The causes of the current financial crises are interwoven and complex. To arrive at their root cause has been described as being like a blind man feeling an elephant (Goodhart 2008, p. 331) for their multifaceted and unclear nature. To commence an understanding of this intricate crisis, an outline of the organization of the large corporations is vital. During the late 20th Century United States of America (US) emerged as a hub of the World Economy. The US based large corporations wanted to expand their businesses overseas, these were the largest contributors to the US Economy, as the US was and still is the economic superpower which rules the world economy, and thus in turn these Multinational Corporations (MNCs) controlled the way the world economy performed. (Davis 2009) These MNCs soon realised the need to increase their share holder value and started to emphasise cutting costs, to facilitate this they moved their manufacturing units outside the US to the countries where they could find cheap labour and thus reduce the costs incurred. This shift of pattern lead to a phase called Industrialization to Post-Industrialization. This Post-Industrialization can be described as the shift of the US economy from manufacturing to a service based economy. The current crisis is the indicator of this shift. This shift in effect started a chain reaction of events which were the governing basis of the fallout. (Davis 2009)
With this shift came a new type of employees, their new jobs were not as secure as they were before- as employees had to change jobs swiftly. To adjust to these working styles, convenient private pension schemes started to pop up. For this reason, gradually pension investment became a very lucrative business, largely dominated by big financial institution investors. (Davis 2009)
At the same time there was a policy change in the way mortgage sector functioned. Traditionally, it was the bank that would raise funds, screen borrowers, and then lend out the money to those finally approved. The banks were responsible for the defaulters and would have to bear the losses. This system provided a good motivation to the banks to carefully measure the creditworthiness of borrowers. Over time, that process transformed and incentives were changed. The banks and some of the brokers now started to sell the mortgages, credit card debts and other outstanding amounts to be securitized, instead of taking the accountability straight. Securitization here means converting assets such as these into a tradable commodity. Both Brokers and the Banks were trying to sell more & more mortgages because their pay and incentives were based on how successful they were in approving and selling those mortgages simultaneously. Since they were selling them, so there was no concern attached on their part, as to whether the borrowers are defaulters or not. (Allen and Carletti 2009) This disproportionate risk taken by the financial institutions became an additional factor of the crisis. (Landskroner and Raviv 2009)
The second stage in this process saw more a complex nature of commerce. The Companies which undertook this business started to pool all the mortgages together with the other tranches. This pool grew and became so compound and complex that it was challenging to ascertain what was in it. The companies were doing this because it was spreading the risk involved. They were mixing the good mortgages with the bad ones and thus this resulted in a very unstable system. The same pattern was seen in mutual funds, credit cards, life insurances etc which ultimately led to the current crisis. (Allen and Carletti 2009)
The Second major reason of this financial crisis was the creation of a bubble in the real estate sector; this sector saw a surge in buying houses and property. One of the major explanations of this was the policy adopted by the Federal Reserve in 2003 to avoid a financial turmoil after the 2000 tech bubble and the 9/11 Terrorist attacks of 2001.They cut the interest rate to a very low level of just 1%, which motivated people to invest more in real estate sector, which was experiencing a growth of roughly 3% then. Soon this market observed a return of about 5 to 10% per year which drew more attention of the investors to this market, eventually people started to buy more and more even if they had to take greater loans to buy the assets. There were more advantages in investing in this sector- for example less interest rate on mortgages and other polices. And when the bubble busted it led to the crisis we see today. (Allen and Carletti 2009)
From the above discussion we can infer that the elementary causes of the global financial meltdown were the amalgamation of both the Credit Boom & the Real Estate Bubble. (Acharya et al. 2009) As most of the countries were hit by this, The UK has been one of the hardest hit by the financial meltdown among the European countries; the crisis which started in 2007 triggered a near meltdown in the banking system of UK. UKs economy was hard battered by the credit crunch, which was amplified by the house price bubble. (Hodson and Mabbett 2009) So we can deduce that if stringent steps are taken to restructure the way financial institutions work, control the amount of credit given in the market and control the housing prices, we can improve the current situation and at the same time reduce the chances of being hit by such a crisis again, a few remedies to do so have been discussed below.
In order to restructure the working of the large, complex financial institutions emphasis should be given to improve their internal governance, this can be done by coordinating with them to adopt a policy of long term assessment and compensation. Regulatory authorities should be set up and their focus should be on greater disclosure of compensation packages and assessment criteria so that overall transparency is increased, this will in turn boost the confidence of the investors again. Regulators should use all their power over these institutions which they have to regulate them, that have been demanded by the public because of the recent government bailout packages. Since the one of the problems associated with these institutions was that of mispriced guaranties, regulators should price the guaranties correctly; this will avoid the systematic errors within the system. Regulators should reduce deposit insurance premiums when the Term Deposit fund becomes well capitalized. Such guarantees should be priced fairly and be collected on a continual basis. (Acharya et al. 2009)
One of the most important steps that the regulatory bodies can take is that they should try to reduce the systematic risks involved with the large financial institutions not only for normal times but in times of macroeconomic failures. To do this they should incorporate a prudential financial regulation which includes risk assessment based on individual characteristics, estimating the contribution of each firm to the downside risk of the economy doing this would help in determining the constraints to be imposed on individual firm. (Acharya et al. 2009)
All these steps discussed above will reduce the threats of the crisis happening due to defective financial structure. But these steps are not exhaustive, regulations in the housing sector are also necessary for example home buyers if buying home on loans, the loan structure should be such that there is no possibility of changing the scheme, also there should be laws such that they should virtually self insure their loan by giving a greater share of deposit and penalising default. (Acharya et al. 2009)
Apart from this there is also an urgent need to limit this financial disaster, there is a need for a global coordination among all nations, especially the major world economies, to have an international financial regulator that will scrutinize the operations of all the central banks across different countries. Most of counties have governance over their central banking system, if countries can be persuaded to have a common regulator then the operations would be more transparent and this kind of collapse can be avoided in the future. (Acharya et al. 2009)
We can conclude from the above described causes, and the suggestions of the remedies, that the countries have to work both internally (i.e. on the national scale on their financial system architecture) and also with international coordination to reduce the burden and risk on one nation and distribute it to the other participating nations. There should also be coordination between the developed and the developing worlds central banks, in the current crisis fundamentally interconnected problems have been dealt with by each country individually, reducing the effect of their collective action. So a systematic and large rank of coordination worldwide will ensure that the future financial systems are strong and stable.
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Acharya, V.V. et al. 2009. The Financial Crisis of 2007-2009: Causes and Remedies. Prologue: A Bird?s Eye View 14(5), pp. 1-56.
Allen, F. and Carletti, E. 2009. The Global Financial Crisis. An address to the Wharton Finance Club, 2009, pp. 1-43.
Davis, G.F. 2009. The Rise and fall of Finance and the End of the Society of Organizations. The Academy of Management Perspectives 23(3), pp. 27-44.
Goodhart, C.A.E. 2008. The Background to the 2007 Financial Crisis. International Economics and Economic Policy 4(4), pp. 331-346.
Hodson, D. and Mabbett, D. 2009. UK Economic Policy and the Global Financial
Crisis: Paradigm Lost? Journal of Common Market Studies 47(5), pp. 1041-1061.
Landskroner, Y. and Raviv, A. 2009. The 2007-2009 Financial Crisis and Executive Compensation: Analysis and a Proposal for a Novel Structure. Stern School of Business, Finance Working Papers, New York. Series/Report no: FIN-09-003
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