Financial Crisis Origins and Amplification Mechanisms

Introduction

In 2008, the world witnessed some of the most severe economic and financial crises of our time. Many financial systems collapsed and subsequently, financial institutions halted their services. As banks liquidated and others faced collapse, it became apparent that the government had to do something to salvage the little that was left of them (Blundell and Atkinson 537). Bailouts became the norm and banks resulted in mergers to avert the threat of collapse. Multiple causes led to the 2008 economic crisis. This paper seeks to explore lending practices and systemic risk as to the causes of the crises. Besides, the paper will highlight how poor policies amplified the crises.

Unscrupulous Lending Practices

The 2008 economic crisis resulted from several causes whose interaction complicated the impact on the entire global financial market. First, the banks indulged in somewhat unethical lending practices (Krishnamurthy 34). The banks and other financial institutions were ready and willing to lend out their money to many clients whom they did not know of their ability to repay the loans. The rationale is that the banks used house property as the collateral for their loans. According to Krugman, this prompted the ‘gambling game’ whereby the banks anticipated the value of property to increase in both the short term and long-term and as such, the banks would ultimately make profits (23).

Although the use of collaterals to cushion the banks has been the conventional means of securing their credit, it became apparent that they could prompt a moral hazard problem in two ways. External collaterals would be appropriate to use if the number of borrowers remains high and when the borrowers use their money independently (Niinimaki 521). With this in mind, the banks are usually almost certain that their loans will make profits.

In the context of 2008, the banks speculated a high level of increase in property value due to the tendency of property to increase its market value in future. As such, the banks undermined the borrowers’ ability to pay back their loans in the hope that their house property would be the collateral. The housing bubble burst deemed their market value lower than speculated and it dawned to the banks that they had made substantial losses leading to liquidation (Krishnamurthy 23).

The banks also used inside collaterals that are funded through capital loans. This included mortgages that may attract both good and bad homebuyers. Despite the need for the bank to substantiate the ability of the homebuyers to repay their loans, the banks ignored this process as it was unprofitable and after all, the mortgages would make high returns in future (Niinimaki 517). As such, the banks ignored the client monitoring process and solely depended on the inside collaterals as the security for their loans. Krugman says that the reason was that the banks found the process being very unprofitable which goes against their principles and motivation (34).

Hence, the banks failed to make a distinction between good and bad homebuyers. In contradiction to the prevalent notion that the housing property value would rise, 2008 saw the market value of house property drop significantly. To that end, the banks made huge losses, as the value of house property was excessively low for the banks to recover their capital loans.

Structural Fragility of the Financial Systems

The Early Warning Systems before the crises of 2008 failed to consider the internal factors brought about by financial systems inability to absorb the external shockwaves (Gramlich and Mikhail 271). On the contrary, they entirely focused on the macroeconomic factors that could affect the banks. Structural instabilities predispose the banks to increased risk due to their sensitivity to both external and internal factors. The systemic risks that are entrenched within the banking systems were the characteristic of the 2008 crisis. The continued interconnectedness of banks implied that a problem within one financial system led to a negative shockwave to other markets with increased systemic risk (Gramlich and Mikhail 273).

In 2008, banks failed to address their respective structural instabilities due to their interconnectedness. The rationale is that the banks could rarely be able to rectify their instabilities all at once. For instance, if a bank decided to engage in a fire sale of its assets, it could imply improved management of its liquidity. However, at the height of 2008, the banks’ need to liquidate the majority of their assets was unrealistic. Gramlich and Mikhail explicate that the interconnectedness of the banks proved a vital factor as the attempt to liquidate their assets led to lowered asset prices leading to the liquidation crises (271). Hence, the interconnectedness of banks at the dawn of 2008 notwithstanding their characteristic structural instabilities led to the crises.

Contagion Effect

Before the 2008 crisis, global financial systems had seen the banks make transformations and assume global appeal (Krugman 45). This was typical of product innovation and financial liberalization. This led to a rise of new classes of risks that further led to the transformation of banks at international and national levels. This exposed the banks to the problem of contagion due to the increased linkages of the banks across the globe (Krugman 201).

