causes, effects and the solutions of the global financial crisis and bis reaction

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This paper describes the causes and effects of the 2007-2008 Global Financial Crisis and the BIS reaction in a simplified model called the Cause-effect-Solution Model(CES Model) by Talent Gosho ..Zimbabwe

TRANSCRIPT

  • 1

    UNIVERSITY OF ZIMBABWE

    R095812A

    An assessment of the causes, impacts of the global financial crisis and the

    intended measures by the Bank of International Settlement

    BY

    TALENT GOSHO

    A

    FINANCE & BANKING STUDENT

    AT

    UNIVERSITY OF ZIMBABWE

  • 2

    Table of Contents

    Title Pages

    1.0 Introduction ............................................................................................................................... 3

    1.1Backround ...................................................................................................................................... 3

    1.2 Terminology used in the paper ................................................................................................... 5

    1.3 Research Objectives ................................................................................................................... 7

    Research Questions ......................................................................................................................... 7

    2.0 Literature Review .................................................................................................................... 8

    2.1Theoretical Framework ................................................................................................................... 8

    2.2 Empirical literature .................................................................................................................... 9

    3.0 Methodology ....................................................................................................................... 11

    3.1 The-Cause-Effect-Solution Model (CES Model) of the GFC ............................................................ 11

    4.0 Interpretation of the CES Model and answering the research questions under discussion. ........ 12

    4.1 Causes of the GFC ........................................................................................................................ 12

    4.1a The Triggers of the GFC. ......................................................................................................... 12

    4.1b Vulnerabilities as causes of the GFC ....................................................................................... 13

    4.2 Effects of the GFC and data presentation ..................................................................................... 16

    4.3 The BIS intended measures to the GFC. ........................................................................................ 23

    5.0 Conclusion and Recommendations. ............................................................................... 25

    5.1 Recommendations ....................................................................................................................... 26

    6.0 Appendix27

    7.0 References ................................................................................................................................ 27

  • 3

    1.0 Introduction The Global Financial Crisis (GFC) attracted so much attention to the extent that the causes and

    the impacts of such were either exaggerated or ignored. Even reactions to curb the impacts and

    even to curtail the crisis were met with mixed opinions and feelings. Consequently, the purpose

    of this paper is to assess the causes of the global financial crisis while exhuming the impacts to

    both the developed and the developing countries. The paper will also highlight the actions

    taken by the Bank of International Settlement through its watchdog-the Basel Committee on

    Banking Supervision in trying to curb the crisis while also analysing the efficacy and caveats of

    such intended measures.

    1.1Backround

    The 1929-33 Great Depression was one of the unforgettable crises that awakened governments

    especially the United States of America when Roosevelt intervened with his contractionary

    monetary policy after he called for the abolishment of the gold standard in response to the

    liquidationist theory of increasing money supply. The intervention by the US government was in

    line with the assertions of Keynes (1936) in his General Theory that the government need to

    intervene in the economy rather that leaving it exposed to the wiles of the invisible hand.

    However this was not sustainable after the World War II when it was decided that that the

    financial system had to be liberalised. Financial liberalisation made the financial system

    precarious and susceptible to the horrors of the capitalist economies which were later

    mentioned by Minsk (1986) in his Financial Instability Hypothesis as highly unstable.

    Since the 1972-73 oil crises, there were many booms and busts that destabilised the world

    economies but all of them were not given much attention because of the gravity of such crises.

    The period of Great Moderation which began in the middle 1980s made governments to be

    more focused in monetary stability while sacrificing financial stability. This was mainly maybe

    due to the fact that the prior crises were linked to production rather than to the financial

    system given Schumpeter (1912) views that many business cycles are linked to the disturbances

    in the production sector.

    The above assertion by Schumpeter was over exaggerated because all the transactions of the

    economy end up in the financial system which is too delicate to be ignored. Focusing mainly on

    the monetary stability created an imbalance because it exposed the financial system to

    manipulation by the speculative participants who could not behave rationally.

    Failure to behave rationally by the participants in the financial system culminated into a deadly

    euphoria that led into the global financial crises in 2007-9 hence Krugman (2009) says what

    went wrong Minsk was right. This is because the regulators were on holiday leaving the

    invisible hand to create an equilibrium which was farfetched.

  • 4

    As mentioned by Bernanke in his lecture series in at Washington University in 2010, the period

    of Great Moderation which began in 1987 and ended in 2006 was similar to the period after the

    WWI which was duped the the roaring twenties. There was noticeable stability in the

    economies that the Federal Reserve was mainly focused on monetary Stability at the expense

    of financial stability. During the great inflation of the 1970s output and inflation were volatile,

    but following Volkers disinflation from 1980s through to 2007(Chairman Greenspan early

    time) both output and inflation were less volatile Bernanke said in 2010. This period was called

    the Great Moderation which was exacerbated by improvement in money supply after

    1979.Consequently, this tranquillity diverted attention to monetary policy and monetary

    stability rather that to financial stability and financial regulation.

    The prelude to the financial crisis now was marked by a rise in housing prices which began in

    the 1990s when housing prices grew rapidly by 130%. This caused mortgaged lending

    standards to deteriorate drastically since there was an overflow of house buyers when house

    buying became a cant lose investment.

    Prior to the early 2000s many homebuyers made a significant down payment and documented

    their finances in detail, but as house prices rose, many lenders began to offer mortgages to less

    qualified borrowers(non-prime mortgages) that required little or no down payment and little or

    no documentation. This generated lowest quality credit and increased the number of nonprime

    loans.

