Impacts on financial institutions
The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. The IMF estimated that U.S. banks were about 60 percent through their losses, but British and eurozone banks only 40 percent.
One of the first victims was Northern Rock, a medium-sizedBritishbank. The highlyleveragednature of its business led the bank to request security from theBank of England. This in turn led to investor panic and abank runin mid-September 2007. Calls byLiberal Democrat ShadowChancellorVince Cabletonationalisethe institution were initially ignored; in February 2008, however, theBritish government(having failed to find a private sector buyer) relented, and the bank was taken into public hands.Northern Rock's problemsproved to be an early indication of the troubles that would soon befall other banks and financial institutions.
Initially the companies affected were those directly involved in home construction and mortgage lending such as Northern Rock and Countrywide Financial, as they could no longer obtain financing through the credit markets. Over 100 mortgage lenders went bankrupt during 2007 and 2008. Concerns that investment bankBear Stearnswould collapse in March 2008 resulted in its fire-sale toJP Morgan Chase. The crisis hit its peak in September and October 2008. Several major institutions either failed, were acquired under duress, or were subject to government takeover. These includedLehman Brothers,Merrill Lynch,Fannie Mae,Freddie Mac,Washington Mutual,Wachovia, andAIG.
Credit markets and the shadow banking system
During September 2008, the crisis hits its most critical stage. There was the equivalent of a bank runon the money market mutual funds, which frequently invest incommercial paperissued by corporations to fund their operations and payrolls. Withdrawal from money markets were $144.5 billion during one week, versus $7.1 billion the week prior. This interrupted the ability of corporations to rollover (replace) their short-term debt. The U.S. government responded by extending insurance for money market accounts analogous to bank deposit insurance via a temporary guarantee and with Federal Reserve programs to purchase commercial paper.
Economist Paul Krugmanand U.S. Treasury SecretaryTimothy Geithnerexplain the credit crisis via the implosion of theshadow banking system, which had grown to nearly equal the importance of the traditional commercial banking sector as described above. Without the ability to obtain investor funds in exchange for most types ofmortgage-backed securitiesorasset-backed commercial paper, investment banks and other entities in the shadow banking system could not provide funds to mortgage firms and other corporations.
This meant that nearly one-third of the U.S. lending mechanism was frozen and continued to be frozen into June 2009.
Wealth effects
There is a direct relationship between declines in wealth, and declines in consumption and business investment, which along with government spending represent the economic engine. Between June 2007 and November 2008, Americans lost an estimated average of more than a quarter of their collective net worth. By early November 2008, a broad U.S. stock index the S&P 500, was down 45 percent from its 2007 high. Housing prices had dropped 20% from their 2006 peak, with futures markets signaling a 30-35% potential drop. Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in late 2008. Total retirement assets, Americans' second-largest household asset, dropped by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total a staggering $8.3 trillion. Since peaking in the second quarter of 2007, household wealth is down $14 trillion.
Global contagion
The crisis rapidly developed and spread into a global economic shock, resulting in a number of European bank failures, declines in various stock indexes, and large reductions in the market value of equities and commodities.
World political leaders, national ministers of finance and central bank directors coordinated their effortsto reduce fears, but the crisis continued. At the end of October 2008 a currency crisis developed, with investors transferring vast capital resources into stronger currencies such as the yen, the dollar and the Swiss franc, leading many emergent economies to seek aid from the International Monetary Fund.
Global effects
The continuing development of the crisis has prompted in some quarters fears of a global economic collapsealthough there are now many cautiously optimistic forecasters in addition to some prominent sources who remain negative. The financial crisis is likely to yield the biggest banking shakeout since the savings-and-loan meltdown. Investment bankUBSstated on October 6 that 2008 would see a clear global recession, with recovery unlikely for at least two years. Three days later UBS economists announced that the "beginning of the end" of the crisis had begun, with the world starting to make the necessary actions to fix the crisis:capitalinjection by governments; injection madesystemically; interest rate cuts to help borrowers. The United Kingdom had started systemic injection, and the world's central banks were now cutting interest rates. UBS emphasized the United States needed to implement systemic injection. UBS further emphasized that this fixes only the financial crisis, but that in economic terms "the worst is still to come".UBS quantified their expected recession durations on October 16: the Eurozone's would last two quarters, the United States' would last three quarters, and the United Kingdom's would last four quarters. Theeconomic crisis in Icelandinvolved all three of the country's major banks. Relative to the size of its economy,Iceland’s banking collapse is the largest suffered by any country in economic history.
