Global Financial Crisis and Changes to Financial Regulations


The international monetary fund was slow to apply the word recession to the current global downturn.

Now, IMF economists have come up with a more precise way to measure global recession: a decline in real per capita world GDP backed up by a look at other global macroeconomic indicators. Those indicators include industrial production, trade, capital flows oil consumption and unemployment

Informally past IMF chief have called it global growth lower than either 3% or 2.5% depending on who was chief economist --- a recession

And based on that definition this is the fourth global recession since World War II and the deepest by a long shot the earlier recessions were in 1975 1982 and 1991. All were one year recessions when measured in purchasing power parity which the IMF favors for global comparisons. If the GDP is calculated in a more traditional way using exchange rates, the recession of 1991 lasted till 1993.

The financial crisis of 2007 has been called the worst financial crisis since the one related to the great depression by leading economists and it is contributed to the failure of key businesses declines in consumer wealth estimated in the of U.S. dollars, substantial financial commitments incurred by governments and a significant decline in economic activity. Many causes have been proposed, with varying weight assigned by experts. Both market based and regulatory solutions have been implemented or are under consideration while significant risks remain for the world economy.

When it all started?

The immediate trigger of the crisis was the bursting the united state housing bubble which peaked in approximately 2005-2006. High default rates on subprime and adjustable rate mortgages (ARM) began to increase quickly thereafter. However once interest rates began to rise and housing prices started to drop in 2006-2007 in many parts of U.S. refinancing became more difficult . Defaults and foreclosure activity increased dramatically as easy initial terms expired, homes prices failed to go up as anticipated and ARM interest rates reset higher.

Significant amounts of foreign money flowed into U.S. from fast growing economies in Asia and oil producing countries. This inflow of funds made it easier for the Federal Reserve to keep interest rates in United States too low from 2002-2006 which contributed to easy credit conditions, leading to the United States housing bubble. All kinds of loans were easy to obtain and as a part of the housing and credit booms, the amount of financial agreements called mortgage backed securities (MBS) increased. Such financial innovation enabled institutions around the world to invest in the U.S. housing market.

Defaults and losses on other loan significantly increased as the crisis slowly expanded from the housing market to other parts of the economy. Losses estimated up to trillions of U.S. dollars globally.

While housing and credit built a series of factors caused the financial system to both expand and become increasingly fragile. Policymakers did not recognize the increasingly important role played by financial investment banks and hedge funds, which were also known shadow banking system. These institutions and some regulated banks also assumed some significant debt burdens in providing credits and did not have a financial cushion sufficient enough to absorb large loans defaults or MBS losses. These losses impacted the ability of financial institutions to lend resulting in slow economic activity. Government also bailed out key financial institutions and implemented economic stimulus programs, assuming significant additional financial commitments.


Some of the most influential causes were:

Easy credit conditions

From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% 1.0%. This was done too often the effects of the collapse of the dot-com bubble and of the September 2001 terrorist attacks and to combat the perceived risk of deflations. The fed then raised the fed funds rate significantly between July 2004 and July 2006. This contributed to an increase in 1 year and 5 year adjustable rate mortgage (ARM) rates, making ARM interest rates resets more expensive for homeowners. This may have also contributed to the deflating of the housing bubble, as assets prices generally move inversely to interest rates and it became riskier to speculate in housing.


Both government and competitive pressures contributed to an increase in the amount of subprime lending during the years preceding the crisis. Major U.S. investment banks and government sponsored enterprises like Fannie Mae played an important role in the expansion of higher risk lending.

The term subprime refers to the credit quality of particular borrowers, who have weakened credit histories and a greater risk of loan default than prime borrowers, the value of U.S. subprime mortgages was estimated at $1.3 trillion s of March 2007, with over 7.5 million first-lien subprime mortgages outstanding.

Subprime mortgages remained below 10% of all mortgage originations until 2004, when they spiked to nearly 20% and remained there through the 2005-2006 peak of the United States housing bubble. A proximate event to this increase was the April 2004decision by the U.S. Securities and Exchange Commission (SEC) to relax the net capital rule, which encouraged the largest five investment banks to dramatically increase their financial leverage and aggressively expand their issuance of mortgage backed securities. Subprime mortgage delinquency rates began to increase rapidly, rising to 25% by early 2008.