    Due to continuous increase in demand for houses, the prices also rocketed until they were not

    affordable and this resembled the peak of the housing bubble. As demand fell, house price also

    started falling. The falling of the prices resembled the bursting of the housing bubble. This

    means that the house owners now had borrowed more than the value of their houses hence

    they defaulted payment of their debt to the banks leading to the beginning of the Global

    Financial Crises (GFC) in 2007-9.

    However the GFC attracted debate all over the world that has led the Bank of International

    Settlement (BIS) to intervene with another tailor made Basel Capital Accord III among other

    measures inorder to curb the devastating effects of the crisis. The BIS enacts all these policies

    through its committee known as the Basel Committee on Banking Supervision which is base at

    the Banking of International Settlement in Basel Switzerland.

    Consequently, the purpose of this paper is to assess the causes of the Global Financial Crisis

    (GFC) in 2007-9 while exhuming the impacts to both the developed and the developing

    countries. The paper will also highlight the actions taken by the Bank of International

    Settlement (BIS) through its watchdog-the Basel Committee on Banking Supervision in trying to

    curb the crisis while also analysing the efficacy and caveats of such intended measures.

  • 5

    The paper shall be in Six(6) parts with chapter one being the Introduction, Chapter two -The

    Literature review, Chapter three -Causes and effects of the GFC, Chapter four- BIS

    intervention, Chapter five- Effects of the crisis to Zimbabwe and the responds, Chapter six-

    Conclusion and recommendations.

    1.2 Terminology used in the paper

    a. Systemic Risk- In finance, systemic risk is the risk of collapse of an entire financial

    system or entire market, as opposed to risk associated with any one individual

    entity, group or component of a system. It can be defined as "financial system

    instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or

    conditions in financial intermediaries". It refers to the risks imposed by interlinkages

    and interdependencies in a system or market, where the failure of a single entity or

    cluster of entities can cause a cascading failure, which could potentially bankrupt or

    bring down the entire system or market (www.wikpedia.com accessed 2013).

    b. Subprime mortgage crises- A situation starting in 2008 affecting the mortgage

    industry due to borrowers being approved for loans they could not afford. As a

    result, a significant rise in foreclosures (repossession of the mortgaged property

    when a loan is not repaid) led to the collapse of many lending institutions and hedge

    funds. The financial crisis in the mortgage industry also affected the global credit

    market resulting in higher interest rates and reduced availability of credit.

    (www.businessdictionary.com).

    c. Subprime mortgage- A subprime mortgage is granted to borrowers whose credit

    history is not sufficient to get a conventional mortgage. Often these borrowers have

    impaired or even no credit history. Subprime mortgages often offer interest-only

    loans. That's because an interest-only loan is easier to afford. The loan doesn't

    require that any of the principle be paid for the first several years of the loan. Most

    borrowers assume they will refinance before the principal needs to be repaid, and

    the monthly payment increases. If they can't refinance, they often are forced to

    default because they can't make the higher payment. Subprime mortgages were one

    of the causes of the 2009 recession (about.com US Economy 2013).

    d. Colleterised debt obligations (CDO) - CDOs, or Collateralized Debt Obligations, are

    sophisticated financial tools that banks use to repackage individual loans into a

    product that can be sold to investors on the secondary market. These packages

    consist of auto loans, credit card debt, mortgages or corporate debt. They are called

    collateralized because the promised repayment of the loans is the collateral that

    gives the CDOs value.

  • 6

    CDOs are a special type of derivative. Like its name implies, derivatives are any kind

    of financial product that derives its value from another underlying asset. Derivatives,

    such as put options, call options and futures contracts, have long been used in the

    stock and commodities markets (ww.investopedia.com).

    e. Mortgage backed securities- Mortgage-backed securities (MBS) are investments,

    somewhat similar to stocks, bonds or mutual funds. Their value is secured, or

    backed, by the value of an underlying bundle of mortgages. When you buy a MBS,

    you aren't buying the actual mortgage. Instead, you are buying a promise to be paid

    the return that the bundle will receive. An MBS is a derivative, because its value is

    derived from the underlying asset (about.com US Economy 2013).

    f. Financial Crisis -An economic recession or depression caused by a lack of necessary

    liquidity in financial institutions. A financial crisis may be caused by natural disasters,

    negative economic news, or some other event with a significant financial impact.

    Financial crises tend to cause decreases in business activities, leading to a self-

    reinforcing intensification of the crisis (www.investorwords.com).

    g. Basel Capital Accord- A set of agreements set by the Basel Committee on Bank

    Supervision (BCBS), which provides recommendations on banking regulations in

    regards to capital risk, market risk and operational risk. The purpose of the accords is

    to ensure that financial institutions have enough capital on account to meet

    obligations and absorb unexpected losses (www.investopedia.com).

    h. Securitisation- Securitization is the process of taking an illiquid asset, or group of

    assets, and through financial engineering, transforming them into a security. A

    typical example of securitization is a mortgage-backed security (MBS), which is a

    type of asset-backed security that is secured by a collection of mortgages

    (www.investopedia.com) .

    i. Financial Instability Hypothesis- Minskys Financial Instability Hypothesis (FIH) is

    best summarised as the idea that stability is destabilizing. As Laurence

    Meyer(2002) put it: a period of stability induces behavioural responses that erode

    margins of safety, reduce liquidity, raise cash flow commitments relative to income

    and profits, and raise the price of risky relative to safe assetsall combining to

    weaken the ability of the economy to withstand even modest adverse shocks.

