Banking, financial, and even insurance-issuing institutions were badly hit by the global financial crisis that happened in 2007 to 2008. It created a serious domino effect that eventually took its toll on the U.S. Federal Government. The struggling dollar and U.S. economy—the world’s largest economy in terms of GDP, led to a serious wave of financial and stock market corrections that were felt globally, especially in countries whose economy is largely dependent on U.S. commodity and financial supply and consumption. The ultimate effect of the global financial crisis of 2009 was an increased uncertainty and negativity in the financial and banking industry. Even six years after the incident, the U.S. economy and other developed and emerging economies that were badly hit are still yet to fully recover from the consequences of the global financial crisis of 2008.
Given the fact that financial institutions failed to assess and more importantly prevent the bursting of looming global financial crisis bubble, risk managers have been continuously challenged to make changes when it comes to the reassessment of risk treatment and strategies; and to identify the financial and banking institutions’ exposure to credit, interest, and other types of financial risks; and to make them in tip top shape so FIs (Financial Institutions) and BIs (Banking Institutions) would not have to resort to filing for bankruptcy and be another burden for the U.S. economy, just in case another financial, real estate, or stock market bubble bursts.
Background of the Study
After the global financial crisis that was argued to have started from the U.S. real estate market in 2008, financial institutions have allegedly made significant changes to their risk management focus and strategies . Risk management has become the first priority on almost all FIs and BIs agenda because stakeholders and regulators, after knowing the anatomy of the 2008 global financial crisis and what really caused them (which apparently was laxity in the loan issuing system of Banks and FIs), are already demanding cushion and protection against financial risks and worse, another possible economic crisis.
The objective of this paper is to discuss the changes that happened in FI and BI’s risk management strategies and their effects on decreasing the likelihood that another global financial crisis would happen. The researcher plans to accomplish this by comparing the risk management strategies before the 2008 global financial crisis to the ones that have been implemented after the incident. The paper will also discuss the changes in mortgage lending procedures where banks have upgraded their lending requirement and are making responsible loan application processing; and the consequences of such tighter loan and credit application procedures such as the lack of available funds and credit for small and medium enterprises due to their inability to qualify for the loans under the new and considerably tighter lending guidelines.
The 2008 Global Financial Crisis
In order to understand the banks and financial institutions’ rationale for implementing a stricter and tighter set of loan and credit application protocols for prospective debtors, the events that happened and that led to the spiraling down of events during the 2008 global financial crisis will have to be studied . Many experts in the financial sector consider the 2008 Global Financial Crisis to be the worst financial crisis since the Great Depression that happened in 1930s.
The spark that ignited this crisis was the threat that large financial institutions and banks would suffer from a total collapse, the suspected unwillingness of the U.S. government to offer bailouts to banks and financial institutions that are under the threat of a total financial collapse; the threatening downturn of the U.S. stock markets towards bearish territory; and the rapidly declining prices of real estate that boosted the percentage of loan turnovers . Financial experts argue that the biggest factor that led to the 2008 Global Financial Crisis was the collapse of the U.S. real estate sector. It can be observed that a few years before the 2008 Global Financial Crisis, the real estate prices in major U.S. cities and metropolitan areas were on astronomical levels.
Despite the astronomical real estate prices, many people still pushed their luck and decided to apply for loans just so they can secure a new home, majority of which were driven by desires for luxury and to engage in speculative forms of investment. Unfortunately, not all of those people who applied for a loan were capable of paying for the corresponding monthly mortgage fees. The steep declines in the prices of real estate prices a few months before the 2008 Global Financial Crisis meant that speculative investors who bought real estate properties when their prices were at an all-time high were paying for their real estate property loans that are way overpriced considering the already low prices of real estate properties.
