Global Financial Crisis an Introduction

8/8/2019 Global Financial Crisis an Introduction

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GLOBALFINANCIAL

CRISISPresented to

Professor Dr. Shafique urRehman

From


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Table of Contents

An Introduction to Global FinancialCrises

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Types of FinancialCrises

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Banking crisis 3 Speculative bubbles and crashes 4

International financial crises 4

Wider economic crises 4

Strategic complementarities infinancial markets

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Leverage 4

Asset-liability mismatch 5

Uncertainty and herd behavior 5 Regulatory failures 5

Fraud 5

Contagion 5

Recessionaryeffects

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The Great Depression

(1930)

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The Global Financial Crisis: HistoryRepeats Itself

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The Financial Crisis and WealthyCountries

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Asia and the Financial Crises 9


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Europe and the financial crisis 10

A crisis that need not have happened 10

The term Global Financial Crisis is applied broadly to avariety of situations in which some financial institutions or assetssuddenly lose a large part of their value. In the 19th and early20th centuries, many financial crises were associated withbanking panics, and many recessions coincided with these panics.

Other situations that are often called financial crises include stockmarket crashes and the bursting of other financial bubbles,currency crises, and sovereign defaults. Financial crises directlyresult in a loss ofpaper wealth; they do not directly result inchanges in the real economy unless a recession or depressionfollows.Many economists have offered theories about how financial crisesdevelop and how they could be prevented. There is littleconsensus, however, and financial crises are still a regularoccurrence around the world.

Types of Financial Crisis

Banking CrisisWhen a bank suffers a sudden rush of withdrawals by depositors,this is called a bank run. Since banks lend out most of the cashthey receive in deposits (see fractional-reserve banking), it isdifficult for them to quickly pay back all deposits if these aresuddenly demanded, so a run may leave the bank in bankruptcy,

causing many depositors to lose their savings unless they arecovered by deposit insurance.

Speculative bubbles and crashesEconomists say that a financial asset (stock, for example) exhibitsa bubble when its price exceeds the present value of the futureincome (such as interest or dividends) that would be received by
http://en.wikipedia.org/wiki/Bank_run#Systemic_banking_criseshttp://en.wikipedia.org/wiki/Recessionhttp://en.wikipedia.org/wiki/Stock_market_crashhttp://en.wikipedia.org/wiki/Stock_market_crashhttp://en.wikipedia.org/wiki/Economic_bubblehttp://en.wikipedia.org/wiki/Currency_crisishttp://en.wikipedia.org/wiki/Sovereign_defaulthttp://en.wikipedia.org/wiki/Paper_wealthhttp://en.wikipedia.org/wiki/Fractional-reserve_bankinghttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Interesthttp://en.wikipedia.org/wiki/Bank_run#Systemic_banking_criseshttp://en.wikipedia.org/wiki/Recessionhttp://en.wikipedia.org/wiki/Stock_market_crashhttp://en.wikipedia.org/wiki/Stock_market_crashhttp://en.wikipedia.org/wiki/Economic_bubblehttp://en.wikipedia.org/wiki/Currency_crisishttp://en.wikipedia.org/wiki/Sovereign_defaulthttp://en.wikipedia.org/wiki/Paper_wealthhttp://en.wikipedia.org/wiki/Fractional-reserve_bankinghttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Interest


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owning it to maturity.[4] If most market participants buy the assetprimarily in hopes of selling it later at a higher price, instead ofbuying it for the income it will generate, this could be evidencethat a bubble is present. If there is a bubble, there is also a risk of

a crash in asset prices: market participants will go on buying onlyas long as they expect others to buy, and when many decide tosell the price will fall.

International financial crisesWhen a country that maintains a fixed exchange rate is suddenlyforced to devalue its currency because of a speculative attack,

this is called a currency crisis or balance of payments crisis. Whena country fails to pay back its sovereign debt, this is called asovereign default. While devaluation and default could both bevoluntary decisions of the government, they are often perceivedto be the involuntary results of a change in investor sentimentthat leads to a sudden stop in capital inflows or a sudden increasein capital flight.

