Main Reasons of Financial Crisis

Introduction

According to scholars, a financial crisis is an expansive variety of situations in that some if not all of the available financial assets abruptly drop a large part of their original value(Martin and Milas, pp.443-459). Notably, in the 19th and 20th centuries, a lot of the financial crises were linked with banking panics and confusion(Kindleberger and Aliber, pp.34-89.).

Similarly, there are instances that can be referred to as a financial crisis these are the stock market crisis, sovereign defaults, currency crisis, speculative bubbles and crashes, international financial crisis and lastly wider economic crisis (Ahrend and Goujard, pp.45-89). It is important to understand that a financial crisis may result in the loss of paper wealth however it does not necessarily conclude in compelling changes in the real economy. This paper will discuss firstly, the possible causes of financial crisis. Secondly, the different impacts experienced in economies as a result of the global financial crisis and lastly evaluate some of the actual or proposed reforms available.

Causes of Financial Crisis

Leverage

According to scholars, leverage is borrowing to fund investment (Higgins, pp.34-57).This is commonly specified as the biggest contributor to a financial crisis. Too much leverage is the cause of all financial crises. Notably, leverage goes above balance sheets and also, it is ingrained in off-balance sheet apparatus for instance derivatives. Equally, the most dangerous leverage is ingrained in structured finance securities. There is no known accounting for leverage this makes it complex and beyond the competence of lawmakers to limiting it. However, the only quick fix is to establish intentional overkill, radical higher capital requirements as well as accepting the consequences.

A hypothetical example of leverage happens when an individual or a financial company only invests their own finances, in the very disturbing case the individual or the company can lose their money. However, when an individual or a financial company borrows for the purpose of investment, the two cases can potentially receive more money from their investment or even in the worst cases lose more than the available. Therefore, leverage creates the risk of bankruptcy and magnifies the hidden returns from investment.

Considering that bankruptcy is the case when a company refuses or fails to honor all the payments promised to other companies, it may result in the transfer of the financial stress from one company to the another. Particularly, the regular strength of leverage in economies usually rises before a financial crisis. For instance, margin buying (borrowing to finance assets in the stock market) become perpetually common before the Wall Street Crash in the year 1929. Equally important, selected scholars believe that financial institutions can add to the fragility by not revealing leverage and as a result adding to the underpricing of risk.

Strategic Complementarities In Financial Markets

It is often and basically observed that an outstanding investment demands each investor in a financial market to make an assumption of what the other investors in the market will do. George Soros who is one of the most renowned successful investor, an author and a political activist once called this need to assume the intentions of other investors ‘reflexivity’(Soros, pp.309-329).

Equally, John Maynard Keynes a British economist related the financial markets to a beauty challenge game in that each player must try to assume which model other players will regard as the most appropriate (Luzzetti and Ohanian, pp.34-78). Self-fulfilling prophesies and circularity may be speculated reasonable proof or reliable information is not made available because of the non-disclosure. Although, in most known case the investors have the motivation to equal their options. For instance, an individual who thinks other investors want to buy more or lots of Japanese yen may foresee the yen to escalate in value, therefore he or she has the motivation to purchase yen as well.

Equally, a depositor in Bank of Melbourne who foresees other depositors withdrawing all their money will await the bank to fail; therefore the depositor has the motivation to withdraw too. Notably, economist refers to this strategy of copying the strategies of others the strategic complementarity.

It is a common knowledge that if individuals and firms have strong incentives to undergo the same thing they expect others to undergo, then self-fulfilling predictions may occur. For example, if investors look forward to the value of the dollar to rise, this may trigger its value to rise and is depositors may expect a bank to fail, this may trigger it to fail. Hence, a financial crisis is at times viewed as a dangerous ring in which investors despise some assets or institution simply because they predict other to do so.

Asset-Liability Mismatch

Asset-liability mismatch is another common factor believed to add to the financial crises that economies or institution may face. Scholars believe that a mismatch may occur when assets that develop interest do not align with the liabilities upon which interest ought to be secured(Park, pp.43-78).

For instance, an asset financed by a liability with a contrasting maturity develops a mismatch. This risk is associated with the institution’s assets (loans) and liabilities (deposits) especially when the two are not aligned appropriately. For example, banks provide deposit account which its customers can withdraw money at any time, then the profits gathered is used to give loans to homeowners and businesses. Now a mismatch will occur when depositors panic and withdraw their money a lot more quickly than the banks can collect all their loans.

Uncertainty And Herd Behavior

Much analysis on the financial crises that have had to happen in the past have emphasized the role of investment mistakes that arise due to lack of proper knowledge and weakness in the human reasoning. Renowned economic historian Charles P. Kindleberger pointed out that major financial crises follow a technical or a financial innovation that expose investors with new or modern types of financial opportunities, which in his own term referred to this as ‘displacement of investors’ expectations’(Pons-Vignon, pp.57-89).

