The Financial Crisis and Its Impact on The Economy

Introduction

A financial crisis is a situation in the global scale economy when there is a short-term termination of massive fiscal contracts causing a wide range of turmoil within the financial sector (Allen, 2012). A financial crisis is characterized by high levels bankruptcy within the banking institutions and a significant decrease in the values of assets. Usually, a crisis in the financial sector affects global scale economy causing substantial consequences economic activities resulting to an extensive recession coupled with low investments and employment rates (Cihak, 2013).

The classification of the financial crisis can be categorized into three major categories which include, debt crisis, banking crisis and currency crisis (Salotti, 2015). Nonetheless, this categorization is not primarily exclusive since some financial crisis is "twin crises." Twin financial crisis occurs when the currency depreciates worsening the banking sector's problem through the financial institution's exposure to foreign currency (Shleifer, 2010). Therefore, a crisis within the banking sector occurs when the financial markets experiences a considerable number of defaults, hence experiencing challenges in repaying contracts on real-time (Reinhart, 2011).

For instance, the 1930's Great Depression impacted much the reputation of the macroeconomic theory and by extension affecting the financial markets and institutions (Garcia, 2013). As a result, the outbreak of the 2008's financial crisis changed not only the various financial institutions, but also, the crisis stretched further to influence the theories and long-held norms, beliefs, and principles with regards to regulation of financial systems. Consequently, the structural organization of the financial system focused more on supervising and reforming the regulations of macro-prudential (Piskorski, 2010).

As a result, the financial regulatory reforms sparked a vibrant debate among various financial markets and institutions, academics and practitioners. Subsequently, the Basel Committee initiated a consultative document to evaluate the significance of the role of financial markets and institutions (Kim, 2013). The committee focused on stabilizing of the financial systems arguing that the cost of the new financial regulatory reforms will be relatively cheaper as compared to the relative benefits (Kim, 2013).

However, contrary to the Basel committee arguments, the banking industry was in support of the position that the new financial regulatory reforms would adversely cripple economic growth as a result of financial intermediaries’ high costs in turn on economic systems (Allen, 2012). Nonetheless, some academic and practitioners argue that the financial principles and beliefs subscribed by the Basel Committee are more likely to guarantee a more resilient financial system (Cihak, 2013).

Therefore, it's essential to evaluate a wide range of banking indicators such as the funding strategy, regulation, business model, market structure and stability so as to assess the causes of an occurrence of a crisis within the financial industry as witnessed in 2007-2009.Moreover, an assessment on the banking sector’s stability, efficiency, profitability and the quality and measure of financial globalization would be helpful in as a far as explaining and consequently evaluating the financial crisis of 2007-2009 ex-post incidence is concerned.

Determinants of Financial Crises

According to the study conducted by Allen on Financial crisis, structure, and reform, the global financial crisis of 2007-2008 was primarily contributed by various factors of financial markets and institution such as financial innovations, restrictions and the regulatory measures (Allen, 2012).

The liberalization and deregulation of financial institutions played a more significant role in creating a financial crisis as a result of the failure on the part of the regulators to control and leverage various risks and uncertainties within the banking industry (Allen, 2012). For instance, multiple activities of the "shadow investment scheme" primarily by the non-bank commercial organizations such as the investment banks were not subjected to strict financial regulations as depository banks. Consequently, fiscal innovations and securitization contributed to accelerating asset booms leading to an increase in the level of leverage.

Financial Regulatory Reforms

A study conducted by Kim on the regulatory reforms within the commercial institutions indicated, that consumers tend to have a productive capacity of monitoring complex financial products (Kim, 2013). Thus, prudent and suitable financial regulatory reforms are significant with regards to maintaining and stabilizing of the financial markets and institutions (Kim, 2013). Nonetheless, some academic scholars and practitioner argue that stringent economic regulations and supervisions are critical in the general overview of the role of financial regulations, while others support lax oversight (Piskorski, 2010).

As a result, some of the financial regulatory reforms have been implemented within the banking industry. However, they vary from different countries. Among the applied regulatory measure includes private-sector monitoring of banks and capital regulations on the minimum amount requirement (Salotti, 2015). Moreover, key indices such as guidelines on procedures of diversifying assets and liabilities and been added to the regulatory measures.

According to Garcia, the complexity of financial tools especially for transferring of risks contributed to the vulnerability of the banking institutions and more vulnerable to small stocks (Garcia, 2013). As a result, sensible supervisory restrictions on the financial transactions become more crucial in ensuring stability within the financial industry. His findings indicated that a financial crisis could be contained by strict entry requirements. However, Reinhart argues that a banking system with firm entry requirements increases its soundness ability. This is because current entry requirements safeguard the banking industry by preventing it from taking excessive risks, and thus facilitating a competitive banking environments (Reinhart, 2011).

Measures of Determinants

Regulation

The study conducted by Salotti on The resolution of failed banks during the crisis supervised the financial regulatory reforms within the banking sector for 143 countries (Salotti, 2015). The findings showed that the regulatory restrictions within the banking sector regarding insurance, real estate market and securities contributed mainly to the 2007-2009 financial crisis. This is because there were no strict entry requirements. Typically, entry requirements indicate what one requires to obtain a banking license, contrary to diversification which evaluates the suitability and correct procedures and guidelines for making asset diversification and allowing the bank to give loans to foreign countries.

Usually, investment regulation measures the extent to which banking institutions adopts supervisory limitations particularly on the required assets. On the other hand, private monitoring measured the degree to which financial regulatory reforms allows private banking sector keep a close look on commercial institutions. Therefore, according to the research conducted by Shleifer, capital regulations can also lead to a financial crisis. This is because tightened regulations on capital destabilize the financial institution.

