Global Financial Crisis-causes and Remedies

Introduction

After the collapse of the twin towers and the tech bubble the American economy was in dire need of a stimulus. The Fed under Alan Greenspan reacted to this crisis by pumping liquidity into the system. This response would have worked well under normal circumstances, since it helps in the growth of the economy, however since due to previous overinvestments in the economy the extra money was not put to productive use. The central role that finance plays in upholding the American economy led to the collapse of a few financial institutions imperilling the economic system of the country and eventually the world. America's financial system failed in its two crucial responsibilities: managing risk and allocating capital leading to the current global recession the world in facing today. ( Stiglitz, 2008 ).

This essay is structured in four parts , the first dealing with the background of the preceding years leading to the crisis. The second part tackles the causes of the financial crisis followed by the solution that can be adopted by the United Kingdom to prevent a recurrence of such a crisis in the future. The final paragraph of the essay is the conclusion that concentrates on the global cooperation that is essential for this financial crisis.

The Post Industrial Society:

The paradigm shift from an industrial society to a post industrial one had a major implication on the global crisis that was about to come. This resulted in a majority of the labour force being involved in the service industry rather than in the manufacturing sector. The structure of the capitalist economy was altered because more than 60% of the workforce today is employed in the service sector and less than 10% in the agriculture and manufacturing sector. This impacted the employment relationships between the large corporations and the millions of blue collared workers in the country. The long-term mutual obligations of old were replaced by expectations of more temporary attachments ( Davis,2009,p.28 ).The practice of off-shoring to countries offering cheap labour that began during that time also aggravated the problem further. This shift was reflected in the eventual bankruptcy of large auto manufacturing industries in the country.

The rise in pension funds:

During the 1980's most companies provided pensions to their employees through a system of “defined-benefit” plans that paid retirees benefits according to their tenure with the company" ( Davis, 2009, p. 31 ).This changed in the early 1980's with the 401 ( k ) plan in which employees were responsible in making investments based on the options offered to them by the corporations. This change helped promote the development of mutual funds as an attractive investment option. This system came to be known as defined-contribution pension plans and resulted in the mutual fund companies becoming "the most prominent owners of corporate America" ( Davis , 2009,p.32 ).These companies were shareholders in many of the companies and this resulted in a complex interconnected financial system which would have severe repercussions later on the American economy.

Securitization:

The traditional model of banking was replaced by a system called securitization which meant that assets were turned in securities and traded in the market ( Davis,2009,.35). Securitization inthemortgage market involvesthepoolingofmortgages into mortgage‐backed securities (MBSs) in whichtheholderof these securities is entitled to some fractionofalltheinterest and principal paid out bytheportfolioofloans. Someofthese securities are straight pass‐through, while others are collateralized mortgage obligations (CMOs) or collateralized debt obligations (CDOs) in whichthepools are trenched and cash flows get paid out according to some priority structure ( Archarya and Richardson, 2009,p.62  ).Mortgage backed bonds were the best form of this system. This resulted in a tangled financial system in which there was little differentiation between traditional commercial banking and the investment banks that sprouted later. Everything from student loans to life insurance schemes got involved in the complex American financial system. Because of this system individuals as well as corporations got entangled and were caught in the web of this financial world and were to be affected when the financial crisis hit the economy.

Subprime problem :

the 2008 financial collapse originated with a political effort to expand mortgage lending to consumers who could not meet normal standards of creditworthiness ( Yandle,2010,p.346 ).In an attempt to make home ownership more affordable interest rates were lowered for potential buyers and in many cases there were no checks initiated to see whether the customer was financially capable of repaying the loan. The risk assessment methods that were used by the banks were deeply flawed under this system. Borrowers were told not to worry about paying the ever mounting debt, because house prices would keep appreciating.( Stiglitz, 2008 ). However the housing bubble crashed and this resulted in a lot of home owners unable to payback the loan and the financial institutions also unable to profit from the assets that they held. Because these mortgages were ingrained and were at the core of the American financial system it resulted in a subprime mortgage problem causing the crash of the entire economy.

Proposals to prevent recurrence of financial crisis:

The policies and measures that should be adopted to avoid another crisis should focus on macro and micro issues that have arisen due to the crisis. The micro management involves supervision of individual institutions and banks, whereas the wider policies at the national level should tackle the systemic problem in the financial sector in the country.

Regulation of the financial sector:

The framework for ensuring efficient regulation should be based upon curbing the unnecessary risk taking incentives that caused the crisis. Given their inherently high leverage andtheease with whichtherisk profileoffinancialassets can be altered, banks andfinancialinstitutions have incentives to take on excessive risks ( Archarya et al,2009, p.110 ). A strong governance from the Financial Services Authority in the UK should be adopted to prevent such practices. This should be coupled with a stringent internal governance system adopted by the financial institutions themselves to prevent collapse and bankruptcy. Because of the global scale of this problem, in terms of the British context it will be easier to implement this type of regulation if it supports the development of a single financial market within the EU. Irregularity in the implementation of regulations between the different member will undermine the effectiveness of the regulatory proposals (European Union Committee, 2008, p.11 ).

State aid in the financial crisis:

The bailout that has been a major government intervention as a measure to prevent the spread of the crisis. These have included nationalisation as well as recapitalisation of banks and in some cases purchase of the defaulted assets by the government. However it must be understood that these practices must not serve as an encouragement to the financial institutions to return to their old practices. This federal policy of providing aid should not encourage a recurrence of inefficient risk management decisions by firms (Poole,2007,p.149 ). The other step that should be taken by the government is too avoid infusing the economy with too much liquidity. As a lender of the last resort the government must ensure that such a solution may in fact prolong the solvency crisis.

Control of the shadow banking sector:

The financial crisis has been a problem of traditional banks as well as shadow banks. The government should ensure that financial trading between such institutions must be controlled. The toxic loans that these institutions dealt in should not be allowed to be spread this time around. Along with traditional banks there should be efficient regulation of the bad accounting practices and poor underwriting standards in such lending institutions within the UK by the FSA. Along with such macro policies individuals' brokers should also be supervised as a micro management of this crisis. 

Conclusion:

Given the global nature of the financial crisis the solutions that must be adopted should on a global level. Individual nations must not retreat form an international solution and try to implement regional policies. This will prove to be a setback than a way forward in tackling this problem. Consumers as well as institutions that thrive on interaction within the financial network will be thwarted by such efforts. Transparency between the various regulatory and financial bodies should also be encouraged to prevent another crisis. Involving global partners and seeking multi lateral solutions are critical if we are to reach a common goal of financial stability in the near future.

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