Question 2: Banking Systems influencing Financial Crisis 1

Question 2: The 2008 financial crisis has been described as a banking crisis. Which aspects of

the banking systems of Western Countries contributed to the financial crisis?

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 Question 2: Banking Systems influencing Financial Crisis 2

Question 2: Banking aspects that caused financial crisis

The 2007-08 financial crisis was a global commercial disaster that affected major

countries around the world. According to most economists, this development was the most

severe financial development since the 1930s where the world suffered from the Great

Depression. The crisis was greatly influenced by the poor incentive for mortgages in the U.S.

During this period, the house prices reduced by 33% (Amadeo, 2019). The new changes in

mortgage encouraged banks to issue more loans to borrowers without proper screening (Allen

and Carletti, 2010). The issue grew into an international banking crisis that saw most financial

institutions closing or incurring high losses. A good example is Lehman Brothers, a leading

banking corporation that collapsed in the USA (Verick and Islam, 2010). The crisis eventually

resulted in the Great Recession and the downturn of the global economy. The severe

development of this crisis is highly attributed to actions by banking systems. As such, the essay

will focus on a detailed discussion on various aspects of banks in Western states that influenced

the 2008 financial crisis.

Synopsis of core readings

The discussion and answering of the aspects of banking systems influencing the financial

crisis will be affected by three core reading materials. One core literature is the 2011 article by

John Campbell. In a synopsis, the report by Campbell discusses valuable lessons that institutions

can have from the financial crisis. According to general arguments presented in this paper;

financial institutions should reduce the number of incentives as it creates high demand than the

market can solve (Campbell, 2011). The article agrees that after analyzing the 2008 crisis,

institutions can address the potential risk by ensuring complimentary services. Such actions help
 Question 2: Banking Systems influencing Financial Crisis 3

to enhance economic performances and promote market stability. It is through complementary

that companies manage to realize stability in the global financial and economic sectors.

The second core reading that will answer the essay question is the paper by James Crotty.

The 2009 article provides a detailed discussion of the global financial aspects that contributed to

the development of a crisis. According to Crotty (2009), deregulation processes in financial

institutions and procedures can be directly related to booms that eventually end in disasters. The

ability for banks to provide more financial services, including loans, resulted in a high supply of

finance, thus ultimately causing a crisis in an economy. The rise of financial markets meant that

government interventions would have little impact on solving the global crisis.

The third core reading that provides useful insight is the article by David Howarth and

Iain Hardie. The article discusses in detail how the market-based banking system influenced the

crisis in most Western states. According to Howarth and Hardie (2013), the rise and severity of

the 2008 crisis were influenced by multiple bank activities. One such action was the lack of

proper communication between banks and academics, politicians, and regulators. The inadequate

disclosure of financial details only provided a misleading impression of the amount of credit and

money created and available in the market. As such, multiple actions by the banks all resulted in

influencing the 2008 financial crisis. The synopsis of these three core readings provides a general

indication that indeed various aspects of banks in the Western States fuelled the development of

the financial crisis in 2008.

Discussion

One of the banking aspects that explains the rise of this financial disaster was the

provision of subprime loans. The NFA (new financial architecture) system that most banks in the

USA adopted encouraged the regulation of subprime lending (Hall, 2019). According to Crotty
 Question 2: Banking Systems influencing Financial Crisis 4

(2009), subprime lending, especially in mortgage sector created a rise of this crisis. The NFA

system created many flaws in the financial markets, making it difficult for authorities to regulate

the developing financial crises. For instance, the provision of subprime lending created fee

earnings to investment brokers, banks, and mortgage brokers (Tudor, 2009). All these parties

benefited from selling the loans since they were entitled to earn a particular fee. It is estimated

that in the USA alone, about $2 trillion was generated as a fee from mortgage loans between

2003 and 2008 (Crotty, 2009). The highest beneficiaries of these fees were the bank executives

and traders. For instance, in Goldman Sachs, a leading investment bank had managed to earn a

bonus of $16 billion in 2006. The high provisions of subprime lending, as promoted by the NFA

system culminated in excess demand, especially for the housing units. Such a development

resulted in the financial crisis as more people became homeowners affecting the prices of houses.

The prices of medium prices homes rose from $175,000 in 2000 to over $275,000 per house in

2008 (Calhoun, 2018). See the illustration in figure 1. Therefore, the banking aspect of following

the NFA system resulted in more subprime lending, which directly constituted a global crisis.

Figure 1: Prices of median-priced homes in the USA

Source: Calhoun (2018)

 Question 2: Banking Systems influencing Financial Crisis 5

Another banking aspect that can be linked to the crisis was the deregulation process that

eventually encouraged fewer restrictions for banks. The official development occurred in the

enactment of Gramm-Leach-Bliley Act that reduced limits on the amount of investment that

banks could place (Calabria, 2009). The introduction of losing monetary policies promoted the

financial crisis. According to Campbell (2011), the U.S. started its deregulation processes in

1970 when the NYSE (New York Stock Exchange) opposed the regulation that prevented banks

from trading their shares. The deregulation meant that banks would enjoy lesser restrictions from

the authorities. The implication of this was that more bank managers engaged in high-risk

investments as they sought to provide many gains to their investors (Bentley, 2015). It

encouraged banks to borrow funds that they would invest and increase their market dominance.