Contagion implies that a change in one financial system leads to ripple effects in other systems. At the onset of 2008, there was the anticipation and pointers deduced that the financial markets were on the verge of collapse. As such, banks began to liquidate their assets while the stocks dropped significantly due to the caution that investors took. Further, the asset prices dropped significantly. Through the liquidity channel, the contagion took effect in the sense that liquidity in one financial market led to a decline in liquidity of the rest of the markets (Krugman 74).

Poor Policies

There were policies before 2008 that led to increased effects of the crises. In the USA, some policies provided a loophole that borrowers exploited without the suspicion of the banks. Bush Administration American Dream (BAAD) allowed numerous citizens to own houses despite their decreased ability to repay the loans. The policy framework required that the banks use it as a threshold through which all people could access mortgages (Blundell and Atkinson 544). Nonetheless, the banks produced many low-quality houses that they would use to fetch profit in future.

Another interesting twist was that some policies allowed the regulators to engage in financial activities (Krishnamurthy 8). It became apparent that the regulators were buying low-quality houses from the banks and selling them to the citizens. As such, the initial stringent balance sheet monitoring process that dictated that the debt-equity ratio ought to be about 15:1 had become redundant as it soared to approximately 40:1 by the onset of the crises (Krishnamurthy 9). Since the regulators were so much dependent on the bank to make profits, they could not stop the banks. Upon the housing bubble burst, the banks could not make profits since they had gone beyond the policies’ provisions.

Recommendations for Future Risks

It is apparent that the 2008 economic crises were prompted by many factors. However, there is a need to focus on the future and avoid such risks. At the outset, the banks ought to engage in ethical lending practices notwithstanding their speculative abilities. When lending out loans, the banks should quantify the clients’ ability to repay the loans without necessarily depending on the speculative nature of house property (Blundell and Atkinson 547). For internal collaterals that are funded through capital loans, the banks ought to embark on monitoring processes that were conspicuously absent at the height of the 2008 crisis.

For the banks to reduce the systemic risk, there is the need for the banks to enhance their ability to withstand the global shockwaves (Gramlich and Mikhail 280). This implies that the banks should ensure that the negative financial effects in other markets should not be a factor that leads to panic at the microeconomic level. Apparently, the banks and financial institutions are so sensitive to the global financial systems due to their structural instabilities that a minor crisis in one market affects the entire world. This is amplified by a contagion that deems the banks unable to withstand the liquidity necessity that is prompted by one financial market.

Finally, there is the need for financial institutions to adopt appropriate policies that will act as a framework to cushion the banks from future risks. Such policies as Bush Administration American Dream (BAAD) were used as populists’ tools whose effects became apparent in 2008. Besides, financial authorities and regulators ought to be guided by a framework that limits them from engaging in financial activities that led to a conflict of interests. This will not only bring about sobriety in financial markets but also enhance the banks’ responsibility to abide by the financial regulations.

Summary

Essentially, the 2008 economic crisis resulted from several channels. First, the banks engaged in unethical lending practices. The banks used both external and internal collaterals as tools to secure their loans and forfeited other bank processes. Besides, the structural instabilities exposed the banks to external factors that were further amplified by contagion. Poor policies led to the conflict of interests between the banks and the regulators. To avoid such risks in future, the bank should uphold high ethical standards, bank systems should be less prone to external factors and redundant and risky policies should be rectified.

Works Cited

Blundell, Adrian and Atkinson, Paul. “Origins of the financial crisis and requirement for reform.” Journal of Asian Economics 20.1 (2009): 536–548. Print.

Gramlich, Dietmar and Mikhail, Vyres. “The structural fragility of financial systems: Analysis and modeling implications for early warning systems.” Journal of Risk Finance 12.4 (2011): 270-290. Print.

Krishnamurthy, Allison. “Amplification mechanisms in liquidity crises.” American Economic Journal 2.3 (2010): 1-30. Print.

Krugman, Patrick. The Return of Depression Economics and the Crisis of 2008. Washington: W.W. Norton Company Limited, 2010. Print.

Niinimäki, Poyes. “Does collateral fuel moral hazard in banking?” Journal of Banking & Finance 33.3 (2009): 514-527. Print.