Was the Financial Crisis Avoidable?

Updated on April 13, 2018

There are different opinions and point of view whether the financial crisis was avoidable or not. According to Sayek & Taskin (2014) financial crisis has been experienced by all countries throughout the world for a very extended period. My focus is on the American markets which were affected by the financial crisis. A financial crisis is a position in which the value of financial institutes, properties or assets drop quickly. According to Investopedia (2010), a financial crisis is frequently connected with banks in which investors sell off assets or take out money from savings accounts with the belief that the price of such property will fall if they stay at a financial institution. The other financial crisis includes stock market crashes, the overflowing of other financial assets and currency crisis (BusinessDictionary.com, 2016).

The crisis, which is considered to have begun in August 2007, was unpredicted. The crisis happened in a circumstance with high and stable development additionally with developing macroeconomic imbalances, low-interest rates and sufficient liquidity. It was not the first time when interest rates were low and asset prices were booming. The crisis was a result of shortcomings in the money related markets which caused a large of a risk. It turned into the worst financial crisis since the Great Depression after the unforeseen occasions of September 2008, which includes the bankruptcy. According to Sargent-Cox, Butterworth, and Anstey (2011) the recent worldwide financial crisis that started in 2008 is an indication of a global economic recession that has affected industrialized and developing countries around the world. It was the collapse of bubble house, low-interest rate, easy and available credit, support of subprime loan, insufficient regulation and mortgages that were at highest which led to a financial crisis in the fall of 2008 (Kaur, 2015). Due to these causes, trillions of dollars in risky mortgages had become fixed during the financial system and sold to investors around the world. This did not happen just in the United States but it was all around the world.

The following essay will examine in depth the arguments for and against the causes of the financial crisis and see whether they were avoidable or not. The second section will include a discussion and opinion on how to avoid a financial crisis. The last section will contain a conclusion that summarizes the main points of the essay. This essay topic ‘Was the financial crisis avoidable?' is an important issue to argue about because it helps understand whether it was avoidable or not.

Causes of financial crisis

At the first place, how did this financial crisis begin? The causes are numerous, yet the immediate and prompt reason for the financial crisis lies in the subprime loan system in America. There is substantial evidence to prove that, in numerous parts of the United States, it had turned into an easy, and less expensive, to get a subprime contract. A Federal Reserve study found that America's most and minimum unsafe borrowers fell severely from 2.8% in 2001 to 1.3% in 2007(Marshall, 2009). A subprime loan system is a sort of loan that is offered to people at a rate above prime and does not meet all requirements for prime rate advances. In other words, it is a housing loan and lent to people who have lower credit ratings. Frequently, subprime borrowers are regularly moved in the opposite direction of traditional moneylenders given their low credit ratings or different components that recommend that they have a reasonable possibility of defaulting on the obligation repayment. In this way, the financing cost is typically set higher than the other loans. In the beginning, numerous individuals are pulled in by the low-interest rate of the subprime loan. However, they later experience the effects of continuously risen interest, which is a particular standard for a subprime loan. The United States consensus shows that the share of the subprime loan was doubled between 2003 to 2004 and was more than 20% in 2006.

The cause of the financial crisis as seen by many was the United States housing market. This happened due to the federal reserve lowering interest rates and also made mortgages appear very attractive to potential buyers (Marshall, 2009). Another cause or factor for the financial crisis is a systemic breakdown in accountability and morals. According to Ivashina and Scharfstein (2010) the banking fear in 2008 left economies all over the world into last recession. When a bank undergoes a sudden rush of withdrawals by investors is known as a bank run. Since banks lend out a significant portion of the cash they receive in deposits. It will be very troublesome if these deposits are suddenly demanded to pay back quickly and cause their customers to lose because they are not secure deposits (Sipko, 2012). At times in which bank runs is called a systemic banking crisis or banking panic. Examples of bank runs take account of the run on Northern Rock in 2007. These types of banking crisis occurred after times of risky lending (Sayek and Taskin, 2014).

Arguments for financial crisis avoidable

According to The Financial Crisis Inquiry Commission, “the crisis was the result of human action and inaction” and stated that it could happen again if we do not learn from history. The crisis was additionally the result of "emotional disappointments of corporate governance and risk administration at numerous financial institutions. Corporate governance is the arrangement of guidelines, practices by which an organization coordinates and controls the procedure. Corporate governance includes adjusting the interests of the numerous stakeholders in an organization such as shareholders, administration, clients, suppliers, lenders, government and the society. Due to improper use of guidelines and procedures for the corporate governance, the result was not fair and caused the financial crisis. There is a saying by William Shakespeare which says that the fault lies not in the stars, but in us.

