Understanding the causes of 2007-09 ‘financial crisis’…and the UK government’s response- An essay by Shirumisha Kwayu

Note to the reader: This is the first entry that is not written by me (i.e. Aikande Kwayu). The blog is now inviting entries by interested people…if you think you may have something to share please feel free to email me.  And now…let’s learn a bit about the recent financial crisis and how the UK government responded. It’s important to understand the UK’s reaction as it has been one of the forefront countries in dealing with the issue… remember how Gordon Brown worked very closely with U.S.A, I.M.F, E.U, etc…proposing bailing out banks etc…so here we go!!!!

The period between 2007 and mid-2009 experienced the worst global financial crisis since the great depression of 1930’s. The crisis was mainly notable for its impact on the banking sector. In the UK, a bank run that was never seen since 1866 at Overend Gurney bank was seen at Northern Rock in September 2007 (Shin, 2009). Some scholars such as Eduardo Pol (2012) argue that the 2007-09 crisis should be specifically termed as banking crisis instead of financial crisis. The rationale being that the crisis inflamed financial shock that hit directly on the banking sector. The period was characterised with failure of large banks such as Northern Rock, Lehman brothers, Bear Stearns and others across the US, UK and Europe. The failure subjected some banks to takeovers as well as prompting government intervention in order to rescue the whole financial system.

The failure of these banks and the crisis in general was a result of major developments that took place in both micro economic level (within the banking industry) and macroeconomic level (within the economy). This essay will discuss: (a) the causes of the 2007-09 banking crisis; (b) and critically assess steps that were taken by the UK government to resolve the problem. The essay ends with a conclusion.

The USA real estate boom is a major factor that led to the 2007-09 banking crisis. The link between the real estate boom and the financial crisis is derived from the classical economic theory, which explicates that a boom is followed by a burst. The period before the crisis began the US housing market was flourishing with rising house prices. The housing market boom was supported by the government ambition for people to own their own houses under the President Bush ‘American Dream’ policy act which loosened some financial constrain for people with lesser income (Wignall et al, 2008). The rising house prices and slack regulation made the real estate business a profitable and nobody seemed to care the level of risk associated with the return from the housing market. The risk shifted to the banks through the mortgage broker who created loans and sold them to the banks and the banks securitized them (Pol, 2012). The banking crisis was created in this movement because the mortgage brokers had no incentive to assess the risk of the loans. The expectation that house prices will continue to rise was what kept sustaining the boom and any falling house price would lead to loss in the market, defaults and exposing the risk, hence crafting the crisis.

Another factor that caused the banking crisis of 2007-2009 was the subprime lending. Subprime lending is the act of issuing loans to borrowers with poor credit history; weak financial or collateral base and they have high risk of default. Normally, the subprime borrowers would not be able to access a loan. Thus, subprime loan will have a short term maturity with instalment that contains a penalty. Mayer et al (2009) estimates that the subprime mortgage relative to total mortgage market in the US grow from 10% to 32% between 2003 and 2005. The burgeoning of the subprime lending was inflated by various factors such as deregulation of the financial sector, increase in securitization and loose supervision of reserve capital ratio in the banking sector.

A global saving glut that occurred in the period before the crisis began is arguably a contributing factor to the 2007-09 banking crisis. Barrell and Davis (2008) suggest that the saving which were done by countries such as China by forming surpluses in their current account and accumulating foreign reserve created availability of liquidity and also enabled western countries such as US and UK to maintain low interest rates in the period preceding the banking crisis. As a result, this global saving glut accounts for the credit availability and increasing house prices. However, this view is challenged by Taylor (2009) suggesting that the US deficit, which is caused by overinvestment and under saving, will offset the saving gap. Therefore, the global excess saving is still controversial as to whether it caused the banking crisis 2007-09.

Innovation and deregulation that took place in the financial sector was a fundamental cause for the banking crisis of 2007-09. James Crotty (2009) argues that the new financial architecture, which is the development of the current financial practices as a result of the deregulation of the financial sector that started in the 1980’s, was the reason for the banking crisis. Authorities across the world abandoned rules that restricted competition and adopted the ones with lesser regulation and had a larger feasibility of innovation. Barrell and Davis (2008), for example, show how the US authority abandoned the Glass-Steagall act to adopt Basel II, which allowed securitization. Additionally, Crotty (2009) notes the role played by the efficient market theory in the development of the new financial architecture and the ignorance of the endogenous financial instability theory by Keynes and Minsky.

