Economic Crisis: Roles of Financial Institutions

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The role of financial institutions in the intermediation process is indispensable in the economic performance of an economy. Through the process, those with surplus funds get the opportunity to have their surplus resources lent to those in need for investment purposes thereby stimulating the economic growth of a country. Failure in the intermediation process will result in financial crises and financial shocks which if not absorbed can lead to contagion in the financial system (Friedman and Posner 121). The 2008 financial crisis is not an exception. Its causes resulted from the failure of parties to estimate the effects of their decision. The components of the financial institutions are banks, credit rating agencies, regulatory authorities, investment bankers and insurance firms all take the responsibility for the crisis that followed the 1930 economic crisis. To begin with, the credit rating agencies that are charged with the duty of determining the risk involved in the lending process underestimated the risk. This, therefore, led to the underpricing of the assets like loans that were extended by the banks. In the US for instance, banks extended their lending services to subprime mortgages who later on defaulted their payments (Elwell 87). The default percentage increased to 6 % from the average of between 0.5% and 2%. Banks earn their income from the interest rates that they give to borrowers. Failure by subprime lenders to repay their debts caused huge financial losses in the banking sector causing financial havoc. The crisis could not have happened if the credit rating agencies did a good job. It is claimed that the agencies applied faulty models, were under pressure from some firms, and the lack of an oversight authority to scrutinize their work (Elwell 96). The financial constraints by the agencies and the competition of the market share are attributed to faulty and misleading results. This period saw a growth in the subprime mortgage from 8% to almost 20%. The increase means an increase in the potential impact on the economy. With the increase in subprime lending in anticipation of a rise in the pricing of houses, the interest rates surged thus leading to the plummeting of mortgage prices (Chacko 165). This later saw the decline in the returns from the mortgage and default in the debt repayment. The banks thereafter entered into foreclosure actions where the houses were disposed to repay the outstanding loans. Most mortgage firms were suspended others stopped operation and few others merged to gain stability (Chacko 173). The burst of the housing bubble found its way into the stock market where the decline in the prices of stocks was experienced. Another justification that the financial shock was avoidable is seen from the failure by the regulatory authorities in ensuring financial soundness in the financial sector. With the adoption of the liberal market in the determination of the prices, the Federal Reserve failed to closely monitor the actions of the commercial banks in their lending process (Elwell 105). The security commission at one time accepted that the banks were self-regulatory. The banks as a result acted without adhering to the market fundamentals. Fed lowered the interest rates to make lending affordable for low-income Americans. With the lowering of the interest rates, moral hazard increased leading to high default rates (Friedman and Posner 129). The government expansionary policy was not called for in the situation making the bailout to institutions untimely and retrogressive. The government intended to increase housing affordability without closely scrutinizing the impact of the lending by banks on subprime mortgages. The inappropriate regulations made violation of corporate governance problems an order of the day and financial intermediaries took more risk than they can manage (Friedman and Posner 134). There were also problems of integrity and ethics were those in the management worsening the liquidity problem siphoned material portion of the money. To aggravate the matter, the regulatory authority failed to comprehend the situation in the banking sector making them vulnerable in their duty. Worse still, the collapse of financial institutions, and the solvency questions of the banks raised eyebrows among the potential investors. The confidence of the investors was lost making them withdraw their investment hence slowing the rate of economic growth. The bank losses made the investors in bank equities withdraw their investment leading to the plummeting of the stock prices (Elwell ).

