assets they were unable to finance, despite the decline in price at the market that was below their real values. The valuation losses weathered bank capital further as banks perceived each other as riskier counterparts because of the spread of TED and this strained possibility of acquiring short-term finances as it generated a downward spiral. The funding problems for banks spread over to borrowers, as banks trimmed down the issuing of loans to preserve liquidity, in so doing slowing down the entire economy. The liquidity issue is a fundamental factor in the financial markets, as banks are forced to avail it in different forms. As in 2008, the liquidity problem resulted into temporary funding of markets that yielded the nationalization of Northern Rock in Britain, whereas in U.S. it prompted the buy off of Bear Stearns by JP Morgan Chase (Christopher, 2008). The crisis became rampant in US that commercial banks stop to lend investment banks because of fear of the exposure to sub-prime mortgages, TED spread and increased credit risk in their asset portfolios. The mortgage defaults led to declining in profit of commercial banks while some investment banks reported losses in their financial statements. The losses had wiped out the previous profits and now the capital in their banking system. Nations that had entered in the Basel Accord forced their banks to possess a substantial value of capital for each dollar of credit that was granted to consumers and businesses (Taylor, 2009) Even though a number of banks globally had tidal wave of damage on their capital base, as more than $135 billion in losses reported came from banks. Global system of regulation After the 2007 crisis, many nations and stakeholders in the global financial markets have advocated for global system of regulation to avoid a repeat of the same. Global system of regulation is very vital in availing solutions to crisis that involves the global financial markets and global financial institutions. Global system of regulation itself is not a guarantee of smooth operation, but mitigation to heavy losses that could occur. The mortgage crisis in 2007 illustrates dire deficiencies in the implementation of sound risk models in the financial markets. The models could entail the evaluation of liquidity risk and counterparty risk and derive scenarios such particular risks may hold in the economy in case of the known unknowns (Acharya and Matthew, 2009). In 2008, the risk models completely failed to halt the known unknowns and weakened changes that were carried out in the regulatory and structural points in financial markets. To avoid the happening of any major occurrence of global credit crunch in 2007, banks need to improve their risk management procedures through support of global system of regulation with a close look at tests and scenario analysis. Global system of regulation may also formulate precautionary measures to avoid a future recurrence or lessen the severe effects associated with credit distresses in financial markets (Acharya, V., and Matthew, R. 2009),A natural measure to avoid a repeat of these crises may be to mandate higher bank capital standards, so as to buffer the financial market setbacks which is the integral part of the economy. However, this could assume a more vital set of issues relating to institutions governance and internal supervisory concerns in banks-commonly referred to as agency problems (O’Quinn,2008). Fried (2012) alleges that the failure to free from sub-prime risk might be the main cause of global credit crunch based on the current episode. However, there are more severe signs that are so pervasive within banking that could lead to such crisis. One should look to both sides of the coin and stop concentrating only on credit risk, as banking setbacks like highly-leveraged transactions, provision of loans to developing states and commercial real estate could instigate such happenings (Acharya & Matthew, 2009). The regulatory community need to reform capital principles to try to reinforce the financial system to be more secure (Brunnermei, 2009), The measures should be flexible and not harsh to banks as stringent standard makes the process of acquiring capital become slowly or else fail to yield tradeoff. Acquisition of capital is in general expensive means of funding at any particular time, and with the prevalence of sluggish system, banks may find it hard to raise capital in moments of great uncertainty. According to Acharya and Matthew (2009), regulatory reforms could be embraced in these areas. Start with governance and then risk management in bank’s capital structure. Regulators could carry out a coordinating role in circumstances where individuals’ actions within the bank become compromising to the sustainable competitive edge of the institution, like supporting the restructuring of workers remuneration package at the expense of investment strategy could result on tail risk. There are also several mechanisms that banks may use to analyze and manage the risk in a financial market. A careful and timely utilization of these mechanisms will help banks analyze the risk associated in their investment and improvise strategy to manage the risk. The mechanisms include (a) Monitoring the trend of the market: this is the most common mechanism that investors use to minimize the two risks in a share market. The only hitch with this method is the intricacy of figuring out the trends in the market as they change incredibly fast, for example, a market trend may last even for one day (Liebowitz, 2009), (b) Portfolio diversification, which is perceived to be the best mechanism that banks use to mitigate unsystematic risk as they are not linked to any market risk. Banks who own diversified number of share portfolios minimizes the risk exposure to their investments compared to ones that have one share portfolio. Mutual Funds are yet another means to diversify the impact, (c) Asset allocation: it is believed asset allocation can partially mitigate systematic risk. By owning different kind of asset classes, with low correlation, an investor will have low portfolio volatility (risk) for the reason that asset classes act in a different way to macroeconomic elements. While in some cases the portfolio of asset categories could be rising some may be diminishing (Barnett et al, 2010). References Acharya, V., and Matthew, R. (2009), Restoring Financial Stability: How to Repair a Failed System, New Jersey: John Wiley and Sons Inc., Hoboken. Antif, M. & Amir S., (May, 2008). The consequences of mortgage crisis expansion: evidence from 2007 mortgage default crisis, University of Chicago Graduate School of Business. Barnett, W.A., Geweke, J. and Shell, K. (2010). Managing investment risk: Stock market. Cambridge University Press, New York. Brunnermeir, M., 2009, Deciphering the liquidity and credit crunch 2007-2008, Journal of Economic Perspectives vol. 23, pp. 77-100. Borio, C., (2008), The Financial Turmoil of 2007: A Preliminary Assessment and Some Policy Considerations, BIS working paper no. 251. Christopher, R.W. (2008), The Subprime Crisis - Cause, Effect and Consequences. At Indiana State University Fried, J., (2012). Who Really Drove the Economy into the Ditch?, New York, NY: Algora Publishing Ghon, Rhee, (2008), “The Subprime Mortgage Crisis: Financial Market Perspective,” a paper presented at the fourth APEC International Finance Conference, November 10, 2008. Liebowitz, S., (2009), Anatomy of a Train Wreck: Causes of the Mortgage Meltdown. Oakland CA: The Independent Institute. Norberg, J. (2009), Financial Fiasco: How America's infatuation with home ownership and easy money created the economic crisis, Cato Institute. O’Quinn, R. (2008). The U.S. Housing Bubble and the Global Financial Crisis: Vulnerabilities of the Alternative Financial System (1-51). Washington, DC Reischauer, D. R., (2010), Subprime Mortgages: Americas Latest Boom and Bust, Washington, D.C.: Urban Institute Press. Taylor, J., (2009), Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, Hoover Press. Read More