Understanding the causes of 2007-09 ‘financial crisis’…and the UK government’s response- An essay by Shirumisha Kwayu Posted on 18/04/2013 by Aikande Kwayu
Note to the reader: This is the first entry that is not written by me (i.e. Aikande Kwayu). The blog is now inviting entries by interested people…if you think you may have something to share please feel free to email me. And now…let’s learn a bit about the recent financial crisis and how the UK government responded. It’s important to understand the UK’s reaction as it has been one of the forefront countries in dealing with the issue… remember how Gordon Brown worked very closely with U.S.A, I.M.F, E.U, etc…proposing bailing out banks etc…so here we go!!!!
The period between 2007 and mid-2009 experienced the worst global financial crisis since the great depression of 1930’s. The crisis was mainly notable for its impact on the banking sector. In the UK, a bank run that was never seen since 1866 at Overend Gurney bank was seen at Northern Rock in September 2007 (Shin, 2009). Some scholars such as Eduardo Pol (2012) argue that the 2007-09 crisis should be specifically termed as banking crisis instead of financial crisis. The rationale being that the crisis inflamed financial shock that hit directly on the banking sector. The period was characterised with failure of large banks such as Northern Rock, Lehman brothers, Bear Stearns and others across the US, UK and Europe. The failure subjected some banks to takeovers as well as prompting government intervention in order to rescue the whole financial system.
The failure of these banks and the crisis in general was a result of major developments that took place in both micro economic level (within the banking industry) and macroeconomic level (within the economy). This essay will discuss: (a) the causes of the 2007-09 banking crisis; (b) and critically assess steps that were taken by the UK government to resolve the problem. The essay ends with a conclusion.
The USA real estate boom is a major factor that led to the 2007-09 banking crisis. The link between the real estate boom and the financial crisis is derived from the classical economic theory, which explicates that a boom is followed by a burst. The period before the crisis began the US housing market was flourishing with rising house prices. The housing market boom was supported by the government ambition for people to own their own houses under the President Bush ‘American Dream’ policy act which loosened some financial constrain for people with lesser income (Wignall et al, 2008). The rising house prices and slack regulation made the real estate business a profitable and nobody seemed to care the level of risk associated with the return from the housing market. The risk shifted to the banks through the mortgage broker who created loans and sold them to the banks and the banks securitized them (Pol, 2012). The banking crisis was created in this movement because the mortgage brokers had no incentive to assess the risk of the loans. The expectation that house prices will continue to rise was what kept sustaining the boom and any falling house price would lead to loss in the market, defaults and exposing the risk, hence crafting the crisis.
Another factor that caused the banking crisis of 2007-2009 was the subprime lending. Subprime lending is the act of issuing loans to borrowers with poor credit history; weak financial or collateral base and they have high risk of default. Normally, the subprime borrowers would not be able to access a loan. Thus, subprime loan will have a short term maturity with instalment that contains a penalty. Mayer et al (2009) estimates that the subprime mortgage relative to total mortgage market in the US grow from 10% to 32% between 2003 and 2005. The burgeoning of the subprime lending was inflated by various factors such as deregulation of the financial sector, increase in securitization and loose supervision of reserve capital ratio...
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