The banking crisis Essay
The term paper is mainly based on the banking crisis resulting from the current financial crisis which has lasted for about three years. The causes of the financial crisis in respect to the roles played by the banks have been discussed in detail. Regulations of Fed and treasury in financial institutions have been discussed together with the specific regulations during periods of the crisis. Finally, some of the banks which have merged or have gone through acquisition have been briefly mentioned.
The banks have been hit the hardest by the ongoing financial crisis which has crippled the world economy. For the last three years, the banking industry particularly in the US and Europe has experienced a major liquidity crisis. Due to the crisis, some major banks have incurred massive losses, which have led to bankruptcy, forcing them into mergers and acquisitions. Prior to the crisis, the banks had advanced a lot of credit to the housing sector. However, as a result of the bursting of the housing bubble, the banks suffered heavy losses as much of the advanced monies could not be recovered (Honohan, 2008).
The Banking crisis
The immediate trigger or cause of the current crisis was the rupturing of the housing bubble in the United States which had reached its climax between the years 2005 and 2006. High rates of defaults, on both mortgages of adjustable rates and as well as subprime mortgages, started to rise quickly thereafter. Increases in loan incentives, marketing and packaging like long-term and initial term trends in increases of the prices of houses had greatly encouraged borrowers to take more difficult mortgages.
This is because they believed that they be in a position of refinancing such loans soon at terms which were more favorable. Between the years 1997 and 2006, house prices in the United States increased by a staggering 124%. The banks could therefore easily advance credit to the housing sector which was very promising (Weale, 2008).
However, by the end of 2008, the prices of houses had reduced by more than twenty percent from their peak of 2006. As these prices reduced, the borrowers who had assumed mortgages of adjustable rates increasingly became unable to avoid high payments linked to the increasing rates of interest and hence started defaulting payment. In fact, in 2007, lenders started proceedings of foreclosure on more than one million properties, which was an increase of about 79%. This figure increased to more than two million in the following year.
By mid 2008, almost 10% of all mortgages in the United States, which were outstanding, were either in foreclosure or delinquent. Again, by the last quarter of 2009, this figure had increased to approximately 15%. These events had a devastating effect on the banking industry. As the rates of default continued to increase, the US banks continued to incur severe losses resulting into the banking crisis. The banks could not recover the monies they had advanced in forms of mortgages to the borrowers (Barrell Fic & Liadze, 2009).
Lower rates of interest have the effect of increasing borrowing since the cost of doing so is less. Between the years 2000 and 2003, Fed reduced rates of federal funds from about 6.5% to a mere 1%. The main aim of the reduction was softening the impacts resulting from dot-com bubble bursting as well as the effects of 9/11 terrorist attack. Hence, prior to the crisis, there was massive borrowing from the banks. However, following the bursting of the housing bubble coupled with the effects of an ailing American economy, most of the borrowers were unable to repay the loans. Therefore, as the financial crisis began, the banks were its initial victims as they suffered massive losses (Shutes, 2007).
Fed and the US’ treasury have the mandate of regulating the financial sector of the country. However, they have extensively been blamed for failure to properly regulate the sector prior to the crisis. But the failure of regulation should not be entirely blamed on these regulatory bodies. Several laws were amended or introduced before the start of the crisis which gave banks more powers to self regulate themselves, thus reducing the role played by both Fed and treasury.
The result of such increased autonomy on the part of the financial institutions was development of risky lending culture. The financial institutions started such practices as sub-prime lending, easy credit conditions and predatory lending. All of these practices increased the risk of default rates, which eventually impacted negatively on the financial institutions. Having seen the devastating effects of the financial crisis on the banks, resulting from lack of regulation, both Fed and treasury’s powers for regulating the banks have been increased (Ramos, 2008).
The banking industry will also have to be regulated to and will be required to operate at higher buffers of capital than they used to operate at prior to the crisis. The main aim of this particular regulation include, sealing loopholes, there will be increased volatility as far as economic inputs are concerned and finally, there may be extra capital charges in the review supervisory process. Furthermore, there is a raging debate on the advantages of introducing a restriction on the ratio of leverage of all financial institutions (Lind, 2008).
The banks as well as the regulators have increased their awareness concerning the risk of liquidity in the money markets. It is therefore expected that when Fed and treasury will introduce liquidity buffers that are higher, the banks will accept them more easily as they have seen the devastating effects of low liquidity buffers.
