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Downfall of Banking Institutions Essay

Introduction:

On September 15 2008, the world woke up to the news of some of the biggest and mightiest names in the financial world going broke. It marked the beginning of the biggest global financial crisis the world had seen since the Great Depression. The crisis had been in the making for several months and when it finally struck it led to a major liquidity problem worldwide. The crisis saw some of biggest banks in the United States and Europe going bankrupt.

The Banking Crisis:

It all began with the US government taking temporary public ownership of the troubled mortgage giants Freddie Mac and Fannie Mae. The problem was caused due to subprime loans which resulted in high numbers of mortgage delinquencies. As a result, the two groups ended up with combined losses $14 billion, prompting the US government to bail them out.[1] Earlier, in March, the US government had also helped in the sale of Bear Sterns Cos. to JP Morgan Chase & Co.

A week after the public takeover of the mortgage giants, two other major banks found themselves in troubles. The 158 year old investment bank Lehman Brothers was hit by bad debts, prompting it file for bankruptcy. Lehman had first tried to sell its assets to raise money, failing which it was left with no choice but to file for bankruptcy. On the same day, Bank of America bought Merrill Lynch in all-stock deal for $29 per share.[2] Another company facing liquidity crisis was the insurance giant American International Group (AIG). The company sought a bail out from the Federal Reserves to prevent it from going into bankruptcy.

 The problems with banks and financial institutions did not end with these three firms. A few days later, the two remaining investment banks, Morgan Stanley and Goldman Sachs converted to traditional bank holding companies which place them under regulator supervision and gives them easier access to credit.[3] Thus within a few days all the major investment banks in the US were brought to their knees.

The problem was not limited to investment banks as a few days later Washington Mutual, the largest savings and loan banks in the US, was seized by the Federal Deposit Insurance Corporation (FDIC) and its assets were sold to JP Morgan Chase for $1.9 billion.[4] Another large US bank, Wachovia, also soon found itself in crisis.

Soon the credit crisis spread from the US to Europe and many of the European banks also found themselves struggling. One of the first banks to be hit was the Franco-Belgian bank, Dexia, which had to be rescued for by the French and Belgian government for 6.4 billion euro.[5] A major financial crisis also hit Iceland as the Icelandic Government seized control of the country’s biggest banks in an attempt to fend off wholesale economic collapse.

Before taking over the banks, the government had suspended trading of all financial instruments. The collapse of the Icelandic banks also triggered fear among the British, who had large savings in the Iceland banks thanks to higher interest rates they enjoyed in there.[6] Thus the US credit crisis had quickly spread across the globe.

The Bailout:

As the world plunged into the financial crisis, the world leaders got together to try and find a solution to the problem. In the US, President George Bush proposed a $700 billion bailout plan for the banking industry. The bill, which was initially opposed by the congress, was finally passed on October 3 2008. The bill allowed the US treasury to clean up banks’ balance sheets by purchasing distressed mortgage-backed securities.[7]

Other governments all over the world came up with similar bailout packages. In England, in an emergency move, Bank of England cut the UK interest rate to 4.5% and announced a £500 billion rescue plan for the UK banks.[8] Germany and France and several other countries gave €1 trillion guarantees to help restore faith in banks. Germany provided €400 billion in bank guarantees and €100 billion in state funds while France provided €320 billion in guarantee and another €40 billion to improve liquidity situation. Spain set aside €100 billion to cover bank lending and Austria announced €85 billion in guarantees and €15 billion in equity.[9]

As the crisis developed, the US government also took several other steps to counter the banking problem. The US Prime rate was successively reduced from 7.5% to 4.0%. On September 19, the Treasury announced a $50 billion program to insure investments. In order to improve the liquidity situation, the Treasury and the Federal Reserve Bank announced that banks could obtain funds via the Federal Reserve’s Discount Window using asset-backed commercial paper as collateral.

In another move to help increase the funds available to commercial banks and lower fed funds rate, the US Federal Reserve announced plans to double its Term Auction Facility to $300 billion. Federal Reserve also increased its swap facilities with foreign central banks to care of the shortage of the US dollar in Europe.[10]

On October 3, the congress passed Emergency Economic Stabilization Act of 2008 which authorized the US Secretary of the Treasury to spend up to $700 billion to purchase distressed assets. All these steps were with only one aim, to prop up the banking sector, put in more cash into the system and to stop the situation from getting worse. Thus within a month of the collapse of Lehman brothers, the world economy found itself combating a major global banking crisis.

Consequences:

The financial crisis, which is still in making and far from over has had far-reaching effects on the global economy. Just about every industry and every business is affected as a result of this global meltdown. The problem started with the subprime mortgage crisis. In the years preceding the crisis, banks had been aggressively lending even to those people who did not have good credit history. This increase in loans had led to increased demands for real estate, driving up the prices of houses to unprecedented level. It also led to over building of houses, which ultimately led to a surplus of houses, resulting in price decline.

