Financial Markets 2018/07 Timezone Group 2 – Q Group Work Submission
Submission 1: The Global Financial Crisis
The Global Financial Crisis (GFC) refers to the longest and deepest recession in generations, as described
by leading economists, that affected the global economy from December 2007 to early 2009. A downturn
in the US housing market, acted as a catalyst for GFC that spread from the United States of America(USA)
to the rest of the world through linkages in the global financial system. Many banks and fund management
institutions around the world incurred huge losses and relied on government support to avoid bankruptcy.
Due to deregulations in the financial industry with the enactment of laws such as The Commodity Future
Modernisation Act in 2000 and the Gramm-Leach-Bliley Act in 1999, banks were permitted to engage in
hedge fund trading with derivatives. This brought about the creation of derivatives that were backed by
the combination of both real estate, which was historical viewed to be safe and insurance. These were
bundled up into mortgage-backed securities that offered higher interest-rates than others in the markets.
The Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act, deregulated the
financial services industry by eliminating barriers that separated commercial banking from investment
banking, merchant banking and insurance underwriting. In short, the act made it legal for bank holding
companies to diversify and become financial holding companies. This act reversed more than 65 years of
USA banking regulation.
The Commodity Future Modernisation Act deregulated credit default swaps and other derivatives. Major
banks began creating sophisticated complicated derivative such as the mortgage-backed derivatives. The
banks with the most complicated financial products made the most money. That enabled them to buy out
smaller, safer banks and reduce their risk as it was transferred to the investors.
Also, the community Reinvestments Act was enacted to encouraged depository institutions to help meet
the credits needs of the community in which they operate, pushing banks to make investments in subprime
areas. As banks created a demand they could not supply with mortgage-backed derivatives, they created
“affordable” interest-only mortgage loans for sub-primed borrowers.
However, in 2004, the raising of the funds rate by the FED, there was a reset on the rate on new mortgages
and housing prices started falling. Previous mortgaged-homeowners felt trapped as they could not afford
their payments but could not sell them as they were above prevailing prices. Also, mortgaged homeowners
had questionable credits as banks allowed people to take out 100% or more loans against their homes value
without due-diligence. In 2007, mortgage-backed derivatives began to crumble as defaulters increased, the
banks stopped lending to each other.
The classic indicators of financial crisis were clear in the GFC. These can be seen in use of borrowed funds
by the banks to purchase asset with the expectation that, the after-tax income from the asset and asset
price appreciation will exceed the borrowing cost. This is termed as leveraging, which creates a risk of
bankruptcy when the income from the investment is less than the investment amount. Inadequate
regulation in the market due to earlier deregulation measure. The former Managing Director of the
International Monetary Fund, Dominique Strauss-Kahn summed it up by blaming the Global Financial Crisis
on regulatory failure against excessive risk-taking. Also, mortgage-backed securities were new, there was
an overestimation of assets based on historical data that did not match or consider the prevailing market
conditions, a good example of this can be seen in crash of the dot com bubble and Enron in 2000s. The
inappropriate trade of subprime mortgages and other over-the-counter derivatives was the ultimate
condition that lead to the crisis as maturity period that does not correspond with period of payment of
liability the acquired trading instrument generated: Mortgage holders were defaulting as the interest rates
were increasing at astronomical levels.
These led to a credit crunch by 2007. Banks begun to restrict access to credit even for the large and medium
–size businesses. The sustained period of careless and inappropriate lending to individuals who could not
afford the mortgages resulted in losses for lending institutions and investors, as the loans turned sour and
the full extent of bad debts becomes known. Insurance hedges could not cover the cost of such bad loans.
Policy-makers and regulators responded to this crisis by expanding the liquidity support to their local
currencies through what is now termed as quantitative easing to prevent economies from stalling. Its
effects is evident in today’s economy in the form low interest rates globally, and bond and equity sensitivity
to interest rate hikes. This was done by extending maturity of financing and broadening the eligibility of
collateral. Central banks and governments together injected capital into banks, guaranteed for liabilities of
financial institutions as well as supporting asset prices. Others also leaned on bilateral swap facilities with
central banks and other entities. Governments stepped in to regulate by passing laws, an example is the
Dodd-Frank Wall Street Reform Act to prevent banks from taking on too much risk in the USA. It allows the
Fed to reduce bank size for those that become too big to fail. Frameworks were developed or reviewed to
offer technical assistance (education and upskilling), as well as surveillance by regulators example is the
King IV of South Africa to ensure accountability, fairness and transparency. Independent bodies like the
World Trade Organisation(WTO) took proactive part in trade negotiations and capacity development,
dispute resolution and outreach into new markets. The Prudential regulation which requires financial
institutions to hold a certain percentage of their capital as reserves based on the risk of the assets they hold
were now strictly enforced. This meant that the riskier the assets, the higher the percentage of capital
reserve required meet regulatory requirements. This is seen in the drive by the Bank of Ghana (Central
Bank) in raising the reserve limit of banks to reflect the markets’ current risk profile.
In conclusion, the Global financial crisis of 2008 proved that banks could not regulate themselves. Even
though regulations have been passed to forestall a reoccurrence, many of the measures are left to
https://masters.wqu.org/ Module 1
1 Michael Simkovic, “Secret Liens and the Financial Crisis of 2008” Archived 7 June 2012
at WebCite American Bankruptcy Law Journal, Vol. 83, p. 253, 2009.
2 Brigham, Eugene F., Fundamentals of Financial Management (1995)
3 ‘Roadmap to Hong Kong Success’. Speech by Mr Norman T L Chan, Chief Executive of the Hong Kong
Monetary Authority, at the Economic Summit 2012.
4 Finland FSA Supervision of listed Companies.
5 Strauss Kahn D, ‘A systemic crisis demands systemic solutions’, The Financial Times, 25 September 2008.
6 Kindleberger and Aliber (2005), op. cit., p. 54.
7 Markus Brunnermeier (2008), ‘Bubbles’, in The New Palgrave Dictionary of Economics, 2nd ed.