The Role of Banks in the 2008 International Financial Crisis

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Introduction

In 2007-2008, a significant economic disaster was referred to as an international financial crisis. It occurred because of several reasons such as deregulation, securitization, and the involvement of banks (the growth of subprime mortgages and the raised rates on subprime borrowers), which will be thoroughly discussed in the paper. The financial industry became deregulated, allowing the banks to participate in hedge fund trading and demand more mortgages to obtain more profits (Tooze, 2018). Consequently, banks created a system of interest-only loans, which later proved to cause a crisis. As one can observe, banks had a preeminent role in the discussed problem during those years.

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The 2007-2008 crisis was the stumbling block of the banking system throughout the world and the most significant cause of its collapse. It brought some of the most prominent financial institutions to bankruptcy overnight (Tooze, 2018). Some people talk that during the crisis even cash machines were empty. As estimated by Tooze (2018), the discussed problem officially began on September 15, 2008, when the wealthiest bank of that time filed for bankruptcy, and George W. Bush refused the bail for them. The crisis first destroyed the United States banking system and shifted onto Europe, where Greece’s whole country became bankrupt.

Some economists nowadays claim to have predicted the crash; however, at the time, it was unimaginable because the available economic model was considered to be perfect. For example, Bernanke believed that the economic model was stable and able to control inflation (Saracco et al., 2016). However, the crisis-hit suddenly and unexpectedly with banks at its center because of those idealistic beliefs. As the financial capitals such as the US and the UK fell, the whole world followed.

Politicians and policymakers tried to reduce the crisis by creating special national reflation designed to sustain the economy, which was later suspended due to severe economies in public spending. Consequently, by keeping the banks afloat, the government attempted to finance them, which affected the finance system negatively and almost collapsed it. Moreover, the discussed problem led to political instability (which can be seen even nowadays), depressed wages, and bankrupt countries, such as the previously mentioned Greece.

The crisis of 2008 happened for the reason that the policymakers attempted to innovate the financial system by increasing the prices of products without an economic explanation. Moreover, the banking system increased the prices for financial assets to make more profits. Under such circumstances, the appearance of the discussed problem became rapid, because no one had expected it. Bank crises, along with financial troubles, became so uncontrollable that more than ten years after the initial collapse, humankind still suffers from it. The banking system became vulnerable in the eyes of economists because they grant loans based on attracted deposits (Tooze, 2018). This system is fully capable of functioning as long as the investments are liquefied. For example, if all clients request the money simultaneously, it will not lead to the bank’s bankruptcy.

In modern times, the banking system is similar to a domino: when one piece falls apart, the entire system crashes as well. To prevent past events from reoccurring, humankind needs to analyze the discussed situation thoroughly. Furthermore, the authorities must recognize the early signs of crisis in their establishments and solve the problem as soon as possible to avoid the unnecessary repetition of the historical events.

The Characteristics of the 2008 Financial Crisis

At that time, the main characteristic of the crisis was that the banks could not serve people their mortgages, which is why people had to sell their homes in an attempt to survive. Moreover, after the initial crush of the banking system, the real estate sector suffered because there was not enough demand for their services, which led to the rise in unemployment. The reduction of working staff is also among the fundamental characteristics of the crisis, and that led to significant inflation.

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The mortgage crisis as a distinctive feature of the problem led to the financial crisis and several major companies’ bankruptcy. Banking investors soon began to suffer the consequences, like the rest of the world. Moreover, the significant feature of the 2008 crisis was the collapse of several central banks, which began from the richest of them – Lehman Brothers. Their bankruptcy file was the beginning of the end because they were considered an unbreakable bank with a high amount of profits (McDonald, 2016). However, their crash affected the other representatives of the banking system shortly after. Banks were collapsing overnight, which led to widespread human panic.

People tried to get their money from the bank, which led to even more dramatic consequences. As another characteristic, people’s panic was extensive and became the cause of inflation and a significant rise in the prices for general goods. Scared that the loans would not be paid, people stopped taking them, and the mistrust towards the banking system resulted in the desperate search for banking investors and the marketing campaign aimed to promote loans (Hasnat & Talukder, 2017). For example, in the case of the AIG, they had to give their company to the government, as they could not pay credits and give people insurance.

The most notable characteristic of the crisis is the rapid collapse of the housing market, which later affected the investors. Investment firms suffered significant losses, which was the reason for the partial loss of pensions and fall of retirement funds for the US. As the financial problems grew, the world’s economy suffered immensely. Furthermore, nowadays, the world’s economy is heavily dependent on cooperation to ensure that the past scenario would not repeat. For example, in 2008, the European (German) bank had to be closed because of severe financial problems, which was later rescued by the government (Hasnat & Talukder, 2017). If the bank cooperated with other businesses, they could have given an essential aid required to save this financial institution from crushing.

