Global Financial Crisis

The global financial crisis brought the international financial system to a grinding halt: the
sudden withdrawal of global liquidity led to a catastrophic downturn in the global economy, which
was only arrested by the swift and coordinated intervention of governments on a giant scale.
The global financial crisis of 2008 is the worst of its kind since the Great Depression.
Rapidly evolved into a global crisis resulting in a number of European bank failures.

Overview
The financial crisis began with failures of large financial institutions in the United States:
Morgan Stanley, Goldman Sachs, Merrill Lynch Deutsche Bank, Barclays. The collapse of the
United States subprime mortgage market in 2007 as housing prices continued to decline (after mid2006) and default rates rose. By late 2008 the crisis had spread globally to institutions overexposed
to the risks inherent in investment products that had packaged United States subprime mortgages
(mortgage-backed securities).
These are the five key stages during the global financial crisis. From sub-prime to
downgrade, the five stages of the most serious crisis to hit the global economy since the Great
Depression can be found in those dates.
9 August 2007- began with the seizure in the banking system precipitated by BNP Paribas
announcing that it was ceasing activity in three hedge funds that specialized in US mortgage
debt.
o 24 January 2008- Analysts announce the largest single-year drop in US home sales
in a quarter of a century. Sandra Michel, a nurse, nearly lost her home in 2008 until
Boston Community Capital stepped in.
o 17 February 2008- After the failure of two private takeover bids, Alistair Darling
nationalises Northern Rock in what he claims will be a temporary measure. It will be
nearly four years before it returns to the private sector
o 14 March 2008- The investment bank Bear Stearns is bought out by JP Morgan. It is
the biggest casualty of the crisis so far
o 7 September 2008- The USgovernment bails out Fannie Mae and Freddie Mac two
huge firms that had guaranteed thousands of sub-prime mortgages. )
15 September 2008- the US government allowed the investment bank Lehman Brothers to
go bankrupt.Up to that point, it had been assumed that governments would always step in to
bail out any bank that got into serious trouble: the US had done so by finding a buyer for
Bear Stearns while the UK had nationalized Northern Rock.
2 April 2009, world leaders committed themselves to a $5tn (3tn) fiscal expansion, an extra
$1.1tn of resources to help the International Monetary Fund and other global institutions
boost jobs and growth, and to reform of the banks.
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 9 May 2010 marked the point at which the focus of concern switched from the private sector
to the public sector.Budget deficits had ballooned during the recession, mainly as a result of
lower tax receipts and higher non-discretionary welfare spending, but also because of the
fiscal packages announced in the winter of 2008-09.
5 August 2011- US hegemony was lost
- Economic recovery was not delivered
- Fiscal policy will be tightened over the coming months as tax breaks
expire and public spending is cut.

Background on the financial Crisis

Expansionary monetary policy with falling interest rates caused asset price booms,
particularly in the U.S. housing sector. This was accompanied with a rapid expansion of lending and
a corresponding decline in underwriting standards and increase in risk, fuelled in part by the
unregulated growth of the so-called shadow banking system. This side of the financial system
developed between 2000 and 2008 and consists of institutions and legal entities that provide
financial intermediation without taking deposits.
There are three causes of financial crisis; macroeconomic, financial market and policy
implementations and regulatory failures.
I.
Macroeconomic Causes
a. Low inflation & low interest rates - Many central banks in the developed countries
have adopted inflation targeting over the last two decades. This change in the
monetary policy framework has been successful in bringing down inflation
expectations. The combination of low, and lower than expected, inflation had the
consequence that key interest rates were kept very low by historic standards.Low
interest rates had several implications. Borrowing by individuals to purchase
residential housing became more affordable and house prices rose substantially in
many countries. Prices doubled or trebled in just a decade. Households in those
countries also recorded a very rapid increase in their indebtedness. The most
common variable to measure debt, household debt/disposable income, reached new
highs in almost all Western countries.
b. Higher risk taking- The increase in demand for debt was not matched by an increase

in bank deposits. Thus banks had to find funds elsewhere. This made them
increasingly dependent on the wholesales funding markets. Financial institutions
thus built up liquidity risks on a large scale. The low interest rates made risk adverse
investors uncomfortable. Treasury bonds sometime yielded less than certain funds
guaranteed return. Therefore these investors sought higher risk in order to receive
higher return. Other investors exploited the low borrowing cost to invest in higher
risk assets. Over time the higher demand for risk reduced spreads between
conventional fixed-income assets as interest rates on risky asset fell. This was
interpreted as a consequence of the more stable macroeconomic surrounding, while
in reality it was also an indirect effect of investors changed behavior on the back of
low interest rates. An overall conclusion is that society severely underestimated risk.
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II.

