Markets and Institutions Role in the Financial Crisis

Introduction

Financial markets and institutions, including banking and insurance companies, encounter several risks whenever a crisis threatens them. The risks may be operational, credit, or systematic in nature. Improper mitigation of these risks may translate into the failure of financial systems operations, thus leading to a crisis. The global financial crisis of 2007-2008 constituted a defining moment of the US economic business cycle. It initiated in the spring of 2007 following a housing slump. Later, it grew into a risky crisis of global economies during the late summer of 2007. In autumn, countries such as the UK experienced credit crunch repercussions through the financial crisis that resulted in the collapsing of businesses coupled with the erosion of consumer confidence. In the effort to prevent the effects of the financial crisis on the global economy, questions have been posed concerning the role of various players in causing and resolving the 2007 to 2009 crisis. This paper responds to such questions in the context of financial markets and institutions.

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Role of Financial Markets and Institutions in Causing the Financial Crisis of 2007-2009

Amewu (2014) argues that financial managers must steer monetary systems in a manner that guarantees respect to the interest of capital owners while curtailing personal interests to pave the way for national coupled with international regulations and policies to prevail. When contextualised from the paradigm of a globalised economy, abolishing controls in capital market transactions expands the scope of financial markets by creating the possibility of the emergence of new alternative financial products (Ozkan, 2012). This situation permits the establishment of new financial institutions. Such institutions may operate with limited or even no regulation from national authorities. In the wake of the financial crisis of 2007-2009, Ozkan (2012) asserts that the phenomenon led to the emergence of shadow banking systems in the United States, which threatened to topple classical banking infrastructures. Hence, according to Panico and Purificato (2013), even though financial markets and institutions may have contributed to the crisis, the changing regulatory environment akin to globalisation had its share in the creation of the problem.

The period of 2007-2008 was characterised by an increased number of customers who were willing to take risks with the objective of making dubious profits in the short term. As Blundell-Wignall, Atkinson, and Lee (2008) reveal, “zero equity mortgage proposals became operative, thus helping low-income families to obtain mortgages”, which they later defaulted (p. 3). This situation induced a high market capitalisation, especially in stock markets (Lleo & Ziemba, 2012). While this state of affairs occurred in financial markets, if banks failed to follow suit, they would have lost the market capitalisation, hence plunging them into a further hostile takeover. Petersen (2013) informs, “More and more banks had to take increasingly risky positions to survive in a wildly accelerating footrace for a better competitive position, finally leading to the near collapse of the financial system” (p. 8). Indeed, in the case of the US, this process took place in a financial market environment that was characterised by independence and the adoption of long-term policies, which promoted the availability of cheap money (de Haan & Kooi, 2000). The Federal Reserve System created the policies while Alan Greenspan initiated them. In Europe, the Euro was introduced in 1999 (Braun & Trein, 2014). This move implied a dramatic drop in the interest rates for some nations, including Italy, Spain, Portugal, and Ireland. Consequently, public debt increased particularly during the period of 2007-2008, hence ultimately leading to the Euro Zone crisis by 2011.

Financial institutions, especially banks, lent money by developing credit lines and other credit commitments. When borrowers took advantage of the available credit commitments, banks were highly exposed to financial risks. In fact, the witnessed falling liquidity supplies compelled borrowers to draw massive sums in the form of credit from accessible credit lines (Eken, Selimler, & Kale, 2012). From 2007 to 2008, the non-financial sector had no or limited access to the short-term loans following the drying up of commercial paper markets. People who utilised the paper resorted to prearranged credit lines from banks to help them in financing it as appropriate. Banks had an obligation to fund loans. Therefore, the funds available for lending became incredibly limited. Consequently, the easiness to which people could convert their assets into cash reduced following the declining availability of cash on demand. The aftermath was an inevitable financial crisis attributable to the failure from the side of financial markets and institutions.

The expanding financial markets increased pressure in the banking system coupled with insurance companies. Subsequently, the firms invested in business segments that were predominantly capitalised by specified financial organisations, including hedge funds and investment banks. For instance, in Germany, banks that had a good reputation in offering short and mid-market services incurred a loss of interest in the segment (Braun & Trein, 2014). They resorted to focusing on investment coupled with offering banking services to big firms. The emerging short-term windfall compelled them to create mergers that resulted in a concentrated market. Future competition was threatened. The international connection increased because of the emerging new products. Consequently, the collapsing of one bank threatened the entire national financial system. This situation made the financial crisis of 2007-2009 inevitable. In the US, prominent and large financial institutions such as Lehman Brothers and AIG could not overcome the collapsing wave by September 2008.

