Causes and Consequences of Crises in the Financial Markets - Essay Example

?Financial Marketing Table of Contents Table of Contents 2 Part A: Causes and Consequences of Crises in the Financial Markets 3 A The ‘Credit Crunch’ 3 A.2: Mechanics of the Crunch 4 A.3: Responsibility for the Crunch 7 Part B: The Political Economy of Financial Markets 10 B.1: The Contribution Which a Well-Functioning Financial Market Can Make To an Economy 10 B.2: The Role of Global Financial Markets in Economic Globalization and an Evaluation of the Gainers and Losers of Such Economic Developments 11 References 14 Part A: Causes and Consequences of Crises in the Financial Markets A.1: The ‘Credit Crunch’ A credit crunch is usually identified as a reduction in the availability of loan or credit in an economy. It is also recognised as a situation wherein individuals face difficulty in obtaining loans from banks. It is identified as an economic condition wherein certain difficulties are faced in obtaining loans along with investment capital by the financial institutions. In relation to the situation of credit crunch, it is usually observed that lenders are unable to provide adequate credits to borrowers, resulting in lessening their purchasing power. The term ‘credit crunch’ is recognised as a sudden restriction in the availability of various elements linked with credits or loans that include credit cards, inter-bank lending along with mortgages due to lack of financial liquidity. Thus, credit crunch is a situation wherein the availability of loans reduces by a considerable extent and accordingly, results into the condition of depression or recession (Cava, 2013). The quotation ‘‘… the 2007 credit crunch is generally considered to have been triggered by losses on subprime mortgages in the USA, but its impact was too wide and too deep to be explained by losses in that sector alone” imply shortage of credit in the US economy (Pilbeam, 2010, pp. 427). This particular concern or issue i.e. credit crunch was commenced in the United States (US) during the year 2007 due to certain factors that eventually led towards the aforesaid critical situation. In this regard, it has been identified that the lenders in the US economy have been facing adequate challenges in recovering their loans leading to bad debt mortgages. Additionally, credit rating failures in the economy caused massive fluctuations to the disposable income within the US economy, during the period 2007-2008. The fluctuation in the disposable income led to massive fluctuations in sub-prime lending, affecting the housing market of the US severely. The losses in relation to sub-prime mortgages also adversely affected the financial market as the financial institutions were unable to repay the increased debt in the housing sector of the US. The subprime mortgages have unfavourably affected the financial system of the US as the customers along with the investors lost confidence in their approaches due to lack of obtaining credits or loans in the economy. It has been conceived that the credit crunch in the US economy mainly caused due to the structure of an inappropriate interest rate policy designed by Federal Reserve (Whalen, 2008). Therefore, based on the above discussion, it can be ascertained that the effect of credit crunch eventually led towards the development of crisis situation in the US and ultimately affected the global economy at large. A.2: Mechanics of the Crunch Credit crunch in the US has led to the development of global crisis, which adversely affected the financial markets of other countries and also impacted the world economy. It has been identified that the interest rates in the US were quite high for a longer time period i.e. during the period 2003-2006. In this context, a constant rise in the interest rates has led to the development of inflation condition in the US. The rise in the interest rates has unfavourably affected the prices in the housing market in the final quarter of the year 2006. Subsequently, the combination of factors including increasing interest rates and declined value of the housing market in the US have made the subprime lending policy of poor quality that eventually raised the instances of defaults in subprime mortgages. In the end of the year 2006, the increased instances of mortgage defaults have reduced the value of subprime ‘mortgage backed securities’ (MBS). In this regard, the decline in the mortgage market has unfavourably affected the financial institutions operating in the US (Parkinson & et. al., 2009). These can be regarded as the ways explaining about how problems in the USA sub-prime mortgage market led towards the crisis in the financial markets along with the global economy. The period of 2007-2008 witnessed a complex credit crunch situation due to the aspect of financial innovation, which has facilitated in developing effective procedures of packaging along with reselling financial assets with new securities. The subprime mortgage segment in the US can be apparently observed offering nonstandard mortgages to individuals possessing instable income as well as credit profiles. In this regard, the banks failed in recovering their debts of loans during the crisis situation. The main cause of the crisis can be apparently recognised as the misconception of risks relating to the packaging as well as reselling financial assets. Consequently, the new financial assets that have been developed in accordance with the policies associated with subprime as well as other mortgages were of low quality that further unfavourably affected the US banking sector. The financial assets were developed as a procedure of forming credit insurance, which was recognised as ‘credit default swaps’ (CDS). These as the form of new assets were provided to the investors as repacked debt securities, which