Financial crisis is a situation where some financial institutions or assets suddenly lose a large part of their value. Financial crises directly result in a loss of paper wealth; they do not directly result in changes in the real economy unless a recession or depression follows. The financial crises are not common. Different types of financial crisis included banking crisis, speculative bubbles and crashes, currency crises and wider economic crises.
11. What is an ‘Asset Bubble’ and what have these got to do with the banking sector?An asset bubble is formed when people or financial institutions buy an asset or a commodity in the hopes of selling it later at a higher price which means they are speculating on future rises in the asset’s value. If there is a bubble, people will all flock to a particular asset, prices of assets will over-inflated.
However if enough people believing now is the time and decide to sell their ‘holding’, the asset’s price will fall, the bubble will burst. Thus, it will cause economic recession and unemployment rate increase with high level of debts. As a result, banks will face bankruptcy.
Why does a problem in the banking sector affect the economy as a whole? Firstly, bank controls the orderly flow of funds between economic agents. Thus, a problem in the banking sector can affect the cash flow in the economy. Second, it mobilizes resources in the form of savings by offering attractive investment opportunities. Thirdly, it pools savings and allocates them in the form of loans to investment projects. The banking sector acts as an intermediary between savers and investors in an economy. By affecting the money supply, that monetary policy can establish ranges for inflation, unemployment, interest rates, and economic growth.Savings and investment cannot occur in an unstable financial environment, thus disallowing for the growth of the economy as a whole.
(Varner, 2010). What has triggered the most recent financial crisis? The trigger of the crisis was the bursting of the United States housing bubble and the sub-prime mortgage crisis. The reasons are relate to the creation of a new financial instrument – collateralized debt obligations (CDO). CDO was a type of Bond linked to the USA housing market and was created and sold by Investment Banks on the Money Markets.Many UK and European banks creating and selling CDO’s also in 2000. However the USA housing market started to crash in 2007, thus these US Bonds became worthless and as the sub-prime mortgage market in the US collapsed, faith in European CDOs also started to fall in value.
(Begg ; Ward 2009, p. 284) By 2007, bank balance sheets around the world saw huge write downs and large reduction in the value of this asset. Some notable banks approached insolvency and most were experiencing large falls in their capital ratios -credit crisis occurred.
Thus, if a bank has make ill-considered loans or investments, which then go into default, the bank’s capital ratios will fall. If all banks made the same poor investment and lending decisions then financial crisis develop. (Brahim, 2011) 14. How did the UK Government initially support banks in the recent financial crisis? The UK Government is bail outs and nationalisation under the Banking (Special Provisions) Act 2008 to initially support banks in the recent financial crisis. The long term support of UK banks came in the form of equity injections; the UK Government became shareholders in banks that had trouble.
Besides, Government take an ownership (equity or stock) interest to the extent taxpayer assistance is provided, so that taxpayers can benefit later. Next, the UK government also support and allowed many institutions to merge if it meant they would survive. (Brahim, 2011). What do they mean by ‘Quantitative Easing’ and has it worked? Quantitative Easing (QE) is a government monetary policy used by some central banks to increase the money supply by buying securities from the market to stimulate their economy.It increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity. QE has not worked so far in this recession because it is not a good time to lend. Firstly, given the banks have cash; they might just hold the cash in their accounts instead of lending it out to consumers as intended.
The problem here is that this whole recession is due to high levels of debt, so by trying to solve the problem by creating more debt is not really a solution. (Ray, 2009)Besides that, if as a bank still had some CDO’s of indeterminate value on books, the bank will not want to lock up this cash in further loans; they will have it on hand to cover any final write down in CDO assets. Likewise, given that many banks have government Bonds from other countries and these governments are themselves struggling with high levels of debt, banks will not want to lock up this cash in further loans, they will prefer to have it on hand to cover any future defaults by these governments. Thus, all of this shows QE will fail. Is the financial crisis that started in 2007 over?The financial crisis that started in 2007 is not over yet because USA unemployment rate is still high and above 9%, European still in trouble. Besides that, economic hardship still remains in many countries.
In addition, the amounts of problem banks are still rising. Furthermore, states continue to slide toward bankruptcy. According to the Center on Budget and Policy Priorities, 48 states are facing budget shortfalls in 2010. (Varner, 2010) However, some economists said that financial crisis in 2007 is ended because stock markets are back for previous level for emerging markets.