For more than 22 months now, the global economy has experienced the most traumatic moments in many decades. Although in some quarters, there seems to be a glimmer of hope, the dimensions in which the crisis manifested itself have made analysts to describe the situation as perhaps the worst financial crisis since the Great Depression of the 1930s. Indeed, for the first time, the world economy has witnessed stagnation or minimal growth since more than seven decades.
But what went wrong? And what factors fuelled the situation to boiling point? At the root of the recent financial crisis was the “search for yield” by financial institutions and investors. The increasing integration of financial markets and the apparent relative stability of advanced economies, for example, the U.S. and the UK (in the form of growing private sector employment, moderate inflation regimes, high savings ratio, stable exchange rates, low real and nominal interest rates, etc.) led investors and financial institutions to begin to search for profitable investment opportunities. This resulted in over optimism, speculation and leverage.
The U.S. housing market became the toast of investors. Banks were extending credit massively to borrowers in the mortgage market (especially in sub prime loans), with the hope that they will reap handsome returns from future rise in house prices which already had begun to escalate at the time. On the other hand, individuals took advantage of this leverage and borrowed money from banks to speculate on asset prices.
Because of the expectation that house prices will continue to rise, coupled with the need to gain market share and competitive position, banks started loosening their credit standards, and as such did not monitor the credit worthiness of borrowers –– a task which, in fact, had been outsourced to credit rating agencies (CRAs). When the U.S. house prices dropped considerably around 15-20 percent off its peak in the summer of 2007, borrowers started to default in large numbers.
Now let’s take a look at the aggravating factors of the crisis. The macroeconomic origins of the crisis can be traced to the easy monetary policy being conducted by the U.S. Federal Reserve at the time. Interest rates were kept low for too long and this encouraged excessive leverage among banks. Also, there were huge fiscal imbalances in many western countries who funded their current account and budgetary deficits by capital transfers from South East Asian countries via international capital markets. China, Japan and Germany were among major lenders to borrowing countries like U.S., U.K and Spain, who used such funds for speculative purposes.
Another major aggravating factor was financial innovation –– the widespread practice of the securitization. Commercial banks changed their business models in which they initiated loans to borrowers and subsequently packaged and sold these loans as securities to investors in search of higher yields.
The development of complex financial products – Collateralised Debt Obligations (CDOs), Asset Backed Securities (ABS), Mortgage Backed Securities (MBS), Credit Default Swaps (CDS), etc., all led to the manufacture of coupon assets and unregulated credit creation. To make matters worse, credit rating agencies were rating many of these securities triple “A” and could not foresee the impending disaster.
More so, the development of unregulated “non-bank” financial institutions known as “shadow financial system” meant that the regulatory architecture was flawed. The implication is that financial innovation grew quickly and moribund the existing regulatory structures, as financial institutions looked for ways to circumvent procedures. Thus, traditional early warning models could not predict the crisis.
Also, there was the notion of self regulation of markets –– the widespread belief that the market self-regulates and that the government can only make matters worse (a view held by Alan Greenspan, former chairman of the US Federal Reserve). Thus, increasing competition in the banking business pushed banks towards more risky activities. Banks developed a new funding structure in which they became increasingly dependent on wholesale sources of funds rather than traditional deposits from customers. In some banks, they obtained no more than 20 percent of their liabilities from customer deposits. When wholesale sources of funds dried up, they began to hoard liquid assets and stopped extending credit.
Other factors which aggravated the crisis were the fusion of banking and capital markets; technological revolution, which aided the internationalisation of financial services; contagion and connectedness of institutions and financial markets which made it easy for risks to be transferred among institutions and across countries.
Lastly, banks, pension funds, and investors all over the world were “shallow” and “greedy” and did not take the care to investigate how their money was used as everyone was carried away by the glamour of money making.
In sum, the recent financial crisis was caused by the interaction of micro and macro elements. That is, the “micro” behaviour of banks and other financial institutions in creating new financial assets; and the “macro” economic strategies pursued by the world’s major countries. Policies should therefore concentrate on covering these interactions if the likelihood of future crises is to reduce.
The consequences of a global downturn like this can be very severe both in terms of huge fiscal costs and external imbalances in the terms of trade.
There is therefore the need for authorities and policy makers to evolve a range of additional instruments to control the growth of the financial sector and its interactions with the wider economy.
Ekpu wrote from the Dept. of Economics, Univ. of Glasgow, UK.