Number Of Causes Raising This Financial Crisis Finance Essay - Free Essay Example

It is said by Penman that there is a bubble largely in financial markets during 2005 to 2007(Penman, 2013). The boom in the real-estate market in the United States resulted in the high housing prices, poor lending practices, and more risk taking by banks. After the bubbles bursting, a financial crisis reduced the market value of stocks by 37 per cent in 2008 (Penman). According to the Oxford dictionary of finance and banking, financial crisis is a collapse in the price of financial obligations, which may lead to a collapse in the economy. In this essay, it will explain the macroeconomic and microeconomic causes accounting to the above mentioned crisis; and then show the measures the UK government taking to solve the problem. In conclusion, the assessment of these actions will be made. Reasons There are a number of causes raising this financial crisis, which will be analyzed from macroeconomic and microeconomic aspects, especially the role of the securitization will be highlighted as a trigger to the crisis. Macroeconomic reasons Long period of low real interest rate Referring to Buckley, the roots of the crisis were planted in the decade before 2007. Table 1 in appendices shows the low real interest rates in the USA in the first seven years of the 21st century, which was not only a feature of the US economy, but also a global phenomena due to the co-ordination of governments around the world. This accelerates the increase of housing prices and asset prices (recall the inverse relationship between bond prices and interest rates) in the USA, in the UK and elsewhere. Furthermore, banks made use of these low rates by increasing their debt levels as a proportion of total financing, for the debt was cheap. However, debt interest is decided by dividends, and debt repayment ranks above shareholders capital on liquidation, so there could be another increased risk to shareholders. Global financial imbalance On the one hand, influenced by the low real interest rates, the West tended to import from capital-poor emerging market countries, for example China; on the other hand, through being a purchaser of bonds, surplus countries were willing to buy deficits countries securities, such as the US dollar government securities, instead of exchanging for their own currency. It means that deficits countries were able to get their fund to balance their deficits more cheaply. Therefore, the American and European governments were immersed in the booming economics, which also hastened the deregulation of their banking system. Microeconomic factors Consumer Inertia It is convinced by the financial institutions that the customers deposits or transactions were safe. Take securitization for example. During the process of securitization, there are several means being used to ensure consumers inertia. Firstly, the special purpose vehicle (SPV) made a true sale, which aims to guarantee the separation of the cash flow. Secondly , credit-rating agencies and insurance companies played crucial roles in keeping consumers confidence. High levels of corporate leverage To attract their shareholders, through enlarging the ratio of assets to equity, the managers of financial firms tried to increase return on equity (ROE), which is the net income generated for shareholders and equals the return on assets (ROA) (Introduction). It is noted that this measure not only creates more profits, but also raises more risk. Take Lehman Brothers for example. Assume its capital fund was 1000 billion, and the usual leverage ratio was 3 to 1, so it can finance 3000 billion (1000 billion * 3); while now it raise the ratio to 6 to 1, without changing other assumption, Lehman Brothers is able to double its financing amount (6000 billion). In fact, according to causes, it is reported that a post-war figure for banks debt to equity ratios of 10 to 1 moved nearer to 25 to 1, with some institutions having ratios of more than 33 to 1 . So banks were taking on burgeoning debt, since too much equals too much financial risk. Compensation schemes and volumetric targeting Due to the boosted firms, managers at banks and other financial firms were further encouraged to take on greater short-run risks. Firstly, wage packages were linked to ROE and/or stock price regardless of the long-term risk. Secondly, more deregulation happened in aspect of asset management, despite it was known that there were bubbles, which like led to a collapse. Skewed incentives of the rating agencies There were two products eager to be highly rated, on is collate debt obligations (CDOs); the other is asset-backed commercial paper (ABCP). CDOs was viewed as resecuritized securities, because it mixed of different tranches of mortgage backed securities (MBS) and asset-backed securities (ABS). It seemed that the creation of CDOs or the further securitization of already securitized assets (ABS and MBS) brought more unpredicted risks t o the market. As to ABCP, it was explained that it typically used short-term debt to finance a pool of credit assets, such as trade receivables. From this basic point, many banks (particularly in the US) dealt with long-term paper by issuing short-term ABSP, rather paying attention to the capital requirements. Limitations of risk measurement, management and regulation During the process of securitization, the whole financial system was involved in the great risk in order to gain more profits. In the meantime, some new legal structures and products were created, but they were difficult to measure risk hidden behind them accurately. UK governments responses After the financial crisis, the UK government recapitalized its banks rather than implementing the troubled asset relief program (TAFP) like the USA. Furthermore, it did its best to apply quantitative easing policy to keep the normal financial flow and prevent deflation or even national economic collapse. Referring to c auses, in the UK, the interest rates were cut from 5 percent to 1/2 per cent between October 2008 and March 2009 by the Bank of England, but it needed time to work through the economy; whilst by open market operations, the central bank offered cash to buy government debt and other debt held by banks and financial institutions, aiming at increase the banks capacity to lend. In the UK, it was GBP 200 billion, which is about 13 per cent of GDP (1.5 trillion). Moreover, the four largest banks in the UK Barclays, HSBC, Lloyds and RBS requested their shareholders to boost their equity capital. It is reported that 43 per cent of the equity in Lloyds, after its rescue takeover of HBOS, and 84 per cent in RBS owned by the British government would be sold to the public in due course. Then as a further important problem, the banks would use this new equity capital to reduce their liabilities, rather than lending them to retail and wholesale customers, although the UK government encouraged th em to lend. In order to promote the transaction, the UK government reduced the Value Added Tax from 17 per cent to 15 per cent for 13 months from December 2008 until the end of 2009, though the result was not significant. Conclusions Since the start of the financial crisis, the global financial markets are suffering, although there is a recovery in the global market in recent years. This financial crisis was caused by several factors, which can be viewed in both macroeconomic and microeconomic aspects. From the basic point, it could be summarized that due to the Long period of low real interest rate and global financial imbalance, the financial institutions violated regulations to chase profits regardless of risks. Facing the difficult problem, the UK government gave a response to protect and adapt its national economic environment. However, the lessons the financial crisis gives to us need to draw attention. Firstly, regulation and supervision in global financial system shoul d be addressed. On the one hand, all the large financial institutions need to create and use financial derivatives properly; on the other hand, the coordination of mechanisms for international bank regulation and supervision ought to be improved. Secondly, the financial institutions are slavishly on probability distributions. It can be seen that they judged the securities only by the short-term returns and ignoring long-term risks.