This was also true for many supervisors and monetary authorities. Leverage was also
increased in order to maintain a high nominal return on capital. Hedge funds and
venture capitalist are obvious examples but banks and many ordinary companies also
increased their leverage. An indirect form of risk taking was that many companies
and financial institutions to a large extent relied on short funding and a wellfunctioning repo market. Liquid markets were taken for granted. However, liquidity
dried up when investors became uncertain over the quality of assets involved in
asset-backed securities and the repo market. Several companies and financial actors
came under acute financial stress when they could not refinance themselves through
their ordinary sources and banks were reluctant to step in.
c. Growing imbalances- For many years a number of countries had been running large
current account deficits. This situation worsened during the 2000s. At the same time
oil exporting countries and some emerging countries, especially China, have been
running large and rising current account surpluses, see fig. 8. A large proportion of
these current account surpluses were invested in developed countries. The increased
demand resulted in higher prices and lower government bond yields and low returns
on fixed income financial assets across all advanced economies.Thus, apart from all
the positive effects of low inflation and low interest rates, a side effect was a rapid
accumulation of debt among households in the Western world. Moreover, the
financial system became loaded with risk although its participants were largely
unaware of this.
d. Failure to address the financial cycle- Many central banks, in particular the US
Federal Reserve, considered that they should not respond to the rapid rise in credit
and asset prices. Instead they should (aggressively) drop the interest rate if asset
prices fell sharply and led to an economic downturn. This approach was based on the
notion that they could not identify an asset price bubble and if they could it would be
dangerous to try to deflate it but they could mitigate the deflationary effects on the
economy of a fall in asset prices.
Financial Market Causes
a. Financial innovations increased complexityb. System- wide risks underestimated
c. Inadequate risk management
d. Credit rating agencies failed to evaluate risks
e. Remuneration systems spurred risk taking
f. Banks circumvented capital requirement regulations
g. Procyclical credit conditions

III.

Policy Implementations and Regulatory Failures

a. Government policies lowered credit control

b. No one responsible for- or understood- system- wide risks

c. A lack of international harmonization and coordination
d. Supervisors did not understand risks or that banks by- passed capital requirements
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e. Winding up procedures for banks