Others have pointed out that there were not enough of these loans made to cause a crisis of this magnitude. Essentially Investment banks and hedge funds used financial innovations to synthesize more loans using derivatives and this why the losses were much greater than the loans.

Predatory lending

Predatory lending refers to the practice of unscrupulous lenders, to enter into "unsafe" or "unsound" secured loans for inappropriate purposes. A classic bait and switch method was used by countrywide, advertising low interest rates for home refinancing. Such loans were written into extensively detailed contracts, and swapped for more expensive loan products on the day of closing. The consumer would be put into an adjustable rate mortgage in which the interest charged would be greater than the amount of interest paid. This created negative amortization which the credit consumer might not notice until long after the loan transaction had been consummated. When housing prices decreased, homeowners in ARM's then had little incentive to pay their monthly payments, since their home equity had disappeared. This caused Countrywide's financial condition to deteriorate, ultimately resulting in a decision by the office of thrift supervision to seize the lender. There is growing evidence that such mortgage frauds may be a cause of the crisis.

Boom and collapse of the shadow banking system

As the shadow banking system expanded to rival or even surpass conventional banking in importance politicians and government officials should have realized that they were recreating the kind of financial vulnerability that made the great depression possible and they should have responded by extending regulations and the financial safely net to cover these new institutions

Apart from this there were a lot of other causes such as Housing Bubble, Commodity Bubble, Deregulation, Credit Ratings etc.

Financial impacts

One of the first victims was northern rock, a medium sized British bank. The highly leveraged nature of its business led the bank to request security from the bank of England. This in turn led to investor panic and a bank run in mid September 2007. Calls to nationalize the institutions were initially ignored in February 2008, however the British government relented and the bank was taken into public hands. Northern rock's problems proved to be an early indication of the troubles that would soon befall other banks the financial institutions.

Initially the companies affected were those directly involved in home construction and mortgage lending such as northern rock and countrywide financial, as they could no longer obtain financing through the credit markets. Over 100 mortgage lenders went to bankrupt during 2007 and 2008. Concerns that investment bank bear streans would collapse in March 2008 resulted in fire sales. The crisis hit its peak in September and October 2008. Several major institutions failed, were acquired under duress or were subject to government takeover. These included the Lehman brothers, Merrill lynch, Fannie Mae, Fannie mac and AIG.

During September 2008, the crisis hits its most critical stage. There was the equivalent of a bank run on the money market mutual funds, which frequently invest in commercial paper issued by corporations to fund their operations and payrolls.

Wealth effects There is a direct relationship between declines in wealth, and declines in consumption and business investments, which along with government spending represent the economic engine. Between June 2007 and November 2008, American lost an estimated average of more than a of their collective net worth. By early November 2008, a broad U.S. stock index the S&P 500 was down 45 percent from its 2007 high. Housing prices had dropped 20 % from their 2006 peak, with futures markets signaling a 30-35% potential drop. Total home equity in the United States which was valued at $13 trillion at its peak in 2006 had dropped to $8.8 trillion by mid 2008 and was still falling in late 2008. Since peaking in second quarter of 2007 household wealth is down $ 14 trillion.

Global contagion

The crisis rapidly developed and spread into a global economic shock, resulting in number of European banks failing failures, declines in various stock indexes, and large reductions in the market value of equities and commodities. Moreover, the de-leveraging of financial institutions as assets were sold to pay back obligations that could not be refinanced in frozen credit markets further accelerated the liquidity crisis and caused a decrease in international trade. At the end of October 2008 a currency crisis developed, with investors transferring vast capital resources into stronger currencies such as the yen dollar Swiss franc, leading many emergent economies to seek aid from the international monetary fund.

Global Effects

A number of commentators have suggested that if the liquidity crisis continues, there could be an extended recession or worse. The financial crisis is likely to yield the biggest banking shakeout since the saving and loan meltdown. The United Kingdom had started systematic injection and the world's central banks were now cutting interest rates. UBS emphasized the United States needed to implement systematic injection. With a recession in the U.S. and the increased savings rate of U.S consumers, declines in growth elsewhere have been dramatic.

For the first quarter of 2009, the annualized rate of decline in GDP was 14.4% in Germany, 15.2% in Japan, 7.4% in the UK, 9.8% in the Euro area and 21.5% for Mexico.

