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Financial crisis is determined as a situation of economic downturn in which the value of financial institutions or assets reduces rapidly. A financial crisis is also associated with improper functioning of banks that influences investors to sell off assets or withdraw money from savings accounts. The financial crisis of 2008 was considered the most dangerous crisis after Great Depression of 1930 (Ivashina and Scharfstein, 2010). This economic down turn began in US in the year 2007 after the bursting of US housing bubble which have recorded significant peak off in 2004. This influences negative growth in prices of houses that spread in entire US financial market along with overseas financial market. The economic crisis collapsed entire banking industry of US, insurance companies, largest mortgage lenders, two government chartered mortgage lending companies, largest commercial banks of the world (Naudé, 2009). Initially, this economic downturn was identified in the US market and then it spread all over the world.
However, several causes were witnessed which influenced the financial crisis. But, the bursting of housing market bubble is identified as the most important reason of economic downturn. In addition to that, this financial downturn was triggered by a complex interplay of policies which encouraged home ownership with the help of easy access to loans for (lending)borrowers (The origins of the financial crisis, 2013). The hike in prices of assets has influenced overvaluation of bundled subprime mortgages on the basis of such assumption that housing prices would continue to escalate etc. Furthermore, it has been evaluated that a flood of irresponsible mortgage lending in America is addressed before several years of crisis. Loans were provided to “subprime” borrowers who are having poor credit histories and are struggling to repay them. These risky mortgages were transferred to major financial engineers of the big banks who considered these loans as low-risk securities by putting large numbers of loan together in pools. This pooling works when the value of risks of each loan is uncorrelated (Erkens, Hung and Matos, 2012). But this approach has proved wrong which resulted in economic downturn.
The housing slump has played important role to influence chain of reaction in all economies. Individuals and investors are not able to flip their homes for a quick profit. Therefore mortgages are no longer affordable for homeowners that increased the number of mortgages defaulted. This situation has caused massive losses in mortgage backed securities and many banks and investment companies were facing shortage of money and cash. It also depressed housing prices and slowed the growth in housing market such as new home building projects and put the thousands of home builders in loss (Allen and Moessner, 2010). The reduction in housing prices has encouraged various further complications as it made many homes much less than the mortgage value. These entire factor played important role to encourage economic downturn.
After the financial crisis of 2008, there has been several legislation and regulatory responses taken by public authorities and various other agencies of the world in order to control lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling, and education along with the qualifications and ability of lenders. In this regard, Housing and Economic Recovery Act of 2008 was introduced in which a new regulator, the Federal Housing Finance Agency is developed with the power to control lending flow with country (Blundell-Wignall, Atkinson and Lee, 2008). In similar way, UK regulators announced a short term restriction on short-selling of financial stock. In this context, G20 has taken appropriate actions in which Financial Stability Board (2010c) examines an overview of the scope along with scale of activities in financial reform at the international (and national) levels since the GFC of 2008. The agency has provided extra attention on strengthening bank capital and liquidity requirements by raising standards for risk management such as Basel III (Goodhart, 2008). These responses also influenced toward strengthening accounting standards and strengthening the international supervisory as well as regulatory standards in order to increase control on financial markets.
In addition to that, both auditors and Credit Ratings Agencies (CRAs) have been faced subject to substantial criticism due to improper valuation. Therefore, Code of Conduct Fundamentals for Credit Rating Agencies was updated in the year 2008. These principles also influenced operations of rating agencies with reference to Central Bank operations and prudential supervision. This thing influenced CRA rating changes and collateral requirements associated with information disclosures which is carried out by issuers of securities (Colander and et.al., 2009). In order to control the lending and mortgage, the Basel Committee has announced enhanced capital requirements for banks with reference to Basel III norms. Therefore, the timetable of application of norms is relatively protracted during 2013 and will be completed till 2018. As per Basel III norms, Minimum Capital Requirement is 8 % of Risk Weighted Assets (RWA) which remained unchanged. In addition to that, Capital Conservation Buffer is also determined in these norms which determines the additional common equity requirement of at least 2.5 % of RWA with constraints on distributions (dividends, bonuses) if overall capital ratio falls below 10.5 % of RWA (Davis, 2015). These norms have been found very effective to control liquidity among banks and it also makes financial institutions stronger.
On the basis of above assessment, some recommendations are provided to manage financial crisis. The public authorities should develop appropriate strategies and formulate an appropriate monitoring agency which has proper authorities in order to check lending and mortgage procedures of banks and other financial institution especially in the housing market. This monitoring agency is found to be very effective for controlling poor mortgage during the peak season of housing market (Goodhart, 2008). Apart from that, United Nations and international monetary controlling authorities should develop proper regulations for different financial markets and lending practices which would lower the chances of financial downturn which is similar to financial crisis of 2008. By strengthening banking and other regulations related to sub-prime lending and mortgage loans etc., central banking authorities of different countries in the world will be able to avoid situation of financial crisis and credit shortage. This approach will help in managing flow of capital in different financial market.
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