    Meyers interpretation highlights two important aspects of Minskys hypothesis: It

    is the behavioral responses of economic agents that induce the fragility into the

    macroeconomic system and after a prolonged period of stability, the economy

    cannot withstand even modest adverse shocks.

    j. Basel Committee on Banking Supervision-The Basel Committee on Banking

    Supervision provides a forum for regular cooperation on banking supervisory

    matters. It seeks to promote and strengthen supervisory and risk management

  • 7

    practices globally. The Committee is comprised of central bank and supervisory

    authority representatives from Argentina, Australia, Belgium, Brazil, Canada, China,

    France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg,

    Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain,

    Sweden, Switzerland, Turkey, the United Kingdom and the United States. The

    Committees Secretariat is based at the Bank for International Settlements in Basel,

    Switzerland. The Basel Committees governing body is the Group of Central Bank

    Governors and Heads of Supervision, which is comprised of central bank governors

    and (non-central bank) heads of supervision from member countries.

    1.3 Research Objectives

    The main objectives of this paper are:

    1. To assess the causes of the global financial crises

    2. To assess the impact of the global financial crises to both developing and developed

    countries

    3. To determine how BIS is intending to deal with the global financial crises

    Research Questions

    The main questions that this paper is intending to answer are as follows:

    1. What exactly were the causes of the GFC?

    2. How did the GFC affected the global economies?

    3. What does the Bank of International settlement responding to the crises?

  • 8

    2.0 Literature Review

    There is a general assumption that United States of America economic failure was the epicentre

    of the global financial crisis. I s this assertion true? It leaves the author with no option but to

    consider what other authors said about the causes and effects of the global financial crisis

    2.1Theoretical Framework

    Fed Chairman Ben Bernanke(2010) postulated that the a major cause of the global financial

    crisis was the period of Great Moderation that left the regulators relaxed This is because

    inorder to forecast the future of the financial system stability , the regulators were dogged in

    the prevailing performance in the system

    Bernankes assertion was supported by Claesberg (2011) who also said the period of great

    moderation left the financial system with a weak regulatory system which left it to dangers of

    systemic risk. Claesber(2011) like Bernanke( 2010) defined The Great Moderation as a period

    from late 1980s to 2006 when there was financial stability that left regulators only concerned

    with monetary stability rather than the financial stability as well as financial regulation.

    Bernanke and Claesberg view are well supported by Minsky (1996) in his Financial Instability

    Hypothesis who said capitalist economies are highly unstable. People in the financial system

    tend to be carried away to the extent that they will be highly leveraged. Minsky mentioned the

    issue of business cycle and postulated that business cycle are solely linked to the financial

    system rather than to production as Schumpeter (1912) asserted .The were three levels in a

    the business cycle that are followed by a financial system that is the Hedge Finance when

    borrowers are able to pay back both interest and capital, the Speculative Finance when

    borrowers cannot pay the principal but are able to pay interest, debts can be rolled over

    inorder to pay back the principal, the Ponzi Finance who cannot pay back both interest and the

    principal .The Ponzi finance signify the beginning of the crisis

    Looking at Minskys assertions, causes of the GFC are easy to deduce hence the GFC was

    termed The Minskys moment in 2009 by Krugman who says what went wrong, Minsky was

    right. Another author who supported the idea of business cycle in the capitalist economies was

    Shiller (2000) in his Irrational Exuberance in which he said people tend to be euphoric such that

    they fail to notice the impending crisis. Greenspan (1996) once mentioned that The financial

    system has Irrational Exuberance ,and the statement caused a fall in stock prices since the

    market thought that there were going to be restrictions imposed.

    Leaven and Valencia (2012) have also suggested some causes of the GFC apart from those

    mentioned above as the collapse of the subprime mortgage market in the USA. They also added

    that derivatives and the collapse of the global trade were the major causes of the GFC.

  • 9

    However, this was also supported by Bernanke who is of the view that the subprime were

    given a long rope at the expense of the world economy.

    The BIS (2010), however tend to differ although they are not conflicting on the cause

    mentioned above but their view is that the crises was a result of the global financial

    interconnectedness which left the economies vulnerable to systemic risk. This is mainly caused

    by globalisation and the liberalisation of the financial system. Poor regulatory frameworks and

    high risk taking through leveraging were major concerns mentioned by BIS (2010) paper.

    Still on the same point, the BIS view was supported by Mckbbin and Stoekel (2011) who

    postulated that the credit cycle and the too big to fail institutions contributed significantly, if

    not wholly to the causes of the GFC. They say that the interblending in the financial system

    exposed all the banks in the global financial system to contagion risk.

    However the GFC had so devastating effects to the world economies. Mckbbin and Stoekel

    (2011) quantified the cost that emanated from the crises and their results shows that trillions of

    dollars were lost due to the GFC.The cost included lost production, disturbances in the

    international trade, government bail outs to the financially distressed firms and many other

    costs.

    On top of that Bernanke (2010) says the GFC increased financial stress and the fall in the stock

    markets especially the SP500. He also noted high unemployment, and collapse of home

    construction as the effects of the GFC.

    In response to the effects of the crisis and the crisis per se, the BIS under its watchdog the Basel

    Committee on Banking Supervision and the Financial Stability Board enacted some measure to

    counter the effects of the global financial crisis. The measure is enshrined in the Basel III (BIS

    2009 paper). Basel III is meant to improve the financial system regulation.