As a result, when this housing bubble burst, many homeowners found that they were unable to make their mortgage payments. This led to a number of bankruptcies and foreclosures. Soon the banks found themselves holding assets which they were unable to sell for a profit, and this led to current financial crisis. Since the crisis was the result of the housing bubble, one of the first industries to be hit by the crisis, even before it had become a full blown global meltdown, was the housing and real estate industry.

As the crisis grew, the problem soon spread from the housing and banking industries to encompass just about every industry in the world. The shortage of funds with the banks meant that they had tightened the cash supply. This led to a liquidity crunch in the market. Many businesses found that they were unable to raise money even for legitimate business purposes. As a result, these businesses began severe cost cutting measures and put many new projects on hold.

Immediately following the collapse of the major investment banks, the work stock markets tumbled. Despite assurances from the governments and the unprecedented bail-out deals announced by leaders all over the world, it did not strengthen the market moods and the share prices continued to fall to all time lows across the globe. The prices of commodities were also affected and oil prices fell from an all time high of $147 per barrel to below $80 per barrel in just a few weeks.

In the modern world, when the world economy is so interconnected, this had a domino effect, and the crisis soon spread from industry to industry and organization to organization, until it had engulfed the entire globe. No country and industry was spared. Even industries which did not seem to have any relation with banking, found themselves struggling. One example of such a side effect was seen on the New Jersey Transit. In an effort to save money, the NJ Transit had handed over its assets to for-profit banks and then leased them back.

However, the internal revenue service found that the deal violated tax rules and allowed the banks until end of 2008 to pay back the tax breaks. One of the terms of the deals was that if the insurance company which guaranteed the lease payments were to undergo significant credit rating downgrades, the Transit companies would have to make the lease payment in full. With AIG’s credit rating being downgraded, these banks are demanding 100% lease payments, which could potential devastate the 30 odd transit companies which had entered into the deal.[11] Although the transit companies are seeking Treasuries cooperation, this is just one of the examples how the financial crisis is having far reaching effects even in sectors which would traditionally seem immune to the crisis.

With crisis tightening the money supply, most firms were forced into cost cutting measures. Many firms started to lay off employees in huge droves. As a result, when common people found themselves deep in debt and with no source of income, they began to cut back on their spending. And this affected the retail, tourism and hotel sector, which have not seen any improvement in its sales even as the festival season is approaching.

Similarly, there has been a drastic slump in the sales of automobiles, in part triggered by the rising coil prices, leading to recession and subsequent layoffs in the industry. In short, just about every industry is facing the consequences of the financial crisis. Perhaps the most shocking of these is the reduced donations to religious institutions and people are tightening their purse strings. Even schools are affected by this downturn as people are sending their children to schools with lower tuition fees.

This global financial crisis has affected just about every country and with each passing day we hear about a new industry and a new country being severely hit by the credit crunch. The banking problems in the US and Europe have already been discussed. However, the problem has taken global proportions. From Asia to Africa to South America, every country is hurting as a result of this crisis.

The emerging economies like China and India, two of the fastest growing economies in the world, have seen their stock markets crash to an all time low. In India, inflation reached 12% and the growth rate slowed from 9% to 7.5%. The currency dived to a five year low against the US dollar. Companies put their expansion plans on hold as they increasingly found it difficult to raise capital. And with most of the export orders coming from the US having dried up, export companies have found themselves struggling. Even the Indian IT industry, the main beneficiary of the outsourcing mania, has found itself struggling in wake of the financial crisis.[12]

In China, many companies are contemplating job cuts and the annual bonus is being put on hold. The weakening demand from North America and Europe has put China’s export sector in a tough situation. The GDP growth rate also slowed to 9.9% for the first quarter of the year. Although the country still has $2 trillion of foreign reserves and a budget surplus, it is not entirely unaffected by the global financial meltdown.[13]

Even in world’s poorest continent, Africa, the global economic crisis is causing concern. The financial crisis has led to a rise in the prices of fuel, food and fertilizers, leading to riots in several African countries. Even in a country where most people do not have bank accounts, a mortgage or equity investment, the global financial meltdown is affecting the lives of common people just as badly as in other country.[14]

Conclusion:

Globalization has made the world a much smaller place. An incident taking place in one part of the globe can have far reaching effects on the rest of world. The failure of some of the major US investment banks was bound to have far reaching consequences. For the past several years, the world had seen unprecedented economic growth. However, the failure of US banks has seen the world economy crash in a hurry. Even federal aids and reassurances by leaders have not been able to help the falling economy. We are now in the middle of one of the worst recessions in history and it will be sometime before the world and the banking sector can completely overcome the present crisis.

