A market crash, though a rare phenomenon that has occurred several times in the past, is an unexpected reduction of stock prices, which results in significant losses. The global financial crisis of 2008 played a major role in the failure of key businesses which in turn threatened the fall of the major financial institutions. The stock market experienced the largest decline in history after the Dow Jones Industrial Average fell 777.68 points intra-day trading, which is the largest single-day drop in history. The decline continued until later in 2009. The key cause of the crisis was the high default rate in the subprime home mortgage sector that appeared as a result of many mortgage loans being offered without adequate security, and this quickly spread to other institutions that held new financial instruments related to these mortgages. However, other financial organizations were also significant participants in this global crisis.
The housing market had become an attractive market for everyone; this was after it peaked in 2006. The events before had seen the housing market crash in 2000 after the period of modest but steady growth in the previous years. In the wake of the new economic recession, there were plenty of affordable assets available for cheap mortgage loans further slowly enhancing the housing sector. Many people and even banks praised the housing market for creating wealth alongside with providing a secured asset, whereby individuals could borrow money to help grow the economy by further investing (Ivan, 50).
To benefit from these rising housing markets, many financial institutions innovated several kinds of financial instruments in a bid to outsmart each other. The loans were then packaged or securitized into collateralized debt obligations and then sold to other people who were to be ideally exposed to the economic risks and benefits associated with it. This was, however, short-lived since it led to the creation of credit default swaps, which in the reality were too complicated to put a precise value.
Hedge funds were created as an investment instrument, and they limited investors’ ability to sell their equity. However, they were located in offshore tax havens that helped minimize their tax liability and were not subject to any financial reporting or supervision (Financial Stability Forum). Businesses also widened their scopes as they sought to guarantee and ensure the related debt. This was temporary since the incorrect pricing of risk led to the fall in the credit ratings that saw the insured debt lack in the market.
Banks were also involved in this mishap as they lost significant amounts of their net worth. They were then forced to quickly obtain new equity for them to meet regulatory requirements and avoid investors from escape from them. Some banks also increased the maturity of their loans. Central banks intervened to enhance liquidity lending government paper and accepting collateral for loans. Initially, this prevented the collapse of some banks for the short period, however, some analysts felt that the liquidity would become stimulating inflation and in turn creating a macroeconomic dilemma. This caused a severe contraction and dysfunction in the interbank, related financial markets, and the economy at large (Financial Stability Forum).
All these forces eventually combined and created a surge of debt and turmoil that in turn led to a crisis in the financial markets with several institutions collapsing. Banks had allowed their balance sheets to bloat, and the regulators proved that they had failed in keeping economic imbalances in check. Government policies had lowered credit control, and it was also evident that the lack of international harmonization and coordination had also resulted into the crisis. Some supervisors did not understand that banks had bypassed capital requirements and the consequent risk that faced them. It was after the occurrence of this crisis that many advocated for government intervention to prevent a growing incidence of mortgage foreclosures and also for a major reform of the new financial system. Several concepts in the Basel accord had been challenged after the crisis, which led to some revisions in a bid to decrease the influence of the crisis.
The Basel III was therefore formulated to address these issues and other potential crisis, as well as strengthen bank capital requirements. It created new aspects like macro prudential elements into the capital framework. Basel III produced improvement on the consistency and transparency of banks’ capital base as well as the reduction of the capital ratio to 7%. The enhanced standards will lead to reduced risk of bank failures since they will be in a better position to absorb economic shocks during a crisis, boost the investors trust, and improve the banks’ balance sheet. This change can help avoid a repeat of the crisis when banks experience a series of losses.
Other changes that were introduced were both the short-term and long-term liquidity of banks being disclosed to the public alongside internal systems (Gualandri et al. 10). It can help monitor an institution’s ability to meet its financial obligations when they occur. The regulation mandates that banks hold liquid assets that can cover a bank for 30 days in case of an emergency. As banks seek to improve the capital adequacy, it may opt to reduce the dividends offered to investors to maintain its long-term reserves and capital. They could also raise new capital from the private sector instead of conserving the internally generated money.
Stress tests are now conducted on the banks, therefore, keeping management alert for potential economic shocks as a result of a market reversal. This helps identify how much capital they would need to absorb and also control the prudential ratios in place and their performance against their associates, as well as industry averages. The off-balance sheet leverage of banks will now be in constant monitoring owing to the changes made to Basel III (Savona 119). The introduction of the leverage ratios saw the adoption of a non-risk based measure that is meant to strengthen the risk coverage of the capital framework. The capital buffers have been increased, and incentives have been granted to increase the risk management of credit exposures. Counter-cyclical capital buffers were introduced with the aim to achieve system stability by protecting the banks from severe lending losses and excess credit growth since these can lead to possible system-wide shocks. Banks are therefore required to build capital buffers during stable periods to absorb losses and support their operations in periods of stress.
Going forward, factors, such as the subsequent rise of creative mortgage-related investment products, unprecedented growth, and consumer debt led to a complete financial turmoil. Even though the financial crisis was resolved by 2009, deep effects were still felt on the housing market. Many individuals were left unemployed because the market crash created the worst recession since the early 1980’s. Regulatory reforms have, however, been adopted by central bankers in a bid to curb the crisis. The events of 2008 have since been a lesson to most economies and have proved what exactly happens when rational thinking gives way to irrationality. When one considers all the factors that led to the financial crisis in 2008, then, maybe, the financial turmoil would not appear as unforeseeable as many would like to believe.