    The author would summarise the above by saying, theoretically, the crisis was a result of

    financial liberalisation and poor regulation whose effects affected the world GDP of which the

    BIS has responded inorder to curb the effects of the crisis.

    2.2 Empirical literature

    The GFC affected all the countries in the world and there is sufficient evidence that Zimbabwe

    was no spared. Empirical literature can evidence that despite the fact that during the period

    when the GFC took place Zimbabwe was I the doldrums of the hyperinflation, it was not spared

    by the GFC as it is not detached from the world trade

    Reduction in production from most sectors of the economy in 2009 were clear evidence of the

    debilitating effects of the GFC.The effects of the global financial crisis have been far-reaching,

  • 10

    affecting both the financial and the real sectors of the economy. The most evident impact of

    the crisis is declining demand for local and regional exports, depressed global commodities

    prices, job losses and currency dislocations Gono expressed this sentiment when he was

    presenting the 2009 Monetary Policy Statement. Although this was subject to criticism by some

    who attributed the problem in the economy the to Gonos money printing mania, there were

    significant evidence that GFC negatively affected the economy.

    Moreover Zengeni 2011 supported Gonos statement as he expressed that declining trend of

    the major indices on the Zimbabwe Stock Exchange has largely followed the effects of the

    global economic crisis. This is because the Zimbabwe Stock Exchange as the countrys single

    capital market is a benchmark to the world economic variable measurement. Volatility in stock

    prices caused by instability in the global economies can be reflected at the stock exchange;

    hence a fall of stock prices during this time was a sign of the implications imposed by a flop in

    the world economy

    In 2009 Vice President Mujuru once mentioned that the country was not spared by the GFC.

    The impact of the world financial and economic crisis will be more devastating in developing

    countries, particularly those on the African continent. At lower levels of development, we are

    more vulnerable to fluctuations in world markets. Coming on the heels of the food and energy

    crises, the global financial crisis seriously threatens sustained economic growth and sustainable

    development on the continent and could reverse progress so far attained towards the

    achievement of the Internationally Agreed Development Goals, including the Millennium

    Development Goals (MDGs) (V.P Mujuru 2009).

    The above information and empirical views shows that Zimbabwe was not safe during the

    financial crisis that rocked d the whole world in 2007-9. The author would surely agree with the

    theorist that the GFC affected all the nations as long as they were involved in the international

    trade. This was mainly due to contagion effect or systemic risk.

    The paper therefore will also answer questions pertaining to the actual causes of the crisis,

    questions about the effects of the crisis and questions about the reactions of the BIS.

  • 11

    3.0 Methodology

    This paper is mainly based on the model of the GFC that the researcher has come up with. The

    model is called The Cause-Effect-Solution Model of the GFC. The model is a summary of the

    GFC and it constitutes some expiation about the major causes of the GFC.

    3.1 The-Cause-Effect-Solution Model (CES Model) of the GFC

    TR

    TOO

    BY THE AUTHOUR, T.GOSHO 2013.

    BIS

    TRIGGERS VULNERABILTIES

    PRIVATE SECTOR

    VULNERABILITIES

    CAUSES

    THE GLOBAL FINANIAL CRISIS(GFC)-2007-2009

    EFFECTS SULOTIONS

    PUBLIC SECTOR

    VULNERABILITIES

    Economic Effects

    Output loss globally

    High unemployment

    Fall in international

    trade

    High government

    spending

    Financial Effects

    Financial stress

    Stock markets plunge

    Debt payment default

    and foreclosures

    Liquidity crisis and risk

    BIS

    BASEL III FINANCIAL

    STABILITY BOARD

    Higher capital

    quality

    Internationally

    harmonised

    leveraged ratio

    Global minimum

    liquidity ratios

    Enhancing risk

    coverage

    Setting up of capital

    buffers e.g. counter

    cyclical buffers

    Too much

    debt

    Great

    Moderation

    complacency

    Poor credit

    rating

    Exotic

    financial

    instruments,

    e.g. CDOs

    Gaps in the

    regulatory structure

    Little or no provision

    for financial systems

    stability

    Monetary policy role

    failure

    Regulatory arbitrage

  • 12

    The CES Model of the Global Financial Crisis above is a summary of what happened in 2007-

    2009. It also shows how the Bank of International Settlement (BIS) is intending to solve the

    financial crisis effects. According to the model above the crisis were caused by triggers and

    vulnerabilities in the global financial system. The effects of the GFC were both economic and

    financial in nature and they affected world economies. The Bank of international Settlement

    came up with Basel III as a direct response measure to the GFC; hence it sis intending to solve

    the GFC effects through this Basel III vehicle.

    4.0 Interpretation of the CES Model and answering the research questions under

    discussion.

    4.1 Causes of the GFC

    The cause of the GFC are categorised into the triggers and the vulnerabilities.

    4.1a The Triggers of the GFC.

    Bernanke (2010) descries triggers of the GFC as the forces that exacerbated the GFC. They

    include the decline in the house prices and associated mortgage losses which resulted into

    foreclosure and default risk. BIS (2009) also mentioned global financial interconnectedness as a

    major trigger of the as it cause systemic risk. The BIS is of the view that in 2006 global financial

    interconnectedness was more sophisticated compared to 1996. The two diagrams below show

    how global interconnectedness of the financial system triggered the GFC:

    Comparing the nature of interconnected ness in the diagram above clearly show that systemic

    risk is high in 2006 compared to 1996. This is because any financial distress in one country can

    JAP

    USA

    UK

    ASIA

    EUR

    CHINA

    OTHER

    CARIB

    1996

    UK JAP

    USA OTHER

    CHINA

    EUR

    CARIB

    ASIA

    2006

  • 13

    easily be contagiously transferred to another country. This is what exactly happened in 2007

    when the house bubble busted in USA, causing global shocks and liquidity problems, hence

    interconnectedness of the global financial system was a major trigger to the GFC.

