Table of Contents
Introduction
The main objective of this paper is to analyze the causes and effects of the Global Financial crisis in the US and the changing functions of the financial system in the current US economy. The crisis was marked as the consequence of the crash of the US Stock Market and baking industry and resulted in de-shaping the US economy. The paper will include the vital reasons for the global financial crisis (GFC). The repercussions of the financial crisis will also be highlighted in the paper. Further, it would include the connection of the global financial crisis with the current economy of the US
Global Financial Crisis: 2008
The Global Financial Crisis (GFC) was a timeframe of extreme stress in the banking systems and the global financial markets between the period of mid-2007 and early 2009 (RBA GOV, 2022). A major downturn in the US housing bubble acted as a catalyst for the collapse of the housing market due to easy credit, insufficient regulations etc., by banks and investors. The severe liquidity contraction in the financial markets originated in the U.S. due to the collapse of the housing market of the United States. The financial crisis had majorly impacted millions of Americans. Almost 5.5 million Americans lost their job due to negligible growth in the economy during the global crisis (Pewtrusts, 2022). Also, the U.S. lost $7.4 trillion in respect to stock wealth i.e., $66,200 on average per household (Pewtrusts, 2022).
Causes of the Financial crisis
- Massive risk exposure in the favorable macro-economic environment – US households began borrowing loans due to the spreading of information about rising real estate prices in the US in the future. Similar expectations led property households and developers in countries like Spain, Ireland etc., to borrow excessive loans for construction (RBA GOV, 2022). The greed for earning short-term profits caused the excessive borrowing of large volumes of risky loans by property developers and households. Therefore, lenders that provided housing loans neglected the loan repayment factor by the other party due to expectations of the continuity of the favorable conditions (RBA GOV, 2022). Hence, loans were provided based on the assumption that they would be repaid regularly.
- Increased borrowing by investors and banks – In order to expand lending power, banks and investors increased their borrowing. Also, loans were taken for a short period in order to purchase assets. For example, the investment banker Lehman Brothers had a debt of $600 billion of which $400 billion was to be covered by credit default swap (CDS) (Business Insider, 2022). Unfortunately, the U.S. stock market, Wall Street, collapsed due to failure of loan repayment by investment banks like the Lehman brothers. At the time of declaring bankruptcy by Lehman, banks panicked and lending stopped (Business Insider, 2022).
- Risky behavior of Wall Street – Securitization also acted as an added cause for the global financial crisis. With the help of securitization, subprime lenders began bundling loans with the motive to sell them to investment banks (Business Insider, 2022). The loan then got transferred to investors in the form of mortgage-backed securities (MBS) (Business Insider, 2022). As a result, financial instruments namely, collateralized debt obligations (CDOs), are aimed at combining multiple loans from investors and banks into a single product with varying risk levels.
Effects of the Financial crisis
After the collapse of the Lehman brothers in September 2008, the risk premium with respect to interbank borrowing rose by 5% due to (APH GOV, 2022). The corporate bonds risk premium went above 6% (APH GOV, 2022). The period from the beginning of the global financial crisis till its end i.e., 2007-2009, marked a Gross Domestic Product (GDP) of $14,478.1 billion i.e., a decrease from $14.769 billion which might be due to lesser consumer spending (Statista, 2022). Also, the unemployment rate increased to 9.25% in the year 2009 due to a fall in demand and supply and cut-off and non-hiring of new labor (Macrotrends, 2022). The United States lost much of its wealth, which was evident from the fact that stocks fell by 40% in 2008 due to inflation (Forbes, 2022). Also, in the same period, the loss incurred by American households was estimated at $3.3 trillion as cumulative home equity due to the crash of the US Stock Market (Business Insider, 2022).
Current Economic state of the US
In the US, banks have become more secure and stable. For European and US banks, the average Tier 1 capital ratio has risen to 15% from 4% of their assets (Mckinsey, 2022). It suggests a high solvency rate of the banks. Therefore, banks are now more inclined towards leveraging their assets and liabilities in terms of having high solvency ratio. Also, banks have retrenched themselves from lending to corporations and shifted towards corporate bond markets. As a whole, banking systems are now more regularized and strict liquidity and capital regulations are followed. Additionally, the reduced debt of US households by 19% points of GDP has been a noticeable event in the past decade (Mckinsey, 2022).
Conclusion
The global financial crisis was a result of negligence in assessing loan repayment criteria by financial institutions and banks. The short-term profit expectation had caused major lenders and investors to borrow money which led to the fallout of Wall Street. Therefore, banks in the current world have become stricter in their regulatory norms to avoid such crises in the future. Hence, the banking industry has become more secure in aspects of capital formation through maintaining a high solvency ratio.
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