Introduction
The United States financial decline that occurred in 1929, prompted many accountants and auditors to believe that unregulated financial markets are inherently unstable and under threat from fraud and manipulation by insiders. This scenario was capable of causing deep financial, social and political unrest. In the mid-1930s, the United States government came up with a strict financial regulatory system that worked effectively through the 1960s. These financial regulations did not hold for long and in 2007 marked one of the world’s worst financial crises, the global financial crisis. Most accountants and auditors consider this financial crisis as the worst after the 1930s great depression.
The effect of the global financial crisis was felt by financial institutions and stock exchange markets. This crisis led to financial institutions collapse, deterioration of the stock exchange market’s performance and prolonged unemployment. The global financial crisis is the key factor behind the reduction in consumers’ wealth worthy trillions of US dollars, the crumpling of many businesses, the deteriorating of financial activities and the 2008 global financial crisis. The global financial crisis was caused by the United States’ banking system liquidity and valuation interplay complication.
In 2007, the United States’ real estate declined due to the housing bubble bursting to result in the deterioration of financial institutions in the world. In 2008 and 2009, global stock markets were affected by consumers’ concern on bank solvency, tainted investors confidence and decline in credit availability (Avgouleas 2009, p.98). During the global financial crisis era, global economies strolled leading to a decline in international trade and tightening of credit. Many governments in the world responded to the global financial crisis by expanding monetary policies, bailing out of institutions and introducing new fiscal stimulus.
Literature review
The global financial crisis was caused by financial architecture which had general perverse incentives that generated crises, exacerbated booms and created excessive risks. The financial system allowed the rewarding of a mega financial institutions like investment and commercial banks, insurance companies, private equity funds and mutual and pension funds to take massive risks although the financial markets were not thriving well (Blankenburg 2009, p. 4).
For instance, mortgage securitization growth brought in fee income to mortgage brokers and banks who sold loans. It also generated income to banks, investment bankers which were involved in packaging the loan into securities, specialist institutions whose task was to service the securities and rating securities for their approval seal. There was no agreement of returning the fee in case the securities suffered a loss. This motivated everyone to maximize loans flow, despite the repercussions involved (Crotty 2009, p.15). In 2003 and 2008 total fees from mortgage securitization and home sales amounted to $2 trillion.
Perverse incentives were portrayed by giant AIG’s financial products unit. AIG’s boom’s increase in profits as a result of perverse incentives, but later in 2008, AIG lost $40.5 billion. Agencies involved in crediting ratings were also involved in perverse incentives. Regarding Basle, I regulations, banks were supposed to maintain eight per cent of core capital against their asset’s total weighted risk. Risks weights were determined by rating agencies hence they easily influenced requirements capital by banks (Carmassi & Gros 2009, p.47).
Innovation made crucial financial products opaque and complex contributing to a global financial crisis. These products could not be priced appropriately thus losing liquidity at the end boom. In 2008 mortgage-backed securities was worth $7.4 trillion during the first quarter which was double the amount in 2001. The increase in these securities led to huge profits at big financial institutions, however, its transparency required for any market efficiency was destroyed (Obstfeld 2010, p.127).
Subprime lending was a cause of the global financial crisis. There was heavy competition among the few supply of creditworthy borrowers, market share and mortgage revenue lenders. This competition caused mortgage lenders to relax on standards considered in underwriting and giving a risky mortgage to borrowers who were less credit worth (Bacchetta & Aghion 2004, p.42). Before 2003 mortgages were strictly regulated by a government-sponsored enterprise. This policing enterprise maintained very high underwriting standards. Later, this government-sponsored enterprise failed due to the shifting of power from securities to the originator and stiff competition from private securities. This led to an increase in granting of risky loans and deterioration of mortgage standards (Ocampo 2009, p. 52).
Commercial banks did not distribute all risky assets to capital markets. People had a notion that commercial banks were not risky, contrarily to previous years where banks held loans they made, this time around they started selling their loans to capital markets (Puri & Rocholl 2011, p. 52). There were five reasons for keeping risky products such as mortgage supported securities and collateralized balance obligations. These reasons include: to win the investors’ confidence and make them believe that securities were secured and bank retained the risks. Second, Collateralized debt obligations could hold the off-balance sheet and did not require capital reserve making it attractive for banks to keep.
The growth of the housing bubble contributed to a global financial crisis. For the period ending in 2001, the cost of a national median home was between 2.9 and 3.1 that of median household income (Nanto 2010). In 2004, the ratio went up to four and 4.6 in 2006. The housing bubble led to very few homeowners paying low-interest rates to finance their homes or taking a second mortgage to fund consumer spending (Mishkin1999, p.10).
Easy credit conditions contributed to the global financial crisis. Borrowing escalated due to low-interest rates. Federal Reserve decreased the target of federal funds rate from 6.5% to one percent. This move was aimed at easing the impact of the dot.com bubble collapse, September 2001 terrorist attacks and containing anticipated deflation risk (Shiller 2008, p.16). The United States elevated current account deficit pressured interest rates down reaching climax in 2006 at the same time as the housing bubble.