    4.1b Vulnerabilities as causes of the GFC

    Vulnerabilities were described by Bernanke (2010) as the weaknesses in the financial system

    that can transform somewhat a modest recession into a severe recession. The financial

    systems vulnerabilities are split into the private sector vulnerabilities and the public sector

    vulnerabilities. These are clear described below:

    a. Private Sector Vulnerabilities

    The private sector was lulled into complacency during the Great Moderation when borrowers

    and lenders took on too much debt (leverage). Minsky (1996) postulate that a period of

    financial stability will eventually leave people in a crisis because of the euphoria amassed

    during the good times hence stability creates instability. Consequently, the period of Great

    Moderation encouraged relation on the part of the lenders and borrower who ended up

    lending to lemons (Arkerlof 1973), hence the lemon problem of adverse selection since there

    was not enough information about the counterparties. This aggravated the crisis several loans

    were given to lemons and uncredityworthy customers. Failure to pay by the borrowers and

    house buyers sparked the crisis and due to the interconnectedness of the financial system, a

    global financial crisis precipitated in 2007.

    Banks and other financial institutions failed to adequately monitor and manage the risks they

    were taking (for example exposures to subprime mortgages). Bernanke (2010) highlights that

    there was poor credit rating by banks. Loans given to the customer were of poor quality and

    were not being managed well due to too much euphoria in the financial system. The exposed

    banks to credit risk since most of their customers were non primes and there were no proper

    documentation considered when the loan was being issued. Consequently when the housing

    bubble burst, the financial firms were the first to be hit and due to the globalisation of the

    financial system, the whole global financial system was thrown into mayhem, and crisis.

    Moreover, the increased use of exotic financial instruments concentrated risk, especially the

    credit default swaps used by AIG. The use of the credit default swaps and the collaterised debt

    obligations also rendered the financial system susceptible to more risk. This sis because failure

    of any one party into the transaction would expose other preceding parties , for example when

    banks sold their securities to investors in tranches, they expected to repay the investor if their

    borrowers(bank customers) pay them(banks) ,but when borrowers defaulted both the banks

    and the investor lost out and the crisis was ignited. It became the global financial crisis due to

    the interconnectedness of the financial system.

  • 14

    b. Public Sector Vulnerabilities

    The public sector vulnerabilities are into two:

    1) Gaps in the regulator structure

    Minsky (1996), attributed the cause of the financial crisis to regulatory failure. The author came

    up with three types of flaws in the financial systems regulation that can cause financial crisis

    and these includes: regulatory relaxation, regulatory arbitrage and regulatory capture.

    Regulatory relaxation can be describe in terms of the Great Moderation when regulators

    relaxed and lost focus on regulating the financial system to ensure financial stability while

    regulatory arbitrage is when the financial system circumvent the regulations put in place while

    taking in high risk assets. Regulatory arbitrage caused firms to circumvent the rule of both Basel

    I and Basel II, when banks relied much on high risk capital in debts that in equity, as well as in

    off-balance sheet transactions like securitisation of assets and the use of credit derivatives like

    credit default swaps. Regulatory capture is a situation when other financial banks are too big to

    the regulators hence they should not be tampered with and these are called too big to fail

    banks or systemically important banks. Regulators were lenient on these institutions like the

    Lehman Brothers, AIG and Northern Rock Merchant Bank. These gaps in the financial system

    contributed seriously to the start of the GFC.

    Regulators especially the Fed gave less attention to financial stability compared to the attention

    that was being given to the monetary stability. This means that there was less financial

    regulation mainly due to the complacency created by the period of Great Moderation. As a

    result when the crisis came, the regulators were found unprepared for the crisis hence a mild

    crisis was transformed into a severe crisis Bernanke (2010)

    2) The role of Monetary Policy

    Some have argued that the Feds low interest rates monetary policy in the early 2000

    contributed to the housing bubble which in turn was a trigger to the crisis (Bernanke 2010). This

    view is based on the theory that low interest rate pushed up investment and high credit

    creation which generated in to fatal investment euphoria. The euphoria under discussion is said

    to have contributed to the housing bubble which busted into a global financial crisis in 2007.

    However, there are arguments against the attribution of monetary policy role as a cause of the

    GFC that include:

    If compared international UK had a house bubble during the 2000s despite tighter

    monetary policy that US

    Size of the bubble shows that the changes in the mortgage rates during the boom years

    seemed far too small to account for the magnitude of house price increase

  • 15

    The timing of the bubble show that house prices began to pick up late 1990s before

    monetary policy began easing and rose sharply after monetary policy tightening in 2004

    (for example in the Asian crisis)

    Consequently despite all the cause given above, economists are still debating about what

    could be the major cause of the GFC, especially when it comes to the issue of monetary

    policy as a cause.

  • 16

    4.2 Effects of the GFC and data presentation

    The effects of the GFC are divided into two as shown on the CES Model above and these include

    the economic effects and the financial effects

    a) Economic Effects

    GFC inflicted severe Output loss globally, high unemployment, fall in international trade and

    high government spending

    1) Global output loss

    Key

    World map1 showing real GDP growth rates for 2009. (Countries in brown were

    in recession.)