Wider economic crisis

Negative GDP growth lasting two or more quarters is called arecession. An especially prolonged recession may be called adepression, while a long period of slow but not necessarilynegative growth is sometimes called stagnation. Since thesephenomena affect much more than the financial system, they arenot usually considered financial crises per se. But someeconomists have argued that many recessions have been causedin large part by financial crises. One important example is theGreat Depression, which was preceded in many countries by bankruns and stock market crashes. The subprime mortgage crisis andthe bursting of other real estate bubbles around the world has ledto recession in the U.S. and a number of other countries in late2008 and 2009.

Strategic complementarities in financial markets
http://en.wikipedia.org/wiki/Maturity_(finance)http://en.wikipedia.org/wiki/Financial_crises#cite_note-3http://en.wikipedia.org/wiki/Fixed_exchange_ratehttp://en.wikipedia.org/wiki/Devaluationhttp://en.wikipedia.org/wiki/Speculative_attackhttp://en.wikipedia.org/wiki/Sovereign_debthttp://en.wikipedia.org/wiki/Sudden_stop_(economics)http://en.wikipedia.org/wiki/Capital_flighthttp://en.wikipedia.org/wiki/Great_Depressionhttp://en.wikipedia.org/wiki/Subprime_mortgage_crisishttp://en.wikipedia.org/wiki/Maturity_(finance)http://en.wikipedia.org/wiki/Financial_crises#cite_note-3http://en.wikipedia.org/wiki/Fixed_exchange_ratehttp://en.wikipedia.org/wiki/Devaluationhttp://en.wikipedia.org/wiki/Speculative_attackhttp://en.wikipedia.org/wiki/Sovereign_debthttp://en.wikipedia.org/wiki/Sudden_stop_(economics)http://en.wikipedia.org/wiki/Capital_flighthttp://en.wikipedia.org/wiki/Great_Depressionhttp://en.wikipedia.org/wiki/Subprime_mortgage_crisis


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It is often observed that successful investment requires eachinvestor in a financial market to guess what other investors willdo. George Soros has called this need to guess the intentions ofothers 'reflexivity'. Similarly,John Maynard Keynes compared

financial markets to a beauty contest game in which eachparticipant tries to predict which model other participants willconsider most beautiful.

LeverageLeverage, which means borrowing to finance investments, isfrequently cited as a contributor to financial crises. When afinancial institution (or an individual) only invests its own money,it can, in the very worst case, lose its own money. But when itborrows in order to invest more, it can potentially earn more from

its investment, but it can also lose more than all it has. Thereforeleverage magnifies the potential returns from investment, butalso creates a risk ofbankruptcyAsset-liability mismatchAnother factor believed to contribute to financial crises is asset-liability mismatch, a situation in which the risks associated withan institution's debts and assets are not appropriately aligned.

Uncertainty and herd behavior

Many analyses of financial crises emphasize the role ofinvestment mistakes caused by lack of knowledge or theimperfections of human reasoning. Behavioral finance studieserrors in economic and quantitative reasoning.

Regulatory failuresGovernments have attempted to eliminate or mitigate financialcrises by regulating the financial sector. One major goal ofregulation is transparency: making institutions' financial situationspublicly known by requiring regular reporting under standardizedaccounting procedures. Another goal of regulation is making sureinstitutions have sufficient assets to meet their contractualobligations, through reserve requirements, capital requirements,and other limits on leverage.