Bibliography

Seager, Ashley. “US mortgage giants Freddie Mac and Fannie Mae taken into public ownership”. Guardian. http://www.guardian.co.uk/business/2008/sep/07/freddiemacfanniemae

Mollenkamp, Carrick, Susanne Craig, Serena NG & Aaron Lucchetti. “Lehman Files for Bankruptcy, Merrill Sold, AIG seeks cash”. Wall Street Journal. http://online.wsj.com/article/SB122145492097035549.html

Kollewe, Julia & Teather, David. “Wall Street in Crisis: Mitsubishi to buy stake in Morgan Stanley”. Guardian. http://www.guardian.co.uk/business/2008/sep/22/wallstreet.morganstanley

“JP Morgan buys Washington Mutual assets from FDIC for $1.9 B”. http://www.thedeal.com/dealscape/2008/09/jp_morgan_buys_washington_mutu.php

Allen, Nick. “Financial Crisis: European banks now hit by the crisis”. Telegraph. http://www.telegraph.co.uk/finance/financetopics/financialcrisis/3141128/Financial-crisis-European-banks-now-hit-by-credit-crunch.html

Helga, Hildur, Power, Helen & Stiff, Peter. “Terror as Iceland faces economic collapse”. The Times. http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article4894904.ece

Clark, Andrew. “Bush signs $700 bn economic bail-out plan approved by Congress”. Guardian. http://www.guardian.co.uk/business/2008/oct/03/creditcrunch.useconomy2

Wearden, Graeme. “Interest rates cut to 4.5% as Brown unveils £500 bn bank bail-out.” Guardian. http://www.guardian.co.uk/business/2008/oct/08/marketturmoil.creditcrunch

Bremner, Charles & Charter, David. “Germany and France lead €1 trillion European bailout.” The Times. http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article4937516.ece

“Global financial crisis of 2008.” Wikipedia, The Free Encyclopedia. http://en.wikipedia.org/w/index.php?title=Global_financial_crisis_of_2008&oldid=251470159

McNichol, Dunston. “Side effect of financial crisis could cost NJ transit $150 million.” http://www.nj.com/news/index.ssf/2008/10/side_effect_of_financial_crisi.html

Lakshman, Nandini. “World Financial Crisis: India’s hurting, too.” Businessweek. http://www.businessweek.com/globalbiz/content/oct2008/gb2008108_870698.htm

“Global financial crisis spills over China’s labor market.” China Daily. http://www.chinadaily.com.cn/china/2008-11/02/content_7165193.htm

Quist-Arcton, Ofeibea. “Effects of Global Financial Crisis Emerge in Senegal.” http://www.npr.org/templates/story/story.php?storyId=96503476

[1] Ashley Seager. “US mortgage giants Freddie Mac and Fannie Mae taken into public ownership”. Guardian. http://www.guardian.co.uk/business/2008/sep/07/freddiemacfanniemae

[2] Carrick Mollenkamp, Susanne Craig, Serena NG & Aaron Lucchetti. “Lehman Files for Bankruptcy, Merrill Sold, AIG seeks cash”. Wall Street Journal. http://online.wsj.com/article/SB122145492097035549.html

[3] Julia Kollewe & David Teather. “Wall Street in Crisis: Mitsubishi to buy stake in Morgan Stanley”. Guardian. http://www.guardian.co.uk/business/2008/sep/22/wallstreet.morganstanley

[4] “JP Morgan buys Washington Mutual assets from FDIC for $1.9 B”. http://www.thedeal.com/dealscape/2008/09/jp_morgan_buys_washington_mutu.php

[5] Nick Allen. “Financial Crisis: European banks now hit by the crisis”. Telegraph. http://www.telegraph.co.uk/finance/financetopics/financialcrisis/3141128/Financial-crisis-European-banks-now-hit-by-credit-crunch.html

[6] Hildur Helga, Helen Power & Peter Stiff. “Terror as Iceland faces economic collapse”. The Times. http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article4894904.ece

[7] Andrew Clark. “Bush signs $700 bn economic bail-out plan approved by Congress”. Guardian. http://www.guardian.co.uk/business/2008/oct/03/creditcrunch.useconomy2

[8] Graeme Wearden. “Interest rates cut to 4.5% as Brown unveils £500 bn bank bail-out.” Guardian. http://www.guardian.co.uk/business/2008/oct/08/marketturmoil.creditcrunch

[9] Charles  Bremner & David Charter. “Germany and France lead €1 trillion European bailout.” The Times. http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article4937516.ece

[10] “Global financial crisis of 2008.” Wikipedia, The Free Encyclopedia

Need essay sample on "Downfall of Banking Institutions"? We will write a custom essay sample specifically for you for only $ 13.90/page

. <http://en.wikipedia.org/w/index.php?title=Global_financial_crisis_of_2008&oldid=251470159>.

[11] Dunston McNichol. “Side effect of financial crisis could cost NJ transit $150 million.” http://www.nj.com/news/index.ssf/2008/10/side_effect_of_financial_crisi.html

[12] Nandini Lakshman. “World Financial Crisis: India’s hurting, too.” Businessweek. http://www.businessweek.com/globalbiz/content/oct2008/gb2008108_870698.htm

[13] “Global financial crisis spills over China’s labor market.” China Daily. http://www.chinadaily.com.cn/china/2008-11/02/content_7165193.htm

[14] Ofeibea Quist-Arcton. “Effects of Global Financial Crisis Emerge in Senegal.” http://www.npr.org/templates/story/story.php?storyId=96503476

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