Secondly, financial crises were avoidable if it does not have enormous negative consequences on investment. According to Inklaar and Yang (2012) one logical explanation behind this is that financial crises build uncertainty and expands the real value of the postponing investment. If investments are made on reliable companies than the financial crisis was avoidable. Investment varies significantly across countries which have an adverse impact on the financial crisis. Furthermore, the adverse effect is also high in some countries due to low tolerance for uncertainty. There were many views and numerous perception on Wall Street and in Washington that the crisis could not have been maintained or predicted. There was a boom in risky subprime loaning and securitization, an unmaintainable rise in housing prices, reports of loaning practices, widespread increase in housing mortgages debt and development in money related firms.

Another argument to avoid financial crisis was that the primary asset of most of the family are their houses and housing prices were decreasing. A reduction in demand also reduces capital expenditures when some development opportunities are no more as valued. As capital expenditures fall, firms require less funding which causes debt and equity issuance also to fall. Furthermore, a drop in demand causes the net value of businesses to fall, which decline the positions on which they can use (Kahle and Stulz, 2013). One of the reasons that the crisis may be avoidable if the housing prices were high.

On the other hand, to avoid financial crisis banks should moreover raise more capital or offer assets. The primary way that banks can decrease their property includes providing securities, not reintroducing loans, and to stop creating new loans. Hence, if banks are compelled to gain securities on account of liquidity, then they may cut the size of their assets to prevent additional leverage and give back loans to new lending corporations. The result for this will have direct predictions for firms, investment and financial plans. The crisis was avoidable if the organizations thought that it is hard to borrow from banks so that bank borrowing may fall. In any case, the effect on total loan relies upon the ability of firms and have to discover different sources of credit. If various sources or substitute types of credit are promptly available for companies, banks may increase lending in other forms of borrowing and the effect of the bank credit supply shock would be reduced and would help to reduce crisis Kahle and Stulz (2013).

Arguments against financial crisis avoidable

According to Sipko (2012) to avoid the financial crisis, the formation of the framework for financial stability would be needed. It also inspects the relations between both monetary and fiscal policies including micro and macro policies and their instruments. The main aim of the macroeconomic policy is price stability. The global financial crisis was mostly among developed countries and there were some other factors which contributed to the crisis.

As stated by Inklaar and Yang (2012) financial crises could not be avoidable due to the harsh effects on the real economy which leads to significant decrease in output and investment. It varies significantly across countries where investment falls no quicker than Gross Domestic Product. On the other hand, a little struggle for change in countries results in investment falls faster than Gross Domestic Product. Financial crises have vast financial related outcomes. Numerous studies and research concentrate on the effect on Gross Domestic Product growth. For example, Hutchison and Noy (2005) found out that currency or banking crises cut output by 5 to 10%. To avoid the crisis, banks need to stop giving loans to increase output. In a recent involvement, Joyce and Nabar (2009) indicated that banking crises have an extremely adverse effect on investment, which results in leading to a faster drop in investment than in output. One reason to avoid a financial crisis is that firms and organizations must postpone their investments in uncertain times. The credit supply shock states that the crisis was not avoidable because the firms that depend on using a loan to be compelled to decrease their capital expenditures. Furthermore, the most very opened companies have witnessed the biggest drop in capital expenditure (Kaji, 2001). So the firms must follow the credit supply shock to avoid a financial crisis. However, firms are expected to be worried about uncertainty too and will lead them to store cash. In ordinary times, businesses would utilize equity to replace partially borrowed funds. However, it influences equity markets also and therefore delays equity issuance and make it too costly (Zingales, 2010).

The financial crisis was not avoidable because the framework for financial stability was required. It also depends on countries how effective their policies are and other factors which contribute also depends on the state (Sipko, 2012). According to Kowalski and Shachmurove (2011) one may conclude that the financial crisis was a result of central banks bringing down interest rates quickly and using clear fiscal policy that required lowering the gap between potential GDP and real GDP.

