4.5.4 The Global Financial Crisis

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    The Global Financial Crisis is also referred to as the Great Recession which was the decline in world GDP in 2008-9. There were several factors which contributed to the economic decline:

     

    • Sub-prime mortgages

    These are mortgages given to those with weak credit ratings and low incomes. Confidence was high and asset prices were high and rising. This meant that banks though this would continue, and interest rates would stay low, so debtors would be able to pay. In the US especially, as safe mortgages were sold as securities to investment banks and further used to lend. When the housing bubble burst in2006 many homeowners defaulted on payments causing banks to lose large funds and had to be bailed out by the government.

     

    • Moral hazard (too big to fail)

    This is when businesses or individuals act in their own interests knowing that any problems that arise will be dealt with by other people or organisations. They have no incentive to act prudently. This is commonly when there is some insurance for problems e.g. if a house is insured, renters may be less cautious. This is present in the banking system as banks may take more risks if they know that the central bank will bail them out. The banking system is viewed as ‘too big to fail’ as the costs to the economy is too great. The financial crisis has been regarded as a moral hazard, due to the degree of risk taking.

     

    • Collapse of lending to businesses

    Banks were more cautious of lending and also those that failed meant that depositors lost their savings. This meant that small businesses who needed loans to start up were much less likely to get them, decreasing the amount of investment which had negative consequences for the economy. Businesses were unable to borrow to expand or get overdrafts which further caused cut

     

    • Speculation and market bubbles

    Speculation means buying and selling something in the expectation of a price change which generates profit. This can create market bubbles which occurred in the housing market. This caused it to be traded more, and demand exceeds supply, so the price rises beyond the intrinsic value. The bubble then ‘bursts’ when the price steeply and suddenly falls to its ordinary level. This causes panic and investors try and sell their assets.

     

    • The role of organisational culture

    There were several aspects that contributed to the recession. Sub-prime mortgages were profitable as they could charge high interest rates and banks became less concerned with caution and more with short-term profit. As well as this, there was asymmetric information as consumers were not aware of the risks of their loans. They also mis-sold items to customers when they knew it was not appropriate for the customer’s needs.

     

    THE ROLE OF BANKING REGULATION

    Banks need regulation as they have a large influence within the economy and if they failed it would have disastrous consequences. Guidelines and regulation are also used to ensure the behaviour of banks is clear to institutions and individuals who conduct business with them.

     

    After 2008, banks were more tightly regulated which included the following measures:

    • Have more equity (money from shareholders)
    • Hold larger reserves of cash to cover losses from risky loans
    • Accept limits on bonuses which encourage risky borrowing and lending

     

    Some of the regulatory bodies in the UK include the FPC, FCA and PRA which were all set up following the financial crisis. The FCA was set up in 2010 whereas the latter two were set up in 2013. However, the increased regulation of the banking sector has led to the growth of shadow banks (organisations which lend for investment). The Lehman Brothers were a shadow bank and their collapse was a catalyst for the financial crisis.

     

    IMPACT OF FINANCIAL SECTOR ON ECONOMIC AGENTS AND GOVERNMENTS

    The low trust in banks had large impacts on the rest of the economy. Low trust in banks and cautious lending meant that there was low business investment. This caused redundancies and lower consumption which caused businesses to further reduce output and fire workers. This uncertainty and low consumption caused inflation to fall and unemployment to rise.

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