For example, between 1981 and 2008, major banks across the U.S. had increased the aggregate

debt to 117% from 22% (Campbell, 2011). These banks imposed interest rates that favored their

effort to improve their financial gains resulting in inflation across different sectors of the

economy. The poor regulations implied that banks engaged in fund trading to put their profit

gains (Bartmann, 2017). They promoted more mortgages as a strategy to sell these loans, thus

crumbling the housing industry. Therefore, the deregulation of banks caused more harm as banks

became more self-centered and increased loan provision resulting in a financial crisis.

The other aspect of the banking systems, which influenced a rise to this financial disaster,

was the use of a market-based model by banks that promoted predatory lending. According to

Hardie and Howarth (2013), banks in western countries such as Japan, the USA, Greece, Japan,

Belgium, Canada, and the U.K. were using this model at the time of crisis. The critical

component of this system was that no deposit (non-markets based liabilities) could be invested in

financing market-based assets. For instance, Japan, Belgium, Greece, and Canada all had higher
 Question 2: Banking Systems influencing Financial Crisis 6

numbers of deposits than loans from clients. Such development created much pressure on banks

as it created a weak market. Predatory lending involved banks in the U.K and U.S.A. applying

misleading sales tactics and abusive loan terms to entice more borrowers (Agarwal et al., 2014).

A good example is Countrywide Financial, a bank that was charged with imposing predatory

lending in the USA. The company applied these poor tactics to increase the number of loan

borrowers. However, the lawsuits and a high number of defaulters resulted in the closure of

Countrywide Financial (Savage, 2011). Such a development contributed to a global crisis as

many individuals failed to honor their repayment. For instance, by the end of 2009, about 2.4

million houses were at risk of foreclosure since their owner defaulted in repaying the loans

(Credit Issue Guide, 2009). As such, predatory lending by banks increased the number of loan

defaulters causing a financial crisis.

The banking aspect of incorrect pricing of risks also promoted the 2008 financial crisis.

Proper understanding of economic performances is influenced by how well the policymakers

follow market indicators to identify areas that require appropriate solutions. However, during the

2008 crisis, the policymakers in countries such as the U.K. and the USA were misled by the

incorrect figures on the pricing of risk (European Bank, 2009). Banks and investors

underestimated the risks involved in the provision of mortgage risks. These individuals paid less

interest on the possibility of house prices reducing given that their value had remained relatively

stable for over 50 years (Lagoa, Leao and Barradas, 2014). The misleading pricing of existing

risk ensured that banks could quickly shift and partition risk between the involved participants.

This meant that investors who supported banks to provide more loans failed to pay the needed

additional incremental compensation. These charges are imposed to be paid by individual or

corporate investors who are undertaking additional risk that can be easily be measured by fees or
 Question 2: Banking Systems influencing Financial Crisis 7

interest rates (Crouhy and Bank, 2009). The poor pricing of the existing risk encouraged the

rapid growth of the mortgage market, resulting in a disruptive financial crisis. The imperfect

measurement of the involved risk by banks affected multiple sectors of the economy. For

instance, AIG (American International Group) miscalculated the associated risk, resulting in this

insurance company getting a $150 billion bailout from the government (Gethard, 2019). The

suffering of AIG represents the general development of the 2008 crisis that was fuelled by

incorrect pricing of the involved risk.

Lastly, another banking aspect that contributed to the crisis is overleveraging. In finance,

leveraging can be a good thing as it helps banks use borrowed capital or other financial

instruments to improve their return on investments. However, overleveraging increases the risk

of any company losing its equity and making losses. For example, in a scenario where the ratio

between equity or assets and equity is at 33-to-1, it means that should the firm's asset reduce by

just 3%, the enterprise will suffer a total wipeout of its equity (Cohan, 2012). This scenario

occurred during the 2008 crisis as many banks across Europe and the USA adopted

overleveraging. Before 2008, most Western states banks had increased their ratio of lending to

equity. For example, in 2008, Bear Sterns' ratio was 36 to 1, while that of Lehman Brothers was

30.7 to 1 (Koesterich, 2014). The high leverage levels imply a high risk that resulted in banks

needing bailout with the likes of Lehman Brother becoming bankrupt. The trend of leveraging

levels is illustrated in figure 2. The implication of overleveraging was that regulators and

creditors found it difficult to reduce the financial risk levels. The high overleveraging promoted

the provision of loans, which increase the debt burden. The development eventually resulted in a

financial crisis as leading banks and other financial institutions suffered from the economic

downturn of high debt levels.

 Question 2: Banking Systems influencing Financial Crisis 8

Figure 2: Leveraging Level across the U.K. and U.S.