A study on Unstable banking, conducted by Shleifer, revealed that the measure of government-owned financial institutions has a higher degree to which the assets of the banking sector are held by the government. Consequently, financial institutions that are owned by the government are more likely to experience a crisis. This is because some officials within the state may lack adequate competency in running the institution and hence making the banking institution less competitive. A less competitive banking sector is weak, making it difficult for the country to defend its local currency when a crisis is experienced in foreign exchange markets.

Financial Innovation

Among the many studies conducted regarding the causes of a crisis within the financial sector, only a few explore the effects of advancements within the financial industry. This may be as a result of the vagueness of the definition of financial innovation or lack of the readily existing information (Piskorski, 2010).

Various studies on financial innovation mostly use the number of patents to measure the level of innovation. Therefore, the pragmatic approach adopted by this study managed to efficiently calculate the aggregate index as a proxy which was used to assess the extent at which advancements within the financial industry in each particular country. The study used the available cross-country data to create a single representation to determine the impact of financial modernization with regards to the role played by financial markets in the causes of a turmoil within the banking sector in 2007-2009.

Financial Crisis in 2007-2009

The global economic crisis of 2007-2009 lead to a worldwide collapse of the economy and subsequent a consequent loss of assurance in the financial scheme (Cihak, 2013). However, notwithstanding a few critical positive economic indicators, the world's economy remained uncertain and fragile. The recent global financial crisis has to lead to a drastic economic downfall spreading from one country to the other. For instance, in the case of the sovereign debt crisis in Greece, several countries in Europe and beyond experienced severe and contagious effects as a result of the crisis.

However, the severity extent of the impact of the financial crisis various from one country to the other. Therefore, this raises a fundamental research question of assessing and determining the key factors that affect the degree and frequency of an occurrence of a turmoil within the financial sector and by extension the causes of a financial crisis within the banking industry in 2007-2009.

Several studies conducted by academic scholars, practitioners and the financial markets and institutions have indicated that the hyperactive advancement within the banking industry and deregulation in the commercial sector have been attributed by different types of crisis especially in the recent decades (Allen, 2012). For instance, the failure of the regulatory and supervisory financial agencies to keep abreast of the fast developing of the financial sector, its products and practices have played a significant role in intensifying the financial crises. Moreover, investment and lending guidelines and regulations by some banking organizations in past years might have contributed to the recent financial crisis and consequently stemming up the tax regulations on the banking industry.

On the contrary, Eichengreen and Portes (1987) argues that financial regulatory reforms play a significant role in assessing the causes of, and the resolutions of financial markets and institutions. As a result, healthy and sound financial, organizational forms and institutional framework contributes adversely to stabilizing the markets with the financial industry by reducing the hazardous difficulties usually related with irregular statistics. Additionally, the financial crisis within the banking industry can be as a result of some restrictions on various activities within the financial sector, hence the bank rendered ineffective with regards to diversifying its financial operations to decrease uncertainties.

Financial innovations particularly the mortgage-backed securities and collateral debt obligations led to a boom in credit operations and the subsequent bubble in assets of financial institutions. This is because uncertainties related with the fundamental assets of the financial institution are transferred to the investors. Additionally, derivatives such as credit defaults swaps are used to protect the financial system against cases of loan or bond defaulters. Nonetheless, they expose the banking sector to systemic risks and uncertainties over-reliance on leverage and speculative investments.

Conclusion

The studies conducted have managed to examine various types of financial innovations and regulatory measures extensively and on the recent financial crisis. The sampling procedure of the study is also appropriate as over 132 countries selected from a global dataset took part in the study. This enhances and guarantees the accuracy of the results.

Therefore, as demonstrated by the empirical findings on the results of economic principles and modernizations variables with regards to the financial crisis are intricate than the suggestions by the present studies. As a result, it's somewhat difficult to make the conclusions on the significance of the financial modernizations in the banking industry. However, fiscal supervisory procedures such as strengthened entry requirements and strict restrictions on financial activities have lowered the probability of banking crisis. Additionally, government ownership of banks and suitable capital regulations contributes to reducing the likelihoods of currency crises. Nonetheless, official supervisory power may lead to a negative impact on the financial sector resulting in a currency crisis.

Moreover, through this study, some of the financial regulatory reforms have been combined, thus countervailing the effects on the financial stability. For instance, implementing firm entry requirements can contain a crisis within the banking sector. Also, it can exacerbate the crisis if its implementation is simultaneous with greater diversification. Moreover, the study has demonstrated further that excessive reliance on the use of economic innovations lead to the recent crisis within commercial institutions.

Also, in as much as the study has managed to shade some light in the causes of a turmoil within the financial sector, it’s vital to conduct reforms on some of the innovations within the banking sector such as private equity in the near future. This is because the effects on the various innovations within the financial industry depends on different types of crisis in the banking sector, and thus, proper assessment of the environment condition will be helpful in stabilizing financial sector without stifling innovation. Also, the study ought to have extended its perspective and overview a more extended time lag. For instance, the study reports the problem on reverse causativeness by using the supervisory information of 2007-2009 crisis. As a result, the findings might be incorrect because of a much longer period of time concerning implementing the regulatory reforms and the detecting the consequences in financial industry.

Finally, the findings of this study encourage academic scholars, practitioners and future researchers in financial markets and institution field to consider the significance of the origin of financial stocks from emerging and advanced market economies. Taking advantage of the rapid growth rate of emerging market economies in the global economic scale and commercial scene, its expected of them to increase the influence of emerging market economies in international financial industry.