The Financial Crisis of 2008

The Financial Crisis of 2008

1. What caused the financial crisis of 2008?

1. Central bank in the time of crisis lend freely at high rates against good collateral and get no returns.
2. United States became addicted to spending and consuming beyond its production capacity. This resulted in disappearance of personal savings, rapidly rising imports, and a huge trade deficit. Eventually, this huge gap was closed by foreign investors, businesses and governments who were willing to purchase U.S. treasury securities, finance U.S. home buyers and banks.
3. The relaxation of underwriting and lending standards encouraged less creditworthy borrowers to purchase risky mortgages, and resulted in an excess amount of subprime lending. When more and more borrowers had difficulty maintaining the repayment schedules, the subprime lending supply chain started to crash. Lack of transparency in the market also contributed to excesses of subprime lending.
4. The growth of housing bubble was the product of very low interest rates, excessive foreign savings, and mortgage securitization and resale. The housing bubble made house prices crashed, unsuspecting investors lost jobs and pensions, and created public pressure.
5. The Federal Reserve lowered the interest rates, thus encouraged borrowings. However, the excessive borrowings increased the severity of the financial crisis because the growth of credit created the demand for financial assets, raising the prices of those assets while lowering interest rates.
6. Excesses and loss of bearings in extremely favorable environments led bankers forget the fundamental of banking, which is the need to understand the clients and the product offered to the clients.

1. What reforms should be made to ensure it does not happen again?

1. Increase transparency in various components of the financial system for financial instruments, markets and institutions. Transparency not only encourages efficient functioning of market, but also prevents markets from overreacting such as herding behavior, excesses of subprime lending, and growth of housing bubble and credit bubble.
2. The bank should increase the interest rate to relieve housing bubble and credit bubble.
3. Companies should be educated to have a responsibility to act ethically and control their employees and agents. Marketing should be ethical and financial arrangements should be sustainable. Lenders and borrowers in the market should has a sense of ethical skepticism and get ready to apply risk management approach to ethics.
4. Make sure bankers know their clients and the product offered to the clients very well, and do not forget about the fundamental of banking.
5. Regulation of mark-to-market accounting, especially fair value accounting in uncertain and illiquid markets.
6. Address the excessive focus on short-term returns because the short-termism leads to the misjudgment of underlying risk.
7. Reduce the pro-cyclicality of the financial system and define the drivers of pro-cyclical behavior.
8. Foster a greater discipline in order to reduce the likelihood of unwarranted fluctuations, assess appropriate risks and maintain a balance of short-term and long-term investments.
9. Obtain a better global insight because the unfettered markets are risky and unilateralism does not work in this economic interdependence world.