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2008 Financial Crisis Essay

After the 2008 financial crisis, there was a global acknowledgement that the way financial markets and institutions had been regulated was inadequate. Indeed, private banks failed to manage risks, shadow banking expanded without barriers set up to control it and the financial reward scheme was too excessive. Governments were willing to transform the financial system substantially in order to make it more stable, more resilient to shocks and more supportive towards the real economy and economic development. They also recognized that those reforms needed to be well coordinated at the international level.

Therefore the G20 developed a certain number of measures to reinforce prudential norms and improve the supervisory capacity of financial authorities. What kind of financial regulatory standards have been created and will it be sufficient to prevent other financial crisis in the future? Three main factors are the cause of the financial crisis. First, a favorable macroeconomic environment, characterized by a lower volatility of growth and inflation, has led to a fundamental underestimation of risk by financial institutions and investors.

Consequently, the financial assets’ price increased due to lower risk premiums. The high level of global liquidity and low interest rates encouraged people to borrow in order to purchase these assets. This underestimation of risk has led to a general rise in debt, an increase in the number of high- risk borrowers, a weakened financial regulation and self-sustained increases in prices of financial assets and real estate. Second, sophisticated new products (securitization, financial derivatives… ) have been developed.

Their main advantage was to allocate the risk among a number of actors and to ensure greater stability in the financial system. However, no review of the potential dangers that these products could bring has been carried out and there was no control of their usage. Third, financial regulations didn’t take into account the existence of systemic risk, contributed to inaccurate risk assessment and showed significant loopholes which countries took advantages of it. The regulation system also poorly analyzed the risks associated with the new financial products.

In addition, those regulations were particularly fragmented and weakened by the competition and the lack of coordination existing between the various financial supervisors, at national and international levels. Finally, the confidence placed on credit rate agencies was too excessive. Their methodologies were imperfects. The subprime crisis that emerged in the USA and led to a global financial crisis is a good example of those excesses. The crisis began in 2007 on the American property market with banks offering the opportunity for risky borrowers to take out mortgages. Following the bursting of the housing bubble, payment defaults increased.

Banks tried to locate the losses but because the downturn in the property market happened during a period when financial products were incredibly sophisticated, there was a shortage of information. Those financial products being little transparent, a moral hazard appeared. Confidence in banks was shaken and a banking liquidity crisis emerged. Despite important government interventions, banks’ difficulties persisted and with the collapse of the Lehman Brothers Bank, the crisis gradually spread to all financial markets and finally reached the real economy at the end of the 2008.

The financial crisis spread to the real economy through three main channels. First, a global confidence crisis emerged: banks, weary, were reluctant to lend money to each other, and households, fearing unemployment, increased their precautionary savings. Companies, anticipating a restricted access to credit, reduced their investments. Secondly, access to credit became more expensive and difficult: due to the increasing risk of default payment, lenders charged borrowers more or refused to lend them money. Restrictive borrowing conditions and the confidence crisis had a particularly negative impact on households and companies’ investments.

Finally, the drop of the domestic demand in countries affected by the crisis led to a contraction of international trade. The crisis spread to countries that had been relatively spared through exportations and exchange rate adjustments. The subprime crisis also revealed the fragility of the euro zone which was more affected by the crisis than the United States. Indeed, lack of appropriate governance, policy mistakes, loss of competitiveness and deteriorated public finances in some member states transformed the financial crisis in one of sovereign debt.

In order to reduce the impact of the global crisis on the economy, at national and international levels, governments have implemented a serie of reforms to strengthen financial stability. These reforms are based on four axes: • Improving the financial solidity of the financial actors through the Basel III Agreement: the solvency of financial institutions have been improved by increasing minimal capital requirements and limiting the level of financial leverage. Basel III also focuses on improving short and long terms liquidity management. For insurance companies, the directive Solvency II aims to strengthen their balance sheet solidity.

Other initiatives have been taken to improve investors’ protection. • Establishing a framework for certain financial instruments and activities: most of those instruments and practices carry a lot of risks so they have to be framed by new measures. Transactions on derivative products have been improved and separation of deposit / credit and investment bank activities within banks have been implemented. • Strengthening of financial supervision: the European Union decided to establish a new financial supervisory framework.

In January 2011, four new supervisory institutions were operational. The development of macroprudential regulations. One of the biggest mistakes made by public authorities was to focus only on micropudential regulations. They only evaluated systemic risk by monitoring each financial institution individually and didn’t take into account the relationships existing between the different financial actors or the evolution of the economic sector. Most of the progress made in the macroprudential field were accomplished by the European Union. An European Systemic Risk Board was created to provide a complete and coordinated analysis of systemic risk.

These new adopted measures have had undeniable positive effects. The reinforcement of financial regulation has reduced systemic risk and the financial leverage of financial authorities. Transparency on derivatives markets have been increased. The efforts to improve the financial supervision system have been important, especially in Europe, and should gradually strengthen the stability and the solidity of the financial system. In addition, the framework of compensation practices has been reinforced. However, those reforms deal only partially with the issues revealed by the crisis.

