Economic and financial crises are common phenomena, even though their occurrence is not frequent. Few crises have global devastating effects as exemplified by the 2008 financial crisis. Economists and other experts can debate about the actual causes of the incident without necessarily reaching a consensus. However, the basic idea is that a financial crisis is majorly the result of mismanagement of finances.
Therefore, it can further b argued that financial institutions, especially banks, have a critical role to play regarding how the financial crises emerge and affect the country’s economy. The main argument in this paper is that banks were the main cause of the crash because of unethical risk-taking behaviors. A brief description of the 2008 financial crisis and the role of the banks will be presented. Additionally, the paper will also feature one of the banks that was affected by the crash.
Characteristics of the 2008 Financial Crisis
The characteristics of the 2008 financial crises can be examined from the points of view of the factors contributing to it and the main effects on the economy. First, the crisis was characterized by a steady rise in subprime mortgage rates. The value of housing in the United States increased, which resulted in many investors joining the real estate industry. Additionally, the business growth in this sector compelled banks and other financial institutions to enter, which led to the formation of new secondary markets. Such markets were rationalized as risk diversification and comprised of lender creating innovative means of funding characterized by fast and loose loan qualification procedures (Thomas, 2017). Therefore, it can be argued that one of the main features of the crisis was a change in financing investments in real estate.
Another characteristic of the crisis can be observed in how the industry responded to the risk-taking by financial institutions. According to Adelino et al. (2017), the quality of the assets declined abruptly as a result of large investors and their risk-taking tendencies. Additionally, the variable nature of the securities and interests on the loans meant that as interests grew, the burden on the consumer rose and the mortgages became undesirable. The crisis was also characterized by blame on the regulators for failing to adequately police the mortgages sector, especially after its collapse. Most importantly, the main characteristics are manifested by the slow economic growth, high unemployment, and one of the highest rates of inflation to ever be witnessed (Knowles et al., 2017). After the crash, many businesses went bankrupt and closed, which caused a massive loss of jobs. The sudden unemployment also caused further economic problems that accelerated the downward spiral of the global economies.
Role Played by Banks in the Crisis
Banks and other financial institutions have largely been blamed for the 2008 crisis because many of their practices were deemed unethical and disgraceful. The banks were responsible for the massive loans without proper approval processes. The banks forced acquisitions and engaged in other such practices as tainted asset purchases, capital infusions, and instantaneous conversion from investment to commercial banks (Schoen, 2017).
Therefore, it can be seen that the banks had seen an opportunity to be exploited without proper regard for the risks involved. According to Schoen (2017), several ethical issues emerged during the crisis where many actors collectively created the situations causing the downturn. In other words, banks were only one of the many types of agents in the mortgage markets. The brokers, for example, pushed clients into dodgy subprime loans, the regulators failed to correct the slapdash lending activities, and the rating agencies engaged in disgraceful practices. However, the most prevalent role was played by the banks through multi-tranched investments, shadow banking, and abysmal risk management.
The activities of the banks can also be blamed on the banks’ governance. The argument for this position is that governance determines the courses of actions of entities. The disgraceful banking activities are a reflection of failed or low standards of governance in the banking sector as explained by Battaglia and Gallo (2017). In addition to the weak corporate governance, the increasingly systemic nature of the banking sector played a critical role in the crisis. The relationship between the corporate governance characteristics and incentives of banks to become more exposed to the systemic risks is not adequately studied.
However, the systemic nature of the banking sector led to a conflict of interest between risk-taking and improving the value for the shareholders. The banks became among the primary investors in the housing market through loans. The risks the banks took were only possible to offer short term performance as explained by the acquisitions and high revenues from the interests on loans. The banks failed to acknowledge the extent of the damages that can be caused to the whole system once the risks materialized.
The financial crisis revealed that banking risk can emanate from overreliance on certain types of assets and or funding. Subprime mortgages became the mainstay of commercial banks’ lending, which meant that the crash of the market causes systemic effects. An overview of the types of risks faced by banks can explain why their role in the crisis was prominent. According to Asmild and Zhu (2016), bank runs are fragile and the banks’ capital structures tend to expose them to huge liquidity risks. The argument is that the capital structure is designed to allow depositors to withdraw funds as needed and, at the same time, buffering the borrowers from the depositors. As a result, illiquid assets are converted into liquid liabilities that leave the financial institutions vulnerable to runs caused by multiple equilibria with different confidence levels.
The bottom line is that the risky business conducted by banks exposed the entire banking and mortgage sectors to the systemic risks of banking. Additionally, the greed of the banks resulted in uncensored and improperly regulated lending practices that resulted in banks remaining extremely vulnerable when the housing bubble burst. The attempts to create value for shareholders caused banks to take up excessive and ill-managed risks. Therefore, as primary players in the subprime mortgage market, the banks played a primary role in the 2008 financial crisis.
Specific Bank Affected
One of the banks that affected and was affected by the financial crisis was the Lehman Brothers. The case of Lehman Brothers illustrates the risky behavior of the banks, which ultimately caused the crash. Additionally, the consequences suffered by this institution show how many large banks suffered from and responded to the crisis. According to Schoen (2017), Lehman Brothers was one of the many banks that made large investments and pursued extremely high leveraged. Lehman’s leverage increased by approximately 22% to reach a 40:1 ratio of the capital structure (Schoen, 2017). Such a ratio means that the capital of the banks was simply 2.5% of its assets with the remaining 97.5% was borrowed (Schoen, 2017). Such a scenario can be described as synthetic leveraging by banks.
When the housing bubble burst, it meant that such banks as Lehman Brothers could not cover their liabilities. According to Knowles et al. (2017), the collapse of this bank in September 2008 resulted in a new era of the sovereign debt crisis which caused prolonged recessions globally. By the time of its collapse, the bank owed approximately $200 billion in the repo markets from the short term borrowing market (Schoen, 2017).
In terms of liquidity, it had only $45 billion ready equity, while the balance sheet as of May 31, 2008, indicated $639 billion in assets and $26 billion in equity (Schoen, 2017). However, the nature of these assets and equity was controversial because it included $21 billion in real estate and $72 billion mortgage- and asset-backed securities (Schoen, 2017). With other such banks as Bear Sterns having fallen, Lehman’s investors became concerned and their actions later proved detrimental for the bank.
The 2008 financial crisis was devastating for global economies and many industries and sectors. Many authors have expressed that the banks and their disgraceful lending activities are to blame. It can be argued that the crisis taught many critical lessons for both the banking sector and the regulatory authorities. First, over-investments in certain assets diminish their quality and desirability, which will ultimately cause challenges for the investors. Secondly, the banks and their capital structures cannot allow them to take extreme risks without appropriate risk management practices. If such considerations were made by the banks, their investments and lending in the subprime mortgage would have been subtler and a bubble could not have been created.
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