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Financial Institutions : Financial Crisis

Question:

Describe about the Financial Institutions for Financial Crisis.

Answer:

Component 1(Analysis):

The first and foremost sign of downfall in the financial markets was emerged in the year 2007 while two major funds related companies in the United states declared to be in serious trouble associated with their holdings of mortgage backed securities. The problems were more prominent in the context of securities that constituted by subprime mortgages. The subprime mortgages are mortgages with the individuals who possesses non-standard history of credit or who are lying within the low income groups (Rey 2015). The financial downfall of 2007 has affected the economic fortunes of various countries and it is also termed as the Great Recession. It started in the sub-prime housing market of United States and spread drastically among all the other countries. The economic impact of this global financial crisis on Australia was comparatively lower when compared with the other countries. During the span 2008 to 2010 the average rate of unemployment in the OECD countries increased from 6.1% to 8.6% however, in marginally increased from 4.2% to 5.2% in Australia at that point of time (Lewis 2015).

Concept of Financial Crisis:

Financial crisis is defined as a situation when the value of the assets as well as the financial institutions drops briskly. The situation of financial crisis is often allied with panic or may be a run to the banks situation when people withdraw money from the savings accounts and selling off the assets with an expectation that the values of these assets will drop if those are kept with a financial institution (Harvie and Van Hoa 2016).

The occurrence of a financial crisis is generally caused when institutions or assets are overvalued and the situation can be worsened by the behaviour of the investors. The rapid actions like selling off the financial assets and withdrawing the savings if are left unattended then this will definitely usher the economy towards recession or depression (Harvie and Van Hoa 2016). Since the great depression in 1929, the financial crisis of 2007 is characterized as the most disastrous recession till now. It has also been investigated that the reason behind this global financial crisis is not a single one there are a widespread reasons behind this event. In the next sections these reasons will be examined one by one (Lo 2012).

Causes of Financial Crisis in Australia and US:

Macroeconomic Causes:

Lower rate of inflation and lower rate of interest:

The last decade was primarily identified with the characteristics of very high stability within the macroeconomic factors. The stable growth rate taken together with quite low and stable rate of inflation was noticed within the country. Therefore, this period is called the period of Great Moderation (Haas and Lelyveld 2014).

There are a number of economic factors which contributed in maintaining this low rate of inflation during the last decade. The communist countries opened up to world trade and that significantly contributed in increasing the supply of low cost labour force in the world economy. Taken together with successive increase in the use of information technology, improved production process can also be divided into different parts and are located in different countries and thereby helping to establish the balance of trade (Haas and Lelyveld 2014). Therefore, almost the entire world became a production centre for various business organizations and different parts could also be manufactured in different regions. This leads to a reduced cost of production in various industries (Haas and Lelyveld 2014).

In a developed country like Australia, the reserve bank of Australia has adopted policies to target inflation. This change in the framework of monetary policy was successful in controlling the rate of inflation (Mun and Brooks 2012). Therefore, the low level of inflation and the lower expected level of inflation have helped to keep the interest rates at a very low level. This lower level of interest in Australia has various consequences, that is people started borrowing excessively for the purpose of purchasing houses and as a result the price of houses also increased, prices almost doubled in a very short time. The households of the country also recorded historic indebtedness.

Taking higher level of risk:

It is quite evident that the increase in the demand for debt is certainly not matched by the amount of deposits with the banks. Therefore, the banks were compelled to look for funds from somewhere else. These incidents made the banks dependent on the wholesale funding markets. Other financial factors such as the hedge funds were dependent on the short term funding on the market while the investments associated with them are long term (Bénétrix et al. 2015). Hence, the financial institutions became subject to a huge liquidity risks.

The investors who are risk averse became uncomfortable because of the low level of interest rate. However, the treasury funds yielded lower returns compared to the guaranteed returns from the other funds. Hence, the investors were subject to take higher risk in order to ensure higher return. Some of the investors exploited the opportunity of lower cost of borrowing for investing in the risky assets (Haldane 2013). With the passage of time the demand associated with risk ranged between the fixed incomes assets because the rate of interest for the risky assets fell.

In order to sum up it can be stated that the entire society underestimated the potential risk. This statement also holds true for a number of Australian financial institutions as well. The financial institutions relied solely on the liquidity of the market and the liquidity of the market was taken for granted. Though the liquidity quickly dried up when the investors became uncertain about the quality of the assets in which they are investing (Chang et al. 2015).

In the context of United States it can be observed that the crisis had evolved because of multiple causes. The most evident cause behind the crisis is the financiers themselves, especially those who thought they have obtained a way to avoid risk but actually was not on the correct path. The year before the crisis evolved saw a constant flow of mortgage loans in the United States (Erkens et al. 2012). These loans were given to the subprime borrowers who also had a very poor credit history and they were struggling hard to repay those debts. Afterwards, these risky mortgage were transferred to the financial engineers positioned at the big banks and they turned these risky assets into low risk securities by allocating them together in a pool. The strategy of pooling is effective only when the risk associated with each loan is not correlated with each other (Arnove et al. 2012).