Fraud
http://en.wikipedia.org/wiki/George_Soros#Philosophyhttp://en.wikipedia.org/wiki/Reflexivity_(social_theory)http://en.wikipedia.org/wiki/John_Maynard_Keyneshttp://en.wikipedia.org/wiki/Keynesian_beauty_contesthttp://en.wikipedia.org/wiki/Bankruptcyhttp://en.wikipedia.org/wiki/Behavioral_financehttp://en.wikipedia.org/wiki/Transparency_(market)http://en.wikipedia.org/wiki/Reserve_requirementhttp://en.wikipedia.org/wiki/Capital_requirementhttp://en.wikipedia.org/wiki/Leverage_(finance)http://en.wikipedia.org/wiki/George_Soros#Philosophyhttp://en.wikipedia.org/wiki/Reflexivity_(social_theory)http://en.wikipedia.org/wiki/John_Maynard_Keyneshttp://en.wikipedia.org/wiki/Keynesian_beauty_contesthttp://en.wikipedia.org/wiki/Bankruptcyhttp://en.wikipedia.org/wiki/Behavioral_financehttp://en.wikipedia.org/wiki/Transparency_(market)http://en.wikipedia.org/wiki/Reserve_requirementhttp://en.wikipedia.org/wiki/Capital_requirementhttp://en.wikipedia.org/wiki/Leverage_(finance)


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Fraud has played a role in the collapse of some financialinstitutions, when companies have attracted depositors withmisleading claims about their investment strategies, or haveembezzled the resulting income.

ContagionContagion refers to the idea that financial crises may spread fromone institution to another, as when a bank run spreads from a fewbanks to many others, or from one country to another, as whencurrency crises, sovereign defaults, or stock market crashesspread across countries. When the failure of one particularfinancial institution threatens the stability of many otherinstitutions, this is called systemic risk.

Recessionary effectsSome financial crises have little effect outside of the financialsector, like the Wall Street crash of 1987, but other crises arebelieved to have played a role in decreasing growth in the rest ofthe economy. There are many theories why a financial crisis couldhave a recessionary effect on the rest of the economy. Thesetheoretical ideas include the 'financial accelerator', 'flight toquality' and 'flight to liquidity', and the Kiyotaki-Moore model.Some 'third generation' models of currency crises explore how

currency crises and banking crises together can cause recessions.

The Great Depression

The 'Great Depression' was a period in United States History whenbusiness was poor and many people were out of work.

The Great Depression began in October 1929, when the stockmarket in the United States dropped rapidly. Thousands of

investors lost large sums of money and many were wiped out, losteverything. The 'crash' led us into the Great Depression. Theensuing period ranked as the longest and worst period of highunemployment and low business activity in modern times. Banks,stores, and factories were closed and left millions of Americans

jobless, homeless, and penniless. Many people came to dependon the government or charity to provide them with food.
http://en.wikipedia.org/wiki/Embezzlementhttp://en.wikipedia.org/wiki/Black_Monday_(1987)http://en.wikipedia.org/wiki/Financial_acceleratorhttp://en.wikipedia.org/wiki/Flight_to_qualityhttp://en.wikipedia.org/wiki/Flight_to_qualityhttp://en.wikipedia.org/wiki/Flight_to_liquidityhttp://en.wikipedia.org/wiki/Kiyotaki-Moore_modelhttp://en.wikipedia.org/wiki/Currency_crisis#Theories_of_currency_criseshttp://en.wikipedia.org/wiki/Embezzlementhttp://en.wikipedia.org/wiki/Black_Monday_(1987)http://en.wikipedia.org/wiki/Financial_acceleratorhttp://en.wikipedia.org/wiki/Flight_to_qualityhttp://en.wikipedia.org/wiki/Flight_to_qualityhttp://en.wikipedia.org/wiki/Flight_to_liquidityhttp://en.wikipedia.org/wiki/Kiyotaki-Moore_modelhttp://en.wikipedia.org/wiki/Currency_crisis#Theories_of_currency_crises


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The Depression became a worldwide business slump of the 1930'sthat affected almost all nations. It led to a sharp decrease in worldtrade as each country tried to protect their own industries and

products by raising tariffs on imported goods. Some nationschanged their leader and their type of government. In Germany,poor economic conditions led to the rise to power of the dictatorAdolf Hitler. The Japanese invaded China, developing industriesand mines in Manchuria. Japan claimed this economic growthwould relieve the depression. This militarism of the Germans and

Japanese eventually led to World War II (1939-1945).

