How the Global Financial Crisis 2007 Started

University of Westminster
Westminster Business School

Group 10
Samar Elmardi – W1540512
Mariam Fakhouri – W1574226
Douglas Nystrom – W1557340


Problem 4
Should banks fail or be saved?

Module leader names: Vincent Gibogwe and

Word Count:

Date: 8th of April, 2016

Executive summary:
























Table of contents:
























Introduction:
There has been a lot of debates and speculation regarding the main purpose of what happened that eventually led to the global financial crisis and why banks failed in 2008. The causes that occurred with the global banking crisis left everyone stunned including banks, economists and the governments, especially as many banks were on the verge of failing. The result of the global banking crisis left many speculations whether banks in the future should be saved or left to fail. There are two main different approaches regarding this issue, these came from Keynesians and monetarist economists. Their main purpose was to try and figure out the best solution as to how the global economy should operate. The monetarism theory would argue that a free market economy is essential whilst Keynes proposed that is should be a mixed economy. This casts a doubt on the effectiveness of regulation and whether these approaches actually prevent the global banking crisis from happening once more in the future. Lastly, this report will discuss the controversial banking bonuses.

Background as to how the global financial crisis started
The global financial crisis started within the US property sector in 2007. People with no jobs, assets nor income were able to acquire bonds backed by mortgages, also known as mortgage-backed securities (MBSs), from banks in order to own a home as it was very low interest rates, which eventually grew up to double-digit numbers in later years (Havemann, 2016). As the property market was growing at a rapid pace, the banks felt no need to actually evaluate the position the restless borrowers had even though they had poor credit history. Moreover, the banks were more than happy to give out mortgages and loans to the public as these mortgages/loans would be integrated into a securitised debt. In brief, securitization is the procedure through which a guarantor makes a budgetary instrument by consolidating other money related resources and after that showcasing diverse levels of the repackaged instruments to financial specialists. The procedure can envelop any sort of money related resource and advances liquidity in the commercial centre (Investopedia, 2003).

Investors bought these debts as they were hoping it would create profit in the longer run through these investments. However, no one was able to fully determine the value of these debts as the securitised debts would be securitised time and time again. Ultimately, these debts were not even close to their actual value even though, at the same time, investors believed it as a highly profitable investment.

One of many sub-prime problems incurred when the Federal Reserve decided to raise interest rates to 5.35%, two years before the interest rates were down at 1% (BBC, 2009). Due to an increase in interest rates and falling house prices made people unable to repay their mortgages and ended up defaulting. Investors suffered critical losses which made them more cautious to acquire more Collateralised Debt Obligations (CDOs). Furthermore, the ones who had to repay these loans was the banks. According to Elliot (2009), this put even more pressure on the banks seeing as a numbers of banks went bankrupt, e.g. Lehman Brothers in September 2008, whilst other banks were saved by huge amount of money being put in by the western governments in order for them to continue operating.


Should banks fail or be saved?
In the UK, people pay taxes that are mostly spent on welfare and infrastructure, e.g. police, roads and health care amongst other things. Nobel economist Joseph Stiglitz stated the following in an interview with the Telegraph: “The UK has been hit hard because the banks took on enormously large liabilities in foreign currencies. Should the British taxpayers have to lower their standard of living for 20 years to pay off mistakes that benefited a small elite? (Evans-Pritchard, 2009). Nonetheless, if the public was to let banks fail, the unemployment rate would increase significantly as many people would lose their jobs. Also, we would see signs of increase in welfare payments and a fall in tax revenue. In addition, one of the governments macroeconomic objectives is to keep the unemployment rate as low as possible. Therefore, if we were to let banks fail then once again, there would be an increase in the unemployment rate.

