financial crisis 2007-2010
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FinancialCrisisok.docxFINANCIAL CRISIS
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FINANCIAL CRISIS
Financial Crisis
Name
Institution
Introduction
Financial Crisis
Gilchrist et al., (2017) defines financial crisis as a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. Asset prices normally have a steep decline in value, businesses and consumers are unable to pay their debts, and financial institutions experience liquidity shortages. It is often associated with a panic or a bank run during which investors sell off assets or withdraw money from savings accounts because of fear that the value of those assets will drop if they remain in a financial institution.
Types of Financial Crisis
Market bubbles is a type of financial crisis where there is prices movements that are based on unexplained fundamentals. (Gilchrist et al., 2017) states that valuation of assets in terms of true value has been an old concern in economics. Bubbles allude to a situation in which the price of assets such as the houses rises above its real value. Debt financial crisis refers to the likely hood that loans given out could be lost. It was inspired by theoretical and practical vision of developed countries, many developing countries in Africa, Asia and Latin America looking to consolidate their countries during, hence took credit greatly from IMF and World Bank. As such, both IMF and World Bank funded them to overcome their financial situation and stimulate their economies but some dint manage to refund (Gilchrist et al., 2017).
The main causes of financial crisis are excessive risk and lending by financiers, central bank and regulatory, macroeconomic backdrop, the Asia glut and European banks
Financial Crisis
Great Moderation is the reduction in the volatility of business cycle fluctuations in developed nations. It is believed to be caused by institutional and structural changes, particularly in central bank policies, in the latter half of the twentieth century. Hands-off regulation refers to any regulation devised by agencies its aim is to encourage qualities like fairness, non-discrimination, openness, transparency, safety, and security. While greenspan doctrine is a view that modern, technologically advanced financial markets are best left to manage themselves (Shirvani at al., 2019).
Main Causes
1) Excessive risk and lending by financiers
According to the 3 equations model, the IS equation y1 = A−ar0 in which real income from housing y is a positive function of autonomous expenditure A and a negative function of the real interest rate r; the Phillips curve π1 = π0 + α(y1 − ye), where π is the rate of inflation and ye, equilibrium output; and the central bank’s Monetary Rule. Equilibrium output refer to the level of output associated with constant inflation in a world of imperfect competition (Yildirim et al., 2017).
Graph
r
rs A1
IS
Y1 ye
2) Central Bank and Regulatory
Adelino et al., (2018) explains that monetary policy is supposed to support the objectives of general economic policy for the purpose of achieving sustainable growth and a high level of employment. Inflation-targeting framework sets two goals, which are a central bank’s commitment to keep inflation low, and to keep the variance of inflation right. a strategy for monetary management, namely inflation-targeting policies, conducted mainly in a discretionary form have been considered to be capable of keeping inflation low while supporting the central bank’s flexibility to manage monetary policy.
3) Macroeconomic Backdrop
The Asian financial crisis was a period of financial crisis in East Asia and Southeast Asia and raised fears of a worldwide economic issues due to financial constraints. Asian Contagion, was a sequence of currency devaluations and other events and spread through many Asian markets. The currency markets first failed in Thailand as the result of the government's decision to no longer peg the local currency to the U.S. dollar (Adelino et al., 2018). Sudden Stops in capital flows occur when foreign financing available to borrower countries unexpectedly dries up. The Tequila crisis created financial turmoil in capital markets and financial contagion. As capital inflows resumed, disruptive adjustments were avoided. Sudden stops became known as a form of financial crisis whose trigger was on supply shocks stemming from world capital markets rather than on domestic policy failings (Shirvani at al., 2019).
4) Asia Glut
Whether the region has a robust enough crisis prevention mechanism to cope with the effects of the deluge of liquidity. Combined with excess domestic liquidity, strong capital inflows have been stoking inflation and bolstering asset prices across Asia, prompting many countries to impose capital control measures. however, to keep their countries’ growth engines humming, most Asian governments have tried to prevent their currencies’ appreciating rapidly and have shied away from the most effective tool in combating inflation: main risks to Asia’s economic outlook this year being inflation China’s ability to maintain relatively strong growth by containing inflationary pressures will be a key factor for the regional and global economic outlook (McCauley, 2019).