In the United States, President Herbert Hoover held office whenthe Great Depression began. The economy continued to slump

almost every month. Franklin D. Roosevelt was elected Presidentin 1932. Roosevelt's 'new deal' reforms gave the governmentmore power and helped ease the depression. The GreatDepression ended as nations increased their production of warmaterials at the start of World War II. This increased productionprovided jobs and put large amounts of money back intocirculation.

The Global Financial Crisis: History Repeats Itself

During the pre-financial crisis of 2008, a lot of the population werealready suffering from the subprime mortgage crisis. Recklessborrowing by consumers along with excessive leveraging ofWallstreet brought the US to the brink. Everybody was caught bysurprise when the news broke out and the degree on howWallstreet really messed up was the focus of everybodysattention.

Fall of First Institution (Bank)Bear Stearns is a global investment bank that was the first to fallwhere JPMorgan Chase saved it by acquiring it in March 2008.During that time, the White House has insisted that the economicfundamentals of the country was still strong. Also that time, theWhite House was confining the subject to just the subprimemortgage sector.


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Fall of Mortgage & their BailmentThe next major institutions to fall are Freddie Mac and Fannie Maewhich are two of the major mortgage companies in the US. The

federal government was forced to bail these companies out bymeans of taxpayer money amounting to $5 trillion. Soonafter,Wallstreet collapsed. As a consequence, Wallstreets fiveinvestment banks which consist of Merrill Lynch, Bear Stearns,Lehman Brothers, Goldman Sachs, and Morgan Stanley, wereeither reduced to being depository banks or collapsingaltogether.

Fall of Insurer (AIG)The next major financial entity said to fall next is the largest

insurer in the world, AIG. AIG was considered to be an entity thatshould not be allowed to go down. Otherwise the consequencesmight result to a new great depression. It was considered a hugerisk to let AIG fall seeing as it has a lot of tie to numerousinstitutions where money is pretty much wrapped around it.

Taxpayers were forced to pay $85 billion to bailout the insurancegiant.

Collapse of the Stock MarketsThe collapse of the stock market together with the fall of severalfinancial institutions were events reminiscent to the pre-greatdepression of the late 1920s and a lot of people thought thatanother great depression is on the horizon. As the 2008 financialcrisis was still building its momentum, easy money fueled thehousing sector like a well-oiled machine that also occured in the1920s. Ever since the US government lowered the mortgage rateto 1 percent, people of every status could virtually own a house.Because of this, mortgages and other types of loans were easilygranted by nearly all banks across the country without even doingsome important checks on them. The tendency to lie about howmuch money one makes was very widespread at the time andanyone who can present a credit rating passes. Loans were even
http://www.allaboutloans.co.uk/http://www.allaboutloans.co.uk/


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granted to people who dont have jobs simply because this crucialinformation are not verified by lenders.

Though risky, plenty of lenders dont mind giving way these loansbecause of a financing tool identified as mortgage-backed

securities. These loans were bulked and resold to banks inWallstreet and banks in Wallstreet bundle these loans into higheryielding mortgage-backed securities and sold to investors aroundthe globe. These newly converted loans then became pooledrisks as many investors across the planet now have their shareon them and because of this aspect it was thought that it willalways be protected.

The Financial Crisis and Wealthy CountriesMany blame the greed of Wall Street for causing the problem inthe first place because it is in the US that the most influentialbanks, institutions and ideologues that pushed for the policiesthat caused the problems are found.

The crisis became so severe that after the failure and buyouts ofmajor institutions, the Bush Administration offered a $700 billionbailout plan for the US financial system.

This bailout package was controversial because it was unpopularwith the public, seen as a bailout for the culprits while theordinary person would be left to pay for their folly. The US House

of Representatives initial rejected the package as a result,sending shock waves around the world.