A significant portion of those speculative investors—which by the way number in thousands, would then decide to not pay their monthly mortgage fees and set their outstanding loans on default. When a loan is defaulted, the bank would have to pay for documentation and other legal services to formally take possession of the collateral, which in most cases, is the real estate property that was loaned. A loan applicant may, for example, apply for a bank loan so that he can pay for a condominium unit located in a metropolitan area. Now, if he fails to honor all of the details in the loan contract and agreement, such as in cases where the debtor fails to pay the creditor (which in this case is the bank) the mortgage fees, either intentionally or unintentionally, the bank will have to terminate the loan contract and set the collateral property for foreclosure.
The foreclosed property will then be added to the bank that provided the loan’s inventory of assets. Unfortunately for the bank, a few years before the 2008 Global Financial Crisis, real estate properties were quickly depreciating. So, for every collateral property they have acquired as a result of default, they were practically turning their liquid assets (cash) into real estate assets. To make the matters worse for banks, such real estate assets were quickly depreciating in value. Their appraisal value during the time loan was being processed was not as high as its appraisal value a few years before the 2008 Global Financial Crisis. The effects on the banks were two-fold.
Firstly, because of the large number of loans being turned into default, the banks’ liquid assets were quickly and surely turning into real estate assets. Unfortunately, banks cannot generate much of a profit from real estate assets. They cannot, for example, issue loans to the government, to an individual, or to a business using real estate assets. A stable supply of liquid assets is absolutely essential for a bank’s survival. During the 2008 Global Financial Crisis, a large number of debtors defaulted on their loans, paralyzing the banks as a result. The Lehman Brothers, a renowned global financial services firm, was one of the banks that were hit the hardest by this catastrophic financial mechanism. It declared bankruptcy in 2008.
Some other small to medium size banks and financial institutions were also put on the verge of bankruptcy. The U.S. government, through its financial arm, the U.S. central bank, seeing the possible long term and large-scale consequences should the plague of bankruptcy spread to other medium and small size banks in the U.S., directly intervened by offering bailouts to other banks, at the U.S. central bank’s expense.
Secondly, assuming that the U.S. banks during the 2008 Global Financial Crisis would indeed be able to sell the foreclosed properties on their outstanding inventory, the value of those sold properties would still be considerably lower compared to when they would sell them during the pre-2008 Global Financial Crisis period when the prices of real estate properties were still high. The U.S. housing bubble allegedly peaked in 2006, as evidenced by the sharp decrease in real estate prices contrary to the housing developers’ forecast that the real estate market would continue to benefit from continuous appreciation in value over the next couple of years more .
Another factor that led to the 2008 Global Financial Crisis that is at the same time, directly related to the topic of this paper was the laxity of the home acquisition regulations, the low and sometimes absent requirements for loan applicants before they are granted loans, the federal government policies that highly encouraged existing homeowners and speculative investors from acquiring new real estate properties; and the overvaluation o the real estate properties during the pre-2008 Global Financial Crisis period.
The conversion of the bank’s liquid assets into real estate assets led to a situation wherein there are insufficient capital holdings from the banks and financial institutions to cover the financial commitments they were making. And that is why when the real-estate housing bubble popped, the banks became very vulnerable. The banks and financial institutions’, aside from formally declaring bankruptcy, became limited because of the limited amount of liquid capital assets. All of these factors and events led to the 2008 Global Financial Crisis.
Changes in Bank Lending Policies after the 2008 Global Financial Crisis
In an academic paper published by the Federal Reserve Bank of San Francisco in 2010, authored by Kwan (2010), the extent or level of banks’ tightening lending policies after the 2008 Global Financial Crisis was assessed, using quantifiable means that is. The other factors that played during the first fire that sparked the crisis such as loan qualities, loan process, financial risks for banks for every loan that they accept, and the possible correlation of each factors with each other, were also assessed. The author concluded that from the unusually loose bank lending conditions in 2007 (a year before the great recession), banks transitioned to a relatively more tightened stance (when it comes to bank lending policies) in the first quarter of 2010, as evidenced by the increased levels of average loan spread. Average loan spread, and the quality and number of loans approved during those two periods (2007 and 2010) were some of the factors that the author used in his assessment.
