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THE GLOBLE FINANCIAL CRISIS 2007-08

Charles Welikhe Wanditi


Jasmeet Gujral

World Quant University


Course: Financial MarketsGroup Assignment Submission 2 –M5

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Authors’ Note
Through this secondary research authors have tried to study the Global Financial Crisis of
2007/8 while emphasizing:
• The primary causes of the Global Financial Crisis (also known as the financial crisis
of 2007/8.
• The market features and conditions that constitute a financial crisis in general.
• How the primary causes of the Global Financial Crisis which led to the features of a
financial crisis.
• The response of policymakers and regulators to the global financial crisis.
• The intended effects of policymakers’ and regulators’ responses.
• The downsides and unintended consequences that can occur when applying regulation
and policy to the financial markets.
• The features of financial markets which often need regulation.

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Global Financial Crisis of 2007/08 after ten years of its inception serves as a critical case
study to understand the complexity of financial market and failure of regulations? In the
below article we have tried to explore and answer questions such as, how the crisis in the
housing sector of the US market engulfed the whole world in a short period? Moreover, need
for good regulatory framework and how the greed of few could lead to the disaster for all in
the absence of proper regulations? We have also tried to describe the circumstances which
lead to Financial Crisis and what led the US housing crisis to become the Global Financial
Crisis. We also discussed the regulatory framework brought into place to avoid such crisis in
future and provided authors view on effectiveness and impact of these regulations, both
intended and unintended.

Financial Crisis could be loosely defined as a market scenario under which liquidity
evaporates because of a significant gap between demand and supply of money (Stijn
Claessens and Laura Kodres, 2014). Such a situation often starts with sudden deterioration in
the perception about particular asset class of a large group of investors who then rush to sell
underlying without many takers in the market causing a massive decline in financial
instruments value. In short duration the financial asset loses a large part of its nominal value,
causing significant losses for institutions holding these assets. When banks have substantial
exposures to such assets, this situation propagates to the general public. As a result, retail
investors and bank depositors worried about losing money by continuing to be a part of these
financial institutions, go for mass withdrawals of deposits, causing bank-run. Bank run acts
as a vicious cycle, further impacting financial institutions’ health and eventually dragging
them to a state of insolvency.

Relaxation of financial regulations generally precedes a financial crisis. Institutions


incentivized to book short-term gains start circulating assets and work on self-fulfilling
prophecies. Driven by the sentiments of the institutions, investors rush to the market without
analyzing and understanding the uncertainties attached to their investment. They increase
their exposure by taking leverage, assuming the up run to continue forever. The situation is
extravagated to dangerous levels when reliable information is not available because of
opaque or lack of disclosure and absence of restriction on institutions to maintain right asset-

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liability match(John Maxfield, 2015).
The Global Financial Crisis of 2007/8 had all the ingredients discussed above to make it the
worst financial crisis post Great Depression of 1929 (Temin, 2010). The crisis originated
primarily from the US housing market and later engulfed the entire financial sector across the
world. Economist around the world attributes financial market liberalization and deregulation
as the two prime factors responsible for the crisis.

The US government’s keenness to encourage home ownership resulted in the mortgage rates
being dropped very low during the period between 2002 and 2005 (Soros, 2008). As a result,
house prices in the US started to increase at a much faster pace from the year 2000 than it had
in the previous decade. Additionally, financing institutions in their greed to pocket more
commissions on mortgage loans started sanctioning subprime loans under the assumption that
house prices will continue to increase forever and with the houses kept as collateral poses
virtually no risk (Calomiris, 2008). To further increase mortgage lending amid rising real
estate prices, mortgage lenders and brokers developed Adjustable-Rate Mortgages (ARMs)
wherein there was a low “teaser” rate of interest that would last for two or three years and be
followed by a price that was much higher. Further, the applicant’s income and other
information reported on the application form were frequently not checked (Options, Future
and Other Derivatives, 2017). The passing of the “anti-deficiency” law, which protected the
public from any personal liability, coupled with the low-interest rate encouraged people to
increase mortgage borrowing as a means to make easy money. Consequentially, the period
from 2000 to 2006 saw a massive increase in subprime mortgage lending (Maioli, 2010).

Investment banks in their greed to mean more and more profit structured collateralized debt
obligations (CDOs) from the mortgages purchased on the secondary market. The CDOs were
perceived to be a promising investment instrument capable of giving high returns in short
terms, while the underlying risks associated with these instruments were not adequately
disclosed. Rating agencies moved from their traditional business of rating bonds, where they
had a great deal of experience, to rating CDOs, which were relatively new and had little
historical data. In addition to this, there was always conflict of interest, with financial
institutions incentivizing the rating of their CDOs for the rating agencies (Wikipedia, 2018).

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The bubble burst in 2007 many mortgage holders found that they could no longer afford their
mortgages. With mortgage holders deciding to default on their loans led to foreclosures and
large numbers of houses coming on the market, resulting in a decline in house prices. As
foreclosures increased, the losses on mortgages also increased. Many financial institutions
and investors that had taken significant positions in some of the CDO tranches with high
leverages incurred huge losses and had to be bailed out with government funds (Hull J.C.,
Options, Future and Other Derivatives, 2017). Furthermore, massive losses were also
suffered by insurance giants that were protecting these CDO tranches, many of which had
been rated initially as AAA (Wikipedia, 2018). The globalization further worsened the
situation as the entire global market was interlinked and fall of the financial system in the US
had the rippling effect on global markets with liquidity evaporating from around the world.

