In 2007-08, the world experienced unprecedented financial crises that brought numerous financial systems down on their knees. While many analysts view the causes of the crises as single faceted, many empirical researches point multiple causes of the crises (Krishnamurthy 2010, p.23). Many subprime banks and financial institutions collapsed and others put in place some measures to avert the danger. Bailouts became a norm as governments attempted to save their respective institutions. This paper seeks to analyze some of the manifest reasons for the global financial crises. Besides, the paper will depend on evidence-based research to ascertain the causative factors.
Unethical lending practices
Niinimaki (2008, p. 514) points out that unethical banking practices by banks and their focus on collateral was partially to blame for the crises. Many companies engaged in the ‘gamble game’ of speculative hike in the future market value of collaterals. Despite the inability of the financial institutions’ clients to repay their loans owing to their meager incomes, the banks used house property as the collateral and assumed that the future value of the collateral would rise and as such, they would make profits. Indeed, collateral can reduce the risk borne by the banking institutions although it became apparent that they have detrimental effect. Niinimaki (2008, p. 514) explains that using collateral to reduce the risk of default by borrowers may affect the banks negatively in terms of engaging in the problem of moral hazard. This happens in two ways.
In the context of external collaterals, the banks may be able to avoid the moral hazard problem in the event that there are a high number of borrowers. Besides, it may happen in instances where the risks and the profits on the borrowers’ projects are autonomous. Owing to the principle of increased numbers of borrowers, the loan portfolio becomes diversified and hence, the deposits are safe when they approach a bank. On the other hand, the principle of large number of borrowers dictates that financial institutions will be certain of the success of the loans. Nonetheless, this requires the banks to monitor the borrowers failure to which, the certainty of successful loans reduces significantly making it difficult for the banks to make returns.
Faced with similar scenario in 2007-08, the banks opted to monitor the clients through collaterals to limit the numbers of potential loan defaulters. However, collateral presents the banks with the problem of moral hazard in the sense that the value of the collateral is indifferent making the banks to ‘gamble’ and speculate high returns in the future owing to increase in their market value (Muller 2006, p. 54). During the financial crises therefore, banks undermined the borrowers’ ability to repay their debts as the future value of collateral was projected to be high enough. Conversely, this was not the case as the market value of house property dropped drastically making the banks to fail.
Further, the inside collaterals are funded by capital loans. They include housing mortgages that presents the banks with another moral hazard problem. Klomp (2010, p. 73) explains that the banks attract both bad and good homebuyers. The former implies that they make an income and fail to pay while the latter depicts a borrower who earns an income and consequently repays their mortgages. According to Niinimaki (2008, p. 521), banks have the tendency of ignoring the process of monitoring the borrowers. The rationale is that the initial cost of the mortgage is prone to fluctuation yet borrowers’ monitoring process is unprofitable and not lucrative for the banks.
As such, the banks are unable to identify and differentiate between good and bad homebuyers. During the financial crises that typified the 2007-08 period, the banks ignored the monitoring process in the hope that inside collaterals would hike in the end. Contrary to their speculation, the housing property values reduced significantly leading to the failure of the banks (Krishnamurthy 2010, p. 21). It is apparent that the inside collaterals usually funded by capital loans tend to influence the banks into dropping the essential borrowers monitoring process (Niinimaki 2008, p. 516). This unethical practice is hazardous and has a moral dimension. Therefore, the financial crises were because of the banks’ failure to uphold ethics due to their dependence on external and inside collaterals.
The Early Warnings Systems (EWS) during the financial crises concentrated their efforts on elucidating the external and macroeconomic factors that affected the banks (Gramlich & Mikhail 2011, p. 273). The rationale of this perspective was the growing interconnectedness of the banking systems across all financial markets. However, they failed to underscore the implicitly evident structural problems that made the banks unable to withstand the negative global financial shockwaves that were apparent in nearly all countries. Structural instabilities expose the banks to sensitivity to both internal and external factors. As such, the banks run under systemic financial risks that compromised their ability to show resilience and absorb the stress factors.
At the outset, systemic financial risk emanates from distress from the instabilities of internal structures as well as other mechanisms that generate stress (Gramlich & Mikhail 2011, p. 279). In fact, systemic risk becomes evident when such factors as capital and liquidity suffer detrimental effects on the real markets. At the dawn of 2007-08 financial recessions, the interaction of banks and other financial institutions made the rectification of structural instability a huge phenomenon.
For example, a bank may embark on a fire sale of assets as a way to manage its liquidity. However, the financial interconnectedness dictates that when the banks liquidate their respective assets at the same time, they are exposed to the scenarios that were witnessed due to lack of liquidation abilities. Gramlich & Mikhail (2011, p. 279) portray systemic financial crises as the prime causes of financial crises implying that the banks experienced negative effects owing to their inability to deal and show resilience. It is worth noting that this capacity is dependent on risk capital and liquidity as a substantial constituent of capital and funding relationships with other banks and financial institutions.
The transformation of financial markets exaggerated the financial crises due to their ability to generate systemic stress. The rationale is that the EWSs overemphasized on the observable factors and signs of systemic stress. They failed to see the underlying factors such as spillovers from the macroeconomic levels although they have proved to be considerable factors that amplify the systemic risk (Gramlich & Mikhail 2011, p. 273). This transformations in the financial markets resulted due to products innovation and the need for the institutions to have a global appeal. Besides, financial liberalization and emergence of new and unprecedented classes of risks transformed the banks at both microeconomic level as well as the macroeconomic levels.