    Map 1 above shows that the fall in growth rate was mainly associated with the developed

    countries notably USA, Europe and some parts of Asia and South America. Africa was not

    severely affected as show by a dominating green colouration.

  • 17

    The bursting of the U.S. housing bubble, which peaked in 2006, caused the values of securities

    tied to U.S. real estate pricing to plummet, damaging financial institutions globally. The global

    recession affected the entire world economy, with higher detriment in some countries than

    others. It is a major global recession characterized by various systemic imbalances and was

    sparked by the outbreak of the financial crisis of 20072008.

    The fallout from the recent crisis on the real sector was large. The median output losses for the

    recent crises are 25 percent of GDP, which is almost 5 percentage points higher than its

    historical median of 20 percent. Output losses differ depending on the size of the initial shock,

    differences across countries in how the shock was propagated through the financial system,

    and the intensity of policy interventions. The output losses for Ireland and Latvia stand out at

    over 100 percent of potential GDP. Losses among borderline cases are also significant, in

    particular for Hungary, Portugal, and Spain. On average, countries with larger financial systems,

    and especially those that experienced rapid expansion prior to the crisis (such as Iceland,

    Ireland, and Latvia), were hit hardest (Laeven and Valencia (2008)). The graph below shows a

    significant drop in the global out due to the GFC in 2008.

    Figure 3: Global output 2004-2010

    SOURCE: WORLD BANK 2010 PAPER

    Figure 3 show the extent to which output has fallen from 2007-2009. Advanced economies

    are the worst to be hit be the crisis compared to the emerging and the developing

    economies.

  • 18

    Mickibbin and stoeckel (2010) came up with monetary figures for global output loss and

    these are shown on the table below:

    Table 1: showing Mickibbin and stoeckel global output losses valuation

    Component of the GDP Amount lost US$ trillions

    Loss to world output $4 trillion Loss of bank market value $5 trillion Government support $15 trillion Mark market asset loss(loss) $24 trillion NPV loss of world output $60-200 trillion

    The table above show how devastating the GFC was interms of monetary loss interms of

    GDP loss. The net present loss value of the world out is $60 to $200 trillion which is an

    alarming figure to talk about. This is merely 5% decrease in the world output within the 2

    years of crisis.

    2) High Government Spending

    Graphic showing (figure 4 below) 2008 October bank bailouts by United Kingdom and

    United States in billions of dollar equivalents. United Kingdom graphics are at top, United

    States below. Green indicates the annual Gross Domestic Product in 2008, pink indicates

    the total government spending in 2008, and grey indicates the various bank rescue

    payments up to 2008 October 13. The 700 billion dollar US bank rescue of the Emergency

    Economic Stabilization Act of 2008 does not include the additional 150 billion dollar

    additional provisions.

    Figure 4 showing USA and UK Government Spending in 2008

  • 19

    3) Fall in employment world wide

    Figure 5 showing a fall in employment in USA from 2007-2009

    GFC resulted in a drastic fall in employment globally. The graph above shows a sharp decrease

    in the employment as shown by the EMRATIO.

    The EMRATIO is computed as the "Civilian employment" divided by "Civilian non-institutional

    population." In September 2012, these were (in thousands) 142,974 and 243,772 respectively,

    resulting in a ratio of 58.7%.

    Civilian employment (FRED Data series CE 160V): Includes those employed 16+ years of

    age but excludes those unemployed or outside the workforce.

    Civilian non-institutional population (FRED Data series CNP 160V): Civilian no

    institutional population is defined as persons 16 years of age and older residing in the 50 states

    and the District of Columbia, who are not inmates of institutions (For example, penal and

    mental facilities, homes for the aged), and who are not on active duty in the Armed Forces. The

    total U.S. population was approximately 315 million during 2012.

  • 20

    b) Financial Effects of the GFC.

    1. Fall in the subprime lending

    GFC resulted in the fall in the subprime lending in 2006. The housing bubble bursted in 2006

    leaving banks with no choice than to stop lending due to the liquidity crunch. The subprime

    lending that had increased to over 20% in 2006 dropped sharply as shown in the graph in figure

    6 below

    Figure 6 showing a drop in the subprime lending in 2006.

  • 21

    2. Securitisation collapsed

    Figure 7 showing the collapse of the securitisation by the financial institution during

    the GFC.

    From Economist Zandi (2010) testimony to the Financial Crisis Inquiry Commission: "The

    securitization markets also remain impaired, as investors anticipate more loan losses.

    Investors are also uncertain about coming legal and accounting rule changes and regulatory

    reforms. Private bond issuance of residential and commercial mortgage-backed securities,

    asset-backed securities, and CDOs peaked in 2006 at close to $2 trillion...In 2009, private

    issuance was less than $150 billion, and almost all of it was asset-backed issuance

    supported by the Federal Reserve's TALF program to aid credit card, auto and small-

    business lenders. Issuance of residential and commercial mortgage-backed securities and

    CDOs remains dormant." Banks and other financial institutions packaged various types of

    loans (including mortgages) into securities and sold them to global investors. This is called

    securitization. In exchange for purchasing the investment, the investor receives a right to

    the cash flows from the underlying loans specified for the security. The chart above (figure

    7) shows how this financing source dried-up, meaning that non-prime mortgages and other

    types of loans could not be originated and sold to investor

    3. Stock Market Plunge

    The GFC caused a severe plunge in the stock market leading to a bearish behaviour. Figure 8

    below clearly shows a fall in the DJI in 2008 due to the effects of the GFC. This because of the

    loss of confidence in the market by the investors who wanted to safeguards their investments.