At the end of October UBS revised its outlook downwards: the forthcoming recession would be the worst since the Reagan recession of 1981 and 1982with negative 2009 growth for the U.S., Eurozone, UK; very limited recovery in 2010; but not as bad as theGreat Depression.
With a recession in the U.S. and the increased savings rate of U.S. consumers, declines in growth elsewhere have been dramatic. For the first quarter of 2009, the annualized rate of decline in GDP was 14.4% in Germany, 15.2% in Japan, 7.4% in the UK, 18% in Latvia, 9.8% in the Euro area and 21.5% for Mexico.
By March 2009, the Arab world had lost $3 trillion due to the crisis. In April 2009, unemployment in the Arab world is said to be a 'time bomb'. In May 2009, the United Nations reported a drop in foreign investment in Middle-Eastern economies due to a slower rise in demand for oil. In June 2009, the World Bank predicted a tough year for Arab states. In September 2009, Arab banks reported losses of nearly $4 billion since the onset of the global financial crisis.
Emergency and short-term responses
The U.S. Federal Reserveand central banks around the world have taken steps to expand money supplies to avoid the risk of adeflationary spiral, in which lower wages and higher unemployment lead to a self-reinforcing decline in global consumption. In addition, governments have enacted large fiscal stimulus packages, by borrowing and spending to offset the reduction in private sector demand caused by the crisis. The U.S. executed two stimulus packages, totaling nearly $1 trillion during 2008 and 2009.
This credit freeze brought the global financial system to the brink of collapse. The response of the USA Federal Reserve, theEuropean Central Bank, and other central banks was immediate and dramatic. During the last quarter of 2008, these central banks purchased US$2.5 trillion of government debt and troubled private assets from banks. This was the largest liquidity injection into the credit market, and the largest monetary policy action, in world history. The governments of European nations and the USA also raised the capital of their national banking systems by $1.5 trillion, by purchasing newly issuedpreferred stockin their major banks.
Governments have also bailed-outa variety of firms as discussed above, incurring large financial obligations. To date, various U.S. government agencies have committed or spent trillions of dollars in loans, asset purchases, guarantees, and direct spending. For a summary of U.S. government financial commitments and investments related to the crisis, seeCNN - Bailout Scorecard.
Regulatory proposals and long-term responses
United States President Barack Obamaand key advisers introduced a series of regulatory proposals in June 2009. The proposals address consumer protection, executive pay, bank financial cushions or capital requirements, expanded regulation of theshadow banking systemandderivatives, and enhanced authority for theFederal Reserveto safely wind-down systemically important institutions, among others.
A variety of regulatory changes have been proposed by economists, politicians, journalists, and business leaders to minimize the impact of the current crisis and prevent recurrence. However, as of November 2009, many of the proposed solutions have not yet been implemented. These include:
Ben Bernanke: Establish resolution procedures for closing troubled financial institutions in theshadow banking system, such as investment banks and hedge funds.[149]
Joseph Stiglitz: Restrict theleveragethat financial institutions can assume. Require executive compensation to be more related to long-term performance.[150] Re-instate the separation of commercial (depository) and investment banking established by the Glass-Steagall Act in 1933 and repealed in 1999 by the Gramm-Leach-Bliley Act.[151]
Simon Johnson: Break-up institutions that are "too big to fail" to limitsystemic risk.[152]
Paul Krugman: Regulate institutions that "act like banks " similarly to banks.[62]
Alan Greenspan: Banks should have a stronger capital cushion, with graduated regulatory capital requirements (i.e., capital ratios that increase with bank size), to "discourage them from becoming too big and to offset their competitive advantage."[153]
Warren Buffett: Require minimum down payments for home mortgages of at least 10% and income verification.[154]
Eric Dinallo: Ensure any financial institution has the necessary capital to support its financial commitments. Regulate credit derivatives and ensure they are traded on well-capitalized exchanges to limitcounterparty risk.[155]
Raghuram Rajan: Require financial institutions to maintain sufficient "contingent capital" (i.e., pay insurance premiums to the government during boom periods, in exchange for payments during a downturn.). The world's severe economic downturn must be addressed alongside and not to the exclusion of other problems - global governance, climate change, the energy revolution, and the rise of a multipolar order
The global financial crisis has implications that go far beyond the financial and economic sectors. Below are nine thoughts in an attempt to see the opportunities in what currently looks like a pretty grim picture.