The efficient market theory proposes that the market is efficient when there is perfect competition and lesser regulation. Whereas, the Minsky’s financial market fragility theory suggests that the financial markets tend to move from stability to instability in the absence of regulations. Therefore, what happened with the deregulation since 1980’s caused a major development in the financial sectors; such development is like derivatives markets. Derivative markets are such as forwards, futures, options and swaps. The development of these new financial instruments is one of the factors that led to the financial boom in the preceding period of the crisis. Derivatives are meant to hedge the risk but in reality they spread the risk across the financial institution.

Practically, though the banks compete with each other they also cooperate through interbank lending and trading of derivatives such as interest rate swaps or foreign currency swaps. The cooperation forms a network of banks across the world, thus a collapse in one of the institution has a multiplier effect to the whole financial sector and hence forming the crisis. For instance, the failure of BNP Paribas in the summer of 2007 prompted the seizure of interbank lending across the world (Shin, 2009). Therefore, it is correct to conclude that the failure of regulatory authorities to cope with the new innovation that took place in the banking and whole financial sector was a cause to the banking crisis of 2007-09.

The above explanations have outlined some of the macro and micro economic factors that caused the financial crisis of 2007-09. Below is the assessment of the UK’s government measures taken to address the crisis.

The UK government used both fiscal and monetary policy to resolve the financial crisis. Hodson and Mabbett (2009) suggest that the Labour government underwent an ideological shift in its fiscal policy as a response to the banking crisis. The UK government loosened its monetary policy to stimulate the economy. The government increased it borrowing tremendously so as to increase transfer of payments and increase spending on goods and service. Also as part of the stimulus package, the government reduced taxes as means of boosting spending. Scholars such as Lee (2009) and the Conservatives deemed the government’s reaction as a shift to Keynesian economic policy. Unfortunately, these fiscal measures did not raise the household disposable income hence they were ineffective. Thus, the UK government was left with monetary policy as means for solving the crisis.

From the genesis of the crisis the government used various monetary policy tools to solve the crisis. When Northern Rock went into a bank run, the UK government decided to guarantee the entire retail- bank deposits in the UK as a means to rescue the banks from failure (Hodson and Mabbett, 2009). Furthermore, in the crisis period, the Bank of England decided to reduce interest rate from 5.75% to 0.5% in the period of crisis as means to promote interbank lending. This measure was unsuccessful. The interest rate reduction was ineffective due to deflation. Consequently, the Bank of England decided to use a more aggressive and unconventional means of injecting money to the economy directly through asset purchase program which was popularly known as quantitative easing. To date the Bank of England has injected £375 billion in the economy through the asset purchase program (Bank of England, 2013). Quantitative easing was successful in removing the liquidity problem which was the centre theme of the crisis that also made the banking crisis 2007-09 to be known as credit crunch. A theoretical criticism of quantitative easing is drawn from Keynesian quote which states, ‘If, however , we are tempted to assert that money is the drink which stimulates the system to activity, we must remind ourselves that there may be several slips between the cup and the lip’.

In conclusion, the financial and in particular the banking sectors need to be regulated with a flexible authority that is capable of adapting with the innovation that takes place within the industry. Measures such as quantitative easing and other conventional methods of resolving banking crisis whether fiscal or monetary will not be effective if not accompanied by institutional restructuring of the financial sector. This essay appreciates international efforts to control the banking sector such as Basel III accord along other on-going efforts by the government to ring fence institution as means of preventing a banking crisis of the 2007-09 scale.

Written by: Shirumisha Kwayu! twitter @shirumisha 

References

Adrian Blundell-Wignall, Paul Atkinson and Se Hoon Lee (2008) “The Current Financial Crisis: Causes and Policy Issues.” Financial Market Trends – ISSN 1995-2864 – OECD

Bank of England (2013) http://www.bankofengland.co.uk/Pages/home.aspx [Last accessed 15th March 2013]

Dermot Hodson and Deborah Mabbett  (2009) “UK Economic Policy and the Global Financial Crisis: Paradigm Lost?” Journal of Common Market Studies,  47/5,  pp. 1041–1061

Eduardo Pol (2012) “The preponderant causes of the USA banking crisis 2007–08.The Journal of Socio-Economics 41 pp. 519– 528

Hyun Song Shin (2009) “Reflections on Northern Rock: The Bank Run that Heralded the Global Financial Crisis.” Journal of Economic Perspectives, 23/1 pp. 101–119

James Crotty (2009) “Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture.” Cambridge Journal of Economics, 33, pp. 563–580

John B. Taylor (2009) “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong.”  National Bureau of Economic, Working Paper 14631

Lee, S. (2009) “The Rock of Stability? The Political Economy of the Brown Government.” Policy Studies, 30/ 1, pp. 17–32.