This Crisis brought to the forefront the cracks in the policies and practices of the regulatory
and supervisory agencies (Reserve Bank of Australia, 2014). There was an immediate
requirement to prevent and reduce the cost associated with the crisis of such a scale which
cost the US economy alone close to $2 trillion (Crotty, 2009). The policymakers brought
many acts and laws as the reaction to the Global Financial Crisis to answer issues of small
capital holdings and management of liquidity by financial institutions; lack of corporate
governance and risk management practices; complexity and lack of transparency in banks
trading books; insufficient oversight of over the counter (OTC) derivative markets; and most
importantly the problem of 'too big to fall' institutions (Radcliffe, 2018).

The initial response of regulators and policymakers was to infuse capital into the market to
bring the market out of the state of crisis. Interest was reduced making capital available in the
market virtually at zero cost and a large number of assets and distresses securities were
bought by fed from troubled financial institutions to improve their health. Freely available
cash helped to reduce liquidity crunch, and backing of the Fed to financial institution brought
back investors' trust on financial institutions. Consequently, the Dodd-Frank Wall Street
Reform and Consumer Protection Act was signed in July 2010 (Clyde, 2018). European

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regulatory body BIS also came up with advanced framework Basel III as an answer to the
crisis (Wikipedia, 2018).

The Dodd-Frank Act established Financial Stability Oversight Council (FSOC) that was
authorized to bring under prudential regulations any non-banking institution it found to be of
systematic importance (Caggiano, J. R., & Dozier, J. L., 2012). This act made in many
formerly free-standing institutions to either convert to absorbed into bank holding companies.
This regulation increased the effectiveness and coverage of regulatory bodies.

Dodd-Frank Act and Basel III also brought in stringent regulations on the capital requirement
and its quality to increase the resilience of financial institutions. While Basel laid down the
condition for Tier I and Tier II capital, Dodd-Frank Act codified stress testing laws (Governor
Lael Brainard, 2015). The attempt was made to make the capital requirement more forward-
looking hence more effective. While the Basel committee released a framework to add the
capital surcharge on banks of systematic global importance, Dodd-Frank initiated Federal
Reserve’s obligation under section 165 consistent with Basel to further strengthen the big
institutions fall of which leads to contagion effect in the market. To also answer the issue of
'too big to fall' Dodd-Frank created orderly liquidation authority. Under this authority, FDIC
can impose losses on failed institutions shareholders and creditors, replace institutions
management. The likely possibility of losses enhance discipline in the market in participants
who earlier assumed exposure to such institutions as a put option and that the government
will always bail-out such firms to preclude contagion effect by disorderly failure(Caggiano, J.
R., & Dozier, J. L., 2012).

In the period of the financial crisis, for most of the institution crisis started with the
evaporation of liquidity which later lead to insolvency. Basel also tried to answer this by
bringing in very-short-term and short-term liquidity requirement in the form of Liquidity
Coverage Ratio (LCR) with 30 days framework and Net Stability Funding Ratio (NSFR)with
the one-year framework. Apart from this many efforts are being made to increase
transparency into OTC market for better regulations. Committee on Payments and Settlement
Systems and the International Organization of Securities Commissions (“CPSS-IOSCO,”

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2012) established the guidelines for Centralized Counterparty and reporting for few OTC
derivative instruments.

However, this is not the complete picture. Many of the economists consider Dodd-Frank
itself as a big regulatory failure. Its short-term impact is considered profoundly negative and
few even blaming it for keeping the average growth rate post return at 2.2%. Dodd-Frank is
considered to have significantly diverted the funds from core lending activities to regulatory
compliance related tasks (Hughes, T. (2018, Apr 30)). Dodd-Frank act is also considered as
failure in answering the major problem of 'too big to fall' by only restricting the acquisition
but not restricting the size of banks by growth. It seems things have even moved in the
opposite direction with six major US banks growing by 20% and with $6 trillion assets by
2011 itself (Greene, 2011). Regulatory burden introduced by Dodd-Frank has further
worsened the situation. Last one decade has seen a significant decrease in small commercial
banks and institutions. Dodd-Frank has not provided enough regulations on rating agencies to
answers the issues of incorrect rating and conflict of interest from the Global Financial Crisis
of 2007/08. Act even failed to provide a useful framework to punish individuals or institution
which lead to the creation of systematic risk beyond capital requirement rules. Even when it
comes to Mortgage Backed Securities, Dodd-Frank was unable to answer the problem
entirely. It just mandated sponsor to hold the position of security by himself but not providing
any reason for not selling the remaining portion to the public in un-fair prices. (Nwogugu,
2013/2014).

The Global Financial Crisis of 2007/08 was primarily attributed to the failure of regulations
by many economists. Hence, regulators came up with many regulations post-crisis, to
safeguarding market from future such event. When it comes to financial markets, regulations
have an essential place. Asymmetry of information distribution profoundly drives financial
markets. There are a small group of people with knowledge and expertise in understanding
the sophisticated instruments and risk associated with them. If not regulated these people may
fall into greed and manipulate the market. Also, the incentive structure in most of the
institutions promotes in generating short-term profit while shielding against any loss this
often leads to people doing wrongdoing to show inflated numbers in books or manipulating

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markets to short-term trends. There is a definite need of regulation to have proper oversight
over activities of institution and individual and make people in power answerable in case of
any wrongdoing.

However, regulations not always have the impact that is intended for them. Regulators need
to have a broad vision while implementing any regulations. They need to understand and
study the entire market as a whole and try to explore its long-term impact on bodies both
directly and indirectly falling under the jurisdiction of such regulation. In the past with
increasing influence of politicians and significant lobbying by financial institutions
themselves, it is legitimate to doubt that the regulators have or could bring to the table such
regulations with a holistic view. Under such a scenario, these regulations at times end of
setting a stage for another disaster instead of controlling them. We have seen similar signs for
Dodd-Frank regulation in the past few years.

References

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