In the pre-crisis era, financial systems, including financial markets and institutions, failed amicably to mitigate the underlying risks. For example, the financial crisis forced many business organisations in the US to draw funds from their prevailing credit lines because they immensely feared potential credit market disturbances (Eken et al., 2012). This concern made the American Electric Power Company withdraw 2 billion US dollars from the credit lines of JP Morgan and Barclays. The strategy ensured that the utility’s cash position improved in fear of credit markets disturbances as the crisis progressed and hence a reduction of the available cash for lending to investors and people who wished to purchase assets. Therefore, the easiness of converting assets into cash (market liquidity) reduced. As the electric Power Company and other business organisations withdrew huge sums of money, banks did not adopt steps to enhance credit resilience and continuity, despite the anticipated crisis.

Role of Financial Markets and Institutions in Resolving the Financial Crisis of 2007-2009

Towards the end of 2010, many businesses in the UK and the US were relieved of the harsh financial situation since the first phase of the crisis was gradually fading. However, the damage done on economies, including their prospects, was irreversible (Foo & Witkowska, 2017). Indeed, many nations regarded the crisis as the worst ever since the Great Depression (Foo & Witkowska, 2017). Did the signs of relief by 2010 mean that financial institutions and the financial markets had adopted effective strategies for resolving the crisis? A response to this question requires a consideration of the causes of the crisis of 2007-2009 while also focusing the debate on whether financial markets and institutions could have mitigated them. This argument arises from the experiences of financial markets and institutions once the crisis had already occurred. Banks could not deploy strategies to resolve or survive the crisis after it occurred. The causes included the witness loss in mortgages, including excessive securitisation and deleveraging (Ghabayen & Ayuba, 2012).

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Many economic scholars claim that mortgage losses were the main cause of the crisis of 2007-2009. However, different theories have been advanced to explain the root of the 2008 global financial crisis. For instance, Adelson (2013) argues that losses in mortgages are too minute to provide a sufficient explanation of the crisis. He asserts that the losses in mortgages realised by 2013 and those that were not yet realised by then were approximately between $750 billion and about $2 trillion. However, depending on the measurement methodology, the total losses due to the crisis were between $5 trillion and $15 trillion (Adelson, 2013). Hence, losses in mortgages only served as an important trigger of the financial crisis. After the crisis was triggered, several other economic issues amplified the effects of the losses. Liang (2012) argues that the global globalisation of financial products by monetary systems created imbalances following the real exchange adjustments done. Financial markets and institutions could not avoid or resist the globalisation of financial products due to the reducing profits in the local and national business segments. Instead of blaming financial markets and institutions for failing to solve the financial crisis of 2007-2008, Liang (2012) argues that the US had the responsibility of managing financial risks and global liquidity, which it incredibly failed.

The US financial systems embarked on deleveraging efforts after 2007. This move led to a reduction of debts issued by various lenders within a financial system when compared to reserves held in the underlying debt. The plan was a reaction to the high borrowing rates in the housing and commercial property sectors. Debt decline implied a reduced capacity of the financial system to create additional loans and/or guarantee effective support for continuing credit facilities. Unfortunately, changing rules and regulations in the financial system implied that banks could not internally regulate deleveraging. Issues such as the excessive securitisation, “the 30-year deregulation trend, the quant movement, the spread of risk-taking culture throughout the financial industry, and globalisation” (Adelson, 2013, p. 16) all explain the root of the financial crisis of 2007-2009. Therefore, the failure to effectively manage financial risks, including those posed by liquidity, securitisation, and deleveraging, potentially explain the critical causes of the international financial crisis of 2007-2009. Unfortunately, financial markets and institutions had no control over the excessive securitisation and deleveraging. Hogan (2012) suggests that a solution to the economic predicament was more attributable to the failure of authorities and monetary policies to respond adequately as opposed to the failure of financial markets and institutions to play their roles appropriately in the internal financial regulation.