    Figure 8 showing a plunge in the DJI in 2008

  • 22

    c) Effects of GFC to Africa (Zimbabwe) financial system.

    Africas low level of financial integration meant that African economies were relatively isolated

    from the direct impact of the financial crisis. Thus, Africa found itself shielded from the impact

    of the 2007 subprime and the summer 2008 banking crises, thereby avoiding the effects of a

    financial crisis that affected the very foundations of international financial markets. Compared

    to emerging countries, Africas external financing (bond issue, stocks and private borrowing) is

    low, representing only 4% in 2007 of overall issue for emerging economies. In 2007, bond issues

    stood at only USD 6 billion, compared to USD 33 billion for Asia and USD 19 billion for Latin

    America. Furthermore, in terms of access to private resources, Africa received only USD 3

    billion in 2007, compared to USD 42 billion in developed countries.

    Although African banking systems were not directly exposed to the sub-prime crisis, there were

    strong indications of increased asset price and risk premium volatility on African financial

    markets as early as the summer of 2008. The contagion and interdependence significantly

    affected the regions financial markets. For some African markets (e.g. Egypt and Nigeria), the

    impact was much higher than for markets in developed countries.

    Africas relatively liquid financial markets not only suffered from the contagious effect but also

    faced amplification thereof, possibly attributable to the over-valuation of stocks and the

    outflow of portfolio investments. African investors, in general, and Egyptian and Nigerian

    investors in particular, recorded within six months an average loss of more than half the wealth

    invested at the end of July 2008. This is higher than the losses recorded on American, French

    and Japanese markets

    In Zimbabwe the financial system was mire by the banking crisis that have emanated from the

    hyperinflation hence the effects of the global financial crisis were adding an insult to an injury.

    Zimbabwes commodities were seriously hit in the international markets forcing mining giants

    like Bindura Nickel Mine, Shabanie Mashaba Mine, and many others to shut down. This is

    because the commodity prices had fallen to their historic low levels.

  • 23

    4.3 The BIS intended measures to the GFC.

    The Basel Committee on Banking Supervision and its oversight body, the Group of Governors

    and Heads of Supervision, have developed a reform programme to address the lessons of the

    crisis, which delivers on the mandates for banking sector reforms established by the G20 at

    their 2009 Pittsburgh summit. This report, which the Committee is submitting to the G20,

    details the key elements of the reform programme and future work to strengthen the resilience

    of banks and the global banking system.

    In response, the Committees reforms seek to improve the banking sectors ability to absorb

    shocks arising from financial and economic stress, whatever the source, thus reducing the risk

    of spill over from the financial sector to the real economy.

    The reforms strengthen bank-level, or micro prudential, regulation, which will help raise the

    resilience of individual banking institutions in periods of stress. The reforms also have a macro

    prudential focus, addressing system wide risks, which can build up across the banking sector, as

    well as the procyclical amplification of these risks over time. Clearly, these micro and macro

    prudential approaches to supervision are interrelated, as greater resilience at the individual

    bank level reduces the risk of system wide shocks.

    4.3a Basel Capital Accord III

    Collectively, the new global standards to address both firm-specific and broader, systemic risks

    have been referred to as Basel III. Basel III is comprised of the following building blocks, which

    have been agreed and issued by the Committee and the Governors and Heads of Supervision

    between July 2009 and September 2010:

    Raising the quality of capital to ensure banks are better able to absorb losses on both a

    going concern and a gone concern basis;

    Increasing the risk coverage of the capital framework, in particular for trading activities,

    securitisations, exposures to off-balance sheet vehicles and counterparty credit

    exposures arising from derivatives;

    Raising the level of the minimum capital requirements, including an increase in the

    minimum common equity requirement from 2% to 4.5% and a capital conservation

    buffer of 2.5%, bringing the total common equity requirement to 7%;

    Introducing an internationally harmonised leverage ratio to serve as a backstop to the risk-based capital measure and to contain the build-up of excessive leverage in the system;

    Raising standards for the supervisory review process (Pillar 2) and public disclosures (Pillar 3), together with additional guidance in the areas of sound valuation practices, stress testing, liquidity risk management, corporate governance and compensation;

  • 24

    Introducing minimum global liquidity standards consisting of both a short term liquidity

    coverage ratio and a longer term, structural net stable funding ratio; and

    Promoting the build-up of capital buffers in good times that can be drawn down in

    periods of stress, including both a capital conservation buffer and a countercyclical

    buffer to protect the banking sector from periods of excess credit growth

    Appendix 1 shows the actual dates set by the Basel Committee so that these intended

    measures can be affected. The implementation period is given up to 2019 and Basel III is

    expected to be a pillar in which the financial system is going to lean on.

    4.3b The Financial Stability Board.

    The Committee is also working with the Financial Stability Board to address the risks of systemic

    banks. On 12 September 2010, the Governors and Heads of Supervision agreed that

    systemically important banks should have loss absorbing capacity beyond the minimum

    standards of the Basel III framework.

    The Committees reforms will transform the global regulatory framework and promote a more

    resilient banking sector. Accordingly, the Committee has undertaken a comprehensive

    assessment of Basel IIIs potential effects, both on the banking sector and on the broader

    economy. This work concludes that the transition to stronger capital and liquidity standards is

    expected to have a modest impact on economic growth. Moreover, the long-run economic

    benefits substantially outweigh the costs associated with the higher standards.