The pooled mortgages were mainly used for the purpose of backing up the securities and were termed as collateralised debt obligations (CDO) and these were divided into tranches in accordance with their degree to default. Investors are more likely to buy safer tranches and this is because they trusted the triple-A credit ratings (Brzezinski 2013). However, this was another mistake because the agencies which were responsible for this credit rating were paid by the banks those issued the CDOs.

Effects of Financial Crisis:

When the financial crisis hit Australia in 2008, the country was in a robust shape and health. The government of the country was debt free, growth rate was high and there were surplus budget. Therefore, these favourable conditions along with excellent terms of trade situations guaranteed that Australia will definitely survive the crisis effectively (Butlin 2013).

Therefore, the strength of the government of Australia have definitely prepared the framework so that the country can sustain this economic storm while the businesspeople, financial markets as well as the consumers were reassured by the massive strength of the economy of Australian (Reinhart et al. 2013). Over and above all, the prevalent political parties in Australia were also in a very good shape and they provided stimulus packages to boost up the financial condition of the country.

Financial Instruments:

In the context of the financial assets the growth associated with securitization was much needed by the financial industry in order to reduce risks amalgamated with the banking system. The purpose of securitization is to repacking the assets and sells them to the investors (Schularick and Taylor 2012). However, with the emergence of global financial crisis it became evident that the diversification of risk by securitization has not been actually achieved.

Financial Institutes:

In case of financial institutions, after the breakout of the global financial crisis financial institutions were submerged into severe problems. The strategies adopted by the financial institutions along with the measures adopted by them to keep the rate of inflation at a lower level failed drastically (Dembiermont et al. 2013). Therefore, the financial institutes started to reform its strategies and the financial frameworks in order to cope up with the current problems. Hence after the hurricane attack of the global financial crisis all the financial institutions realized the mistakes and started reforming the structure and policies adopted by them.

Financial Markets:

The financial markets also experienced a severe downfall; people started selling off their financial assets as a result of the lower rate of interest. Therefore, the financial market was overwhelmed with withdrawal of investments and hence was about to break down.

Measures implement by the Government:

The budget of 2008-09 in Australia established a balance between the inflation and tackling the risks imposed by the conditions of global economy as a whole. The government of the country was well aware about the fact that the global financial crisis may lead to further deterioration of the conditions of the country (Chor and Manova 2012). As a precautionary measure the government of Australia strengthened the financial condition of the country by allowing the operations of automatic stabilizers and thereby building a buffer of $21.7 billion which can be used for future policy actions. The government supported the households by providing the facilities of tax cut and making payments to the pensioners (Bernal et al. 2013).

The Reserve Bank of Australia is responsible for both the monetary policy as well as maintaining the fiscal framework has also implemented some steps in order to ensure the financial stability of the country. It provided the financial institutions with timely liquidity while the international money market was not functioning. The Reserve Bank of Australia also reduced the bank rate from 7.25% to 6% (Herndon et al. 2014).

Component 2 (Research):

Analysis of the elements of Global Financial Crisis:

In the middle of 2007 the sudden metamorphosis of Global Financial Crisis had shaken the global economy drastically. It is the worst recession that the entire world has ever experienced since the last six decades. The causes and the effects of this global financial crisis have been discussed in the previous sections. However, there were other factors as well along with the traditional factors that gave rise to the global financial crisis (Ball 2014). For instance the increasing imbalance, for number of years many countries were running a large current account deficit. The situation further worsened in the year 2000. During the same time the countries which exports oil and some of the emerging countries such as China possesses a large amount a current account surplus (McKenzie et al. 2014). These current account surpluses were again invested in the developed countries. Hence the increased demand give rise to an increase in the price level and it has also lowered the yield of the government bonds along with lowering the return from the fixed income financial assets.

However, apart from all the; positive effects of lower rate of inflation and lower level of interest rates the side effect was an increase in the accumulation of debts among the households. The financial system was also burdened with risk while the participants were not aware about this fact (Moghadam 2015).

Most of the central banks specifically the Federal Reserve of US, decided not to respond to the quick rise in the credit level and the prices of the assets. Else they decided to lower the rate of interest if there is a fall in the price of the asset and usher the economy towards a downturn. However, this approach was specifically based on the fact that the Reserve Bank could not find out the financial bubble and if they could identify the bubble it would have been dangerous if they try to deflate the bubble (Cavusgil et al. 2014).