By March 2009, The Arab world had lost $ 3 trillion due to the crisis. In April 2009, Unemployment in the Arab world is said to a time bomb. In May 2009, the United Nations reported a drop in foreign investment in middle-eastern economies due to a slower rise in demand for oil.

In June 2009, the World Bank predicted a tough year for Arab states.

In September 2009, Arab banks reported lost nearly to $ 4 billion since global financial crisis onset.

Bailout Plan

Emergency and short term response

The U.S. Federal reserve and central banks around the world the world have taken steps to expand money supplies to avoid the risk of a deflationary spiral, in which lower wages and higher unemployment lead to a self reinforcing decline in global consumption. Governments have enacted large fiscal stimulus packages, by borrowing and spending to offset the reduction in private sector demand caused by the crisis. The U.S. executed two stimulus packages, totaling nearly $1 trillion during 2008 and 2009.

This credit freeze brought the global financial system to the brink of collapse. The response of the USA Federal reserve, the European Central Bank, and other central banks was immediate and dramatic. During the last quarter of 2008, these central banks purchased US$2.5 trillion of government debt and troubled private assets from banks. This was the largest liquidity injection into the credit market, and the largest monetary policy action, in the world history.

Governments have also bailed out a variety of firms as discussed above, incurring large financial obligations. To date, various U.S. government agencies have committed or spent trillions of dollars in loans, asset purchases, guarantees and direct spending.

Regulatory Proposals and long term responses

American president Barack Obama and key advisers introduced a series of regulatory proposals by economists, politicians, journalists and business leaders to minimize the impact of the current crisis and prevent recurrence.

However as of April 2009,

  • Ben Bernanke: Establish resolution procedures for closing troubled financial institutions in the shadow banking system, such as investment banks and hedge funds.

  • Joseph Stiglitz: Restrict the leverage that financial institutions can assume. Require executive compensation to be more related to long term performance. Re instate the separation of commercial and investment banking established by the glass-staegall act in 1933and repealed in 19999 by the gramm-leachy-beiley Act.

  • Simon Johnson: Break up institutions that are too big to fall to limit systematic risk.

  • Paul Krugman: Regulate institutions that "act like banks" similarly to banks.

  • Alan Greenspan: Banks should have a stronger capital cushion, with graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage.

  • Warren Buffet: Require minimum down payments for home mortgages of at least 10% and income verification.

  • Eric Dinallo: Ensure any financial institution has the necessary capital to support its financial commitments. Regulate credit derivatives and ensure they are traded on well-capitalized exchanges to limit counterparty risk.

  • Raghuram Rajan: Require financial institutions to maintain sufficient " contingent capital"

  • Michael Spence and Gordon brown: Establish an early warning system to help detect systematic risk.

  • Niali ferguson and Jeffery Sachs: Impose haircuts on bondholders and counterparties prior to using taxpayer money in bailouts. In other words, bondholders with acclaim of $100 would have their calm reduced to $80, creating $20 in equity. This is so called a debt for equity swap. This frequently done in bankruptcies, which the current shareholders are wiped out and the bondholders become the new stockholders, agreeing to reduce the company's debt burden in the process. This is being done with general motors.

  • Nouriel Roubini: Nationalize insolvent banks. Reduce mortgage balances to assist Homeowners, giving the lender a share in any future home appreciation.

  • The Australian Government is committed to responding effectively to this crisis. Aus AID has a developed a strategic Action Plan for responding to the Global Recession. Aus AID focuses assisting developing countries to reduce poverty and unemployment. Outsourcing can also help in aiding the global crisis as it is cost effective.
  • In 2009, The IMF estimates Per capita GDP will decline 2.5%, using purchasing power parity, compared to a 0.4% contraction, on average, during the three previous recessions. Industrial production, trade, capital flows and oil consumption in the 2009 recession will fall much more sharply than in the previous global recessions, while unemployment will increase more.

    What about 2010? The IMF's current forecast estimates a small per capita GDP decline, when measured by market exchange rates, and a tiny increase when measured by purchasing power parity. By either of those measures - the IMF didn't release forecasts for other macroeconomic indicators it used in this exercise - the world will be hovering around recessionary territory next year too.

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