Longstaff (2009, p. 436) articulates that the financial crisis was as an effect of contagion in the financial markets. Contagion is a major source of systemic distress owing to the temporary increase in financial institutions’ connectedness that was evident at the start of the crisis. Longstaff (2009, p. 439) uses the financial variables such as VAR to illuminate the changes that ensued after the crises. The crisis saw a rise in contagion at the onset of the subprime crises. The financial indices such as ABX provided the predictive factors of the looming crisis due to their indications of reduced yields in Treasury bonds and corporate spreads. Besides, it was a strong pointer that the stocks were poised to yield diminished returns. To cushion their firms from the impending crisis, contagion took effect making the crisis to penetrate other financial markets due to the high information flow.
Krugman (2010, p. 56) claims that the liquidity channel fueled the contagion in that a shock in financial markets leads to an overall decline in the liquidity of the rest of the markets as the institutions in the crises sought to liquidate their assets at the expense of other regions. The initial effect therefore was the reluctance by investors to put their money in stocks and a negative fluctuation in asset prices (Longstaff 2010, p. 443).
It is important to notice that a financial crisis in one market reduces the ability of the institutions to access funding from other markets. Subsequently, it leads to reduced trading activities and accessibility of credit to other markets. This was a major precursor of the subprime crises. The rationale is that they rendered the global financial markets unable to manage the liquidity crises partially due to their respective structural instabilities.
Regulation and Leverage explosion
Prior to the financial crises, there had been time-particular factors that led to the problem. The existing policies provided a channel through which the mortgage rated products were at the disposal of the borrowers. For instance, Bush Administration American Dream (BAAD) became a regulatory framework that allowed many Americans to access mortgages notwithstanding their ability to repay or own a house. The regulators exposed the institutions to stringent balance sheet controls and increased capital requirements leading to the boom of low-income mortgages (Bogle 2005, p. 211). Such social policies coupled with minimal interest rates prompted the banks to take advantage and undermine the securitization process. Although the equity to debt ratio permitted by the regulators was 15:1, it soared to 40:1 in many occasions (Blundell & Atkinson 2009, p. 543).
The trend could not be contained as the regulators were amongst the buyers of the low quality mortgages. Besides, there would be a decrease in revenues were the banks not allowed to continue with their strategies. By the time it became apparent that the boom was about to burst, the regulators therefore could do little to cushion the institutions. In fact, measures to counter the imminent crises were not effective owing to the complexity of the issues that surrounded the tax and social policies that the banks were using to increase their advantage.
The events that preceded the global financial crises happened within policy frameworks that are typical of unclear roles of the regulators. These roles rarely change with the ever-changing financial environment across all the markets. Brunnermeier (2009, p. 76) asserts that the regulatory agencies are often mandated with responsibilities that they are ill equipped to handle effectively. Plagued with initial distortions of the hitherto prevalent policies, regulators prescribed deregulation as a strategy to counter the deteriorating effects. This resulted to worse effects than initially predicted.
Such policies as the Gramm Leach Biley Act in the US bestowed bank subsidiaries to undertake some financial activities that led to competition with other firms in different sectors. The effect was overlapping responsibilities of the subsidiaries that led to conflicting interests. As such, the real situation in the regulatory frameworks precipitated the financial crises where the subsidiaries were allowed to be at the center of monetary policies.
In sum, the global financial crises came about due to interaction of multiple causes. First, the financial institutions engaged in unethical behavior of using collaterals as the security for their loans. The lenders anticipated the market value of external collaterals to rise and as such, make profits. However, the housing bubble burst led to a sharp decline in the property prices leading to banks’ collapse. Internal collateral that are funded hugely through capital loans facilitated the banks to offer homebuyers with mortgages despite their inability and unwillingness to pay. To that end, the banks had ignored other bank monitoring processes due to their unprofitable nature. Upon the decreased asset value, the banks experienced huge losses that led to crises.
Second, the contagion effects amplified the structural instabilities of firms where crisis within one microeconomic area affected the macroeconomic markets through liquidity channel. Third, social policies and tax regimes allowed low-income earners to access mortgages through financial institutions with ease. The banks therefore took advantage of the two factors and produced more low quality houses contrary to the regulations. Finally, poor policies allowed subsidiaries of banks to conduct financial activities. This led to conflict of interests and overlapping roles amongst other effects that culminated to the escalation of the crisis.
Blundell, A & Atkinson, P 2009, ‘Origins of the financial crisis and requirements for reform’, Journal of Asian Economics, vol. 20 no. 1, pp. 536–548.
Bogle, J 2005, The Battle for the Soul of Capitalism, New York, Yale University Press.
Brunnermeier, M 2009, ‘Deciphering the liquidity and credit crunch 2007-2008’, Journal of Economic Perspectives, vol. 23 no. 1, pp. 77-100.
Gramlich, D & Mikhail, V 2011, ‘The structural fragility of financial systems: Analysis and modeling implications for early warning systems’, Journal of Risk Finance, Vol.12 no. 4, pp. 270-290.
Klomp, J 2010, ‘Causes of banking crises revisited’, North American Journal of Economics and Finance, vol. 21 no. 1, pp. 72-87.
Krishnamurthy, A 2010, ‘Amplification mechanisms in liquidity crises’, American Economic Journal, vol. 2 no.3, pp. 1-30.
Krugman, P 2010, The Return of Depression Economics and the Crisis of 2008, Washington, W.W. Norton Company Limited.
Longstaff, F 2009, ‘The subprime credit crisis and contagion in financial markets’, Journal of Financial Economics, vol. 97 no.1 , pp. 436–450.
Muller, J 2006, ‘Interbank credit lines as a channel of contagion’, Journal of Financial Services Research, vol. 29 no. 1, pp. 37-60.
Niinimäki, P 2009, ‘Does collateral fuel moral hazard in banking?’, Journal of Banking & Finance, vol. 33 no. 3, pp. 514-52.