Source: Koesterich, 2014.

In conclusion, the essay seeks to understand the aspects of banking systems that could

have resulted in a financial crisis. The general argument is that indeed multiple elements of

banking directly or indirectly influenced the 2008 financial crisis. The discussion has been

influenced by three core readings that provide much insight into the aspects of the financial

crisis. These readings include articles by Campbell, Crotty, Hardie, and Howarth. All these three

agree that banking systems impacted the rise of global warming. One of the discussed aspects is

that banking systems were the provision of subprime loans that constituted to rise in several

defaulters. The other reason is less restriction due to deregulations. It encouraged banks to use all

means to ensure they make a profit. The other reason was the predatory lending that increased

the debt burden by enticing borrowers with misleading actions. The banking systems also applied

incorrect pricing of risks making it tough for businesses and policymakers to formulate proper
 Question 2: Banking Systems influencing Financial Crisis 9

strategies to overcome the financial crisis. Lastly, the overleveraging level increased the risk for

banks and eventually led to closure due to poor market performances. All these elements of

banks all influenced the development of a global crisis.

 Question 2: Banking Systems influencing Financial Crisis 10

References

Agarwal, S., Amromin, G., Ben-David, I., Chomsisengphet, S. and Evanoff, D.D., (2014).

Predatory lending and the subprime crisis. Journal of Financial Economics, 113(1),

pp.29-52.

Allen, F. and Carletti, E., (2010). An overview of the crisis: Causes, consequences, and

solutions. International Review of Finance, 10(1), pp.1-26.

Amadeo, K. (2019). What Caused the 2008 Financial Crisis and Could It Happen Again?.

[online] The Balance. Available at: https://www.thebalance.com/2008-financial-crisis-

3305679 [Accessed 6 Jan. 2020].

Bartmann, R., (2017). Causes and effects of 2008 financial crisis. Hochschule Furtwangen.

Bentley, K., (2015). The 2008 financial crisis: How deregulation led to the crisis.

Calhoun, M. (2018). Lessons from the financial crisis: The central importance of a sustainable,

affordable and inclusive housing market. [online] Brookings. Available at:

https://www.brookings.edu/research/lessons-from-the-financial-crisis-the-central-

importance-of-a-sustainable-affordable-and-inclusive-housing-market/ [Accessed 6 Jan.

2020].

Campbell, J.L., (2011). The US financial crisis: lessons for theories of institutional

complementarity. Socio-Economic Review, 9(2), pp.211-234.

Credit Issue Guide (2009). Restoring Integrity to the Financial System Predatory Lending and

the Economic Crisis. [online] Responsiblelending.org. Available at:

https://www.responsiblelending.org/allies/issue-guide-economic-crisis-financial-reform-

sept-2009.pdf.
 Question 2: Banking Systems influencing Financial Crisis 11

Cohan, W. (2012). How We Got the Crash Wrong. [online] The Atlantic. Available at:

https://www.theatlantic.com/magazine/archive/2012/06/how-we-got-the-crash-wrong/

308984/ [Accessed 6 Jan. 2020].

Crotty, J., (2009). Structural causes of the global financial crisis: a critical assessment of the

‘new financial architecture’. Cambridge journal of economics, 33(4), pp.563-580.

Crouhy, M. and Bank, I., (2009). Risk management failures during the financial crisis. The First

Credit Market Turmoil of the 21st Century, 10, p.241.

European Bank, (2009). (Under-)pricing of risks in the financial sector. [online] European

Central Bank. Available at:

https://www.ecb.europa.eu/press/key/date/2009/html/sp090119.en.html [Accessed 3 Jan.

2020].

Gethard, G. (2019). Falling Giant: a Case Study of AIG. [online] Investopedia. Available at:

https://www.investopedia.com/articles/economics/09/american-investment-group-aig-

bailout.asp [Accessed 5 Jan. 2020].

Hall, M. (2019). Who Was to Blame for the Subprime Crisis?. [online] Investopedia. Available

at: https://www.investopedia.com/articles/07/subprime-blame.asp [Accessed 7 Jan.

2020].

Hardie, I. and Howarth, D., (2013). Framing market-based banking and the financial

crisis. Market-based banking and the international financial crisis, pp.22-55.

Koesterich, R. (2014). The must-know basics of financial system deleveraging. [online]

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180306006.html [Accessed 5 Jan. 2020].

 Question 2: Banking Systems influencing Financial Crisis 12

Lagoa, S., Leao, E. and Barradas, R., (2014). Risk management, the subprime crisis and

financialisation: the role of risk management in the generation and transmission of the

subprime crisis (No. wpaper37).

Savage, C. (2011). $335 Million Settlement on Countrywide Lending Bias. [online]

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settlement-reported-on-countrywide-lending.html [Accessed 2 Jan. 2020].

Tudor, C., (2009). Understanding the roots of the US Subprime Crisis and its subsequent

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Verick, S. and Islam, I., (2010). The great recession of 2008-2009: causes, consequences and

policy responses.