Mayer, C., Pence, K., Sherlund, S., (2009) “The rise in mortgage default.” Journal of Economic Perspectives 23, pp. 27–50.

Ray Barrell and E. Philip Davis (2008) The Evolution of the Financial Crisis of 2007-8 http://dspace.brunel.ac.uk/bitstream/2438/5132/1/0825.pdf [last accessed March 15, 2013]

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9 Responses to Understanding the causes of 2007-09 ‘financial crisis’…and the UK government’s response- An essay by Shirumisha Kwayu

  1. Castro Shirima says:

    Shirumisha,

    This was a wonderful article / essay! It is well researched and academically framed-up
    I predict it might be used as a powerful tool for those in the financial and banking sector to equip themselves with the abcs of controling and regulating the said sector with maximum flexibility and potential success!

    After reading the same is when I can understand why it is more proper to name it “Banking Crisis” than “Financial Crisis” as it was so called! Your discussion as to why it is so called and pricise justification made me to think of the current housing programme our NHC has embarked on-though I stand corrected can you workout something on this?

    Lastly but not least, I congratulate you for this piece of knowledge which brings in power to our people, policy makers and actors of the Government at large! Shall you take measures to have it published ?

    Thanks

  2. Agreed! There were interconnected legal, economic and political reasons that led to the banking crisis in the United Kingdom. Some of these reasons were domestic, but others could be traced in the United States and weaknesses of the European Union in relation with the liberalisation of financial markets.

    The United Kingdom adopted various measures to deal with the financial including bank nationalisation, state guarantees, brokered mergers, capital injections, impaired assets reliefs and liquidity schemes.

    These ranged from interim to long-term responses. From the legal perspective, the Financial Services Act 2010 enacted before the national election in May 2010 to amend the Financial Services and Markets Act 2000, was intended to strengthen the powers of the Financial Service Authority and to give it a financial stability objective.

    However, after entering into power, the Coalition Government announced major reforms to the regulatory structure including the transformation of the Financial Service Authority to become a new prudential supervisor for banks, investment businesses and insurance companies, and to introduce a separate regulator for consumer protection, conduct of business and markets.

    The prudential regulation would go to a subsidiary of the Bank of England (Prudential Regulatory Authority), a new Financial Policy Committee in the Bank of England responsible for macro-prudential regulation and other functions to be vested in a Financial Conduct Authority. Whether these measures will help to improve the current public perceptions on banks is a matter to be seen.

  3. Thanks Proches,
    I’m very grateful for your further analysis and I appreciate that you have given it from Law perspective. Thanks again

  4. ROZII says:

    a very usefull and well lituratured information …. much better then the amount of sooo long extending articles i have read

  5. The interest on this type of loan is low as you provide having a safety deposit.
    However, there can be a way you can get a pay check advance if
    you know where you should check for.

  6. Widrcito says:

    Voluntary. They have created dluobe speak to make the people think that slavery is involuntary. Which is really involuntary servitude.If your not obligated to have ID why do you think they keep asking you for it?To get you to wave your rights and self incriminate with employee ID. ( Can I see your ID to see If you have volunteered for us to own you?)Ive seen magistrates push attorney`s out of the way to get to his chambers to avoid what is coming down the pipe.When you find the mutual fund, go see who are the major share holders, Im sure it wont be a surprise.

  7. Yonathan says:

    seems to have a US slant.I’d be interested to see how/if this apeipls in the UK?As with all legalise, this looks tricky to translate and summarise.I assume that you are alluding that If you can challenge Servitude or block presumutions that your Strawman is dead, the banks can be blocked from claims on your (Strawman’s) Estate e.g. a Mortgage.What we really need is an automatic legalese to English translator which can translate legalese based on all the sneaky re-definitions in a document and referenced documents, then summarise it, but I doubt that this is a trivial task, due to all the deliberate ambiguity and sloppyness.

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