Weak and fraudulent underwriting practices were behind the global financial crisis. The financial crisis inquiry commission agreed that during 2006 and 2007 the standards for underwriting were prevalent. This led to purchasing of defective mortgages in 2006. Predatory lending contributed to the global financial crisis. Unscrupulous lenders lured borrowers to take unsafe loans aimlessly. Most financial institutions used the bait and switch method to trap borrowers by nationally advertising low-interest rates loans on home financing (Xu 2009, p.238).
Positive accounting theory
Positive accounting theory focuses on actual world events and analyses them from an accounting transaction perspective. It is based on a firm’s actions like the implementation of accounting policies, and reaction to new accounting policies. Generally, the broad objective in positive accounting theory is to predict and understand policies in accounting that vary according to firms. Also, it considers the consequences involved. For them to thrive in the market, firms have to be well strategized and organized (Watts & Zimmerman 1990, p.132).
In positive accounting theory, firms should increase their costs related to contracts to guarantee efficiency. For instance, contract costs include account ting variables, monitoring costs, renegotiation and negotiation. Firms usually go for accounting policies that minimize the cost of contraction. Regarding dynamism, firm flexibility is of the essence when considering accounting policies although this move is associated with opportunistic behavior due to personal interests involved. Implementing standard accounting policies contradicts policies in accounting to increase accounting costs and ensure flexibility in a dynamic environment due to opportunistic behavior (Deegan 2009).
Positive accounting theory hypothesis include bonus plan, debt covenant, and political cost. Through bonus plans, firms select accounting procedures that facilitate the shift in earnings. This shift leads to the violation of debt covenants. Profitability can lead to an increase in political tension and a change in regulatory standards. Positive accounting theory is achieved by accounting policy change, discretionary accruals management, real variables change and timing of new accounting standards implementation (Godfrey et al.).
Roles of positive accounting theory variables in causing the global financial crisis
Positive accounting theory variables had a role in causing the global financial crisis. Financial activities which contributed to the global financial crisis have a found reflection in positive accounting theory. The fragility of financial status is interrelated to the business cycle. After the recession, most businesses lost huge financing and opted for a hedge since it is safest. Most firms tend to seek speculative financing as their economy and profits proliferate. This idea is pushed by low profits that cannot pay interests throughout. Despite all, businesses acknowledge that profits increase as time goes by and cover interest without experiencing challenges (Allen 2009).
Modern banking systems have increased in complexity over two decades. Despite running off-balance-sheet vehicles or using various financial instruments to shift credit risk, banks are evenly susceptible to panics and runs they were at the beginning of the previous century. In the summer of 2007 holders of short term, liabilities refused to fund banks, expecting losses on subprime and subprime related securities.
Loans reflect more investments and as a result the economy further grows. This leads to lenders developing the notion that by lending more they will get more in return. Most of the lenders ended up lending money without the guarantee of full success. Lenders do know that repaying the loans by such firms will be a problem, but still end up lending them because they believe these businesses will refinance from elsewhere due to anticipated profits gains. This is described as Ponzi financing which has contributed to the economy taking heavy credit risks.
During a global financial crisis, giant banks were not regulated by finance regulators. They were allowed to measure their risks. Additionally, they were allowed to set their capital requirements. Deregulation created a state that these giant banks could not accurately evaluate their risks. The financial system had general perverse incentives that generated crises, exacerbated booms and created excessive risks. It allowed the rewarding of mega financial institutions like investment and commercial banks, insurance companies, private equity funds, and mutual and pension funds to take massive risks when the financial market was not thriving well (Scott 2009).
Banks did not distribute their risky assets to the capital market. Customers viewed commercial banks as non-risky, but this was not the truth since they had ventured into selling their loans to capital markets through securitization. Commercial banks maintained risks such as mortgage supported securities and collateralized balance requirements. Financial regulators allowed banks to own assets that were not indicated in their balance sheets. These off-balance sheet assets did not require capital support. Innovation created crucial financial products opaque and complex contributing to the global financial crisis. These products could not be priced appropriately thus losing liquidity at the end boom.
Subprime lending contributed to the global financial crisis. This was culminated by heavy competition among the few supply of creditworthy borrowers, market share and mortgage revenue lenders. This competition contributed to mortgage lenders to ease standards considered in underwriting and give a risky mortgage to less worth credit borrowers.
Conclusion
In the past quarter-century financial crisis has been fueled by financial market globalization, deregulation, rapid innovation in the financial sector and moral hazard due to often government bailouts. The detrimental effects of the global financial crisis indicated world’s neoliberal financial system was deregulated. For many decades financial markets size was greatly inflated due to innovation and deregulation. The severity and scope of the global financial crisis is a warning that the growth path of the financial market for past years is unsustainable and should be resolved. It is unrealistic for financial assets to remain so large relative to the real economy since the real economy sustain such inflated financial claims by generating cash flow constantly.
Financially, it is not efficient for human, material, and income resources in large proportion to be captured by the financial sector. Financial markets should be forced to substantiality shrink relative to nonfinancial sectors. Processes that caused financial collapses such as illiquid, non-transparency, financial crisis, and complex securities should be banned or marginalized. In the short run, governments contain financial collapse while in the long run initiate contraction and complete change of financial markets.
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