Some of the known examples of this include the Mississippi Bubble that occurred in the year 1720 and the South Sea Bubble also occurred in the same year. The two instances occurred when the concept of company stock investment was unfamiliar and new at the time. Recently, common financial crises come after the changes in the investment circle developed by the financial deregulation as well as the crash of the dot-com bubble in the year 2001 this began with the irrational excitement around the internet technology.

Lack of knowledge and experience in financial and technical innovations may guide and explain how investors frequently and grossly overestimate asset values. If investors in a new class of assets highly profit from the rising assets while other investors learn about the innovation, others may follow in the investment expecting to earn more profits and as a result, contributing to the rise of the prices even higher. Now if such herd behavior results in the escalation of prices above the original value of the assets, a crash may be unavoidable. On the other hand, if the price falls and the investors realize there is no other gain in the investment the opposite may happen. A price decrease may cause a rush and quick asset sale supporting the decrease in amounts.

Regulatory Failures

Governments have tried to destroy and eliminate financial crises through controlling the financial sector. The major goals and achievements of regulation or control are transparency; helping banks’ financial standing publicly known by demanding often reporting under uniform accounting routines (Financial Incentives Had No Effect on Hypertension Care in UK, pp.1-10). Similarly, regulation helps banks and financial institutions to have enough assets to meet their constitutional obligations, by capital requirements, reserve requirements as well as other restriction on leverage.

It is important to note that some financial crises have been directed to inadequate control, and have helped transformation in regulation in order to avert repetition. For instance, the former International Monetary Fund (IMF) managing director Mr. Dominique Strauss-Kahn blamed the 2008 financial crisis on regulatory deficiency to protect against risk-taking in the financial structures, more importantly in the United States. However, exaggerated regulation has also been named as a potential motivation for financial crises. To demonstrate, the Basel II Accord has been castigated for demanding financial institution to increase their capital when there is a risk, in return this might cause the banks to reduce lending specifically when capital is limited potentially provoking a financial crisis.

Global Financial Crisis (GFC)

The global financial crisis was first experienced in July 2007 with an economic condition in which the investment capitals become hard to find (credit crunch), and a liquidity crisis caused by the loss of confidence by the investors in the monetary worth of sub-prime mortgages(Taylor and Clarida, pp.45-90). As a result, the US Federal Bank injected a large amount of capital in the financial markets. By end of 2008, the financial crisis had escalated leading to the crashing of stock markets around the world. The consumer confidence fell as individuals narrowed their belts in the anxiety of the future.

The GFC of the year 2008 was compared to as a sledgehammer pointed at the glass screen of the world’s economy. In many different ways, the world is still trying to get back to balanced position. Evidently, the GFC was felt by every generation and memories and visions of businesses in ruins is stripped open and will never be forgotten nearly. The question every individual is asking can it happen again? And how well are the people prepared to incase this financial Armageddon befalls again?

Ten years ago the Dominos began falling from poor bets on the US subprime mortgage market. Firstly, the Bear Stearns and then the Lehman Brothers collapsed. The GFC that set the world ablaze has up to now left many sectors trying to set up their foundation again from the grassroots. The comparison of what was experienced in the United States and what followed knocked down the world as well as the current stands in Australia emerge gloomy on the surface. It is important to note that America was over-reliant on household loans in that instance, with 98% of its GDP being summed up by mortgages.

Australia now stands at 123% of GDP which is the second highest in the world or similarly it is the second wealthiest country in term of wealth per adult. However, the Australian financial system is improbable or unlikely to collapse is that the Reserve Bank of Australia is keenly monitoring the bank rates as well as ensuring the financial institutions remain workable. Notably, the biggest factor that supported the GFC was that loans were being given to people who never had a chance to pay them back.

The Impact of GFC on Economies

The impact felt by different economies after the GFC was as follows lost outputs, lost exports, lost remittances, lost aid especially in the third world economies, lost capital inflow and so on. Resulting from the global financial crisis was that emerging as well as developing economies across the globe faced a steep slowdown in output success. It was noted that the real GDP of both the emerging and the developing economies dragged from 8.3% in 2007 to 6.1% in 2008 and later to 2.4% in the year 2009. The real GDP of nations in the CIS (Commonwealth of Independent States), CEE (Central and Eastern Europe), as well as the western hemisphere weakened in the year 2009 although in developing sub-Saharan Africa, Asia, as well as the middle east real GDP was experienced below average rates in the years running to the financial crisis.

Actual or Proposed Reforms

The world economy has marked progress five years later, world unemployment is down, and credit is available also the home prices are up. However, in order to protect the economy against the financial crisis experienced there is still a lot that will have to be accomplished.

Firstly, the regulatory and the authorities concerned must ensure that the economic recovery reaches both the small businesses and the middle class. The current policy of asset investment commonly known as quantitative easing, which practiced by the Federal Reserve has managed to reduce unemployment kept the interest rates low as well as strengthened the economy. However, to support this policy, there is a need to move from the now fiscal policy which in many instances has proved to oppose this goal. This entails giving relief to the people facing foreclosure and encouraging options that make student credit compensation more manageable for borrowers.