Main Causes and Effects of the 2008 Financial Crisis

The issue of liquidity is going to be my main focus point when looking at the 2008 financial crisis and it will constantly crop up. Liquidity refers to the ease with which an asset, or security can be turned into cash without affecting its market price. In the period leading up to the Great Recession there was a massive increase in the availability of credit for banks and loan providers which in addition lead to an increase for consumers, in the US aided by Freddie Mac and Fanny Mae (government backed loan providers). In this essay I am going to try and discuss and link together the many historical and economic factors that lead to the credit crunch and as a result the Great Recession. I will then dive into the effects of the Great Recession and look at what steps were made to make the banking institutions less vulnerable/likely to fail, and also look at the policies implemented to help the UK out of a recession.

My hypothesis on why there was a financial crisis in 2008 going to be an extreme version of what is common practice in the modern financial system “holding a mixture of long-term, illiquid assets financed by short-term liabilities”, now it’s not that practice alone, but I believe the Great Recession was a result of banks having an over reliance on market liquidity.

The first example of this over reliance on liquidity in financial markets comes from the British bank Northern Rock, which hit financial trouble in mid-2007. Its assets were long term and very illiquid (securitized mortgage notes and its liabilities were short term). Banks in this time would rely on constant short-term financing, to pay off the recent maturing liabilities, and to fund the acquisition of new assets (leverage). But what lead banks to be in such a condition where they could borrow with such excessive leverage. To do this I am going to look back at historical factors which lead to this explosion in liquidity. First, I would like to look at the changes in in the ease of capital flows, I believe that after the collapse of the Bretton Woods System, which had a slow decline over the years, 1968-73, and then the slow move for the UK to a floating exchange rate in 1992 which massively increased the ease of flow of money as countries are no longer trying to maintain exchange rates through restrictive policies, because floating exchange rates are automatically adjusting. In the period from 1970 – 2007 there is a huge increase in capital mobility. This saw a huge increase in capital flows and helped grow the UK banking sector from 300% of GDP in 1997 to 500% in 2007. This led to banks raising funds globally increasing the global interconnectedness of the financial system. But even with the increase in liquidity it is hard to trace why banks such as northern rock taking excessive leverage. Since 1939 in the UK there had been wide scale financial repression, banks had to hold large amounts of capital in the form of government binds and they were limited in their deployment of it, that was until 1980 where the repression was lifted and few capital controls were brought in, with the Bank of England as a lender of last resort banks had little incentive not to take excessive risk, creating a huge morale hazard. This led to a situation where there was high liquidity and banks had limited controls their capital deployment, couple this with an exploding US housing market and the creation of profitable derivates in terms of the mortgage-backed securities. With the collapse of the housing market in the US following the fall in house prices in 2006. What this leads to is a vicious cycle with house pricing falling, people then have negative equity (900,000 UK homeowners pushed into negative equity), then owners foreclose or default, then the supply of houses increase and the price of houses (assets). This effects banks in the following ways: when the mortgage payments decline and the fees fall, then the value of the mortgage bonds fall, then the banks’ assets reduce and as a result they can loan less; so, they do, this results in a contraction in the economy as there is a fall in the availability of credit, which reduces investment which is part of aggregate demand. The contraction in the availability off credit creates problems for banks who in light of the worsening circumstances want to reduce exposure by selling assets and reducing liabilities but in a collapsing market it doesn’t make sense to sell, long term illiquid and the markets are illiquid as well and the amount of leverage allowed is lower to raise funds (lower proportion of debt required) as seen with Northern Rock. As well as Northern Rock the government had to bail out Lloyds, RBS, HBOS and Bradford & Bingley with a bill that roughly amounted to 20% of GDP. We can see because of banks over reliance on liquidity to maintain their operation, they failed.

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In terms of the effects of the 2008 financial crisis I am going to split them into two sections. The first will cover the effects of the recession and the resulting government policy used to curb those effects. The second will be about the preventative measures brought in to stop a similar banking collapse happening again. The recession of 2008 was a demand side collapse. The reduced availability of credit creates problems for banks that the reduced availability of credit creates problems for banks that and one of the main things this resulted in was the collapse in the derived demand for labor. Where the demand for goods and services in the economy is jointly linked to the labor which helps generate the supply of those goods. This has an adverse effect on youth unemployment. “Unemployment is especially prevalent among those aged 16-24”. One of the surprising knock-on effects is the increase in the number of people applying to university there was an increase of “11.6 percent” in people applying to university through UCAS in 2010. This is because when there is a time of economic downturn the opportunity cost of going to university is dramatically reduced because of the fall in potential earnings if you had not gone to university. In the aftermath of government sponsored bailouts of UK banks. There are many fiscal changes, in order to recover from the increase in debt. The budget will have been affected by a fall in: tax receipts from stamp duty (in a housing crisis funny that); VAT as a result of reduced expenditure, wide spread unemployment and a loss of equity for many and also increased spending on unemployment benefits. One of the main aims of the coalition government was to “to create the most competitive tax system in the G20, to make the UK one of the best places in Europe to start, finance and grow a business”. This can be seen through a reduction in corporation tax (a reduction of 5.5% in the average marginal rate of tax) and also greater implementation of EIS (enterprise investment scheme) with capital gains relief on new British business if the investment is held for longer than three years. The reasons for this increase in tax incentives is because the governments want businesses to be incentivized to set up or increase production and thus in the process hire more people, to give more people income and have more money going round the economy and therefore have appositive multiplier effect. As a result of these the unemployment rate started to fall in 2012. The government also embarked on other supply side policies, through investing in R&D infrastructure (construction workers were disproportionally hit by the crash) and investment this is on one side to help provide some form of employment and also increase the productive capacity of the UK economy.

In light of the financial crash there obviously would be research and action taken to come up with more precautionary measures. I am looking at two sources, the Vickers Report and the Basel III recommendations. The Vickers Report suggested the ‘ring-fencing’ of retail banking from the investment and commercial side of banks. This only became mandatory on the 1st of January 2019. The implementation of higher reserve asset ratios, forcing banks to hold more high-quality liquid assets as a proportion of liabilities proportion of liabilities as recommended by both the Vickers Report and the Basel III recommendations.

Referring back to my hypothesis we can see that the main cause of the 2008 financial crisis was banks over reliance on liquidity in financial markets and as we can see from the finding and recommendations shown above the main stressor, other than the ring-fencing of banks, is to implement regulations that force banks to hold liquidity themselves. This would help reduce the damage done to these incredibly large ‘too big to fail’ institutions (banks so large that their demise would place systemic risk on the economy). The increase in the mobility of capital as a result of the fall of the Breton Woods exchange rate system and also the forgoing of many capital controls in 1980 are two of the biggest historical factors leading to huge liquidity link that with the position of the Bank of England as a lender of last resort and there is the perfect recipe for banks to take excessive risk.

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