Asia and the Financial CrisesCountries in Asia are increasingly worried about what ishappening in the West. A number of nations urged the US to

provide meaningful assurances and bailout packages for the USeconomy, as that would have a knock-on effect of reassuringforeign investors and helping ease concerns in other parts of theworld.Many believed Asia was sufficiently decoupled from the Westernfinancial systems. Asia has not had a subprime mortgage crisislike many nations in the West have, for example. Many Asian
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nations have witnessed rapid growth and wealth creation inrecent years. This lead to enormous investment in Westerncountries. In addition, there was increased foreign investment inAsia, mostly from the West.

However, this crisis has shown that in an increasingly inter-connected world means there are always knock-on effects and asa result, Asia has had more exposure to problems stemming fromthe West. Many Asian countries have seen their stock marketssuffer and currency values going on a downward trend. Asianproducts and services are also global, and a slowdown in wealthycountries means increased chances of a slowdown in Asia and therisk of job losses and associated problems such as social unrest.

India and China are the among the worlds fastest growingnations and after Japan, are the largest economies in Asia. From2007 to 2008 Indias economy grew by a whopping 9%. Much of itis fueled by its domestic market. However, even that has notbeen enough to shield it from the effect of the global financialcrisis, and it is expected that in data will show that by March 2009that Indias growth will have slowed quickly to 7.1%. Although thisis a very impressive growth figure even in good times, the speedat which it has droppedthe sharp slowdownis what is

concerning.

Japans output for the first 3 months of 2009 plunged at itsquickest pace since records began in 1955, mostly due to fallingexports. A rise in industrial output in April was expected, but waspositively more than initially estimated. However, with highunemployment and general lack of confidence, optimism forrecovery has been dampened.

Europe and the financial crisisIn Europe, a number of major financial institutions failed. Othersneeded rescuing.In Iceland, where the economy was very dependent on thefinance sector, economic problems have hit them hard. Thebanking system virtually collapsed and the government had to


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borrow from the IMF and other neighbors to try and rescue theeconomy. In the end, public dissatisfaction at the way thegovernment was handling the crisis meant the Icelandgovernment fell.A number of European countries have attempted

different measures (as they seemed to have failed to come upwith a united response).

For example, some nations have stepped in to nationalize or insome way attempt to provide assurance for people. This mayinclude guaranteeing 100% of peoples savings or helping brokerdeals between large banks to ensure there isnt a failure.

The EU is also considering spending increases and tax cuts said tobe worth 200bn over two years. The plan is supposed to help

restore consumer and business confidence, shore upemployment, getting the banks lending again, and promotinggreen technologies.

Russiaa economy is contracting sharply with many more fearedto slide into poverty. One of Russias key exports, oil, was areason for a recent boom, but falling prices have had a big impactand investors are withdrawing from the country.

A crisis that need not have happened

This problem could have been averted (in theory) as people hadbeen pointing to these issues for decades. Yet, of course, duringperiods of boom no-one (let alone the financial institutions andtheir supporting ideologues and politicians largely believed to beresponsible for the bulk of the problems) would want to hear ofcaution and even thoughts of the kind of regulation that many arenow advocating. To suggest anything would be anti-capitalism or

socialism or some other label that could effectively shut up eventhe most prominent of economists raising concerns.

Of course, the irony that those same institutions would nowthemselves agree that those anti-capitalist regulations arerequired is of course barely noted. Such options now beingconsidered are not anti-capitalist. However, they could be


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described as more regulatory or managed rather than completelyfree or laissez faire capitalism, which critics of regulation haveoften preferred. But a regulatory capitalist economy is verydifferent to a state-based command economy, the style of which

the Soviet Union was known for. The points is that there arevarious forms of capitalism, not just the black-and-whitecapitalism and communism. And at the same time, the mostextreme forms of capitalism can also lead to the bigger bubblesand the bigger busts.

Documents

Global Financial Crisis an Introduction