Nevertheless, among the 2008 world crisis characteristics, there was a decrease in the overall consumer demand. The reduction happened for several reasons: the insecure development, the possible loss of the job, fear that they would lose all the money they have, and die of starvation. Consequently, it led to the collapse of the US’s exports, affecting the economy of Asian countries. For the reason that the American banking system has failed, Chinese manufacturers faced the reduction of consumer demand, which later led to more than 10 million people losing their jobs.

Unemployment rates increased and went up from less than 5% to 10%, growing the highest value since the ’70s (Hasnat & Talukder, 2017). The crisis reached almost every part of the economic development in the world. Leading firms went bankrupt, and the world faced problems they have never seen before. Furthermore, nowadays, people are dealing with the consequences of the banking crash and trying to fix the world’s economy.

The Role Played by the Banks in the Crisis

The role of banks in this crisis, as estimated earlier, was a deciding one because the crash began from the banking system and slowly escalated further. In the given case, banks’ prominent role is expressed through the ability to pay people loans and present money to other structures (Niepmann & Shmidt, 2017). When the world’s situation is stable, banks are providing the deficit agencies with the required payment to ensure that their business would not collapse. Therefore, when the financial system began to crash, the others soon followed, dragging the world into a significant crisis.

As mentioned earlier, because of innovative financial instruments, banks got involved in high-risk investments, which later became the reason for the world’s crush. The appliances were not priced correctly and were not liquefied. During the crisis, the financial system’s risk became more apparent; banks did not have the reserves necessary to pay loans, so the whole procedure went downhill (Niepmann & Shmidt, 2017). The loans given to the large companies decreased significantly (more than half of the large borrowers would not borrow the money from the banks).

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That is why when the biggest bank in the US went bankrupt, people lost trust in banks and stopped taking loans. For that reason, the housing segment and imports suffered immensely. Later, inflation appeared, and the shortage of working places and all of that started because several banks were crushed at the same time and desperately needed support from the government. Moreover, at that time, banks had low leverage and lower returns, which was the reason for the crisis in the long run.

As the experts estimate, the great financial crisis’s origin happened to occur because of the banking collapse and the overly indebted US economy (Niepmann & Shmidt, 2017). For that reason, the real estate business had almost been destroyed. The first sign of the future disaster with the credit system was the failure rates of subprime mortgages, which became a grave shock for the real estate business. Low-quality loans became the catalyst for the future catastrophe in 2008; large default rates on subprime mortgages were adding to the problem.

The mortgage crisis was the first push towards the global problem, and, later, general humankind panic and inflation. This catastrophe was triggered by the collapse of house prices, leading to people’s inability to pay the loans. If to speak about another significant role the banks have played in creating a critical situation worldwide is in creating lower interest rates. For example, in some banks, the initial interest rates were around 10%, and closer to the crisis, they lowered to the 1% mark (McDonald, 2016). That happened because of the government, which attempted to interest people in loans more.

Additionally, the crisis escalated when the pressure on interest rates appeared, which occurred because of the deficit. The US had always had to borrow money from abroad for a long time, which significantly lowered the interest rates and created the perfect conditions for the crisis of 2008. During that time, such a thing as the housing bubble appeared, and it was financed with mortgage-based securities, debt obligations, which were under a higher rate. It seemed financially profitable, but soon as the interest rates decreased, the housing bubble popped.

As a consequence, banks were to blame for the worldwide crisis, which would appear later. Consequently, several major financial establishments filed for bankruptcy in 2008, which significantly disrupted businesses and consumers’ credit flow. There were many reasons for the critical situation worldwide; however, the banks played a crucial role in the overall crisis. Along with unwise management, their policies were behind the financial collapse, which is still existing.

A specific bank case that affected/was affected by the crisis

As mentioned in the article, the crisis officially began on September 15, 2008, when Lehman Brothers filed for bankruptcy. The company, which was about $600 billion, became bankrupt seemingly overnight, which later became the most prominent case of a large company’s collapse (McDonald, 2016). They were the fourth-largest business, that was invested by the U.S. with several thousand employees around the globe. They became the largest victim of the subprime mortgage policy, and later the financial crisis and were the main contributor of the many other banks collapsing.

As written by McDonald, the company started developing mortgage-backed securities and other debt obligations similar to many other financial magnates (McDonald, 2016). During the time of the primary housing boom, Lehman acquired several mortgage lenders, which specialized in Alt-A loans (McDonald, 2016). More specifically, these kinds of loans could be made without the full set of documentation (for example, without the proof of income to pay the mortgage).

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The strategy of Lehman appeared flawed, as they have done a colossal miscalculation. In 2007 their stock reached almost $60 billion, but the housing market started showing the first signs of apparent miscalculations made by the government around that time (McDonald, 2016). In March 2007, the firm employees calculated that the giant drop in the stock would not affect the business severely, which was the first of many mistakes for the firm.

As history suggests, the employees were wrong, and Lehman’s stock soon fell sharply as the credit crisis began. At the point of that month, the company canceled several thousand mortgage-related programs as well as the offices of Alt-A lenders in a couple of states. Nevertheless, during the fourth quarter, they managed to get a temporary rebound (McDonald, 2016). Still, they did not stay afloat for too long, as they have missed the opportunity to trim their massive mortgage portfolio.

