Financial crisis refers to a situation in which the demand for money exceeds the amount of money in circulation. This mostly leads to people withdrawing a lot of money from the banks compelling the banks to liquidate some of their assets or collapse. The crises are caused by Massive external borrowing, merging credit with equity culture, fluctuation in business banking model and taxation, slack monetary policy, and high-risk lending habits (Frieden par.1).
Financial crises cause to fall in security prices, collapsing of firms, and tightened credit, which results in reduced aggregate demand as well as mass unemployment. The 2007-2010 crisis was however fueled by the burst of the housing bubble in mid-2007, failure of the regulating authorities and the inability of credit raters to correctly rate the risk in mortgage financial products (Kolb 139).
Bank focused on giving credit to as many people as possible without taking into consideration whether they were able to repay. This was done with full backing from the state government. This led to a lot of bad debts while at the same time, there was a lot of investment s in the housing sector, causing a rise in house prices (Baer par 3). Banks lacked the liquidity to continue funding loans and resulted in selling assets to improve their liquidity position. At the same time, banks tightening lending regulations, which led to a credit crunch.
Notably, financial transactions that are beyond the regulation of the state mostly involve use of short term liabilities to refinance long term and highly illiquid assets by investment banks which are not recognized by central banks as depository banks.
Because credit is readily available, many people take loans fuelling rise in asset prices (Kolb 123). Too much of this kind of loans led to inability of these banks to pay their creditors, forcing them to sell their assets to pay debts hence market disruptions and in the worst scenarios sharp fall in asset prices leading to the credit crunch.
Similarly, bank managers received bonuses and other rewards when income from interest on loans increased. This encouraged them to source for more clients to give loans. On the same note, managers were not required to be answerable for their actions in case of non-performing loans or lose incurred when they engaged in unregulated lending (Baer par 5).
This made banks to venture in risky high lending by loosening the lending procedures while giving assets speculative values. As a result, the housing bubble built up and eventually, when these loans could not be paid, and bad debts piled up the bubble burst.
Moreover, banks financed high risk, low quality, and adjustable-rate mortgages because of the high returns that were associated with the housing sector. Consequently, most of the families were highly indebted.
This was because house prices were increasing (Frieden par 6). When the housing prices started falling, repayments became high due to increased mortgage rates. This led to crushing in prices of securities that were associated with the mortgages. On the other hand, investor confidence reduced, which led to a reduction of investments in the mortgage market, leading to the tightening of credit and unfortunately, the financial crisis.
Central banks’ conduct was also to blame. Central banks have the habit of bailing out banks when the crisis has set in, which makes the banks lose their morals when they are giving out loans. Banks stop applying due diligence when issuing loans and issue a huge amount of loans to low credit worth customers. This is done expecting that the Federal Reserve Bank will come to their aid if these huge loans turn to bad debt (Kolb 133).
Notably, deregulation of financial institutions was very crucial in cultivating the ground for the financial crisis. Banks had the freedom of bypassing some very crucial lending regulations. They based the criteria of assessing customers’ credit worthiness on short term assets, which are easily disposable. Consequently, many people easily disposed of assets used as collateral, thus leaving the financial institutions with virtually no security. On the same note, deregulation of financial institutions made them increase their risk lending behaviors.
Lending on speculative assets became the order of the day (Baer par 7). Many customers were given money just by showing proof that they would build houses. As a result, banks gave credit to some people who could not afford the same in ordinary circumstances.
If financial institutions were highly regulated, they could not have given credit on speculations and the housing bubble could have been averted. On the same note, despite loosening some lending rules, financial institutions gave mortgages with adjustable interest rates. This meant that the financial institutions would raise interest rates whenever the market conditions were not in their favor (Baer par 8). This was all possible due to deregulation.
The government embarked on bailing out troubled firms which needed financial support to bounce back to their feet. In a move to inject money into the credit market, the government purchased preferred stocks that were introduced (Baer par.10). Banks were also taken into consideration when the government bought their private assets, increasing the banks’ liquidity. Expansionary fiscal and monetary policy was also applied to boost consumer spending, which in turn would spur economic growth.
It was also proposed that shadow banking should be highly regulated while at the same time, measures to cushion the banks financially were taken, which included strict capital requirements (Kolb 140). Banks, which were the largest contributors to the housing bubble, were also limited by the introduction of regulations in their involvement in property trading.
Reduction of interest rates was among the measures taken by the Federal Reserve Bank. Interest rates were reduced to discourage people from depositing money and encourage both private and public consumption. On the other hand, due to reduced interest rates, exchange rates also depreciated about other currencies (Frieden par 6).
The decrease in interest rates was a disincentive for banks to pass on the credit to consumers because the return to the money was low. However, the banks had a lot of money in their possession and consequently relaxed their lending rules, to increase the chances of getting borrowers (Frieden par 6). On the same note, the decrease in exchange rates and increased money supply increased consumption of local commodities, thus increasing aggregate demand (Kolb, 2010).
The crisis took a relatively shorter period due to the efficiency of actions by the FED and the government, which addressed the causes effectively. Banks were able to bounce back to normal operations while the various firms in liquidity crisis were bailed out. All the measures taken were aimed to cushion the financial market from further decline, but it did not work to expectation in all situations (Baer par.15). The injection of liquidity in the banks was expected to be passed on to consumers through loans and mortgage refinancing.
On the contrary, the banks chose to invest the money in more profitable international markets and currencies, leaving the US economy to decline further (Frieden par.9). In the short run, the financial crisis ended, but fundamental changes in the financial and bank markets were not instituted, which is a cause of worry to many market players.
The measures that were implemented were tackling the problem head-on. However, this will not prevent future recurrence of the same. Therefore, the government should put in place measures to counter the crisis before it happens (Kolb 141).
Financial institutions play a very important role in the economy. They can provide information on what the market players should expect in the future, and they also provide finances to these players. Financial institutions can, therefore, manipulate the market to their advantage risking various economical repercussions (Frieden par 9). It is evident that deregulation of financial institutions contributed to a larger extent the credit crunch and should, therefore, be controlled to deter repetition of the same.
Business cycles are unavoidable, and investors will always speculate where high returns are possible and invest in these sectors making bubbles somehow imminent. As such, it is upon the government to regulate the players in the various sectors of the economy through instituting strong policies to deter market crushes.
On top of that, regulating agencies should react swiftly to signs of impending economic disasters and prevent that beforehand. Most measures taken were short-lived and cannot be depended upon to save the economy in case of a looming disaster. This calls for long term solutions to the financial crisis.
Baer, Justin. “Wall Street: From Recession to Regulation.” Financial Times 2010: All. Print.
Frieden, Jeffry. “The Financial Crisis: Foreseeable and Preventable.” The New York Times 2011. Print
Kolb, Robert. Lessons From the Financial Crisis: Causes, Consequences, and Our Economic Future. New York: John Wiley & Sons, 2010. Print.