But, there are many challenges which are involved like designing measures that are relatively simple for financing liquidity risk. There is also the challenge of whether or not to require banks to operate minimum liquidity buffers. Fed also require to determine, how the frameworks of regulation can be adjusted in order to lean against the risks of build-up as well as leverage during periods of boom (Honohan, 2008).
One of the major causes of the current banking crisis resulted from banks operating in the shadow sector. Their activities did not only affect them, but also spilled over to the banks operating in the mainstream sector. The emergence and increased significance of these institutions was mainly because Fed and treasury failed in regulating them as well as their activities.
Therefore, one major role these two regulatory bodies will assume because of the crisis facing the banking industry is the regulation of virtually all activities being carried by banks regardless of whether they are operating in the mainstream or shadow sector. Both Fed and treasury will need more powers to enable them ensure that the activities and operations of these banks are not carried at the peril of the entire financial sector of the country (Barrell Fic & Liadze, 2009).
Fed and treasury have bailed out some banks in order to mitigate the massive losses that are being experienced in the sector. Bailing out of the banks is also aimed at increasing their financial so as to enhance the recovery process. As more and more banks are bailed out, the effects of the banking crisis will reduce and the sector will recover faster. Fed and treasury are also exercising their powers by lowering the rates of interests together with the minimum reserves required. These actions are aimed at stimulating the economic growth through increased level of economic activity in the country.
This is due to the fact that these actions are aimed at increasing the level of liquidity in the economy. It is possible to prevent reoccurrence of a banking crisis in the future. However, in order to fully caution such a crisis in future, all the stakeholders must perform their roles effectively. Fed and treasury have to increase their regulatory roles in order to monitor all the activities and operations of the financial institutions that are likely to result to another liquidity crisis. On their part, the banks should in future avoid high risk lending behaviors which increase the rates of defaults (Honohan, 2008).
The current banking crisis has brought about several major changes in the financial institutions. Some of the major banks such as Northern Rock have been acquired after suffering major losses and becoming bankrupt. Others have been forced to merge with other banks in order to continue operating. It is even worse for some banks which have already been liquidated or have been declared insolvent as a result of the financial crisis.
The Lehman Brothers investment bank has already been forced to file for bankruptcy protection following a series of making losses. In order to increase chances of surviving the current banking crisis, some banks have been forced to merge. Merging increases the capital base and mutual benefits of the merging organizations, thus reducing their chances of being liquidated or being declared bankrupt (Weale, 2008).
The insurance corporation federal deposit of the United States, have the option of either assuming bank deposits or permitting banks to assume such deposits. The most significant banks that have been acquired affecting FIDC negatively include the acquisition of Merrill Lynch and Countrywide Financial which were acquired by the Bank of America and JP Morgan Chase acquired Bear Streams.
Another major bank which has been acquired is IndyMac Bank; FIDC changed its name to Bridge Bank, following its massive failure, until such a time when disposal of funds can take place. The failure of some of the major banks which assume deposits on behalf of FIDC or which the latter assumes deposits on their behalf is in itself a major crisis. For several years, FIDC have never faced such a crisis in which major banks are incurring heavy losses frequently and being forced into mergers and acquisitions (Barrell Fic & Liadze, 2009).
The banks are the major contributors to the current banking crisis being experienced across the world today. They advanced money to high risk borrowers whose chances of re-servicing the loans were low. As a result, the rates of defaults increased dramatically making most banks to incur heavy losses. Some banks were therefore compelled into mergers and acquisitions, while others were either liquidated or were declared bankrupt.
Bank regulation is very essential in the stability of an economy. Both Fed and treasury should therefore devise new means through which they can regulate the operations of the banks in order to avoid reoccurrence of a banking crisis in the future. These regulatory bodies have lowered the rates of interest as well as the minimum reserves required for commercial banks. Such regulations will enable them reduce chances of another banking crisis.
Barrell, R., Fic, T. & Liadze, I. (2009): Fiscal Policy Effectiveness in the Banking Crisis, Journal article of National Institute Economic Review, Vol. 23
Honohan, P. (2008): Risk Management and the Costs of the Banking Crisis, Journal article of National Institute Economic Review, Vol. 17
Lind, D. (2008): New York’s Other Banking Crisis, Magazine article of The Next American City, Vol. 34
Ramos, A.D. (2008): Too Much the Investment Banker: Why U.S. Treasury Secretary Hank Paulson Should Approach the Banking Crisis More like a Regulator, Magazine article of The International Economy, Vol. 22
Shutes, K. (2007): The Banking Crisis, Magazine article of Teaching Business & Economics, Vol. 11
Weale, M. (2008): Commentary: the Banking Crisis and the Economy
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