5) European Banks
Excessive growth in bank credit is owing to the artificially low interest rates set by a central bank. The interest rates are below the rate of the market for loanable funds that supply and demand clear. As a result, the information embedded in market prices or interest rates is distorted. Entrepreneurial decisions are affected, causing misallocation of capital across the economy and the credit-sourced boom results in a widespread malinvestment. A sustained period of low interest rates and excessive credit creation leads to an unstable imbalance between saving and investment. The boom fed by the credit expansion turns to recession when the money supply contracts and eventually resources are reallocated back (Black et al., 2016).
Theories and Methodologies
The hypothesis of financial instability was developed by economist Hyman Minksy. He argued that financial crisis are endemic in capitalism because periods of economic prosperity encouraged borrowers and lender to be progressively reckless. Over periods of prolonged economic prosperity and high optimism about future prospects, financial institutions invest more in ever-riskier assets in search of higher returns, which can make the economic system more vulnerable in the case that default materializes. When bad economic news eventually happens, the financial system risks being too highly leveraged and is at risk of systemic collapse as asset prices start falling and real incomes and jobs contract (Blecker, 2016).
Policy Changes to Limit Risk
To limit risk, there is the financial leverage which is the ratio of equity and financial debt of a company. It is an important element of a firm's financial policy. Leverage is an essential tool a company's management can use to make the best financing and investment decisions. It provides a variety of financing sources by which the firm can achieve its target earnings. Leverage is also an important technique in investing as it helps companies set a threshold for the expansion of business operations (Altunbas et al., 2018). Altunbas et al., (2018) also suggests use Fiscal policy when necessary which means by which a government adjusts its spending levels and tax rates to monitor and influence a nation's economy policies are used in various combinations to direct a country's economic goals. Liberalization of countries in emerging markets provides new opportunities for investors to increase their diversification and profit. It opens a country to the rest of the world with regards to trade, regulations, taxation and other areas that generally affect business in the country. All developed countries have already gone through this liberalization process, whereas emerging countries need to undergo a series of changes (Altunbas et al., 2018).
New Financial Instruments
A mortgage-backed security is an investment similar to a bond that is made up of a bundle of home loans bought from the banks that issued them. Investors in MBS receive periodic payments similar to bond coupon payments. A collateralized debt obligation is a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors. Helps give Senior Debt a Higher credit rating, but lower interest rates. Junior Debt a Lower credit rating, but higher interest rates. A credit rating agency, is a company that assigns credit ratings, which rate a debtor's ability to pay back debt by making timely principal and interest payments and the likelihood of default (Black et al., 2016).
Conclusion
During the global crisis, most banks need to limit themselves based on policies for crisis management, but explored new monetary policies. Whereas the Europe area is integrated monetarily, banking systems are still national. It implies that the member states are vulnerable to the cost of the banks. With more frequent financial crisis, central banks need to increase regional and international financial coordination. Central banks operate different policy instruments during financial crises and at other times, but their tasks should be similarly related to financial stability.
· Bank concentration and interconnectedness some explanation about this part
References
Adelino, M., Schoar, A., & Severino, F. (2018). The role of housing and mortgage markets in the financial crisis. Annual Review of Financial Economics, 10, 25-41.
Altunbas, Y., Binici, M., & Gambacorta, L. (2018). Macroprudential policy and bank risk. Journal of International Money and Finance, 81, 203-220.
Black, L., Correa, R., Huang, X., & Zhou, H. (2016). The systemic risk of European banks during the financial and sovereign debt crises. Journal of Banking & Finance, 63, 107-125.
Blecker, R. A. (2016). Finance, distribution, and the role of government: heterodox foundations for understanding the crisis. Studies in Political Economy, 97(1), 76-86.
Gilchrist, S., Schoenle, R., Sim, J., & Zakrajšek, E. (2017). Inflation dynamics during the financial crisis. American Economic Review, 107(3), 785-823.
McCauley, R. N. (2019). The 2008 GFC: savings or banking glut? In The 2008 Global Financial Crisis in Retrospect (pp. 57-85). Palgrave Macmillan, Cham.
Shirvani, A., Stoyanov, S. V., Rachev, S. T., & Fabozzi, F. J. (2019). A New Set of Financial Instruments. Available at SSRN 3486655.
Yildirim, Y., Yasar, E., & Adem, A. R. (2017). A multiple exp-function method for the three model equations of shallow water waves. Nonlinear Dynamics, 89(3), 2291-2297.
