A financial crisis is a disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that financial markets are unable to efficiently channel funds to those who have the most productive investment opportunities. As a result, a financial crisis can drive the economy away from equilibrium with high output in which financial markets perform well to one in which output declines sharply.
The recent financial crisis or more specifically the recent global financial crisis derives its roots primarily from the triggering event in the US economy i.e. a short fall of liquidity in their financial system, which has destructed their major financial institutions on which the US economy heavily relied on. The reasons behind the liquidity short fall are primarily the bursting of Real-Estate bubble in the US economy. The optimism of financial experts in the US led them to innovate the financial products being offered by various financial institutions due to a directive by the Government (post bursting of Dot-Com bubble) i.e. to ease out the masses financially and provision of easy credit. For this purpose, the Government also de-regulated the financial market. This in turn, resulted in heavy investments by the financial institutions, individual investors and foreign investments kept on increasing in real-estate sector through financially innovated products (mostly derivative instruments), which included Adjustable rate mortgage (ARM), Mortgage-Backed securities (MBS) and sub-prime mortgages etc. The stakeholders were very optimistic about the real estate sector; however, the prices in the sector did not rise up to their expectation levels and the financial institutions, which had made huge investments in real-estate portfolio, suffered from huge losses which caused the alarming problem of liquidity short fall.
To get at the background of the US (and currently global) financial crisis one needs to address issues which include, first, the prevalence of high stakes in financial markets with uncertainty. In such situations the risks (as are involved in holding financial assets) often turn out to be disproportionately high when one compares those to what eventually comes out as their realized returns.
A second factor, which similarly contributed to trigger the global financial crisis, relates to financial innovations, which go with deâ€regulation in financial markets. By generating derivative instruments, which aim to protect asset values in uncertain markets, these innovations also, make it possible to invest and acquire financial assets much more easily. For example, with 'futures', a typical derivative product which arranges for a contract in the security exchanges for sale and purchase of a financial asset in some future date , the deal can work to the convenience of both buyers and sellers by insuring against uncertainties in the market; while dispensing with cash transactions at the time of the contract. Thus the buyer contracting a 'long' (buying) position deposits only a fraction of the contracted price as 'margin', with the security exchange.
The current crisis is widely considered distinctive in several respects. First, it appears to be the first genuinely global financial crisis to hit the emerging market economies, affecting, as it has, Asia, Russia, South Africa, and Latin America. Second, it appears to be exerting a much greater impact on commodity prices, financial markets, and economic activity throughout the world including in the industrialized countries-than was true of the prior two emerging markets crises. Finally, the current crisis, particularly as it has taken hold in Asia, appears to be more deeply rooted in financial imbalances in the private sector than in the public sector financial problems that characterized the 1980s debt crisis and the Mexican 1994-95 crisis.
Global imbalances manifested through a substantial increase in the current account deficit of the US mirrored by the substantial surplus in Asia, particularly in China, and in oil exporting countries in the Middle East and Russia. Moreover, global macroeconomic imbalances were the major underlying cause of the crisis. These saving-investment imbalances and consequent huge cross-border financial flows put great stress on the financial intermediation process. The global imbalances interacted with the flaws in financial markets and instruments to generate the specific features of the crisis. Such a view, however, offers only a partial analysis of the recent global economic environment.
Then another important cause of the recent crisis is excessive or over-leverage at the macro level, which had a trickle down impact. Furthermore, the environment of very low interest rates for a longer period and subsequent relaxation of lending standards, which can be termed as de-regulation primarily. In addition, since the macro financial and economic environments were stable at that time, this led to the optimistic point of view on the risks inherent.
However, this trend of easy money had to end and so it did with the rising inflation rates in the US economy when the Government tightened its monetary policy. This led to a reduction in mortgage repayments by the borrowers since their repayment capacity eroded due to the increased interest rates in the economy. Hence the advances or loans extended by the financial institutions to the many borrowers against sufficient collateral base, started to become NPL (Non-performing loans). It is very interesting to note this fact here there were many stress tests conducted by various financial institutions just before the crisis hit them, and they came out perfectly fine in a way that they showed that the institution is securitized well and will be able to absorb any shocks in the forth coming times. However, in reality, the perceived value of that collateral led to a disaster since this was backed by assets (primarily real estate), which lost their value followed by heavy investments in this sector. So in fact, the financial institutions had a heavy perceived net-worth base on which they conducted their business but it was not real and this fact had to unveil one day, which marked the beginning of the recent financial crisis.
To give a further deep and precise insight into the causes of the crisis, the following point wise discussion would be useful.
The financial markets themselves became more complex hence giving rise to the crisis. Moreover, the extensive utilization of non-banking financial institutions in the financial intermediation process led to the complexity of financial sector.
The innovation in financial products and the extensive use of derivative instruments led further to the complexities. As discussed above, these securities had assets at their back, which lost their value. (Property prices fell.). In addition, the derivative instruments caused a decline in transparency on the financial scene.
Another very important point to note here is that we can not deny the tradeoff between efficient financial intermediation and a stable financial system by using an extensive de-regulated environment and operating with financial products that reduce the financial environment's transparency.
Globalization or global village had its own impact. The cross border transactions that were carried out in huge numbers and volumes with an optimistic approach, lacked due diligence which trickled down to the recent crisis pond and kept on accumulating.
The financial innovation techniques developed at a much faster pace than the counter risk-mitigating models and techniques. The policy makers did not account for the real risks inherent in the extensive usage of so-called financially sound and safe products but in actuality, they were far more complex and lethal.
The market participants, however, had almost the same share of market information, yet there were certain conflicts amongst them, which also caused uncertainty on the financial scene.
The risk-takers, compensated for their excessive risk taking regardless of the fact that this could be leading to a global financial crisis and the risk-takers hence did not do proper homework and/or prudence.
The misconception of US being the wealthiest nation, because then it should be showing the highest domestic saving amounts but in fact, the foreign capital inflows finance the huge current account deficit. Primarily, the US economy is a consumption-based economy.
The regulations added the most to the financial crisis. As discussed earlier that financial risk mitigation models were not developed at a pace equivalent to the pace of financial innovation. Similar is the case with regulatory framework, which did not evolve as an effective tool in combating and unforeseen circumstances. The markets put to work on self-governance but this did not work out in the end.
Lower interest rates offered for an extended period, which was unreasonable since it gave birth to the real-estate boom, which perhaps is the prime cause of this crisis. The governing bodies did not account for its implications because it eventually could have controlled the money supply.