Furthermore, we believe that banks should be saved due to the fact that, especially the biggest banks, they have huge amount of deposits/assets from private accounts. For example, if the government were to let these banks fail, there are no insurance whether these people will retrieve their money which they had deposited into the bank. However, the banks shareholders should not be protected - the value of the shares should be allowed to fall without the government offering any support or repayment. Thereby, the authors believe, the government helps keep the public's trust in the banking system. Additionally, the overall economy was mostly recovered through changes in monetary policy that were put in motion by central banks.  


Regulating banks
Due to the financial crisis in 2008, regulators and the government has implemented new approaches in order to try and prevent a future financial crisis. The Financial Services Act 2013, who replaced the Tripartite structure, was created by Financial Services Authority (FSA), Bank of England and the Treasury. The FSA is mainly looking after the interests of consumers, and also supervises the individual banks. Bank of England has said to look after the money markets and the Treasury provides money for the public (BBC, 2013a).

Moreover, the FSA was put to an end in 2013 and as a result, three new bodies was created. These were the Financial Conduct Authority (FCA), the Financial Policy Committee (FPC), and also the Prudential Policy Committee (PRA) (BBC, 2013b). Ultimately, the banks has become more strict towards banks through the implementation of the Financial Services Act 2013. In addition, further regulation after the financial crisis has become a lot more efficient. For example, overall economies are moving further away from the so called “recovery stage” and the growth in the global economy has been significantly steady. Although, a negative outcome that might have resulted due to stricter regulations is that the UK’s credit ratings has been downgraded from AAA (the highest possible) to Aa1 (Hurley, 2013).

By implementing regulation, this subjects banks to certain restrictions and requirements. Some argue that by having strict regulations, this prevents banks from basically doing what they want, instead they have to follow protocol. As shown by evidence, by having non-strict regulations, banks were a lot more confident regarding their trading. As mentioned earlier, one of the key reasons why the financial crisis occurred was due to the fact that banks were making poor decisions by letting people buy homes even though they might not have had the ability to repay these mortgages/loans in the future. Eventually, this led to the conclusion that restless borrowers lost their investments and the banks were left with no money.

How should banks be regulated in the future?
After the financial crisis in 2008, the UK’s financial sector has been very delicate. The authors would argue that one of the first steps would be to enforce an uncompromising regulation into the structural reform. For example, one approach could be by promoting a way of making trading less complex. In conclusion, making CDO’s and securitised debts into one universal asset would make it much more efficient to trade for mortgages in the future. By implementing a more efficient system of trading, this would be to an advantage to regulators and traders. This could ultimately lead to UK’s credit ratings going back to the top AAA ranking. By implementing these changes, this would automatically create a higher demand for UK currency, British Sterling Pounds.

Furthermore, by restructuring the UK banking reform, this could prevent the UK from getting punished by any possible future banking crisis that might occur in other countries. According to Lagarde (2013), the global economy is becoming more and more connected and globalized than ever. This leads to the UK’s economy being altered through what might occur in other countries economies. Additionally, the UK cannot change the global banking system and the only thing they can do is to try and protect themselves from what might occur in the future which could easily have a significant negative effect on the UK economy.
Banker bonuses
Banker bonuses has long been a very controversial topic. Some would argue that one of the main contributions to why the financial crisis happened in the first place was due to the enormous greed amongst bankers (BBC, 2011). Depending on how well you perform, the bigger bonus you might receive at the end of the year. In relation to the aforementioned, the authors would argue that based on these facts, these performances clouded the bankers judgements overall and which eventually made them make poor decisions.

On the other hand, some would argue that the amount of risks the investment bankers take on within a bank are substantial. Working as an investment banker, your job is to turn the public investments into profit. Seeing as if the bankers would not receive such high bonuses they are currently receiving, this would automatically decrease their motivation towards performing at their outmost ability. Their actions can have direct effects on currency rates, inflation amongst other things. One of the main reasons why banks exist are because it wants to serve the greater good of the society.

Conclusion






Recommendations
Higher amount of regulations and more control regarding what is and what is not permitted by bank activities.