The financial institutions along with the financial markets have developed significantly over the last few years. In the developed countries the deregulation acts of financial markets along with the effects of globalizations has gave rise to the formation of a large and complex cross border financial institutions (Reinhart and Rogoff 2014). The markets based on global operations also got integrated with large capital flows across the borders and thereby providing the emerging economies to gain an increased share in the international trade.

Developments in the context of the financial markets during the last twenty years possess certain aspects that made the financial system more vulnerable to the market shocks. The financial institutions became more dependent on the liquidity for their financing activities (Reinhart and Rogoff 2014).

Component 3 (Recommendation and Conclusion)

Now in order to summarize it can be stated that the entire study have efficiently focused on the contemporary issues associated with the global financial crisis. Therefore, it is quite evident that the causes and effects of financial crisis are stated accordingly in relation with the Australian and the American financial markets. In order to conduct the study a wide literature review of the literatures available in this regard has been conducted. This has helped the author to gain a broader overview of the entire subject. In the light of the knowledge gained by conducting the literature review the study has been conducted and the issues have been tried to address. Hence, in the context of the financial situation of Australia it can easily be stated that the country is obviously in a very good shape till now and the policies and frameworks adopted by the government of Australia is perfect for the country. If another crisis emerges the current economic framework of the country is so designed that it will be able to cope up with the situation uqite easily. Therefore it is recommended that the country should obviously follow the policy framework implemented by the Australian government. In case of United States, the economy of US is not in a very good shape like Australia. However, the current situation of the country is quite good, with lower level of unemployment rate, moderate rate of inflation and interest rate. Hence the financial market of the United States will be able to operate efficiently. The worsening effects imposed by the global financial crisis have been mitigated and the economy has rebounded back into its initial stages. Therefore, as a recommendation for the economy of United States it can be stated that the country should adopt a more lenient financial framework and that will ensure the prosperity of the entire economy.

Reference List:

Arnove, R.F., Torres, C.A. and Franz, S. eds., 2012. Comparative education: The dialectic of the global and the local. Rowman & Littlefield Publishers.

Ball, L.M., 2014. Long-term damage from the Great Recession in OECD countries (No. w20185). National Bureau of Economic Research.

Bénétrix, A.S., Lane, P.R. and Shambaugh, J.C., 2015. International currency exposures, valuation effects and the global financial crisis. Journal of International Economics, 96, pp.S98-S109.

Bernal, J.A.L., Gasparrini, A., Artundo, C.M. and McKee, M., 2013. The effect of the late 2000s financial crisis on suicides in Spain: an interrupted time-series analysis. The European Journal of Public Health, p.ckt083.

Brzezinski, Z., 2013. Strategic vision: America and the crisis of global power. Basic Books.

Butlin, N.G., 2013. Investment in Australian economic development, 1861-1900. Cambridge University Press.

Cavusgil, S.T., Knight, G., Riesenberger, J.R., Rammal, H.G. and Rose, E.L., 2014. International business. Pearson Australia.

Chang, S.S., Stuckler, D., Yip, P. and Gunnell, D., 2013. Impact of 2008 global economic crisis on suicide: time trend study in 54 countries.

Chor, D. and Manova, K., 2012. Off the cliff and back? Credit conditions and international trade during the global financial crisis. Journal of international economics, 87(1), pp.117-133.

Dembiermont, C., Drehmann, M. and Muksakunratana, S., 2013. How much does the private sector really borrow? A new database for total credit to the private non-financial sector. BIS Quarterly Review March.

Erkens, D.H., Hung, M. and Matos, P., 2012. Corporate governance in the 2007–2008 financial crisis: Evidence from financial institutions worldwide.Journal of Corporate Finance, 18(2), pp.389-411.

Haas, R. and Lelyveld, I., 2014. Multinational banks and the global financial crisis: Weathering the perfect storm?. Journal of Money, Credit and Banking,46(s1), pp.333-364.

Haldane, A.G., 2013. Rethinking the financial network. In Fragile stabilität–stabile fragilität (pp. 243-278). Springer Fachmedien Wiesbaden.

Harvie, C. and Van Hoa, T., 2016. The causes and impact of the Asian financial crisis. Springer.

Herndon, T., Ash, M. and Pollin, R., 2014. Does high public debt consistently stifle economic growth? A critique of Reinhart and Rogoff. Cambridge journal of economics, 38(2), pp.257-279.

Lewis, W.A., 2015. The evolution of the international economic order. Princeton University Press.

Lo, A.W., 2012. Reading about the financial crisis: A twenty-one-book review. Journal of economic literature, 50(1), pp.151-178.

McKenzie, D., Theoharides, C. and Yang, D., 2014. Distortions in the international migrant labor market: evidence from Filipino migration and wage responses to destination country economic shocks. American Economic Journal: Applied Economics, 6(2), pp.49-75.

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