Financial markets and institutions are important players in the monetary systems. Amid government regulations that can effectively resolve a financial crisis, fiscal markets and institutions have a role in contributing to the debate on the resolution of the economic predicament. Nations look for strategies for protecting themselves from financial crises such as the one experienced in 2007-2009 (Horatiu, 2012). Hence, in the current context, financial markets and institutions had a role in contributing to such strategies by prescribing less risky ways of funding budgets. The most important ways cold have included equity capital and deposits (Filbeck, Preece, & Xin, 2016).

Other alternatives included the wholesale of uninsured deposits, the repurchasing of agreements, and unsecured instruments. Financial markets and institutions had the role of helping in the analysis of potential risks presented by these alternatives. Nonetheless, in the 2007 to 2009 financial crisis, they never played effectively this role. For instance, repos were used in financing highly risky assets, among them the “private-label mortgage-backed securities” (Eken et al., 2012, p. 25). Towards the mid-2007 period, all these securities were possible to fund through short-term loans acquired from the repos. However, players in the financial system did not identify this opportunity. Following the global financial crisis, the above approach changed to the extent that by the end of 2008, only about 55 percent of all such securities were possible to fund from the repos. Batchelor (2015) attributes this challenge to the failure of financial institutions and markets in their forecasting role. They incurred huge losses since selling securities in a collapsing financial market was the only available option.

Conclusion

Following the stock market crash witnessed in the period of 2007-2008, the US Treasury and Congress embarked on various strategies for helping to resolve the financial crisis. The two arms used strategies such as capital injections, liquidity measures, adjustments in housing markets, and various insurance schemes. These efforts aimed at resolving the crisis without focusing on the role of financial systems in causing the crisis through their investment in highly risky business segments. Although the paper admits the failure of regulatory authorities in resolving the crisis, financial markets and institutions had a role to play. They ought to have taken part in the analysis of various internal interventions for solving their inherent problems, especially investment decisions, which led to the witnessed liquidity crisis.

References

Adelson, M. (2013). The deeper causes of the financial crisis: Mortgages alone cannot explain it. Journal of Portfolio Management, 39(3), 16-31.

Amewu, G. (2014). Implications of mergers and acquisitions on stock returns before and during the 2007-2009 credit: An event study. African Review of Economics, and Finance, 6(1), 102-111.

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Batchelor, R. (2015). Financial crises and forecasting failures. The International Journal of Applied Forecasting, 1(36), 28-31.

Blundell-Wignall, A., Atkinson, P., & Lee, S. (2008). The current financial crisis: Causes and policy issues. Financial Market Trends, 1(1), 1-21.

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de Haan, J., & Kooi, W. (2000). Does central bank independence really matter? New evidence for developing countries using a new indicator. Journal of Banking & Finance, 24(1), 643-664.

Eken, M., Selimler, H., & Kale, S. (2012). The effects of global financial crisis on the behaviour of the European banks: A risks and profitability analysis approach. ACRN Journal of Finance and Risk Perspectives, 1(2), 17-42.

Filbeck, G., Preece, D., & Xin, Z. (2016). The ABA top performing banks in a time of financial crisis: Can they outperform the worst? Banking and Finance Review, 8(1), 1-20.

Foo, J., & Witkowska, D. (2017). Comparison of global financial market recovery after the 2008 global financial crisis. Oeconomica Stetinensia, 17(1), 109-128.

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Ghabayen, A., & Ayuba, A. (2012). The impact of global financial crisis on Jordan. International Journal of Business and Management, 7(16), 80-88.

Hogan, J. (2012). Monetary policy-conventional and unconventional: Taming the financial crisis. Poznan University of Economics Review, 12(2), 7-18.

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Liang, Y. (2012). Global imbalances and financial crisis: Financial globalisation as a common cause. Journal of Economic Issues, 16(2), 353-362.

Lleo, S., & Ziemba, W. (2012). Stock market crashes in 2007-2009: We were able to predict them? Quantitative Finance, 12(8), 1161-1187.

Ozkan, G. (2012). Emergence of international political economy as a sub-discipline of international relations and impact of the global crisis on international political economy. International Journal of Business and Social Science, 3(13), 198-204.

Panico, C., & Purificato, C. (2013). Policy coordination, conflicting national interests and the European debt crisis. Cambridge Journal of Economics, 37(1), 585-608.

Petersen, H. (2013). Hans-Georg Petersen, Alexander Martin Wiegelmann risk taking, principal agent problems and breakdown of corporate social responsibility (CSR): How to reestablish safe-assets and capital funding for social security. Equilibrium, 8(2), 7-30.

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