Thought 1: The west is in trouble and has become a potential source of instability for the world
During the eight years of the George W Bush administration, the west's political leadership has been squandered. But now the economic fundamentals of the western way of life are also being squandered. This is serious. Barack Obama's election will re-establish the credibility of the United States in the world but it will not reverse the trend of decline. The challenge ahead is to manage a peaceful decline of the west while rescuing as many of the west's liberal political and economic values as possible. This will only work if the multipolar world is accepted as a reality and as an opportunity for a new style of global cooperation and governance.
Thought 2: The troubles of the west are contagious
Even in decline, the west will weather the financial crisis and a recession better than emerging and developing countries. It can be hoped that solid democracies should be better equipped to deal with economic instability. But how will Russia and China behave in a recession? Despite systemic differences, there is no room for complacency if Russia, China and other emerging economies suffer economically, as instability there will have huge political (and economic) repercussions for the west. Economically stable times are usually better for settling differences.
Thought 3: Leverage requires sound and credible resources
The world is still celebrating the Obama revolution in the US. But the hard times ahead will require hard decisions from the new US president. He has a large bank of goodwill from people around the world and he should use this credit wisely and responsibly. The financial crisis has also taught a useful lesson: in international politics, it is possible to leverage support and resources successfully only if your resources are sound and credible; for example, leveraging support from others on human rights and democracy only works if your own house is in order. Otherwise, playing with other people's credit can and will backfire.
Thought 4: Global issues have to come to a boiling-point before global action is taken
But if they boil over and a global interdependent system is close to a standstill, global leaders can and do act. Who would have thought that trillions of euros would be found within a matter of weeks to deal with the global financial crisis? This should be a lesson for other global issues such as climate change and poverty. How much would the recommendations in Nicholas Stern's review of climate change cost to implement? How many G8 summits were spent talking about "making poverty history", without the required follow-through? The question is whether we will have to come to boiling- (or drowning-) point before such dramatic government action will be taken on climate change and poverty-reduction. On climate change, global leaders cannot afford to wait until the system comes to a standstill, because it will then - even with all the money in the world - be too late to get it going again.
Thought 5: Globalisation is here to stay
We are interdependent, no question. Naomi Klein's No Logo was fun; No Lehman Brothers is the hard reality of globalisation. On the opportunities side, the attempts of major countries to work together shows that hardcore globalisation can force global government action. Will history books mark the collapse of Lehman Brothers as the start of building a 21st-century global-governance system?
Thought 6: Global governance has made a comeback
A new opening for global governance in the 21st century has emerged, and it is created by awareness that "it's the economy, stupid". We need new global governance which can both manage the ascent of China, India, Russia, Brazil as well as the relative decline of the United States and Europe. Europe and the US must concentrate on shaping this new global governance and enshrine its progressive values within it, while they still have some power to do so.
Thought 7: The early European Union: a model for 21st century global governance
The EU started as a coal-and-steel community, not as the value community of today. While the architects of the EU had a value-driven vision of Europe in mind, they started pragmatically with coal and steel. This can be a lesson for global governance. Can we rebuild global governance based on global financial governance and then move ahead in ways that echo the EU's evolution? Could this be an example for building a global open society? This would certainly be in line with the EU's founding father Jean Monnet, who thought that "the community we have created is not an end in itself. The community itself is only a stage on the way to the organised world of tomorrow". The conclusions of the EU financial summit of 7 November 2008 are a step - albeit timid - in this direction.
Thought 8: Yes we can create a new energy revolution
While we are still in the midst of the financial crisis, global leaders are already turning to the fast approaching recession in the real economy. After major bailout packages for the banks, major economic stimulus packages are now in preparation. This is the right approach. But these packages should be targeted and used to stimulate the new, renewable-energy growth sector and help to initiate an energy revolution which creates sustainable growth now and in the future. The trillions of euros which will likely be spent on fighting the global recession should be spent on fighting climate change at the same time. It's a question of efficiency and forward thinking. And it combines the urgent with the important. The European Union's structural-funds model, based on EU co-funding of up to 80%, can be used to disburse the EU's new energy-stimulation package, making it attractive also for east-central European member-states to join the new energy revolution.
Thought 9: A tightening of funds in the development and non-profit sector makes reforms essential
Development money will be scarce, at the least in the short term. This will apply to governments' development aid but also the non-profit sector in general. The outcome may be a consolidation in this sector - but also lots of broken promises. However, rather than competing for scarce resources, the development community should use the crunch in development aid to assess approaches and structures, to reform in a way that allows letting go of ineffective models. Competition for creativity should result in doing things better with less.
Undoubtedly there are many more sophisticated angles to the global financial crisis. The importance is to understand the crisis as an opportunity which should not be wasted.