According to proposals of some of the key personalities in the financial, real estate, and stock market industries have come up with their own proposals as to how banks and other financial institutions can be protected from systemic risks that could undermine the entire U.S. financial system. One of the most relevant proposals at this point would be the increased minimum down payments for home loans and mortgages of at least 10 percent and some income verification and lifestyle inspection for mortgage applicants. As what can be recalled, banks before implemented very loose lending practices that led to the subprime mortgage crisis which eventually led to the great recession mainly due to the lack of liquidity. Individuals before can readily apply for a mortgage loan even though they are unemployed or without paying for a certain percentage as down payment. Now, after learning their lessons, even though there is no formal federal policy regarding this, banks is now issuing loans based on this proposal.
Banks and financial institutions have also started to move to restrict the level of leverage they can assume to a certain level that is presumably considerably lower compared to what they had during the pre-2008 Global Financial Crisis period. Used in conjunction with this strategy was the stockpiling of huge sums of cash for capitalization purposes. These capitals may well be used to offer more loan and mortgage products and services after a market correction but mostly, such capital funds are used to serve as buffers in case loans get bad and a systemic financial risk explodes.
The Effects of the 2008 Global Financial Crisis on Banks and Financial Institutions’ Risk Management Strategies and Practices
In order to directly prevent the occurrence of a similar meltdown that happened in 2008, the U.S. Federal Reserve System created a resolution instructing banks to tighten their lending standards and requirements so that only individuals and organizations that are capable of paying their loan duties would be qualify for credit. This is the direct opposite of what happened during the 2008 Global Financial Crisis wherein even unemployed individuals were surprisingly granted loans by banks and financial institutions. There is one major consequence of implementing this type of policy however. Firstly, the real estate sector, which is one of the sectors in the U.S. that drives economic growth and creates the most number of jobs, would experience a significant slump in growth both in terms of size and profits because a large number of prospective buyers would already have limited options on how to finance the properties they are eyeing to buy. This resolution is still in effect today.
According to an academic journal released by the Journal of Economics and Finance in 2013, the changes that the 2008 Global Financial Crisis caused have something to do with the three factors namely: bank market share, bank efficiency, and bank profitability . During the pre-2008 Global Financial Crisis period, market concentration and profitability were the factors that guided the bank’s behaviors as evidenced by the number of loan applications they approved despite the lack of reassurances for efficiency. Efficiency pertains to the number of loans granted relative to the number of loans with a good positive performance—or in this case, loans that were not defaulted despite the sharp declines in real estate property prices. Also, prior to the crisis, risk assessment and management, and market saturation and concentration had a quadratic relationship.
As the percentage of market saturation increased, the level of financial risks that the bank carried also increased and then vice versa. After the crisis, this quadratic relationship was reversed. As market concentration and saturation increased, there was no reciprocal increase in financial risks. It can therefore be inferred that prior to the 2008 Global Financial Crisis, banks did not focus too much on the efficiency of their credit handing and handling process. All that they, the banks, thought about was the profit they could bag in after the loan they had granted to a not-so-capable individual has already pain in full, without giving due attention to the debtor’s capability to pay the mortgage and other loan fees. The result was a historically low level of loan efficiency. There were a larger number of loans that did not generate profit than the number of loans that did. And so, as the number of credit contracts the banks approved increased, the financial risk the bank was putting itself in also increased, hence the quadratic relationship between market concentration and financial risk.
After the 2008 Global Financial Crisis, however, this changed. Banks and financial institutions already learned their lessons, albeit the hard way. They now have a bigger eye for efficiency than for market concentration and profitability. And as a result of that, the quadratic relationship between the outstanding number of loans and the financial risks of handing out loaned credit has disintegrated. Banks and financial institutions, knowing that they are handing out loaned credit only to those who are capable of paying them back, with interests of course, can now rest assured that an increased number of loan products and services patronage would not automatically be translated to an increased level of financial risk unlike during the pre-2008 Global Financial Crisis period wherein things were otherwise .