Some banks receive bailouts from the government to mitigate the panic on possible panic that would engulf the financial sector. The poor performance of the stocks caused stock crashes and made difficult the availability of funds for listed firms. The role of the insurance firms in the crisis must not be underestimated. Insurance firms as a major player in their financial market are obligated to ensure banks brokers and other players from losses that may arise. The failure by the insurance industry to estimate the size of potential losses and shield investors from losses is indeed an abdication of roles. If risk could have been properly estimated and the firms would be protected from losses, the recovery period could be shortened and economic growth would be achieved. It will be suicidal to underestimate the responsibility of the investment bankers and brokers in the crisis. The fact that the brokers concentrated on the commission and revenue they were top earn at the expense of the stability in the financial system. The brokers failed to act rationally and aimed at selling more than the risk the institutions could absorb. The investment bankers concentrated all their efforts on the short-term bonus rather than the impact of their actions on the long-run sobriety of the market (Friedman and Posner 139). This made the risk pendulum swing against the interests of the bankers. The misleading advice to the banks and investors was prone to make the crisis divulge. It is therefore important for individuals and investors to view their actions with wide latitude and altitude. To reverse the financial crisis, the financial institutions had to correct their previous actions. The regulatory authorities i.e. the central banks ensured that they closely monitored the commercial banks to avoid overtaking risk. Through this, the banks had to adhere to the lending rules by strict adherence to the credit ratings of the borrowers (Chacko 181). As a result, the defaulting percentage declined to cause sanity in the financial markets. To ensure that the financial banks continued to extend their loans to the public, central banks intervened and at times guaranteed the repayment of the loans. This was aimed at stimulating the demand and encouraging the threatened institutions to extend their products. The central banks in the different jurisdictions also recapitalized the banks to improve the balance sheet values (Elwell 114).

The European central bank for instance advanced a total of 115 billion Euros to improve the banks’ liquidity. As a recovery strategy, central banks had to adopt strategies that are aimed at stimulating the demand and encouraging investment. This was the main purpose for which the government agencies assisted the commercial banks to continue lending business. The government’s aim was to avoid a credit crunch, which could arise when there were no loans to be granted to those in demand of funds. The roles that were played by the banks in the recovery were also paramount in the recovery process. Some of the banks that experienced financial difficulties merged to gain financial stability. In the US, for instance, 25 banks merged and operated as an entity in order to improve their balance sheet values (Elwell 165). The banks also improved their corporate governance by maintaining a leverage ratio that was within their ability to undertake. Adherence to the regulations promulgated by the controlling agencies made the economies around the world recover from their financial problems. The lowering of interest rates as demanded by the Fed was a positive move by these institutions to improve liquidity conditions.

The central banks across the globe increased the capital requirements of the lending institutions to increase their debt capacity. In some countries, the minimum capital requirement was increased by more than two times to ensure banks are in positions to increase their landings without compromising on the risks incurred. The government authorities also intervened and came up with legislations that were aimed at controlling the investment portfolio held by banks. Banks were warned against putting all their investment in mortgages to reduce their risk through diversification. After the crisis, most credit rating agencies were deregistered because of the faulty ratings that caused underestimation of risk. These actions were to ensure that the determination of default risk was not impaired (Friedman and Posner 146). The banks would thus offer loan services to only those with high ratings. Many brokerage firms were also thrown out of business for failing to adhere to the market fundamentals when doing brokerage. Stringent regulations to monitor the operations of the financial institutions were justified if the recovery was to be realized promptly. The insurance industry as well participated in the recovery process by making compensations to institutions that made huge losses. Finally, the 2008 financial crisis could have been avoided if participants in the financial market adhered to market fundamentals. The regulatory bodies and the financial institutions should work closely to enhance efficiency and soundness in the financial sector. Financial intermediaries hold the keys to economic recovery and financial stability across the world.

Works Cited

Chacko, George. The Global Economic System: How Liquidity Shocks Affect Financial Institutions and Lead to Economic Crises. New Jersey: FT Press, 2011.Print.

Elwell, Craig K. Economic Recovery: Sustaining U. S. Economic Growth in a Post-Crisis Economy. Diane Publishing, 2011.Print.

Friedman, Jeffrey and Richard Posner. What Caused the Financial Crisis. University of Pennsylvania Press, 2010.Print.

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