The company could be afloat for a little while, but as the world’s situation has deteriorated quickly, they have lost the majority of their fortune. In June, Lehman announced that they had lost almost 3 billion for the quarter (McDonald, 2016). Although they have tried to save the situation by liquefying a part of the money, it was still too late, as the company was already collapsing. Over the summer, they tried to connect with several potential partners but failed.

The news of Lehman’s crash led to a significant increase in credit swaps. The clients started to abandon the company, along with the number of creditors. The company had lost everything in a second, and they had several billions of dollars of debts. One of the investors has said that the only way to save the company is to sell a majority stake to a strategic partner, which was later revealed to be a faulty strategy because the company’s immediate response was another major plunge.

If to speak about the role of Lehman’s collapse in the other crisis, it was immense. The destruction of the company that size roiled financial markets for some time. Many economists questioned whether it was the government’s fault that Lehman failed, especially compared to the companies, which were near collapse, but received the government funding. Lehman has become the catalyst for further inflation, the decrease in the bank’s trust, and so much more. Furthermore, nowadays, it is a compelling case for economists to speculate whether it was the management’s fault or someone else’s.

Conclusions

To conclude, 2007-2008 were the years of the significant economic disaster, which occurred for several reasons. The financial industry lacked regulations, which allowed the banks to participate in various programs, which later led to their demise. Banks have created a system of interest-only loans, which later became not only the stumbling rock for the financial system but the whole world. During that time, some of the most prominent institutions filed for bankruptcy as their fortune disappeared overnight.

At that time, the banking system was similar to the domino: when one piece had shattered, others would soon follow. Therefore, after the crash of some banks, soon appeared inflation, some other businesses collapsed and became non-existent. To prevent such unfortunate events from reoccurring, the government tries to implement some rules; they attempt to recognize the early signs of crisis and work through the problems as soon as possible.

Some of the crisis’s main characteristics were the inability of financial systems to provide people with mortgages, which is why some people had to sell their houses to sustain their families. The real estate sector soon followed the critical situation, as there were fewer and fewer people to be interested in their services. No one has money so that no one could afford a house. Another characteristic was the sharp rise in unemployment (which had doubled during those years).

One of the most prominent global crisis features was various significant companies’ bankruptcy, including several central banks. People began to panic, which only worsened the problem and brought inflation. The housing market collapsed, investment firms suffered, the world’s economic state declined significantly. Some banks needed to be saved via the government (a similar situation occurred in Germany). Consumer demand had also decreased since people were concerned for their financial state, whether they would be fired, whether they would have the opportunity to buy the necessary goods later.

As mentioned earlier, banks’ role was prominent in the overall crash because their system had failed first. Their methods used a set of innovative instruments, which later proved to be faulted. Banks got involved in high-risk investments with no apparent guarantee of a successful outcome. That is why some of the most significant banking systems went bankrupt seemingly overnight, so people had lost trust in banks and generally stopped taking risky loans.

The crisis and all the problems it had brought had officially begun on September 15, 2008, when Lehman Brothers filed for bankruptcy. That was a significant problem at the time because the company appeared to be the fourth-largest U.S. financed company. They became the largest victim of the subprime mortgage policy and the most prominent organization to collapse. Furthermore, their main mistake was in faulty management and taking a risk if Alt-A loans, which could be made without the full set of documentation such as the proof of income. Their strategy appeared flawed, and because of several miscalculations, they became the largest business to shatter overnight.

References

Hasnat, B. & Talukder, I. (2017). The role of banking sector during the global financial crisis of 2007 and 2008. International Journal of Scientific and Research Publications, 7(2), 189-193. Web.

McDonald, O. (2016). Lehman Brothers: A crisis of value. Manchester University Press.

Niepmann, F., Schmidt-Eisenlohr, T. (2017). International trade, risk and the role of banks. Journal of International Economics, 107, 111-126.

Saracco, F., Di Clemente, R., Gabrielli, A. & Squartini, T. (2016). Detecting early signs of the 2007–2008 crisis in the world trade. Scientific Reports, 6(30286).

Tooze, A. (2018). The forgotten history of the financial crisis: What the world should have learned in 2008. HeinOnline. Web.

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BusinessEssay. (2022) 'The Role of Banks in the 2008 International Financial Crisis'. 5 January.

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BusinessEssay. 2022. "The Role of Banks in the 2008 International Financial Crisis." January 5, 2022. https://business-essay.com/the-role-of-banks-in-the-2008-international-financial-crisis/.

1. BusinessEssay. "The Role of Banks in the 2008 International Financial Crisis." January 5, 2022. https://business-essay.com/the-role-of-banks-in-the-2008-international-financial-crisis/.


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BusinessEssay. "The Role of Banks in the 2008 International Financial Crisis." January 5, 2022. https://business-essay.com/the-role-of-banks-in-the-2008-international-financial-crisis/.