further raised complexities in the overall financial system of the US. These financial assets were offered in the market segment as highly rated assets and would provide by the rating agencies. But the newly developed financial assets were not safe as these assets had been associated with the housing market of the US which declined in a rapid manner. Respectively, a fall in the prices of house also led to the decline in value of these assets, which increased mortgage defaults at large. Additionally, the investors of these new assets leveraged with other securitised assets with the objective of recovering their respective mortgages. Contextually, the risks along with the losses that were attached with these financial assets have adversely affected financial along with money markets by a significant extent. Moreover, the banking system in the US was ineffective in reviving the economic along with the market conditions. In this context, lack of credit availability in the US has led to the development of credit crunch, which was further accountable for developing the crisis in the economy (Mizen, 2008). There are various factors that are accountable for worsening the crisis situation and predating of this financial crisis on a global context. It has been identified that the US housing price has augmented by a greater degree during the period 2007-2008. Contextually, the US economy faced with the conditions of increased defaults in relation to subprime lending and other US mortgages. There are various banking institutions such as Paribas and UBS among others that failed in obtaining adequate hedge funds associated with MBS market with the intention of recovering subprime debt and demonstrated heavy losses due to low quality mortgage generation policies and securities. Additionally, the availability of credit in the economy has decreased the confidence amid the financial institutions due to the losses suffered from the housing market and subprime lending. In this regard, inter-bank lending rates has increased and further led to the decline in the inter-bank lending market. The banking sector has also been viewed to be declined in inter-bank lending process due to the fear that the financial institutions would be unfavourably affected from writing-down of assets that include commercial property as well as corporate bonds among others. In this context, the US banking sector faced adequate challenges in relation to liquidity crisis. Subsequently, it has been viewed that the liquidity crisis of banks has extended the number of mortgage lenders on a global context. The financial crisis in the US has mainly affected the countries whose financial markets along with the investors are associated with the US business market conditions. The global economy has been affected as the equity market tumbled unfavourably, imposing extensive impact upon real world economy at large. Additionally, the deprived trade operations in the US market have further intensified the crisis situation on a global context. The global trade operations have been affected owing to the reason that import as well as export activities of the US have declined due to uneven market conditions. In this manner, it can be affirmed from a broader understanding that a crisis in the financial markets has eventually turned into a crisis in the real world economy (Fratianni & Morchionne, 2009). A.3: Responsibility for the Crunch The crunch in relation to subprime mortgage mainly occurred due to fall in the US housing market and inappropriate banking policies along with regulations of the financial sector. The crisis resulted into generating various disruptive conditions such as declined interest rates, inappropriate financial regulation and inefficient financial structure among others. These factors are deemed to be the imperative factors that are accountable for the development of the crisis situation. In this regard, it can be apparently observed that the financial institutions are affected largely due to the prevalence of high inflation rates that has been rising on a continuous basis from the period 2003 to 2006. It can be affirmed that these factors were further accountable for adversely affecting the market conditions and the financial system. The interest rates are observed to be high and consequently, the prices of the housing markets increased in an immense manner. The housing bubble resulted as the homeowners refinanced their houses at low interest rates. The prices of houses declined sharply and in this regard, the management and the governance of banks with inappropriate analysis provided low financial assets and loans at low interest rates that eventually increased credit availability in the market. Subsequently, the aforementioned factors have led towards the growth of instable market conditions due to the availability of low quality financial assets and securities to people with inadequate credit profiles. Contextually, the banks with the provision of low quality financial assets were unable to recover their debts and mortgages. The financial institutions have developed certain effective financial products such as MBS with the intention of spreading the financial risks that are associated with subprime mortgages. This would eventually aid in recovering the financial institutions from the crisis situation. The aforementioned aspect is often recognised as the notion of financial innovation. Financial innovation has been taken into concern in this regard with the aim of transferring credit risks associated with banking sector with the development of new securities. The poor quality bonds, securities and assets have increased the instances of defaults in recovering the mortgages from the markets. In this respect, the increased mortgage defaults have intensified the crisis situation by a greater extent (Parkinson & et. al., 2009). The accountants and the auditors who produced the financial statements of certain relevant institutions can also be held responsible for affecting the economic along with the market conditions of the US by a certain degree. The financial innovations on the basis of which new financial assets are offered to the investors are provided with good ratings. The auditors and the accountants in order to recover the banks from the rising financial debts transferred inappropriate assets from the banks’ balance sheets, which further led towards the development of complex along with opaque assets. Moreover, the accountants along with the auditors have been identified to fail in assessing the risks that are attached with the financial innovation technique. The auditors were also ascertained to be using inappropriate fair value accounting approach in assets pricing. Contextually, the auditors failed in analysing the risks that are attached with financial assets offered in the market segments, leading towards undercapitalisation of the financial sector as a whole. In this respect, the issues concerning inappropriate financial assets have further intensified the financial crisis situation and adversely affected the financial system. The individuals associated with the operations of financial institutions have been involved in conducting malpractices along with fraudulent activities in terms of providing inadequate financial information. Contextually, the misrepresentations and fraudulent acts in the financial reports are seemed to adversely affect the performance of financial institutions in the long run (Fratianni & Morchionne, 2009). The national, regional along with the global regulators are recognised to be playing effective role in seeking that the operations of financial systems are executed in accordance with which financial information should be recorded, measured as well as disclosed. But the regulators are observed to be ineffective in their approaches to analyse and determine the risks that are associated with new financial assets and securities that further intensified the credit crunch situation (Tarca, 2012). Part B: The Political Economy of Financial Markets B.1: The Contribution Which a Well-Functioning Financial Market Can Make To an Economy Well-functioning financial markets are recognised to be playing effective role in developing a healthy along with a balanced economy. Moreover, apart from these, these sorts of markets facilitate in better flow of monetary policy in an economy. Contextually, these markets also assist an economy to develop economically with better stability on a long-term basis. The markets are also considered to be playing significant role in minimising risks and developing financial stability in an economy. In this respect, it can be affirmed that well-functioning financial markets are essential consideration towards the development of stabilised conditions in relation to price and economic variables (The Central Bank of Iceland, 2008). In a well-functioning financial market, capital flows in an effective manner from the lenders to the borrowers. Investors with adequate financial funds offer capital to appropriate borrowers who require those funds essentially. This sort of market eventually facilitate the lenders as well as the borrowers in meeting their respective financial needs with the assistance of financial intermediary or directly. The market segments that are financially developed facilitate firms in performing their business operations successfully with better expansion opportunity. Additionally, the consumers in well-functioning financial markets are offered with efficient credit facility. Well-functioning financial markets assist in developing better confidence amid investors with the availability of efficient performing financial institutions, developed financial markets along with appropriate financial instruments (State University of New York, n.d.). Well-functioning financial markets provide ample opportunities towards developing stabilised financial conditions in an economy. However, it can be affirmed certain damages can be caused when such markets breakdown or don not function normally. These damages can be apparently observed in the form of various risks that include systematic risks, credit risks, legal risks, operational risks and liquidity risks among others. The financial markets that are well-functioning are fundamentally based on complex transactions of high monetary values along with volumes. In this regard, the financial markets might face the risks of obtaining obligations within due period that may rise due to liquidity collateral issues. In addition, the lenders along with the borrowers may face the issue of credit risks and other risks due to unsettled financial transactions. In terms of the significance of meeting the requirements of surplus and deficit agents, liquidity risks can be taken into concern. This implies that individuals and firms may face adequate challenges in meeting their financial obligations due to insufficient funds. The breakdown of well-functioning financial markets might adversely affect the business operations of firms due to increased level of expenses and the availability of inadequate capital (BIS, 2012). B.2: The Role of Global Financial Markets in Economic Globalization and an Evaluation of the Gainers and Losers of Such Economic Developments Financial globalisation develops a linkage through which capitals are aided to flow in an appropriate manner on a global context. Globalisation provides better opportunities in relation to develop economic along with societal conditions on the basis of which an efficient integration is developed within an economy. In this regard, ‘World Trade Organisation’ (WTO) has developed free trade policies, which