According to Kahle and Stulz (2013) the crisis was not avoidable because the bank lending supply states that in 2007, large banks experienced massive losses on their portfolios of arranged financial securities and mortgages. Since banks are very opened and cannot just give more problems, so this is a huge loss as the rate of equity falls. On the other hand, to avoid this crisis banks should either raise more capital or offer assets. The primary way that banks can decrease their property includes providing securities, not reintroducing loans, and to stop making new loans. Hence, if banks are compelled to gain securities on account of liquidity, then they may cut the size of their assets to prevent additional leverage and give loans to new lending corporations.

The above arguments which are not for the statement say that a huge decrease in aggregate demand can lead businesses and firms to lose for the second time and make it difficult for them to access the debt markets. A huge increase in uncertainty may decrease in capital expenditures because it would make it ideal to delay actual options.

Conclusion

The purpose of the study was to determine that the financial crisis was avoidable or not. It began by explaining in detail the causes and consequences of the financial crisis. Followed by theories and their predictions. The last section included a conclusion and it states that the financial crisis was not avoidable because the arguments for against the statement were more than for the statement.

In summary, the financial crisis was not avoidable because it suggests that the bank supply shock indicates that reliable bank firms may have a huge decrease in capital expenditures. The credit supply shock expects that reliant credit company may have a significant reduction in capital expenditures. For both or either of the suggestion, it is supposed to have a smaller decrease in capital expenditures for firms that do not rely on credit. The shock demand suggests companies that are bank or credit reliant are not affected differentially because all businesses are affected. Finally, the balance sheet multiplier points out that more incredibly forced firms should experience a bigger decrease in capital expenditures. However, due to these reasons, the financial crisis may not recognize by researching whether some businesses reduce capital spending and others do not. Therefore, the issue is to recognize the businesses and take a severe action against them. These arguments suggest that many firms are more influenced than the others because of their source of funding (Kahle and Stulz, 2013).

The evidence of this study suggests that financial crisis was not avoidable. However, some issues must be taken into account depending on firms or banks that they choose in order to avoid a financial crisis.

References

BusinessDictionary.com. (2016). What is a financial crisis? Definition and meaning. [online] Available at http://www.businessdictionary.com/definition/financial-crisis.html

Inklaar, R. and Yang, J. (2012). ‘The impact of financial crises and tolerance for uncertainty.’ Journal of Development Economics, [online] 97(2), pp. 466–480.

Investopedia. (2010). Financial Crisis Definition | Investopedia. [online] Available at http://www.investopedia.com/terms/f/financial-crisis.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186

Ivashina, V. and Scharfstein, D. (2010). ‘Bank lending during the financial crisis of 2008.’ Journal of Financial Economics, [online] 97(3), pp.319–338.

Kaur, I. (2015). ‘Early Warning System of Currency Crisis: Insights from Global Financial Crisis 2008.’ The IUP Journal of Applied Economics, [online] 14(1), pp.71-83.

Marshall, J. (2009). ‘The financial crisis in the US: key events, causes and responses.’ Business and transport section, 9(34).

Minarik, J. (2012). ‘Courting an Avoidable Financial Crisis.’ Econ Journal Watch, [online] 9(1), pp. 60-70.

Nelson, S. and Katzenstein, P. (2014). ‘Uncertainty, Risk, and the Financial Crisis of 2008.’ International Organization, [online] 68(2), pp.361 - 392.

Kahle, K.M and Stulz, R.M (2013). ‘Access to capital, investment, and the financial crisis.’ Journal of Financial Economics, [online] 110(2), pp. 280-299.

Kaji, S. (2001). ‘What Can Countries Do to Avoid a Financial Crisis?’ World Economy, [online] 24(4), pp. 567-589.

Kowalski, T. and Shachmurove, Y. (2011). ‘The financial crisis: What is there to learn?’ Global Finance Journal, [online] 22(3), pp. 238–247.

Sargent-Cox, K., Butterworth, P., and Anstey, K. (2011). ‘The global financial crisis and psychological health in a sample of Australian older adults: A longitudinal study.’ Social Science & Medicine, 73(7), [online] pp. 1105-1112.

Sayek, S. & Taskin, F. (2014). ‘Financial crisis: lessons from history for today.’ Economic Policy, [online] pp. 447–493.

Sipko, J. (2012). ‘Financial Stability and Reform of the Financial System.’ Creative and Knowledge Society, [online] 2(2), pp. 58-69.

Zingales, L. (2010). ‘A Market-Based Regulatory Policy to Avoid Financial Crises.’ CATO Journal, [online] 30(3), pp. 535-540.

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© 2018 Waleed Ahmed

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