The current financial crisis is yet another global crisis that shook the world economy and forced governments and financial institutions to ponder once again on the overall working of financial regulatory systems. The crisis which began in the US and then spread to Europe, has now affected the livelihoods of almost everyone in the world. There are a number of reasons why many financial institutions became insolvent. In addition to easy lending of loans, they include securitization and changing nature of banking, excessive use of derivatives, inflow of easy money from the developing economies, improper financial regulations, inconsistent government policy and weak oversight (Suetin, 2009). These reasons were also the cause for the inflation of credit and housing bubble in the financial market before the ultimate crash. Many predict that the economy will not revive well and truly till 2012. Under these circumstances, it becomes important to understand the causes of the current crisis, devise immediate and long term mechanisms to control and resolve it, and implement appropriate monetary policies and financial regulatory mechanisms to prevent the recurrence of a similar crisis (Brunnermeier et al., 2009). This essay discusses the main causes of the global financial crisis and the measures that UK government could take to reduce the impact of such a crisis.
Causes of Current Financial Crisis
The main causes of the economic turmoil was the borrowing of cheap money from the emerging markets, especially Asian markets and the lax interest rate policy adopted by the US government during 2007. This led to substantial increase in the current account deficit of the US which in turn, caused global macroeconomic imbalances in the world (Lane, 2009). These global imbalances interacted with the flaws in the financial markets to put great stress on the financial intermediation process (Portes, 2009). There was also a change in the pension financing in which the employees can use the money from their pension funds for investing in various kinds of funds, especially mutual funds (Davis, 2009). People now had more money to invest. Low interest rates and huge cash inflow created easy credit conditions fueling a housing construction boom. It became easy to obtain various types of loans and consumers assumed an unprecedented debt load (Economist.com, 2008).
Another cause to which the crisis can be attributed to is the transformation of the traditional model of banking system through “securitization”-that is, turning assets into securities traded on markets, (Davis, 2009). In this, a number of homeowners pooled monthly mortgage payments in the form of mortgage-backed bonds, which ultimately went to the investors as interest payments on bonds. Such financial innovations were supported by the authorities and considered as a means of risk-sharing and thus benefitting the borrowers, the investors as well as the banks. The banks borrowed even more money in order to lend out and make more money. Running out of who to loan to, banks turned to the subprime borrowers (those who are low on creditworthiness), that is, riskier loans. The problem arose when subprime borrowers defaulted on the loans and banks failed to pay the interest to the investors. The banks were trying to manage the funds by selling the mortgaged properties of the borrowers but due to the decline in the housing prices they could not get the actual amount of the loans. Many global financial institutions and banks that had borrowed and invested heavily in subprime mortgaged-backed securities reported substantial losses as well as bankruptcy by some. The financial schemes became increasingly complex and lacked transparency. The investors were faced by lack of confidence in investing their money after the crash which further accentuated the problem. Problems started to appear in other credit markets as well such as credit card debts and car loans.
After almost complete transition to postindustrial society, the US had offshored its production units to foreign contractors (Davis, 2009). The bankruptcy of major financial institutions of US sent ripples around the world. Almost all the countries suffered from high inflation rates and declining growth rate. Other developed countries like the UK were also badly struck by the crisis as they were also following the same financial framework and have inter-linkages with the US economy. The prices of commodities specially oil and food rose rapidly, making it difficult for even the common man to sustain the times of crisis.
The market driven economies of the world had liberalized their lending and financial policies, to suit market situation prevalent then. But it lacked understanding of long term implications of the same, which ultimately brought about the poor state of affairs.
Steps by UK government
Every crisis signals some weakness in the financial system and emphasizes the need to design mechanisms and policies in order to reduce the impact of any future crisis. The UK is the second most badly hit economy by the global financial crisis, after the US and the hardest hit among the European economies. The UK government should reformulate policies to reduce the risk of financial crisis and prevent itself from the contagion.
Greater levels of transparency are required in the financial system, especially with respect to innovative financial instruments and practices that can encourage imprudent investments, and immoderate spending (McCreevy, 2008). This is the lesson to be learned from the securitization issues that lead to the fall of major investment banks. The trading decisions of certain market players have significant impact on the financial framework and hence government should strengthen their disclosure requirements. Increased transparency will make the market less volatile, especially when the market conditions become adverse.
There should be better standards and regulation of credit rating agencies (Erian, 2007). The rating that they give for different bonds and debt instruments can instigate the buyer to purchase the debt instrument or make him refuse the debt instrument. This can help in making prudent buying decisions when it comes to the debt market. These agencies are paid by the financial institutions for which they give prime ratings and in most cases investors buy the bonds based on these ratings even without knowing what actually lies behind them. The government should properly monitor the working and performance of these rating agencies and make them legally responsible for their work.
A major problem faced during boom times is falling capital ratios of banks. The government should keep a limit (cap) to the extent till which banks can leverage up during good times (Brunnermeier et al., 2009). This will help maintain better funds for the crisis period. The government can also maintain capital ratios by introducing funds requiring each bank to pay a particular amount periodically which can be then paid back during credit crunch.
The government should also have better coordination with their foreign counterparts to improve international exchange of information and better crisis management arrangements. There is also a need for international coordination among regulatory and supervisory policy to prevent the spread of any such crisis across national or regional boundaries. Also, the monetary and fiscal policy of the government should have coherence between the short-term benefits and long-term implications. All the regulations should be countercyclical, that is, they should be more stringent during the credit booms (Brunnermeier et al., 2009). The government should intervene and prevent excess leveraging by banks in times of booms in order to counteract the repercussions during crisis.
Though the regulation of the financial system is necessary to reduce the chances of such crises recurring, but the regulation is considered to be better if it is industry initiated rather than government initiated (McCreevy, 2008). Being better prepared will help a country face the global crisis with reduced impact and vulnerability.
Although the booms and shocks of the business cycle are part of the economic reality and are as such out of our control, the intensity of these can be controlled to some extent. Imprudent and unchecked spending and lack of stringent regulation especially in the area of financial innovations have led to the current crisis, but we can look to reduce the ill-effects of subsequent crises by better regulatory mechanisms, more transparent systems, and better coordination between the government and financial institutions. This will eventually lead to a more secure and sustainable economic order. The world seems to be recovering from the current financial crisis but its effects will be echoing for years to come.