facilitates in better flow of goods along with services in an unrestricted manner. The free trade policies have minimised trade barriers and raised openness of different economies leading towards the conduct of better trade operations. In this respect, countries are facilitated with the opportunity of producing goods along with services based on the concept of comparative advantage, which implies that countries produces goods or services with the assistance of abundant resources that are accessible within them. Respectively, the free trade policies assist countries in developing best products with effective designs at an economical rate. It has been argued that the trade policies developed by WTO have been identified to form the situations such as increased business market competition, enhanced innovation and augmented free trade among others (World Trade Organisation, 2013). In this regard, it can be comprehended that countries with the availability of various assets like human capital, industrial sector development and free financial markets among others are offered with the opportunity of developing efficient products or services economically that are traded in other countries proficiently. However, it has been argued that the free trade policies of the WTO impose unfavourable impact, which can be measured in terms of increased level of business market competition amid domestic and international firms in the realm of producing innovative products with the assistance of advanced technologies. Moreover, the increased competition on a global context has encouraged the governments of developed countries in formulating different effective policies on the basis of which trade operations should be conducted. In this respect, the government of these nations tend to acquire short-term gains through subsidies, red tape complexities and other environmental associated policies. On the other hand, the government increases the cost of trade operations, raising complexities in trade operations at large. In this similar context, free financial markets are identified to possess various sorts of uncertainties and risks that might arise due to government intervention and increased level of credit along with liquidity risks among others that may adversely affect the stable financial conditions of an economy. Additionally, it has also been argued that increased competition and trade complexity have augmented the chances of providing consumers in different market segments with out-dated along with unattractive products by bloated as well as inefficient producers. In this respect, it has been observed that the aforementioned factors are accountable for closed down of different industries. Subsequently, increased competition due to free trade policies is also held responsible for augmenting unemployment rate. It is argued in this context that financial markets and trade policies are effective for the development and the integration of global economy. The integration of global economy will further facilitate in developing the world economy. But the factors such as competition and government intervention might impose unfavourable impact especially on global economy and trade operations by a certain degree (World Trade Organisation, 2013). Thus, it can be ascertained that free trade policies along with free financial markets have eventually contributed in facilitating the development of a global economy and at the same time raising complexities in the trade operations as well. References BIS, 2012. Principles for Financial Market Infrastructures. Committee on Payment and Settlement Systems. [Online] Available at: http://www.bis.org/publ/cpss101a.pdf [Accessed December 15, 2013]. Cava, 2013. Liquidity Shocks and the US Housing Credit Crisis of 2007–2008. Research Discussion Paper. [Online] Available at: http://www.rba.gov.au/publications/rdp/2013/pdf/rdp2013-05.pdf [Accessed December 15, 2013]. Fratianni, M. & Morchionne, F., 2009. The Role of Banks in the Subprime Financial Crisis. MOFIR. [Online] Available at: http://docs.dises.univpm.it/web/quaderni/pdfmofir/Mofir023.pdf [Accessed December 15, 2013]. Mizen, P., 2008. The Credit Crunch of 2007-2008: A Discussion of the Background, Market Reactions, and Policy Responses. Federal Reserve Bank of St. Louis Review, Vol. 90, No. 5, pp. 531-568. Parkinson, M. & et. al., 2009. The Credit Crunch and Regeneration: Impact and Implications. An Independent Report to the Department for Communities and Local Government. [Online] Available at: https://www.ljmu.ac.uk/EIUA/EIUA_Docs/The_Credit_Crunch_and_Regeneration_Impact_an_Implications(1).pdf [Accessed December 15, 2013]. Pilbeam, K., 2010. Finance and Financial Markets. Palgrave MacMillan. State University of New York, No Date. Financial Instruments, Financial Markets, and Financial Institutions. Chapter 3. [Online] Available at: http://www.oswego.edu/~edunne/340ch3.htm [Accessed December 15, 2013]. Tarca, A., 2012. The Case for Global Accounting Standards: Arguments and Evidence. Documents. [Online] Available at: http://www.ifrs.org/Use-around-the-world/Documents/Case-for-Global-Accounting-Standards-Arguments-and-Evidence.pdf [Accessed December 15, 2013]. The Central Bank of Iceland, 2008. The Importance of Well-Functioning Financial Markets. BOX III-1. [Online] Available at: http://www.cb.is/lisalib/getfile.aspx?itemid=6309 [Accessed December 15, 2013]. Whalen, C. J., 2008. The Credit Crunch: A Minsky Moment. The Credit Crunch of 2007. [Online] Available at: http://www.mps.it/NR/rdonlyres/D27537E2-FE99-4675-BC4E-9186DF4B924B/28637/Whalen.pdf [Accessed December 15, 2013]. World Trade Organisation, 2013. Understanding the WTO: Basics. The Case for Open Trade. [Online] Available at: http://www.wto.org/english/thewto_e/whatis_e/tif_e/fact3_e.htm [Accessed December 15, 2013]. Read More