Can We Prevent Another Financial Crash?

by Harry Leggett

A financial crisis is a disturbance to financial markets, which has effects right through the financial system meaning that the market cannot efficiently allocate capital. In 2008 the US housing and mortgage market fell through, the effect of this on all other markets was that there was a liquidity crisis and people referred to it as a “credit crunch”. This then led to a. Banking crisis which created a sovereign debt crisis. The recession was at its worst in 2008-2009 however it took a while for a lot of countries to rid the burden of the debt. Prior to the 2008 financial crisis there had been years and years of low interest rates, dangerously low to zero and also excessive risk taking and leverage of the banks, particularly within the sub prime lending, hence the collapse of the sub prime mortgage market. There were lots of social risks that were a result of the financial instability, for example the taxpayers had to pay the bailout costs, the shareholders lost equity and employees lost jobs. The banks were lending out too much money which led to an asset price bubble and the banks could not afford to cover their losses their make, causing bank insolvency. This is shown by Northern rock who suffered a run on the bank, meaning their was a large amount of cash withdrawals by account holders due to a drop in confidence. Due to the banks handing out risky loans and mortgage the banks liabilities on their bank balance sheet far outweighed their assets. Systemic risk is 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, that can be contained therein without harming the entire system. The behavioural economics of people reacting to other peoples worries ultimately led to people having low confidence in the banks and causing a run on multiple banks.

After the 2008 financial crisis the government made certain interventions into the financial market which attempted to stop a future financial crisis. These policies are called macro-prudential regulations, they attempt to mitigate risk to the financial system as a whole which is often referred to as systemic risk.

The aim of a bank is to help people look after the money, they provide loans and oversee costumer transactions. After the 2008 financial crisis the banks were in an awful state. Two banks had been bailed out by the taxpayers, causing uproar within the economy. In years gone by the owners would pay, however in 2007 the government had to use tax payers money to bail out the banks. Now a bank would pay in a far less destructive way than before. The shareholders and creditors would have to pay instead of the tax payers. The users of the bank have an insurance that they can have up to £75,000. People were worried about the safety of their money, if it could happen to northern rock could it happen to my bank? To prevent a liquidity crisis occurring within any of the main banks in the UK the government intervened within the market and created new laws and regulations in order to stop the banks abusing consumer trust. The government implemented strong regulations so that stop an imbalance between liquidity and capital within a bank. The bank balance sheets are now controlled and monitored so that the bank cant go into liquid insolvency. Capital is not borrowed money; it takes the form of funds raised by banks selling shares or profits retained from earlier trading periods. Capital can help a commercial bank to mitigate losses (loss bearing) incurred in its trading - for example if the holders of unsecured loans default on repayment. If a commercial bank incurs losses and does not hold sufficient capital, it may not be able to repay its creditors. Capital also avoids the need to make payments at times when a commercial bank is not profitable. Payments to shareholders depends on the profits generated by the business, and the use of past profits involves no ongoing payments. If the bank is not profitable, it does not have to pay dividends to its shareholders, whereas it would have to pay interest on loans, It is not unusual for commercial banks to suspend the payments of dividends during profitable periods. Other implementations made by the government were the government made an attempt to reduce public and private sector debt to reduce solvency risks. The effects of the government intervention was very dramatic. Interest rates plummeted to a low and quantitive easing was at a very low level. The effect of this on the economy was that zombie. Businesses, Businesses that are only just surviving, were held up by the low interest rates. Low interest rates mean there is little incentive to save and more incentive to spend, and also it is cheaper to borrow within the economy, therefore meaning that companies can borrow in the short term to hold up their business. This led to a worry from the government that the economy was becoming dependent on low interest rates. This is dangerous in the long term as low interest rates will tempt banks into taking greater risks, some have said that the brutally low interest rates have led to secular stagnation, where there is little or no economic growth in the short run.

As a result of the 2008 crisis the bank of England created new committees within the organisation to regulate the economy. One of the central banks roles in the economy is to retain financial stability, this is accomplished by the MPC, PRA and the FPC, all of which are chaired by the governor of the bank of England. 5 people from the bank and 4 appointed by the chancellor. The MPC attempt to meet the inflation rates and report their inflation report. The PRA regulates individual financial institutions to improve their safety and soundness. The FPC meet 4 times a year and are given the challenge of overseeing the stability of the financial system. The committee is given tough powers to tame systemic risk by clamping down on loose credit, overheated sectors and previously unregulated parts of the financial system. The FPC can make recommendations and directions to the MPC or the PRA. They may ask the PRA to tell the banks to earn more capital. The banks role is to attempt to keep the financial system stable.

In conclusion I believe the new committees, stress tests and increase in regulation have led to a stronger foundation for the financial market. However I also believe an increase in debt and credit has made everything more stable. Yields have never been lower, markets have never been higher. People are trying to work out what is going to cause the next credit crunch? The central banks? No one ultimately knows, however we can learn from the last financial crisis that the following chain of events often preceed a financial crisis. The banks offer rubbish loans and don’t set aside money for the future. The share prices will plummet. As the banks take more risks to take more returns, the share price then goes through the roof. The bank then records record profit. Our free market system encourages bad deals, ultimately everyone looses out except a few senior CEOs.