Macroeconomic imbalances, partly responsible for the financial crisis, were not resolved. Countries’ current account remains unbalanced: United States versus Asia for example. The efficiency of central banks interventions to inject substantial liquidity in the economy is also being called into question and their impacts on inflation and financial stability remain sparsely identifiable. Furthermore, accounting standards have not been modified although they are considered procyclical and their accelerator effect is known to have accentuated the financial crisis.

Moreover, the regulation of the Shadow Banking System has yet to be improved and financial supervisions reforms are lacking in the USA. If they do not want a repeat of the subprime crisis, they will need to better improve their financial regulations. Finally, the initiatives taken to limit the role of rating agencies have been weak and gave little results. The liquidity issue also has been inadequately treated. By imposing liquidity ratios on banks that force them to reduce the size of their balance sheets and to replace credit by public debt, authorities limit the banks’ role as a financer of the economy.

These ratios may also lead to a concentration of available savings in banks’ balance sheets to the detriment of the interests of investors. Last but not least, there is a lack of international coordination concerning the implementation of those reforms, especially in Europe. Most of these reforms will not have the desired effects and, instead of improving financial stability, will hamper growth and increase risk. Europe, in particular, will be badly affected. First, the financing of the economy will be more difficult, especially for SMEs.

Before the crisis, most economists found the financial liberalization favorable to investment, innovation and growth. A financial system restricted by rules was considered very harmful to the economy. Indeed, a strengthened regulation of the financial sector can boost economic activity by increasing financial stability but it can also reduce investment, demand and potential growth The tightening of prudential standards, especially the one promoted by Basel III, was the subject of several recent simulations by private sector economists and central banks.

Although it is difficult to assess devices that have not yet been implemented, it was found that Basel III will have recessive effects on short-term economic activity and medium-term potential growth. Other studies suggest that Basel III would promote financial stability and reduce the volatility of the economy. However, this reduction in volatility would only have marginal effects on economic growth. From a microeconomic perspective, companies which do not have access to capital markets or a strong self-financing capacity would be penalized. For small and medium businesses and midsize companies, the consequences would be disastrous.

The SMEs, which have higher levels of risk than other economic agents, will face a credit shortage and an increase of their costs. Large companies also will not be spared. The amendment of prudential norms, especially the Basel III directive, will also fundamentally transform the role of banks in the economy without guarantee of better risk management. SMEs will be the most affected by these developments because they are very dependent on banks regarding their funding. The banks perform four functions: balance intermediation, risk management, financial transformation and customer support in their operations.

First, the function of financing and risk management will be constrained by the increase of the solvency ratio and the limitation of the leverage effect. Secondly, the liquidity ratios implemented will reduce the transformation function of the banks. Indeed, the volume of long-term loans to businesses and individuals will be reduced. Lastly, customers’ support could be modified for certain banking activities. Furthermore, risk management will be more aleatory. Those new regulations will increase the share of disintermediated financing: companies will need to find new sources of funding.

The most complex risks will be transferred to the shadow banking system which could augment systemic risk. The new regulatory standards are also calling into question the European model of economy financing and instead are promoting the American model. The financing of the economy’s modalities are different in European and in the Anglo-Saxon countries. The euro zone is dominated by the “originate to hold” model in which most of the funding are intermediated by balance sheets. On the contrary, the US financial system is organized according to the model “originate to distribute.

In order to alleviate their balance sheets, banks resort to massive securitization of loans that they have granted. In this context, intermediary financing is largely done by entities located in the non-regulated banking sphere. Consequently, the shadow banking system is well developed. The use of securitization by American banks allows them to be less constrained by the new liquidity rules promoted by Basel III and to be less dependent on interbank funding. Because of their funding methods and flexibility in setting new prudential norms, the United States will be mechanically less impacted than the euro area.

Therefore those reforms push Europe to adopt the American model based on securitization activities and a bond market. However, the euro zone will have little luck in applying the American model to its economy. Indeed, the European bond market remains weak despite recent developments. Doubts exist about its ability to replace banks for the financing of the economy: the price of the bond funding is more volatile, to finance itself on the bond market is also more expensive, the European SMEs and local communities have little access to markets bond and financing via the bond market is dependent on the grades attributed by rating agencies.

Finally, the preference of European investors for liquid investments makes particularly difficult this change of model. In addition, control of Shadow Banking thwarts its development. Moreover, it seems paradoxical to want to strengthen financial stability by encouraging countries to adopt the American model whereas it was in the USA that the crisis broke out. All of these elements explain why those reforms will strongly impact Europe.

If the course of the crisis is now well documented, its origin remains complex and is the result of a complex tangle of factors: poor functioning of financial markets, growing global imbalances and failing public policies. Although the crisis emerged in the United States, it has especially hit Europe, revealing weaknesses that result from inadequate economic policies and governance. To avoid the appearance of a new crisis, many reforms have been put in place or are under discussion. However, they only partly address the challenges revealed by the crisis.

Today, it has become clear that those reforms, apart from minor improvements, didn’t have the desired effect and were unable to reduce the volatility of capital, prevent systemic risk and ensure access to financing. Furthermore, most of these measures, by disrupting the financing of the economy, will have a negative impact on economic activity. What is more worrying, by changing the role of banks in the economy, these measures will help to spread risks that won’t be fully controlled. Finally, Europe will be more adversely affected by these developments than other countries.

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