f. Governments guarantee the financial system

Causes & Lessons of the Crisis

Four Horsemen of the Financial Apocalypse (Joel Wolpert)
According to Joel Wolpert, there were four major areas of Governance Weakness, which led
to the global financial apocalypse / crisis, namely, [1] Remuneration Process; [2] Board Practices;
[3] Risk Management; and [4] Shareholder (In) Activism.
Governance of the Remuneration Process
Most market commentators believe that remuneration practices played a role in promoting
the accumulation of risk that lead to the crisis the design, implementation and supervision of
remuneration schemes did have systemic impact on the financial system. Boards must enquire
whether the companys remuneration model is aligned with prudent risk taking and long term
objectives and strategy of the company.
There were flaws in the remuneration practices in the investment banking sector. Bonus
driven remuneration structures encouraged reckless / excessive risk taking. The design of bonus
schemes was not aligned with shareholders interest or long term sustainability of banks.
Remuneration policies and practices were not at arms length boards did not exercise
objective judgment conflict of interest dilemma of risk taking and remuneration structure
during boom, the board was less independent in monitoring remuneration and more accommodating
in their bargaining.
Remuneration schemes were not transparent they did not measure consequences
transparency must be improved by disclosure in non-technical terms.
Remuneration in many cases is only upwardly flexible rewards for failure are cause of
concern. Senior remuneration levels were ratcheted up with undemanding performance targets.
Weak link between performance and remuneration need to determine long term KPIs ensure
that generous incentives must be match by strong risk management systems.
Instruments should only reward executives after long term performance has been realized
tail-end risk.
Remuneration structures must be flexible.
Governance process must be explicit (consultants/NEDs) Big problem is ration of CEO
remuneration to that of average employee.
Say on Pay must be implemented shareholders resolution in respect of directors
remuneration.
The failures in the executive remuneration process have caused governments to endeavor to
regulate the pay in financial institutions. Having regard to the governments interest in the stability
of the financial system, intervention in pay structures is as legitimate as the traditional forms of
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financial regulation. Governments goal is to promote the safety and soundness of the financial
system rather than addressing shareholders concerns about excessive levels of pay. Regulation of
pay would make the executives of financial companies work for, rather than against, the goals of
financial regulation.
Board Practices
Corporate governance failed to foresee / mitigate the global financial crisis. There was an
absence of guidance of appropriate boardroom behaviors this was a structural weakness. There is
a need for the better articulation of the business case for best practice corporate governance. Boards
were captives of their own histories disclosure failed to inform shareholders sufficiently.
Evidence from the financial crisis indicates that some NEDs have not fulfilled their role of
providing strong independent oversight of the executive management. NEDs will need to raise their
technical skills in order to exercise rigorous oversight they will need to demonstrate competence
with regard to risk management, regulation and the business model of the firm. This may require
NEDs to work on a more fulltime basis and be remunerated accordingly. NEDs need to be properly
supported to strengthen their technical expertise.
Boards must be competent and capable of independent judgment.
Board member duties must be formalized continuing technical training in the case of
financial companies boards is essential.
Governance and risk management skills of board members must be augmented. Risk that
adding extra governance requirements is likely to lead to more box-ticking and hamper effective
scrutiny by non-executive directors by occupying time with form rather that looking at substance.
A robust board evaluation process is required. Independence is critical problem with board
members who have served for too long under the same CEO / Chair.
Boards / Audit Committees must critically evaluate: (1) Going concern; (2) Liquidity risks;
(3) Fair value estimates; and (4) Risk disclosures.
Risk Management
The greatest shock from the financial crisis was the failure of risk management. Joel Wolpert
(2009) presented the Seven Bad Habits regarding risk management which contributed to the in
the global financial crisis. These are: [1] Failure to embrace appropriate enterprise risk management
behaviors; [2] Failure to develop and reward internal risk management competencies; [3] Failure to
use enterprise risk management to inform managements decision making for both risk-taking and
risk-avoiding decisions; [4] Over-reliance on the use of financial models, with the mistaken
assumption that the risk quantifications, which were used as predictions, were based solely on
financial modeling were both reliable and sufficient tools to justify decisions to take risk in the
pursuit of profit; [5] Over-reliance on compliance and controls to protect assets, with the mistaken
assumption that historic controls and monitoring a few key metrics are enough to change human
behavior; [6] Failure to properly understand, define, articulate, communicate and monitor risk
tolerances, with the mistaken assumption that everyone understands how much risk the organization
is willing to take; and [7] Failure to embed enterprise risk management best practices from the top
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all the way down to the trading floor, with the mistaken assumption that there is only one way to
view a particular risk.
Well run companies made catastrophic errors of judgment. Risk management was not
properly overseen, monitored or reviewed at board level it did not address company risk appetite.
Need alignment between corporate strategy and risk appetite.
Each category of risk is correlated the banking sector had specific risks with regulatory /
systemic impact. In the case of financial companies risk volatility is greater systemic risk requires
prudential oversight. Regulation cannot remove risk risks must be understood, managed and
communicated.
Board must oversee the risk management structure.
Risk Governance requires: [1] Greater awareness and improved implementation of risk
management; [2] Improved disclosure of risk management processes and practices; and [3] Risk
management must be integrated with internal control.
The Financial Crisis: [1] Risk was not focused on the business context; [2] Risk was not
properly defined; [3] Risk responses were not properly developed (no recognition of the extended
enterprise); [4] Poor disclosure of foreseeable risks; and [5] no link with remuneration / incentives.
Necessary to have separate role of Chief Risk Officer. Effective risk managers need a
combination of technical competence, communication skills and stature in the organization so as to
provide genuine challenge to business managers.
Risk management must be seen in a corporate perspective where the risk management
system is continuously adjusted in line with corporate strategy and the appetite for risk. Board
oversight of risk management must be improved and directors must be given all the information
they need to make informed decisions.
It is not understood that risk management is not only about measurement, but rather about
the quality of the decisions companies make in the face of uncertainty. Therefore, a reliable risk
process identifies specific risk exposures (including model limitations) and ensures continuous
measurement of those exposures. Effective risk oversight is more about ensuring that the correct
what if questions have been asked and understood from the business model perspective rather
than focusing on scenarios based solely on historical quantitative data.
Shareholder (In) Activism
Bull market automatically aligned interest of some shareholders with management.
Shareholders in general have not been proactive in relation to the financial crisis.
Institutional shareholders were guilty of being too passive and reactive.
There has been a disconnection between size of shareholding and voting behavior. Many key
decisions are made or approved by a small number of shareholders. Separation between asset
ownership and asset management has created a systemic governance problem.
There is a strong view that shareholders are at fault for boards lack of oversight over risk
management and remuneration systems. The lack of involvement and action by institutional
shareholders reduced accountability of both boards and management.
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There is a need for stronger links between non-executive directors and institutional
shareholders. Institutional shareholders did not scrutinize or monitor boards in the banking sector
this encouraged risk taking. The non-executive directors at banks were a cozy club which lacked
expertise / diversities and lacked adequate time commitment to their responsibilities.
Companies must do more to support constructive engagement with their shareholders.
Shareholders must take responsibility to be active individually and collaboratively to engage with
senior management and NEDs and question the effectiveness and structure of boards they must
also challenge management to ensure that business plans are credible.
Capitalism without owners has been shown to fail. Governance flaws indicate that stronger
shareholder oversight is required. The dawning of shareowner democracy could be a significant
development in corporate governance. Corporate governance framework should be complemented
by advice of analysts, brokers, rating agencies and others that is relevant to decisions by investors.
Stakeholders need to better understand financial statements and be held to account in the way the
information is used.

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