In another academic journal published by the Journal of Finance in 2013, the authors attempted to determine whether some banks are more prone to perform poorly during financial crises. Specifically, the authors explored whether there is something—be it a technical or a procedural characteristic or feature, unique about some banks that make them perform worse or preferably better during a financial crisis by reviewing a sample group of banks’ history of key performance measures during the 1998 financial crisis and comparing them with the key performance measures obtained during the 2008 2008 Global Financial Crisis. Results showed that “performance of banks during the 1998 financial crisis predicts their performance and whether they failed during the recent financial crisis.”
A financial institution’s survival in another wave of financial challenges does not depend on whether they have already learned their lessons on responsible risk management methods and strategies or not, but more on their performance in the past crises . This result is allegedly consistent with the risk culture hypothesis and inconsistent with the learning hypothesis in the financial industry. Nonetheless, unless the authors becomes able to supply the academic community with up to date information about what it really is that makes some banks vulnerable to financial crises such as the ones that happened in 1998 and ten years later, the risk culture hypothesis would remain as it is.
The tremendous increase in debt levels and the considerable decrease in loan requirements created the perfect formula for the 2008 Global Financial Crisis. Another factor that contributed to the spiraling down of the U.S.’ financial situation during the recent crisis was the absence of a holistic approach in ensuring the health of the U.S. financial system—whose functional units are the banks and insurance corporations, during a financial emergency situation. To make up for that shortcoming, the government, under the Obama administration has formally signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into federal law in 2010 as a direct response to and to prevent the events that triggered the Great Recession from reoccurring .
The 2008 Global Financial Crisis led to nationwide calls for dramatic changes, and in some cases, a complete overhaul in the financial regulation and financial risk management system. The Dodd-Frank legislation was one of the administration’s answers. Under this new legislation, the following proposals which are now coded into federal law were listed:
- The consolidation of regulatory agencies; elimination of the national thrift charter, and new oversight council to evaluation systemic risk
- Consumer protection reforms including a new consumer protection agency and uniform standards for plain vanilla products as well as strengthened investor protection.
- Comprehensive regulation of financial markets, including increased transparency of derivatives
- Tools for financial crises, including a resolution regime complementing the existing Federal Deposit Insurance Corporation FDIC authority to allow for orderly winding down of bankrupt firms, and including a proposal that the Federal Reserve System receive authorization from the Treasury for extension of credit in unusual or exigent circumstances.
- And other various measures aimed at increasing international standards and cooperation including proposals related to improved accounting and tightened regulation of credit rating agencies.
One of the overall effects of this legislation was the standardization of requirements for banks to secure a certain percentage of their assets for capital purposes so that they would be more protected in case their outstanding loans go bad and their balance sheets assets fall in value, just like what happened during the 2008 Global Financial Crisis. This would allow the banks, and the U.S. economy to be more resilient against the highly volatile markets that may affect the health of the financial system such as the stock market and the real-estate market.
Conclusions and Recommendations
Since the government has done its part, the banks and financial institutions have also been expected to work towards a healthier and more resilient financial system. After the 2008 Global Financial Crisis, banks and financial institutions now implement a more stringent set of loan application procedures to filter out speculative investors and other individuals and corporations who really cannot afford to pay for the money they are planning to borrow.
Wells Fargo, the Bank of America, and other major financial and banking institutions, as a response to the recent crisis, have stockpiled (stored) billions of dollars’ worth of capital, in the form of liquid assets, as a buffer against future losses or in case their existing loans go bad and some tremendous market and industry shifts and correction occur.
It is recommended that the government, the U.S.’ central bank, together with the individual banks and financial institutions, as well as the investors, help each other in keeping the country’s financial system healthy, by engaging in financial transactions that create win-win situations. The banks, FIs, and the federal government have the largest roles to play in achieving such goal. The banks, for example, may keep on enforcing stricter loan approval policies to keep speculative investors at bay and in stockpiling liquid assets for capital reserve purposes just in case something problematic happen again in the financial system; the federal government in partnership with the central bank on the other hand, may create mandates that for banks to follow to keep them more focused on efficiency than they used to be on market concentration and profitability.
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