    III framework and related supervisory sound practice standards. It is also conducting work in

    the following areas:

    A fundamental review of the trading book

    The use and impact of external ratings in the securitisation capital framework

    Policy response to systemically important banks,

    The treatment of large exposures;

    Enhanced cross-border bank resolution;

    A review of the Core Principles for Effective Banking Supervision to reflect the lessons of

    the crisis; and

    Standards implementation and stronger collaboration among bank supervisors through

    supervisory colleges.

  • 25

    5.0 Conclusion and Recommendations.

    The Global Financial Crisis (GFC) attracted so much attention to the extent that the causes and

    the impacts of such were either exaggerated or ignored. Even reactions to curb the impacts and

    even to curtail the crisis were met with mixed opinions and feelings. Consequently, the purpose

    of this paper is to assess the causes of the global financial crisis while exhuming the impacts to

    both the developed and the developing countries

    Given the CES Model used in the text by the author, the major causes of the are the

    complacency created by the Great Moderation period that left bank taking more risks without

    proper credit rating. The GFC was termed the subprime mortgage crisis because it was

    triggered by the housing bubble that bursted in the US.

    Regulatory relaxation and the gaps in the regulatory structure were also among the major

    causes of the GFC, because regulators especially the Fed was mainly concerned about the

    monetary stability at the expense of financial stability. When the crisis started the regulators

    was not even ready hence according to Bernanke a mild crisis was made a severe crisis.

    The GFC had severe effects to the global economies. Map 1 in the text shows clearly shows that

    developed countries were the main affected economies. This is because these economies have

    greater interconnected financial systems unlike African financial system which is somewhat

    dislocated from the global financial system (ADB paper2010).

    The loss to the economies was in form of GDP losses and Table 1 shows that $US60 -200 trillion

    was lost during the GFC. This is because international trade was disturbed and liquidity crunch

    started to creep in reducing investment and output growth.

    Unemployment was one of the severest effects of the GFC; this is because most firms especially

    banks scaled down inorder to contain the cost associated with the crisis.

    However the Bank of International Settlement through its watchdog the Basel Committee on

    Banking Supervision came up with Basel III as a countermeasure to the GFC. The capital accord

    help to strengthen the financial system at a global level by enhancing the quality of capital,

    encouraging the use of global harmonised leverage ratio, setting aside of capital buffer , the use

    of statutory liquidity ratios and to encourage appropriate risk management.

    The Committee is also working with the Financial Stability Board to ensure the enforcement of

    the Basel II. The supervision is aimed at reducing the caveats associated with regulatory

    relaxation that causes the GFC.

  • 26

    5.1 Recommendations

    The author would want to recommend the following to the regulators be it for developing

    countries or the developed ones:

    There is need for flexibility in the financial system so that when a crisis comes the

    system can quickly be manoeuvred so as to reduce the impact of the crisis. The 2007-

    2009 GFC was intensified and prolonged to 3 years because the system was not flexible

    enough to manoeuvre and adopt new systems.

    The use of countercyclical capital buffers is one of the best resolutions that the BIS has

    put in place. This has to be enforced so as to ensure that financial institution will not be

    found wanting when a crisis comes. This is because capital can be accumulated I good

    times and used in times of crisis.

    Above all, financial stability should be given precedence. This sis because monetary

    stability is a product of financial stability. The fact that regulators concentrated much on

    monetary stability proved to be dangerous and contributed the GFC hence regulators

    should ensure financial stability.

    Regulation of financial system is key to its stability hence government involvement in

    the financial system is indispensable for economic growth and financial growth as was

    postulated by Keynes (1936)

    However, the purpose of this paper was to assess the causes of the global financial crisis while

    exhuming the impacts to both the developed and the developing countries. The paper also

    highlighted the actions taken by the Bank of International Settlement through its watchdog-the

    Basel Committee on Banking Supervision in trying to curb the crisis while also analysing the

    efficacy and caveats of such intended measures.

  • 27

    7.0 References

    1.) Bank for International Settlements 2010 The Basel Committees response to the financial

    crisis: Report to the G20.

    2.) Bernanke (2010), Lecture Series, Th cause and Effects of the Global Financial Crisis.

    3.) BIS (2009), Annual Report, 29 June.

    4.) BIS (2010), An assessment of the long-term economic impact of stronger capital and

    liquidity requirements, Basel Committee on Banking Supervision, BIS.

    5.) IMF (2009), World Economic Outlook, October,

    http://www.imf.org/external/pubs/ft/weo/2009/02/index.htm.

    6.) Minsky, Hyman P.( 1986), Stabilizing An Unstable Economy. Yale University Press.

    7.) Schumpeter, Joseph A. (1934), Theory of Economic Development. Cambridge, Mass. Harvard

    University Press

    8.) Keynes, John Maynard,( 1936), The General Theory of Employment, Interest, and Money.

    New York: Harcourt Brace.

    9.) Akerlof, G.A., and R.J. Shiller, (2009), Animal Spirits How human psychology drives the

    economy, and why it matters for global capitalism. Princeton and Oxford: Princeton University

    Press

    10.) Shiller, R.J., (2000), Irrational Exuberance. Princeton: Princeton University Press

    11) African Development Bank (2009) Financial Crisis Monitoring Group Weekly Report January

    2009

    12.) African Economic Outlook 2008/09, Preliminary results